Bank Stocks: Invest or Trade?

by: Amit Kumar, CFA

The bank stock index, BKX, is down 75% since hitting 121.06 on 02/20/2007 and the volatility has ranged between 50-250% since the credit spreads blew up in summer of 2007. Bank stocks are behaving more like options with exceptional levels of volatility reflecting everyday market sentiment, making a difficult case for longer term investment. In the next 3-5 years, increased regulatory oversight could result in lower financial leverage, increased capital requirements and scrutiny of asset quality, and consequently lower sustainable earnings level.

The Fed's ZIRP will help some banks earn their way out of the down cycle and some other banks, such as WFC and PNC, could benefit from tax assets from acquisitions, however, any bullish bet on banks would mainly hinge on the bottoming of the credit/ housing markets and a resolution for bad assets on bank balance sheets. If the past is any predictor (the RTC resolution trust took more than five years to dispose $458.5b of assets and cost around $160b to resolve), removing toxic assets from bank balance sheets will be a torturous, long exercise.

The current crisis shares many characteristics of past crises, from the 1907 banking crisis to the 1989 S&L crisis; however, the severity of the current crisis certainly gives it the financial tsunami status. Banks’ credit ratings have seesawed from AAA in the 70s to BBB/BB in the 80s and 90s, back to some AAAs in the new millennium and now going back to BBB/BB. If we were to take clues from the past, the period of recovery for the current crisis seems to be painfully long, and can easily last between 5-10 years.

In the 90s, Citigroup (NYSE:C), which hit $1.39 in October 1990, ended up as a multi bagger a few years later; however, a second act seems next to impossible with a 36% US stake and complex balance sheet to resolve. That said, there will be winners coming out of the crisis, and traditional commercial banks such as USB, FHN, and TCB seem to have better odds than their universal bank counterparts such as Citigroup. USB has one of the lowest financial leverages, generates over 50% in fee-based revenues, has adhered to conservative lending standards and their loan book is holding up better than many of their peers.

Quick recap of the crisis: The current crisis began around the bankruptcy of New Century from subprime delinquencies and spread to Structured CDOs, SIVs/ conduits and forced banks (HBC, C being the first ones) to bring SIVs on balance sheet and take massive write downs. Monoline insurers became the next victims from their CDS/ financial guarantees on super senior ABS-CDO structures. While various rate cuts, Fed interventions, and the subsequent bailout of Bear Stearns eased the market temporarily, a fresh wave of solvency crisis hit the market as the investment banking business model and AIG’s counterparty credit was called to question - Lehman’s (OTC:LEHMQ) bankruptcy, AIG's bailout, and later the sale of a banking unit to Barclay’s (NYSE:BCS) and Merrill’s merger with Bank of America (NYSE:BAC) put pressure on the remaining investment banks to merge with deposit franchise or convert into bank holdings. The US Treasury went back and forth on RTC or the "good bank/ bad bank" structure and ended up injecting TARP preferred equity, and most recently converting preferred equity to common. The US Treasury announced plans last month to stress test banks for their capitalization needs and private public partnership; however, Wall Street has been disappointed with the lack of details on the plan so far and the consensus view is calling for action on illiquid/ hard to value assets that remain an overhang on the bank balance sheets.

For now, bank stocks may continue to be “trading stocks” for quite a few months, and it may be difficult to profit from long or short positions. Any good bank stock investments could take at least 5 years to play out. Bank stocks, or even bonds, pose significant political risk in terms of ad-hoc policy decisions and even nationalization (to many bank CEOs, nationalization means 1c dividends and loss of management control). While the Obama administration has made statements denying any intent to nationalize banks, they will run out of options if they do not start addressing the most critical issue of bad assets on banks' balance sheets.