It has now been nearly five years since the first cracks began appearing in the subprime mortgage market, which was one of the leading indicators for the calamities to come. Since that time, the global economy has endured transformational political, economic, and social changes that are more significant than anything we have seen since the end of World War II. I live and work in Orange County, California which was considered ground zero for the subprime mortgage market. It's been interesting seeing the wealth transfer and economic upheaval that has taken place, and while the local and national economies are significantly stronger than they were in 2009, I definitely don't see or feel that same sense of optimism that existed prior to the Financial Crisis. Nowhere is this more evident than the confounding valuations of U.S. banks, which despite vastly stronger balance sheets and liquidity profiles, trade at valuations where "depressed" would truly be an understatement.
The stock market turned in 2009 once the U.S. government decided that it was time for everybody to work together to help save the economy. The TARP program boosted capital and confidence, while the "mark-to-market" accounting changes which had created such a vicious and self-fulfilling negative feedback cycle were reversed, enabling banks to withstand the lack of liquidity and day trading mentality which were reducing prices on long-term investment assets far lower than any reasonable forecast of future cash flows would imply. As the economy and stock market recovered at a rate far less than most economists would have liked, after such a deep recession, politicians and regulators shifted to partisanship and confidence crushing saber-rattling.
This has stagnated economic growth by delaying job creation and hindering lending at a time when we are seeing a global deleveraging process. As Winston Churchill aptly proclaimed, "Americans can always be counted on to do the right thing….after they have exhausted all other possibilities." For both America and Europe to truly recover, politicians on both side of the aisle must work together to promote growth and reduce fiscal waste. To achieve these desired ends, it only makes sense to work with the banks as opposed to working against them, despite the negative sentiments of the populous. When the economy turns, those that are willing to endure the short-term volatility in financial stocks are likely to be richly rewarded when stock market performance once again mirrors business performance.
On 6-6-2011 Bank of America Corp (BAC) traded at $11.18. At that price the stock was still trading at a substantial discount to book value and tangible book, which stood at around $231 billion $132 billion respectively. The past year has been a transformational one for Bank of America, as they have had to tackle enormous legal problems related to their ill-fated Countrywide acquisition. The company has $15.8 billion reserved for reps and warranties; despite these huge legal costs and a vastly bloated expense structure that is being cut down dramatically, Bank of America was still able to increase equity and tangible equity to $232.5 billion and $147 billion, respectively. Earnings were negligible due to goodwill write-downs and DVA/CVA adjustments, but under the leadership of Brian Moynihan Bank of America has increased its Tier 1 common equity ratio to 10.78%. The company has $406 billion of global excess liquidity so they should be able to pick up attractive investment opportunities as their European competitors deleverage.
Although tangible book value has grown in excess of 11% over the last twelve months, the stock has plummeted to a recent price of $6.95. This 38% decline is mystifying as there is no doubt that Bank of America is a more financially sound company than it was a year ago, and they are likely to post tremendous earnings growth over the next several years, even taking into consideration a weak macroeconomic backdrop. A $74.5 billion market cap versus a tangible equity of $147 billion, it is one of the most glaring disconnects between price and value that I have ever seen. As of March 31st, 2012, Bank of America's net exposure to Europe is only $9.7 billion with only $1 billion in sovereign debt. At today's price, an investor is able to acquire the stock at about three and a half times normalized earnings of $2 per share. Click here for more details on Bank of America.
One year ago Citigroup Inc. (C) traded at $39.55, and had equity and tangible equity of $171 billion and $133 billion respectively. Although weak net interest margins have drastically reduced all banks profitability, Citigroup generated $11 billion in net income over the last twelve months. Equity rose $11 billion to $182 billion, while tangible book value increased 11% to $147 billion. Citigroup has the capacity to earn $15-20 billion per annum during a normal cycle so the $11 billion represents trough earnings. Citigroup has boosted their Tier 1 Common Ratio to 12.4% and the Total Capital Ratio is 17.6%. 25% of consumer banking revenue comes from high growth emerging markets, giving Citigroup the potential of attaining a higher valuation than its U.S. peers as the company continues to gain investor confidence. While business performance hasn't been exceptional as to be expected with a rough macroeconomic outlook, it has been solid, yet the stock's performance has been abysmal. At a current price of $24.79 the stock has dropped an amazing 37%. The bank's European exposure to peripheral Europe is very manageable with net current funded exposure to the GIIPS of $9.1 billion. The company made a mistake by overreaching in their share buyback plans during the CCAR process, because this delayed the company from increasing intrinsic value through accretive buybacks. An investor can acquire $147 billion of tangible equity and $15- $20 billion of annual earnings power for $72.5 billion, setting the stage for potential 20% per annum returns moving forward. For more details on Citigroup please click here.
Morgan Stanley (MS) has gone from trading at $23.03 a year ago, to a recent quote of $12.30. On 6-6-2011 Morgan Stanley's most recent financial statements indicated $58 billion in equity and $47 billion in tangible equity. Over the last year the company has increased equity and tangible equity to $62.3 billion and $51.5 billion respectively. The company earned a paltry $3 billion due to a huge loss on their MBIA Inc. (MBI) hedge and a significant conversion of Mitsubishi UFJ Financial Group, Inc. (MUFG) of its preferred investment. This conversion boosted tangible equity and will reduce the amount of preferred dividends that the company will have to pay moving forward. While Morgan Stanley has the highest common equity and liquidity in its history, the company's market cap is only $24 billion. We believe the company could post $6 billion of earnings per annum over the course of a normal economic cycle, which means the stock is trading at 4 times normalized earnings. As of March 31st, 2012 Morgan Stanley had GIIPS Net Exposure of only $2.4 billion.
All three of these companies are cutting costs, selling non-core businesses, and increasing capital. None of these companies currently pay a material dividend nor are they aggressively buying back stock, but that should change by early next year and I'd be shocked if the valuation disconnect isn't reduced by then. Credit trends and U.S. real estate have shown solid improvement, which is obviously hugely beneficial for these institutions. Counterparty risk will likely be reduced through a European TARP-like program, and any change towards a Euro-bond solution would be immensely favorable. Buy buying these stocks in times of extreme pessimism and selling them once the world becomes more optimistic, an investor has the opportunity to materially improve one's financial condition over the long term. I'd love to hear a solid bear argument that doesn't rely on technical indicators or abstract conspiratorial comments pertaining to accounting or credit default swaps, as I believe in constant fact checking, so all comments as always are welcome whether they are positive or negative.