Updated: Oct 18, 2020
New York | We start this edition of The Institutional Risk Analyst by noting a couple of important developments in the world of financials. First, Western Alliance Bancorp (NYSE:WAL) Friday announced it had purchased Galton Funding, “a rare example of a depository taking title to a nonbank, non-QM originator,” Inside Mortgage Finance reports. Rare indeed, but also a red flag.
WAL is a great performer and ranks in the top decile of Peer Group 1, the 127 largest US banks about $10 billion in assets. But when you see commercial banks buying non-QM loan businesses, that does kind of give us a certain feeling of déjà vu. The reason that Citigroup (NYSE:C) still has not addressed chronic internal controls issues goes back decades ago to the acquisition of several nonbank businesses.
Second, we hear from the regulatory channel in Washington that the Department of Housing and Urban Development has internal estimates of seriously delinquent loans (as opposed to merely delinquent) peaking in the 13% range during this credit cycle.
We noted last week in The IRA Premium Service (“The Bear Case for Mortgage Lenders”), that there are a number of large servicers that could capsize in the next downturn in housing. Is it not strange that certain mortgage firms were literally on death’s door in April and now are going public in October? Hmm.
Yes, there is a loving and forgiving Lord. And yes, there is a reason why the smart money on Wall Street is focused today on creating new private fund strategies focused on late vintage servicing assets, non-performing loans (NPLs) and early buyouts (EBOs). Do have a look at those FOMC-induced mortgage IPOs, but then remember where those emerging issuers stood in credit terms just six months ago.
Third, we see that Morgan Stanley (NYSE:MS) has agreed to acquire Eaton Vance Corp (NYSE:EV) for $7 billion, roughly 5.5x book or 15x EBITDA. This is a premium vs the closing price last Wednesday, but is about where the stock traded in 2018. This transaction increases the size of the MS asset management business above $1 trillion in AUM and further differentiates MS from competitors like Citi and Goldman Sachs (NYSE:GS). Both of these banks are in The IRA Bank Dead Pool.
“People who hang around trying to buy great companies cheaply never get anything done,” Mr. Gorman said last week when the deal was announced. Bravo. In the nuclear winter of financial repression engineered by the Federal Open Market Committee, there are no cheap earning assets.
Below we take a look at the top five US depositories as Q3 2020 earnings season begins. You’ll notice a certain subtext operating for all five names, specifically revenue and earnings estimates that fall off the edge of the proverbial table in 2021.
At 1.3x book at the close on Friday, JPM is hardly cheap as a stock, especially with the dismal outlook for earnings through the rest of 2020. The equity of this $3.1 trillion total asset behemoth is still down almost 30% from the highs this year, but the debt securities for JPM and other banks have tightened considerably from the wide spreads of April 2020. Long the debt and short the equity has been a winning trade through the first half of the year.
Of note, the Street has consensus JPM earnings for 2020 at almost $11 per share, but dropping to just $6 in 2021. Five-year growth estimates are showing a negative number at present compared to 15% growth rate over the last five years. As the chart below illustrates, the net income of the top five banks is running at roughly half of the pre-crisis levels. More, the top-five banks are now constrained in terms of share repurchases (none) and dividends (limited).
To buy the common equity of JPM or any top-five bank is a bet on when the credit impact of COVID will subside sufficiently to allow banks to return to profitability and resume at least normal dividends. Share repurchases could be suspended for years to come for the largest banks.
For JPM, the key indicator for us is whether the bank continues to build credit loss provisions through the end of the year. We expect US banks as a group to put aside $40 billion plus in additional loss provisions in Q3 2020.
The lack of visibility on future revenue and earnings is a function of a absence of clarity on forward credit losses. Unlike the 2008 financial crisis, the 2020 COVID meltdown is about recognizing credit losses on loans and bonds rather than a sudden mark-too-market on fraudulent mortgage loans and securities. Assessing the true credit impact of corporate defaults and bankruptcies on banks, REITs, and equity and bond investors, will take years to resolve.
While Wall Street wants a quick answer to the COVID credit question, this hope is unlikely to be fulfilled. The basic reason for this is that commercial loan markets move at a glacial pace, especially when the market for the collateral is falling in value. As we noted in the Q3 2020 edition of The IRA Bank Book, loss given default for commercial bank exposures was already rising before COVID exploded onto the scene.
Source: FDIC/WGA LLC
Bank of America (NYSE:BAC)
At 0.9x book as of the Friday close, the common equity of BAC is fairly valued. With a 1.55 beta and a 2.8% dividend yield, the second largest bank by assets at $2.6 trillion has above average volatility with a moderate dividend yield, for now. The Street has a consensus estimate for earnings $2.75 per share in 2020 but just $1.64 in 2021, hardly a rousing endorsement. We own BAC preferred but not the common.
BAC has actually outperformed JPM by some measures, but this is to be expected given the conservative stance taken by BAC management over the past decade. Sure, the common is still down 28% since the start of the year, but BAC has actually been outperforming the bank half of JPM on earnings and losses, as shown in the chart below.
It is tempting to blame the rising tide of delinquent commercial and consumer loans on the COVID pandemic, but in fact the credit cycle was already a bit ripe when 2020 began. The Fed’s manipulation of credit markets and risk preferences has kept loss given default low so far, but if we ever see asset prices weaken, then credit will deteriorate quickly and dramatically. In any event, COVID’s devastation of many sectors of the economy means big losses for lenders and institutional investors in everything from aircraft leases to small multifamily apartments.
U.S. Bancorp (NYSE:USB)
USB has long been the smallest and among the best performing money center banks. The strong funding base and diverse mix of business lines, but little Wall Street exposure, has always made USB one of our favorite names. We sold our USB common equity position earlier in the year, but put the proceeds into USB preferred during the March selloff. We look for periods of volatility to add to these preferred holdings.
At 1.3x book value for the equity, USB is hardly cheap and, indeed, is still down 34% YTD. That said, USB’s strong credit profile has the bank trading among the tightest credits to the swaps curve at 33bp for five-year credit swaps vs 47bp for JPM. The Street has USB reporting $4.16 per share in 2020 earnings, but falling to just $1.60 in 2021.
Wells Fargo (NYSE:WFC)
With the bank’s common down more than 50% YTD and wallowing at 0.65x book value, WFC might seem like a bargain. Because of the steep discount to the bank's book value of equity and the other metrics, we understand why some of our readers might be attracted by WFC. At some point, the management and board of the bank are going to turn things around. This might seem like an attractive thesis -- until we recall that the bank’s problems are largely self-inflicted.
Despite the sanctions imposed by the Federal Reserve Board and the continued dysfunction of the WFC board and management team, however, the bank has continued to generate relatively strong results. The Street consensus has WFC revenue down 15% for 2020 and flat in 2021. We’d not be surprised to see WFC beat those metrics, but in any event, we think the bank’s paper is money good. We purchased some of the preferred below par during the second quarter. As Pete Najarian likes to say, “Giddy up.”
In our latest risk profile on Citi this past September, we noted that the bank is largely a prisoner of history, meaning that despite the progress made by CEO Michael Corbat, the options are limited for his successor Jane Fraser going forward. At 0.54x book for the Citi common, the stock is down 44% YTD and shows little sign of improving in the near term. We wrote:
"Our overall assessment of the quantitative and qualitative factors behind Citigroup is negative. The bank under-performs its peers financially, takes outsized risks compared to its large bank peers, and has no clear strategy for improving asset returns, access to funding or the bank’s overall risk profile."
The Street has C delivering $8 per share in earnings in 2020, but falling to half that amount in 2021. Again, the theme here is that things will get a good bit worse before they get better. The Street consensus on revenue growth is flat in 2020 and down small in 2021, but clearly the expectation is for credit costs to consume a bigger chuck of Citi's revenue next year. Get used to it.
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