Seeking Alpha

A Contrarian View: Buy The (Large) U.S. Banks

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Includes: BAC, C, FAS, GS, JPM, MS, WFC, XLF
by: IP Banking Research
IP Banking Research
Deep Value, banks, tech, large-cap
Summary

This is not 2008/2009. The banks are not the epicentre of this crisis.

The large U.S. banks have a fortress balance sheet.

Goliath is winning given the scale and digitisation strategy.

Concerns over loan provisions are misunderstood given the new accounting standards. Loan losses are up-fronted.

A contrarian view. Buy the large U.S. banks now.

I was reading with interest an article by Limelight Alpha Management Partners titled "Don't Buy Falling Financials, Buy These Stocks Instead".

Whilst the rationale noted in the article appears sound on the surface - as a banking specialist who is probably closer to the topic, I felt there was a benefit in presenting a contrarian view. But one that is supported by a deeper analysis of known facts.

A closer look at Limelight Alpha's rationale

The article's bearish view is premised on the Federal Reserve stress test results and associated outcomes. The author highlights the restrictions and/or caps on dividends and buybacks whilst highlighting additional credit losses risks should the economy deteriorate further.

The conclusion is stark:

In short, if you want to buy banks now, you're going to have to assume current reserves are already adequate, and currently, that's a tough argument to prove.

Judging by the price reaction, it appears that Mr. Market agrees with the above.

The contrarian thesis

This is not a repeat of 2008/2009.

The large U.S. banks are not the epicentre of the crisis and are unlikely to experience a permanent capital loss. Nor will there be a re-regularisation of the banking sector as we have seen post-2009.

The Fed's so-called restrictions/caps have a limited practical impact on most banks (but the headlines certainly drove the share price down!). In fact, the sub-context suggests that the Fed is your friend!

Importantly, newly introduced accounting rules require banks to front-load loan losses much earlier than in the past. The peak in incremental loan loss provisions is likely to hit a peak in Q2'2020 and the banks' earnings power is ample to offset these, even when measured on a quarterly basis. Especially so for banks that have large capital markets business that generates tons of income in this kind of environment.

Finally, the banks have entered this crisis from a position of strength (capital, liquidity and, risk management), and they will come out in an even stronger position and largely unscathed.

I reiterate, this is not global financial crisis (GFC) - there will not be a need to rebuild capital or face massive regulatory reforms again. The warning to investors is don't try to fight the last war.

As such, at current valuations, I am bullish on the large U.S. banks, especially ones that have a sizeable capital market presence. These include JP Morgan (JPM), Bank of America (BAC), Citigroup (C), Goldman Sachs (GS) and Morgan Stanley (MS).

The valuation

The below chart sums up the YTD action for these banks. As can be seen, the banks more exposed to the consumer have been hit harder than the pure-play on investment banking. Not a big surprise really. The capital markets have been exceptionally robust, where the stress in the banking system has so far manifested mostly in the consumer credit segments.

ChartData by YCharts

The best yardstick for banks' profitability is the return on tangible equity metric (RoTCE). And valuation of banks is generally viewed through a price to tangible book value metric. As a general statement, banks' cost of capital has traditionally hovered around ~10 percent. So if a bank is expected to deliver 10 percent return on equity, all else being equal, one would expect a valuation of 1.0x tangible book. JPM, as an example, in recent years, delivered a RoTCE in the high-teens and has typically traded at 2.x times tangible book (implying a cost of capital of around ~8-9 percent). Citi's cost of capital appears higher perhaps, unjustifiably so.

ChartData by YCharts

As you can see below, all of the banks are trading well-below their historical range of price to tangible book. These are quite distressed valuations - in Citi's case, this implies buying a dollar for 70 cents. This can only make economic sense if you believe that:

1) The banks' assets on the balance sheet are massively overstated; and/or

2) The banks will be forced to raise capital; and/or

3) Coming out of the crisis, the banks RoTCE is expected to be materially lower than pre-crisis.

I believe there is a low probability for either of these options to occur.

Let us consider the details.

Loan loss provisions

Clearly a key risk for the banks but also a very manageable one. Since the majority of the pain is likely to be taken in the first half of 2020 (unless we are facing a long depression).

2020 is the first year that U.S. banks operate under the new Current Expected Credit Losses (OTCPK:CECL) accounting standard. The key difference to the prior standard (incurred losses), is that CECL effectively front-loads loan losses provisions. Management is required, at each reporting period, to estimate the future credit losses based on projections incorporating expected economic conditions as of that date.

The net impact is that banks get to recognize losses earlier than actually incurred, and depending on the economic data trajectory (e.g. unemployment and GDP primarily) will update (write-back or increase) the provisions on each reporting date. CECL also appears to be pro-cyclical as it is likely to exert pressure on banks' profitability just as you enter a crisis and exactly at the point where governments want the banks to be there supporting the economy. So perhaps not such a great idea. Also, note that there is a modest transitional relief in place from inclusion in the capital ratios that equates to 25% of year-to-date provision.

The below summarises loan loss provisions taken by the large U.S. banks:

The Q2'2020 loan loss provision (incremental) are expected to be of similar magnitude to Q1'2020 for most banks. Whilst actual loan losses will only be incurred later on.

Even after absorbing such large loan losses in Q1 and Q2, the banks are still very profitable. Take Citigroup as an example, it delivered $2.5 billion of net income and $1.05 EPS for Q1'2020 whereas the quarterly dividend is 51 cents. Citi clearly benefits from its diverse business model with robust capital markets income performance in Q1 and Q2 partially offsets the loan loss provisions.

Now the way CECL works, it is also pro-cyclical on the other side of a crisis. So once a recovery takes hold, one would expect a reversal of some of the loan provisions rather quickly. And that could boost capital, earnings and capital returns potential for the banks.

The Fed is your friend

Mr. Market was very disappointed with the Fed's stress tests results.

All the large U.S. banks have dropped following the announcement.

To me, the Fed's approach seems quite a reasonable and balanced one - it did not outright ban the payment of dividends (like the European and UK regulators opted to do).

As can be seen from below, most of the large U.S. banks have plenty of capacity to maintain current dividends (with the exception of Wells Fargo (WFC) that delivers a 7% yield). Of course, if the economy is not going to materially deteriorate from where we are now, dividends may be cut temporarily.

The Fed temporary prohibition on buybacks and dividend increases in Q3 is a completely academic exercise. No banking CEO, in such times of crisis, would contemplate doing so anyhow.

Finally, requiring the banks to resubmit their capital plan in Q4'2020 is just prudent. This is part and parcel of a regulator's role in times of crisis looking to ensure financial stability.

It is also worth noting that a day before releasing the stress tests, U.S. banking regulators also rolled back some important regulations. Specifically easing of the Volcker rule as well as releasing capital tied up in derivative transactions between different affiliates of the same bank.

Make no mistake about this - the Fed is your friend.

Coming out the other side of this crisis

This crisis will pass. The question investors need to ask themselves - how will the banks fare in the post-crisis "new normal"?

Capital position

The banks are currently very well-capitalised even when you take into account the front-loading of loan loss provisions.

Take Citigroup as an example. As of Q1'2020, it maintains 11.2 percent common equity tier 1 (CET1) ratio compared with a regulatory requirement of 10 percent. Once the crisis subsides and the pro-cyclicality of CECL works in the opposite direction as well as other RWAs reduction (e.g. repayment of revolvers and less RWA allocated to trading), I expect Citi to print a CET1 ratio well above 12 percent. This could translate to excess capital of ~15-20+ billion which is likely to be delivered to shareholders via buybacks above and beyond BAU earnings!.

Citi has the track record as well - having reduced its share count from 3.2 billion several years ago to current ~2.1 billion. JPM and BAC position will be similar as well. Note that under the new regulatory framework, in general, the Fed will not object for banks' capital returns on quantitative basis. This provides banks with much-needed flexibility going-forward.

Consumer bank - Goliath is winning!

Most of the stress in the current crisis is arising in the consumer bank. It primarily manifests as credit losses on consumer loans (credit cards, car loans, mortgages etc). As mentioned above the loan loss provisions are front-loaded under CECL. These have a real potential to reverse in subsequent periods, in my view. I believe the wild card is the fiscal bridge provided by governments to place income in the hands of consumers that is making a real difference. Clearly the revenue line is also adversely impacted as spending in the economy reduces (especially in the travel and leisure categories).

The longer-term outlook is very favourable. As Mike Mayo describes it; "Goliath is winning". The large U.S. banks have the scale and dollars to invest in digital banking presence that is complemented by branches, where it makes sense.

The large banks are also very well positioned in the Credit Cards business. In recent years, the margins compressed, especially in the Rewards segment of market. The COVID19 pandemic likely reversed that trend and improved the banks' bargaining position, especially in the travel and leisure segment. I also expect the large banks to add in some bolt-on (and accretive) acquisitions of Cards portfolio. In summary, scale does matter in the consumer segments and the large U.S. banks will likely benefit.

Corporate and Investment Banking - low risk business model

The business model is very different to the roaring 2000s prior to the GFC.

Today the business model of the large U.S. bank is predominantly serving investment-grade corporates (typically large/MNC clients). The large U.S. banks typically do not warehouse most of the risk on their balance sheet. They help their clients access the capital markets (syndicate, bond issuances, IPOs , advisory etc). They earn a large proportion of their income as fees.

Markets division

The markets business comprises of FICC and Equities trading business. The large U.S. dominate this business and it is effectively an oligopoly. The barriers of entry are very high given the huge technology investments and scale required to make the economics work. By and large, the European banks retreated to a more regional/product specific models as opposed to a universal banking model. Whilst revenue wallet declined in the years following the GFC (due to electronification of trading as well as the Volcker rule), in recent years, the industry wallet has stabilised and now growing. As noted, the U.S. banks have been taking substantial market share from international peers over the last 10 years. It is a business earning well above the cost of capital for the top 3-5 players.

During the recent crisis, the Markets division has performed exceptionally well - with ~40%-50% year-on-year for the likes of Citi and JPM.

Analysts sometimes describe Markets income as "low quality" earnings given its volatility. I think they are completely missing the point - on economic risk/reward returns, I much prefer these volatile prints on "accruals-like" income such as Credit Cards lending.

Investment Banking

This business line comprises of debt and equity underwriting as well as advisory (e.g. M&A). The shift away from corporates utilising bank's balance sheet to accessing the capital markets is a secular tailwind. Especially, in European and Asian markets where the capital markets are not as developed as yet. Given their scale and global presence, the U.S. will likely capitalise on the development of global capital markets. This is a significant growth opportunity for the U.S. banks.

Other businesses

Other businesses include corporate lending, private banking (especially ultra high-net-worth clients), securities services (custody) and transaction banking (e.g. treasury, trade finance, payments).

All of these are very profitable (on ROE basis), low risk and generate steady annuity-like returns. And scale matters once again and the U.S. banks are dominating these by leveraging technology investment dollars and monetising their lucrative client base.

The bottom line

This is clearly not 2008/2009. The U.S. banks are in great shape and are operating from a position of strength. The regulatory backdrop is also quite favourable. Digitisation of front and back office processes is a huge tail wind that should substantially improve margins.

Yes - there are significant near-term headwinds including loan loss provisions, low interest rates and generally weak economy.

Having said that, the large U.S. banks are weathering this crisis quite well.

Loan losses have been taken early, capital ratios remain strong and for the most part dividends are continued to be paid for now.

Looking further ahead, the large banks' business model is clearly suited for the "new normal". The large U.S. banks already lead with technology and digitisation of banking services. COVID19 is the great accelerator.

Once the economy recovers, I expect the Consumer segments of large U.S. banks to deliver ROE of ~20 percent and the Corporate & Investment bank to hover around mid-teens.

I also expect the cost of capital for large banks to reduce. It makes no sense for Mr. Market to demand the same cost of capital as was the case prior to the GFC.

I prefer the more diversified large U.S. banks with both large Consumer and Investment Banking operations. As such, I prefer Citi and JPM with a larger allocation to Citi due to much lower but perhaps underserved valuation.

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Disclosure: I am/we are long C, JPM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.