Bank earnings start coming out on Friday and a number of other events warrant a look at the sector for short-term risks and long-term potential. While odds still put the President in the White House for another four years with presumably greater regulatory scrutiny of the sector, recent court cases may set precedent for less oversight. The sector has outperformed the general market year-to-date and investors may want to reposition their portfolios in those names with stronger valuation arguments.
A Romney win for financials, hope springs eternal
Governor Romney's strong showing in the first presidential debate gave him a boost in the polls and banking shares could be up on hopes of a Republican win in November. While the Governor has backed some increased regulation of the industry, his first priority would be to overturn Dodd-Frank and possibly weaken oversight by the Consumer Financial Protection Bureau. Though the President is still favored to win another four years, any further gains for the Romney-Ryan ticket could lead to a bounce in the financials.
Clearer and just as favorable is recent court challenges by the industry against provisions in Dodd-Frank. Federal regulators have already lost two rulings, one involving regulation designed to limit speculative commodities trading and another last year making it easier for shareholders to influence board seats. A recent case, yet to be decided, revolves around the requirement of mutual funds to register with the Commodity Futures Trading Commission. The industry is disputing the law on procedural grounds, arguing that Dodd-Frank was put together haphazardly and without a clear design for actual implementation.
With big money behind the cases, it is clear that the industry will continue to fight the reform and incremental wins could boost shares in the large-cap banks.
Are the market darlings dead money?
Wells Fargo (WFC) is everyone's darling lately but may be running out of steam. The company reports earnings on the 12th with expectations for $0.87 per share, up 21% from last year. Even if expectations are met and trailing earnings increase to $3.17 per share, the stock will still trade for a relatively expensive 11.1 times. The provision for loan losses has declined in the last three quarters with $1.8 billion reported last quarter. The loan loss allowance has declined over the period as well and stood at $18.3 billion last quarter. As long as the housing market continues to recover, there will be some support for the shares but the 35% run over the last year may be a little premature.
The bank was sued by the government on Tuesday for loans insured by the Federal Housing Administration that subsequently defaulted when the housing market collapsed. Federal prosecutors maintain that the bank made false assertions about loan quality. While the bank has denied the charges, settlements have been the theme over the last few years and could cost shareholders millions.
While certainly not a market darling, Bank of America (BAC) may be one of the most overvalued of the large-cap financials. The bank reports on October 17th with expectations for $0.07, much better than the $0.90 per share loss during the same quarter last year but the company has missed expectations four of the last seven quarters by an average of $0.07 when it misses. Expected earnings for the quarter would bring trailing earnings to just $0.44 per share and valuation to a hefty 20.9 times. The bank may need to increase reserves for mortgage buybacks. Mortgage buyback requests were $22.7 billion in June against only $30.3 billion in allowances and a charge of just $1.8 billion in provisions reported in the last quarter.
The bank may be able to save $350 million in interest expense through 2013 from a redemption of $5.1 billion in trust-preferred securities reported last week. The company will take a $100 million pretax charge in the fourth quarter to retire the notes next month.
Digging for deeper value
While sentiment for JP Morgan (JPM) has rebounded since this year's large trading loss the shares still trade fairly cheaply to earnings. The company reports on October 12th with expectations for $1.21 per share, up 18.6% from the same quarter last year. The company beat expectations last quarter by more than 70%, so there is a fear that merely meeting expectations this quarter could be a disappointment. If the bank does earn $1.21 for the quarter, it would bring trailing earnings to $4.51 and the stock's valuation to 9.3 times trailing. Loan losses of $214 million taken last quarter were only a tenth the amount taken in the same quarter the year before and well off their peak. The bank still holds $23.8 billion in loss allowances on the balance sheet and could release some of that amount if losses continue to moderate.
Moody's warned investors on a recent commercial-mortgage bond offering issued by JP Morgan. The rating agency was initially asked to rate the deal but Standard & Poor's was ultimately chosen after Moody's would not rate all tranches investment-grade.
Citigroup (C) reports earnings October 15th with expectations for $0.97 per share, down more than 20% from the same quarter last year. Expected earnings will decrease last four quarters' earnings to $3.39 per share and bring the price multiple up to 10.4 times trailing. In contrast to Bank of America, Citigroup may benefit from a release of loss allowances over the next few quarters. The bank has kept its loss provision expense fairly high over the last four quarters, reporting $2.6 billion against income in the second quarter. While total allowances have been decreased this year, it still stands at $27.6 billion as of last quarter.
Citigroup recently won a federal appeals court ruling against Morgan Stanley (MS) related to a $245 million payment for a swap agreement. The court upheld a prior ruling that Morgan Stanley should have paid Citibank for its swap agreement after the collateralized debt obligation to Capmark defaulted in 2009.
Using options for a better entry-point
I am generally not a fan of trying to time the market or individual names for any period shorter than a few quarters. Long-term potential in some of the cheaper names with a short-term gain or loss around earnings may offer investors the chance to apply an options strategy.
Selling at-the-money calls with October expirations on a stock position protects investors on some earnings-related downside risk while allowing for a short-term gain as well. If the shares fall, your purchase price is lowered by the amount of the call premium. If shares rally on strong earnings, a quick gain is made and a better entry point may come along ahead of year-end.
For example, selling the October $35 calls on Citigroup lowers an investors cost basis in the shares to $34.23, 2.6% lower than the current price. The calls expire next week and offer an upside of more than 2% if the shares continue to rally.