R. Christopher Whalen
Oct 19, 20236 min
October 19, 2023 | Premium Service | Are bank stocks cheap? Banks are certainly inexpensive compared with other sectors and have been for a long time. Banks trade for single digit price-to-earnings multiples. Residential mortgage REITs at least trade in the low teens in terms of P/Es. We recall the judgment of Kevin O’Leary on CNBC a few years back: “Banks are dead money.” Indeed, today many banks are book insolvent thanks to the Federal Open Market Committee, but that is mostly an earnings problem.
This week we had caught up with Ralph DelGuidice, who has contributed to this blog in the past, about the world of banks. As we discuss below, commercial banks have a number of ways to deal with impaired assets that are not readily apparent to equity investors. But the large universal banks that ply the capital markets and make use of essentially infinite leverage in the derivatives markets also face a number of serious challenges ahead.
If you think of all of the low-coupon debt and loans sitting in the portfolios of large banks, these assets are going to be with us for years, even decades, to come. But is that bearish for commercial banks? That depends on whether we are talking about banks that make loans and take retail deposits vs banks that trade the markets and manage assets, real and borrowed.
The former group is currently under downward pressure due to fears about credit, while the latter are still benefiting from the lift they experienced during COVID and zero interest rates -- for now. The latter group of dealer banks, joined by some of the larger hedge funds, use leverage that is proportional to what the system allows, to paraphrase Ralph.
Two words: centralized clearing. In a world where derivatives dealers and their customers must actually own the Treasury collateral they use in centrally cleared trades, the use of leverage will be significantly reduced. Systemic risk and dealer earnings will decline. The chart below shows some of the mind-boggling gross derivatives positions of the larger dealers and Peer Group 1.
Source: FFIEC
Let’s consider two of the larger “asset gatherers” among the bank group. The results from Morgan Stanley (MS) in Q3 2023 were modestly down, but the market punished the leading Wall Street dealer and asset manager nonetheless. Asset management, the most stable MS line item was actually up. Trading and ibanking were down small, leading some bears to pile on the stock. Overall, this was not a bad quarter, but the Street responded negatively because MS is still relatively expensive vs other mainstream banks.
Unlike Goldman Sachs (GS), which saw earnings drop by a third, the MS business remains stable and liquid. And most important, MS has very little in the way of credit expenses, at least on balance sheet. The stock market chart below going back 40 years suggests that MS is delivering better value than GS and by a wide margin.
Source: Google Finance
At current market valuations, you might argue that MS is relatively cheap, but the firm is still trading significantly above early 2020 levels, reflecting the boom in capital markets activity during the period of zero interest rates. In fact, the asset gatherers such as GS, MS, Charles Schwab (SCHW) are still trading well-above early 2020 levels, but depositories as a group are arguably cheap looking at the five-year chart. But will they get cheaper? Most likely, in large part because the equity manager herd is largely clueless about credit markets.
Source: Google Finance
GS got crushed after reporting a one-third drop in earnings YOY but up sequentially from the horrific Q2, mostly on the back of higher expenses. You can see why the firm has been cleaning house of personnel because compensation expenses (up 16%) led other line items higher – $1.3 billion higher in terms of operating expenses. If you want a reason to criticize CEO David Salomon, it is for being a poor operating manager.
The good news for GS is that provisions for credit losses fell 99% from Q2 2023, a reflection of the fact that the firm moved the festering GreenSky loan portfolio into held for sale as it heads out the door. GS has been reporting very high credit losses vs average assets compared with the other large US banks. Hopefully the disposal of GreenSky will end this period of outsized credit losses, although GS is still growing its credit card portfolio. GS does not break out net losses in its GAAP disclosure, so we’ll have to wait for the Form Y-9 to be released by federal regulators.
Source: FFIEC
At GS, MS and many other banks with market facing businesses, the drop in transaction volumes is forcing some painful choices. Professionals who were tasked with processing new deal volumes in 2022 are now migrating to restructuring tasks in 2023. As one veteran commercial loan buyer told The IRA this week: “It may be time for me to go fix broken toys again.”
For GS, the drought in deal flow is a far more painful problem than for MS because the latter has a more diversified business. GS is a two legged stool, with capital markets and investment banking as the primary drivers, and the firm’s low yielding asset and wealth management business a distant second. The platform solutions segment is too tiny to matter in terms of revenue, but holds the firm’s credit card portfolio and other non-core assets. That is, risk.
So if the asset gatherers are a bit pricey, what about the mainstream banks? The answer is that each institution will need to work through its own particular loan portfolio issues. While the commercial real estate sector is currently experiencing a lot of credit losses, the worst exposures are in the market for commercial mortgage backed securities (CMBS) rather than on the books of banks. Indeed, the restructuring of commercial real estate assets may not actually be bad for banks and may create some opportunities.
Let’s take an example. A number of highly excited analysts have contacted us in recent weeks, declaring that regional banks are toast because of their exposure to commercial real estate in footprint. The truth is more complicated because banks are mostly protected by the 50% loan-to-value ratios in commercial loans. So in the event of default, the bank wipes some or all of the equity and demands more cash from the “owner.” If the debtor balks, the bank owns the property at 50% of the original loan amount.
Even if we assume that the Federal Open Market Committee is going to keep interest rates at current levels indefinitely, we think it is important for investors and risk managers to remember that commercial real estate is unlike residential assets in some very fundamental ways. For banks with non-performing commercial assets on their books or in CMBS servicing portfolios, restructuring the loans may actually generate value.
But, again, if you think of all of the performing, money good low-coupon debt and loans sitting in the portfolios of large banks, the only way out is restructuring. As Ralph notes correctly, banks will sell risk shares on these assets to the Street and use the proceeds to buy as much new, high coupon paper as possible. That is not a very exciting trade compared with other industry sectors, but at least it holds the promise of getting bank equity returns positive over time.
Bottom line: We are starting to like some of the commercial lenders and are adding to our position in New York Community Bank (NYCB). We believe that the bank's Flagstar loan servicing platform will be well-positioned to benefit from today's commercial real estate market and the coming correction in residential real estate -- still several years away.
We are not big fans of the large dealer banks such as MS, GS and to some extent JPMorgan (JPM) because of the poor outlook for capital markets volumes and interest rates. Even more profound, however, is what the SEC's central clearing rule and the Basel III capital proposal implies for future leverage and thus equity returns. We think bank derivatives activity will continue to trend lower and may actually accelerate downward, with negative implications for earnings.
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