Following the March stock market crash, many investors searched for pockets of value in a rich value market. Unfortunately, it appears that many of these “cheap” companies are value traps with high risk of bankruptcy, as opposed to turnaround opportunities.
One area where true value is evident is one that many would not expect, banking. Most bank stocks remain down 30-50% this year despite the rally in major indices. Many investors fear the banks are heading for a repeat in 2008 that will see a massive bankruptcy. Although cycles do rhyme, they do not repeat themselves and it is rare for the worst performing sector in one recession to be the worst performing sector in the next.
Indeed, the problems facing banks today pale in comparison to those faced in 2008. Notably, extreme leverage, an unsupportive central bank, and assets with hidden risks. The latter is possible today, but bank leverage is much lower and global central banks are much more supportive.
Bank valuations are now extremely low. The SPDR S&P Bank ETF (KBE) is currently trading at a weighted average TTM P/E of just 8.1X and is 25% below book value. Risks are higher today, but Federal Reserve policy directly supports banks’ capital and will likely offset losses. Additionally, banks have pushed much of their riskier debt into secondary markets, as evidenced by the rise of corporate bond and leveraged loan markets.
KBE could see more downside before bottoming out. However, I believe it will outperform other stock sectors in the future. Once it bottoms out, I think a big and quick rally will follow as the market realizes the value opportunity in the banks.
How quantitative easing boosts banks
Banks are almost entirely guided by broad macroeconomic principles. The management of individual banks matters, but much less than it seems in other sectors of the economy. Thus, it seems reasonable that we begin the discussion with a top-down view of banks.
Most know that quantitative easing is the digital creation of money, created for the purpose of fostering liquidity in the economy. Mechanically, the Federal Reserve “creates” money which it uses to buy securities on the secondary market. The main sellers of these securities are the banks. Today, this includes treasury bills, mortgage-backed securities and, more recently, corporate bonds.
Fortunately, bank assets are updated weekly, so we know what US banks have. As you can see below, QE led to a decrease in the percentage of commercial banks’ assets in MBS and Treasuries and a significant increase in bank liquidity:
Obviously, the current QE effort is more extreme than the previous one; however, the 2010-2015 rounds were similar. Cash increased while Treasuries declined. It does not reduce bank leverage, but it does give banks more dry powder when needed and at a time when capital returns are generally higher.
By far, risk-free cash is the fastest growing section of bank assets, with most other categories, including consumer and home loans, declining. However, commercial and industrial lending has increased as banks provide emergency PPP financing to businesses. See below:
As you can see, commercial lending is increasing with QE while other higher risk lending areas are decreasing. Some of these assets are sold to the Federal Reserve and others in the secondary market. Banks have also tightened lending standards, which has led to a natural decline in consumer loan assets.
Overall, this had resulted in little change in the value of bank equity and a moderate increase in bank leverage. See bank equity in red (right axis, bank assets minus liabilities) and leverage in blue (left axis, bank liabilities to assets) below:
As you can see, banks had a total liability to asset ratio of 96% in the 2000s. Before the crisis, only 3-4% of most bank assets were in cash, compared to 16% today. It is therefore not surprising that the banks experienced a liquidity crisis where they all lacked liquidity.
In the red you can see the bank bailouts which led to a significant increase in bank equity and a substantial decrease in bank leverage. Bank leverage has remained low over the past decade, but has increased recently with quantitative easing. It is important to note that the crisis did not lead to a decline in the value of commercial banks’ equity, but only an increase in indebtedness. This means that the potential for future earnings will likely be higher.
Bank valuations do not take into account their “Fed Put”
In 2008, the banks were bailed out and their capital was restored. So far that hasn’t happened today as the banks have more than enough dry powder to survive a storm. In general, asset quality has improved (ie increased liquidity and decreased consumer lending) while lending has improved.
Of course there is a hidden bank bailouts today. Under the stimulus bill, banks receive between 1% and 5% commission for origination of PPP loans (depending on the size) which is much higher than the cost of origination. These loans also have bear interest at 1% and are 100% guaranteed by the SBA. Essentially, this is a big risk-free profit for the banks.
So while bank leverage has increased, the only areas where we see a significant increase in assets are commercial loans (i.e. secured PPP loans) and liquidity. In general, these are low-risk asset classes. This will leave banks with greater short-term revenue and more dry powder to buy riskier debt at a discount in the future.
I believe it is absolutely clear that the Federal Reserve is acting to directly support commercial banks. Both increasing their earning potential and decreasing their balance sheet risk. However, this is not taken into account in bank assessments. A decade ago, most banks traded at low valuations and many have posted high returns thereafter. However, P/B valuations are now somewhat lower than they were after the recession. See below the P/B changes for KBE’s main banks:
Again, the weighted average share in the ETF is 25% below its book value and has a P/E of 8X. Of course, bank stocks have been at the low end of investor popularity for most of the past decade. Performance was below average due to the generally flat yield curve and tighter leverage requirements. However, leverage has gone up, as has the yield curve:
So, it looks like we’re heading into a period of increased cash flow for most banks. Short-term rates are expected to remain at zero through 2021, so banks are likely to see a sustained increase in net interest margins.
Investors are giving banks extremely low valuations due to an expected increase in loan losses. It’s likely and I think the recovery will take much longer than the decline. Real GDP is expected 42% drop this trimester which is worse than at the time of the depression declines. However, banks have a very low risk positioning with assets increasingly concentrated in federally backed ones and cash. Given lower bank leverage today, it would take a much larger increase in loan losses from failing banks than in the past.
After the crisis, banks will have a steeper yield curve which will significantly improve their profitability. They will also likely have more dry powder due to their large cash reserves. This will likely lead to a sustained increase in net interest margins and volume, possibly driving many banks’ profits up by 50% or more.
In the short term, it is entirely possible, if not likely, that the KBE will decline further due to investor fear. However, I think the rebound will be much stronger in banks than in most other sectors. It also seems clear that losses here will be minimized as the Federal Reserve increases its direct support for the US banking system. All in all, I think this makes KBE a solid “long-term buy”.