The current credit crisis has provided a once-in-a-decade opportunity to buy the large money-center banks.
Now that many of the large money-center banks have retrenched and raised capital to support their balance sheets, Morningstar analyst Ryan Lentell is cautiously optimistic about their long-term prospects. I recently sat down with Ryan and his colleague Jaime Peters to review what's happened and where they think we'll go from here.
Justin Fuller: One can't help but hear about the massive write-downs at many of the large money-center and investment banks over the past several months. Can you give me an overview of what has happened?
Ryan Lentell: The root of the problem was that many of the large banks were holding large positions in mortgages, mortgage-related securities, and leveraged buyout loans on their balance sheets. As the issues surrounding the subprime mortgage market collapse started to weigh on housing and the housing bubble eventually burst, these securities lost tremendous value. As a result, banks had to take large write-downs. Because banks are highly leveraged and operate with a small amount of equity in relation to the total amount of assets on their balance sheets, many of those that reported large quarterly losses were forced to seek outside capital to plug the resulting hole in their balance sheets.
JF: How much worse do you think it can get?
RL: I think the majority of the write-downs tied directly to subprime mortgage-related securities are likely behind the large U.S. banks. These securities have all been significantly marked down, and since mid-March the market for these securities has shown signs of improvement. Moreover, a significant amount of pessimism around the continued decline in housing prices is already priced into these securities. That said, things could always get worse, and there is a tremendous amount of uncertainty today about when we will see a bottom in real estate.
Additionally, I think many of the commercial and retail banks (like Citigroup
JF: Do you think the majority of the capital raises are over for these banks?
RL: This is the big question today. As we look at it, the capital positions at the majority of the big banks appears adequate. However, each bank's financial strength is different. For example, JP Morgan is operating from a position of strength today, while Bank of America's position is somewhat weaker. For specifics, I would point investors to our individual company reports. Additionally, I would say that if it appears the economy starts to soften even more than it is today, we might see some banks look for capital prematurely. For the most part, the banks would prefer to be overcapitalized than undercapitalized, given the high uncertainty about the future direction of the markets.
JF: One criticism of these banks as potential investments is that their core earnings power will be permanently impaired. What is your take on that?
RL: This criticism comes up a lot today, specifically with the investment banks. Going forward, it is likely that there will be somewhat more regulation of investment banks following the collapse of Bear Stearns and the Federal Reserve's extension of credit directly to the primary dealers. Today, the form of any increased regulation is just conjecture. It is likely that the investment banks will operate with somewhat lower leverage, and in isolation, lower leverage would reduce earnings. However, as leverage is coming down, risk premiums are increasing, and I think that this will mitigate much of the effect of the reduced leverage in the long run. At their core, investment banks are in the business of buying and selling risk. They will likely be paid somewhat more for this service going forward. Additionally, the securitization market is virtually closed today, which cuts off one revenue stream to banks. Some were more dependent on the securitization than others. Merrill Lynch was a big collateralized debt obligation underwriter. However, Merrill has a diverse revenue stream, including an army of retail brokers, that will help to offset the lost securitization revenue. For other banks, especially banks like JP Morgan Chase that did little of this business, the effect will be minimal.
JF: Who do you think is best positioned to do well coming out of this environment?
RL: This is probably not a surprise, but I think JP Morgan Chase is one of the best positioned. Its balance sheet is in probably as good of shape as any of its competitors'. This allowed JP Morgan to acquire Bear Stearns, and I believe that this will likely be a highly accretive acquisition. Additionally, JP Morgan's strong balance sheet will allow CEO Jaime Dimon to undertake another acquisition on the retail banking side if he can find a target at the right price. Additionally, Goldman Sachs has managed the crisis as well as anyone. Out of the banks that made big mistakes, I think Morgan Stanley is in position to recover rather quickly because it never was a large CDO underwriter, and its core business appears to be in good shape.
JF: Which are you still most concerned about?
RL: There are lingering issues about Citigroup and how effective CEO Vikram Pandit will be in improving efficiency. Across the board I would not rule out further write-downs or capital raises, especially, if the credit markets weakened further. Continued stability and liquidity in the credit markets is the real key for the banks, going forward. Additionally, my colleague Jaime Peters has some concerns about Bank of America's capital level, which she believes could need some new equity when, or should I say if, it closes the Countrywide
Jaime Peters: Bank of America is currently operating with less capital than its long-term goal, despite dipping into the capital markets multiple times already. If Bank of America acquires Countrywide, the potential write-downs on Countrywide's held-for-investment loan portfolio could wipe out all of the target's book value. Consequently, Bank of America would need to provide capital to support Countrywide's balance sheet at a time when it has little to spare. At this point, we peg the chance Bank of America has to go back to the capital markets/cut its dividend around 50%.
JF: What do you think this means for investors?
RL: I think long-term investors will do well over time investing in these banks. However, investors should expect continued volatility in the near term. The issues in the housing in the credit markets are not going to disappear overnight and will continue to pressure the banks and produce negative headlines. I would caution investors to look at each bank individually. Each bank has a specific set of risks.
Justin Fuller, CFA, is an equity strategist with Morningstar.