Bank stocks have gotten hammered this year. In fact, they only trail energy in terms of worst-performing asset classes.
(thanks Callum Thomas for this chart)
This makes sense. If I were to boil it down in one sentence its “banks do not do well in recessions.”
Borrowers may default on loans and banks use leverage so those defaults add up quickly. In good times, banks also tend to reserve less and take less provisions for loan losses (i.e. losses they generally expect on their portfolios in the future) because its hard for them to see a recession on the horizon – and it also juices net income in the short term.
Then… a recession hits. Banks need to take further provisions and people realizes they may not be invested in a bank that can fully weather a business cycle like they thought.
That’s somewhat true today, but different in a lot of ways as well. Yes, banks so far have taken huge loan losses, major ones detailed below:
- JPM — $8.3 billion provision
- Wells Fargo – $4.0 billion provision
- Bank of America – $4.8 billion provision
- Citigroup – $4.9 billion provision
They took these provisions because we just so happen to be entering the worst economic crunch anyone reading this has ever seen. I mean, the global economy just ground to a halt. Unemployment has surged. And no one knows how long consumers’ trepidation of traveling, splurging, and so on will last.
At the same time, banks’ balance sheets were essentially forced to be in the strongest position we’ve seen for some time. The last crisis in 2008-2009 was a financial crisis. In response, governments attempted to impose “never again” policies to shore up our financial institutions (arguably, this lowered lending and caused our recovery to be much slower, longer and more painful than it otherwise would have been) and bank stocks were put into the penalty bin.
As you can see below, banks tier 1 capital ratios going into this recession far exceed what they were going into the last recession. While this is a health crisis and not a financial crisis, they still face pain, but should be able to withstand the impacts better.
I think this has created an opportunity in the bank stocks. We can now buy leading franchises below book value and collect meaningful dividends along the way.
Here is a list of banks and financials I am looking at:
You can read my comments for each one above, but I want to very briefly focus on some names I think are worth taking a deeper dive on (frankly, I think the banks in general look cheap and it was very hard to find 4 just to drill into – I think a basket of the above makes a lot of sense, excluding any you don’t want exposure to of course).
This bank is absolutely in the penalty box right now. I mean literally – its in a penalty box. The “fake account” scandal resulted in a freeze on the banks assets as punishment so they could get a handle on what was going on in the firm and improve governance. They are a bank, which requires a lot of trust, and Wells Fargo broke that trust.
How quickly tides turn, though. I remember when Wells Fargo was what JP Morgan is today. The “good” bank. Led by a trustworthy team that wasn’t like those other greedy Wall Street banks. And for that, Wells used to trade at 0.5x-1.0x premium to the group (much like JP Morgan does now). You can clearly see a “changing of the guard” going on here. If you didn’t know when the scandal happened, I am sure you can now pick it out.
But Wells has a new CEO and if you have a long time horizon, I am sure they will figure it out. The CEO, Charles Scharf, has a very interesting pedigree.
- CEO of Visa from November 2012 to December 2016
- CEO of JP Morgan’s Retail Financial Services for 9 years (2004-2012)
- Managing director at One Equity Partners, JPM’s private equity arm
- CEO & CFO at Bank One in 2000-2002
- CFO of Corporate and Investment bank at Citigroup (1999-2000)
- 1995-1999 he was the CFO at Salomon Smith Barney
This guy gets banking. And he’s led some very large firms and divisions.
I understand why Wells Fargo trades at a discount to JPM. It can’t grow. Its brand may be irreparably harmed.
But I doubt that lasts forever. Just like Domino’s improving its pizza brand, a bank can improve too. Recall Soloman Brothers and Bank of America were once hated entities that came back considerably in terms of sentiment and trust.
Time heals all wounds as they say. We just need Wells to survive. Can they do it? Well, again, their capital structure is in healthy shape:
Wells does have exposure to high risk industries, like Oil & Gas and Retail that will be under pressure this year, but it is still very diversified. Also note, when they say retail, that breaks down to other exposures. For example, department stores are only 18% of their total retail exposure, so less than 1.5% of total commercial and industrial loans.
I like Wells Fargo here. I think the dividend is probably maintained so I’m collecting 8% per year to wait. Even if its cut in half, it still would be a 4% dividend (clearly, if they did that things would not be going swimmingly, but over the long run it should even out).
It’s difficult to actually compare Discover to a name like Wells Fargo. Discover is mainly a credit card business (80% of loans), private student loans (~10% of loans) and personal loans (~10%). So if I were to sum up what makes Discover different than the other bank stocks, its that it is more of a bet on the consumer. And these are generally unsecured consumer loans, so they carry risk.
In Q1’2020, Discover increased its reserve ratio for its credit card portfolio to 7.2% (up from 5.9% at the end of 2019) and this is actually somewhat light compared to peers (Synchrony reserved 11%, Capital One reserved 9%, American Express reserved 7%). So there is a risk they need to have additional reserves in 2020. I would say that is the bulk of what people expect and that has people concerned.
On the call, management called out a few things to assuage reserve fears:
To give you a sense for how our card portfolio compares today, with how it looked at the end of 2007, our contingent liability, meaning the total open to buy for our card products has been reduced from roughly 5.7 times loans to around 2.7 times. And the percentage of the portfolio below a FICO score of 660 has gone from 26% at that time, down to 19% at the end of 2019. So, while we are not immune from the impacts of deterioration in the economy our portfolio is significantly better positioned than it was ahead of the last financial crisis.
So the open-to-buy has reduced by about $54 billion from the last recession to this recession. Average FICO scores in the portfolio have increased between 500 and 600 basis points, which is a material change. Our underwriting, frankly, is far more sophisticated than it was 10 years ago. And frankly, the actions that this business undertook when the pandemic started to actually drive some real difficult employment numbers was drastic and very, very quick.
Open-to-buy risk is when a consumer is under financial duress so they draw down on their credit cards. So one, they sap liquidity available and two, they increase the risk because the card lenders’ exposure to riskier credits grows. It seems as though Discover is in a stronger position today.
Again, if you have a long time horizon, you’re buying a financials that earns a 22%+ ROE for only 1.5x TBV. That seems too cheap to me.
And now, for something different again. I actually looked up BNP Paribas, the french bank that is one of the largest in Europe, to see how negative rates would impact the US stocks. Clearly ROAs go down, but BNP’s 5-year average ROE isn’t that bad (the shape of the yield curve matters).
Look, a 8% ROE is not that great. But that is 8% return on book equity… and I can buy BNP right now for 0.4x that book value, so return on MY equity should be much higher in the long run.
Let me show a summary example. Assume a bank has $100 of beginning book value, earns 8% on equity and pays out 40% of its income. In year 10, I sell the bank to 0.4x book value, so I get no benefit from multiple expansion or ROEs improving.
The return on my equity is much more attractive.
Look BNP is like any other bank – it will have issues this year. But BNP is a highly diversified bank and I really like how thorough their management team is – their Q1’2020 investor deck was 84 pages!
BNP right now is planning to pay out 50% of its earnings as a dividend, which will be somewhere between a 9-10% yield on the stock. However, the ECB has told European banks that they need to shore up liquidity to support the economy and to cancel dividends for the time being. Even with the dividend, BNP expects to have a 12% CET1 ratio (about 300bps above the Basel III minimums) so I think that would be a huge boon to be able to pay out its earnings.
Last one I am looking at is a small, southeast US bank called Synovus. As shown in the table at the beginning of this post, it trades around 0.7x book and has OK, but not great capital buffers. The banks CET1 ratio is 8.7% compared to their goal of 9%. However, new bank accounting standards result in taking higher losses upfront (called CECL), so the management team relayed that CECL reduced CET1 ratios earlier in the cycle.
As for the downturn, Synovus used to be heavily exposed to commercial real estate, land and 1-4 Family units, but since the crisis has been working to reduce that exposure and get more diversified.
As the company noted, because the loss rates of those sectors was so high, this significantly de-risked the company in a stressed scenario.
We have significantly reduced our exposure to 1-4 family residential, land and investment properties as well as CRE in aggregate. By simply utilizing historical loss rates, the remix of our portfolio alone would result in a 50% reduction in losses. Combined with the improvements in underwriting and portfolio management, we would expect losses to decline even further when evaluating the impact of the severely adverse scenario
Part of the diversification was driven by the banks merger with Florida Community Bank back in 2018. Its funny to look at where Synovus trades now (0.7x BV) compared to when the deal was struck.
But while merging with a Florida bank diversified the company away from being a mainly Georgian bank, Florida isn’t a great spot to be right now. Tourism drives their economy (Disney World!) and COVID-19 will surely wreak havoc. SNV noted 13% of loans were in deferment, which is pretty high compared to peers and the company noted it was in mostly at risk sectors, probably lining up with this slide:
The good news is that the company said “a lot came in, in the first week or 2. We’ve seen it trail off considerably to the point now where we’re really not adding many deferments to that book. And just want to make sure that we’re clear on it. It’s really just a 90-day program.” So seems like the worst is behind us and hopefully back up in running at quarter end (timing well with a re-opening, I would suspect).
Commercial & Industrial loans make up $17.7BN (or 47% of total exposure):
Within C&I, the specialty divisions such as senior housing and premium finance comprise about 14% of total loans and have been a significant contributor to our growth story while also possessing some of the best credit metrics over the last several years. The overall portfolio is well diversified by industry and geography and is extremely granular with almost 35,000 loans with an average original loan balance of approximately $770,000
So clearly the bank is exposed to a bunch of smaller sized loans.
Clearly, SNV is a riskier story, and I would size a position in a portfolio as such, but I think owning Synovus makes sense to buy for a few reasons:
- Dividend: Mgmt team seemed committed to the dividend, so we pocket ~7% to wait
- The bar is already set low – company used to trade above 1.5x book value. I think BV by YE2021 could be ~$30/share, so trading at 1x would be nearly 60% upside plus a HSD dividend
- Take-out candidate: Any bank that wants to increase its southeastern presence or market share could look to acquire SNV. Float a take-out for 1x TBV and I’m sure the synergies would be large and very accretive for the acquirer (branch consolidation, back office savings, etc).
All that said, would I buy more Synovus or Wells Fargo or BNP? I’d probably choose the latter two.