Update: US Banks Post-QE

June 15, 2022 | Premium Service | As markets wait to find out how high the FOMC will jump in fighting inflation and pursuing credibility, we are going to focus on some obvious opportunities in the markets presented by rising interest rates. Big picture, a lot of assets that traded at a premium a year ago are now at a discount.

“Negative-incentive Ginnie paper prepays faster than does negative-incentive conventional paper,” First Horizon Financial (FHN) SVP Walter Schmidt wrote in a June 14, 2022 report. “And since the market is now clearly in a negative incentive position with almost every asset priced at a discount to par, faster-prepay assets should perform better.”

In other words, you can buy GNMA MBS at a discount and profit from prepayments at par. Schmidt notes that the largest non-banks service roughly three quarters of the unpaid principal balance of the Ginnie Mae sector while only 14% is serviced by the five largest commercial banks.

“This leads to more aggressive servicing tactics, particularly along the lines of cash-out refinancings,” he concludes. Approximately 44% of the conventional market is serviced by “aggressive non-bank servicers,” FHN adds. Yeah, and those aggressive nonbank servicers will keep prepayment rates elevated as a matter of survival.

Meanwhile, Signature Bank (SBNY) got a 2x4 in the mouth earlier when concerns about the demise of the crypto market caused the equity market value of this $120 billion asset unitary bank to crater. The SBNY common is down more than 40% YTD.

SBNY just came off of a strong Q1 2022 earnings report, thus the down move caught many investors by surprise. Net income in Q1 2022 increased $148.0 million to a record $338.5 million vs $190.5 million in Q1 2021. What's not to like? Crypto.

"The stock was suffering from the selloff in bitcoin as many on Wall Street see it as a cryptocurrency play, as the bank has a digital payments platform, named Signet, and because it offers a loan product collateralized by cryptocurrencies," Marketwatch reports.

SBNY management needs to explain to investors just why they decided to risk the bank’s excellent reputation on something as absurd as lending on crypto tokens. Taxi medallions, an asset class where the bank was once active, would be a superior speculation. When you recall that SBNY traces its lineage back to Republic National Bank, the obvious question is this: What would Edmond Safra say?

Large bank leader American Express (AXP) has given back just 10% YTD in terms of its equity value, one of the best performances among financials. Next on the list is the low-beta Toronto Dominion Banks (TD), which is down 11% so far in 2022. The leader in our large bank group is HSBC (HSBA), which is up almost 20% YTD in a larger flight to perceived quality. Our bank surveillance group is shown below c/o Bloomberg.

June 15, 2022

What is remarkable but not surprising is looking at where the market’s volume is concentrated. Aside from HSBA, other volume leaders include Bank of America (BAC), Wells Fargo (WFC) and Citigroup (C), which is now trading less than half of book value. How does anyone explain this seemingly irrational behavior by investors? Big is better than quality in times of market uncertainty.

Other names that are out performing the group that we have highlighted in the past include Raymond James Financial (RJF) and U.S. Bancorp (USB). As the market deflates a lot of aspirational stocks in coming weeks, we are looking to add to our holdings of preferred and possibly even some common. That said, we are in no hurry and are more inclined to add to positions in energy and technology.

Truth to tell, even with the selloff to date, the financials are not particularly cheap. AXP at 5x book value is cheaper than it was in January, but not yet compelling for our money. USB and JPMorganChase (JPM) are still trading well above book value. Our basic view is that the whole banking complex will trade lower on credit fears arising from a recession, but lackluster financial performance will add to worries.

Meanwhile over at Citi, the noise regarding the Ukraine war and sanctions have pushed the stock down to what seem silly levels. We are less worried about the possible credit risks to the bank and more concerned by the army of consultants from McKinsey that are swarming the Citi operations. Even by past standards, the consulting expenditure at Citi on various risk remediation projects has become massive and will likely show up in operating expenses as the year progresses.

As the bubble created by the Fed’s QE exercise collapses, we expect more substantial names in the financial sector to come back into vogue. We do not anticipate a bounce in pre-tax income for banks, adding to downward pressure after 18 months of artificially enhanced results. The fact of more aggressive action by the FOMC may push funding costs up faster, making our earlier prediction of a narrowing of net interest margin come to pass.

A lot of Street peeps have been caught off guard in financials, in particular our Twitter buddy Jim Cramer, who has made us a lot of moolah over the years. On banks, however, the Street has largely refused to accept the magnitude of Jay Powell’s impact on NIM and pre-tax earnings, which remain down $40 billion per quarter vs the end of 2019. Even as the FOMC raises interest rates, we are dubious that asset returns will keep pace in the near term. Thus we caution our readers to be prepared for disappointment from banks in the near term.

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