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For Banks, Uncertainty Reigns

Questions surround the banking industry, but opportunities are out there for investors with a healthy tolerance for risk.

Philip Guziec, 10/18/2011

Banks have been on somewhat of a rollercoaster ride in the past couple of years, and there's little on the horizon to suggest that the ride is coming to an end anytime soon. I recently sat down with members of Morningstar's financial-services team to discuss where banks stand, and their message was clear: Amid uncertainty, look for banks with solid fundamentals.

Philip Guziec: What's the status of the ongoing saga with the global banking industry?

Jim Sinegal: Three major issues hang over the banking sector. The first is Europe. Everyone knows that the banks have a lot of bad assets to deal with, and we haven't seen a good solution to that problem. Second, a lot of macroeconomic concerns have come back in the past few weeks. What is GDP growth going to look like in the United States? What are the implications on credit growth for banks, and how does that affect their profitability going forward? Third is regulation. For the next year, at least, we are going to see a lot of new regulations finalized around Basel III and the Dodd-Frank Act. No one's sure exactly how that's going to turn out.

Guziec: In terms of regulation, what's the range of outcomes that you see for long-run banking earnings and valuations? If you see a healthy bank, how do you figure what the impact of regulation is going to be?

Sinegal: There are two ways to look at it. First is, what will the final regulations be? How much capital are banks going to be able to hold? Second is, how is that going to affect their profitability? Is decreasing leverage going to proportionately reduce profitability? Or are banks going to find ways to deal with that? In a lot of areas, banks are going to find ways to deal with it. You always see new fees, and we've seen a lot of that already. Banks have a lot of ways to deal with it, but the uncertainty has been an issue regardless. 

Guziec: So, your take is that one way or another we're going to get ROEs going forward that are comparable to what we saw over the past decade? What are we looking at?

Sinegal: Banking, at its heart, is a cost-of-capital, commodity-type business. So, on average, I think we're going to see cost-of-capital-type returns, and you could argue that the cost of capital will maybe go down a little bit with lower leverage. Some of the most-advantaged banks will still be able to deliver pretty good returns.

Guziec: How about the macro/GDP situation? You've got a short-term impact on banks. Do you think we're going to lose any more banks? How does that affect the long-run scenario?

Sinegal: That's something you have to worry about. If you're investing in banks, you don't want to necessarily pay for a lot of margin-expansion and credit-growth potential. You want to make sure that there's a big enough margin of safety to account for a poorer macroeconomic situation going forward.

Erin Davis: In a slow-growth environment, you have to be careful of banks looking for growth in riskier areas, too. That's what we're seeing in Europe. A lot of the European banks are seeing slow growth in their home markets, so they're expanding into other markets. Turkey's very hot right now, but there's a lot of uncertainty there, both politically and economically, and that could turn out badly. There's maybe less of that in the United States, but it's always something to watch out for.

Sinegal: There's always something to worry about with banks. A lot of people right now are worried that credit growth in developed markets is going to be slow, so there's a good argument that you might want to move toward emerging markets that have a lot more room for expansion on the credit front. The flip side is that those countries are still emerging markets, which historically have had a lot more volatile economic results. So, do you settle for slow, maybe negligible growth in developed markets, or do you take the risk of faster, more-volatile growth in emerging markets?

James Leonard: Where the United States is right now, compared with four years ago, in terms of bank regulation and supervision, is 200% better.

Guziec: "Better," meaning better contained, or "better," meaning better for earnings?

Leonard: Better in terms of not being allowed to blow themselves up. Their capital levels are much better. They're more scrutinized in terms of what they're doing with structured products and things that can get out of control quickly before anyone realizes it. From that perspective, banks are safer than they were, but there are still the global problems that we run into every 10 years. I do think that banks will have lower earnings, but I think investors should definitely be willing to pay for that, given where the price/earnings multiples are. Are you going to get great, tech-boom-of-the-1990s numbers? No. But you're getting safe, relatively sound investments for low prices.

Guziec: Given that there's not a lot of potential opportunity for growth and an ongoing slow macroeconomic environment, how do you see banks reacting?

Michael Kon: The natural thing for the industry to do is consolidate. Unlike Japan, where they had a fairly concentrated market compared with the U.S. market, here you have more than 7,000 banks operating in a market where regulatory costs are going up, funding pressures and margin pressures exist because of low interest rates, and there is a limit to how much you can cut your operating expenses. The only way to grow or to improve your returns on capital is to buy your competitors, cut costs, consolidate your branches, downsize the operation, gain scale in the local market, and improve your pricing power.

Guziec: Is the potential earnings growth of consolidation reflected in share prices now?

Kon: I don't think so. There's too much economic uncertainty right now for the stock market to reflect this scenario.

Sinegal: It was at the end of 2010. There were a couple of deals in the industry, and everyone got really excited about the prospects of more M&A. The problem is this: When stock prices jumped, all of a sudden there was a much bigger gap between buyers and sellers. I think that gap will continue to narrow over time. You have a lot of banks now that are much healthier with a lot more capital, but with loan demand low and securities not yielding very much, there's not a lot of good places to put it. One thing you could do with your excess capital, if you're a healthy bank, is buy someone else. And I think that as time goes by and loan problems are out in the open, buyers are becoming more comfortable with sellers' books, and at the same time, the pressure on sellers is increasing because of all these factors that look certain to hurt profitability.

Kon: We've been talking about it for a year now, but a lot of uncertainty regarding Europe and uncertainty on the regulatory front prevented banks from making bold moves. We've seen some deals this year--M&I Bank got bought by Bank of Montreal BMO, Royal Bank of Canada RY sold its subsidiary in the southeast U.S., Capital One COF did two deals--I think things are going to accelerate once we get an idea of where Europe is headed and more clarity on the regulatory issues.

Guziec: Given the uncertainty, the fact that takeover premiums aren't priced in--where are the best opportunities if investors want to scoop something up now?

Kon: The opportunities for investors will be where most of the pressure is. And the pressure is more on the smaller banks than the larger banks, at least for now. For the larger banks, there is a limit to how much they can buy. Bank of America BAC can't merge with J.P. Morgan Chase JPM because it would probably become a monopoly in the U.S. deposit business. So, the pressures are on the small banks because of high regulatory costs and low margins. Probably most of the sellers will come from that group.

Sinegal: And you could argue that it's probably better to play the buyers rather than the sellers. I think the buyers are going to be the ones to benefit, more so than in other industries, where people focus on the sellers hoping for some sort of takeout premium.

Kon: I think the exception to that is a unique company; for example, Discover Financial DFS. There are only four global card networks. Issuers don't have credit card networks; they have to rely on networks such as Visa V and MasterCard MA, and a unique network such as Discover's could be attractive to a large issuer. Another example is Northern Trust NTRS. A lot of larger banks talk about growing in the high-net-worth space; Northern Trust is the 800-pound gorilla in the space, and it is fairly digestible, in terms of size and market cap, for a larger institution.

Guziec: We haven't talked about Europe yet.

Davis: There's a lot of macroeconomic uncertainty in Europe that's affecting bank share prices. It's unusual to find a bank in Europe trading for book value, even, which means that investors think that there are questionable assets hidden in their books.

Sinegal: I think they're right.

Davis: There are a lot of banks in Europe that still need to raise capital. Some of that is now less hidden because of the European stress test--all of the big banks had to disclose what their sovereign debt holdings were and what their exposures were, country by country--but it's still not clear what kind of markdowns we're going to see on sovereign debt.

Sinegal: The two things you want to see when you invest in a bank are good assets and stable funding, and a lot of the European banks have neither.

Leonard: And it's not the traditional problems. You normally see a bank with some traditional problems in certain assets, but now you're talking about the sovereigns, and that's a little more shocking, at least to U.S. investors.

Davis: For the most part, European banks' mortgage books look fine. Their problems are much bigger and less plain vanilla. And a lot of banks, and even some pretty big ones, are depending on the European Central Bank for funding--they aren't able to fund themselves sufficiently through deposits. There's a rush to try to gather deposits, but there are only so many deposits to go around, and that's causing net interest margins to compress. There are a lot of problems.

Guziec: For investors in U.S. banks, are there concerns related to the European situation?

Sinegal: I don't think that there are a lot of direct exposures that are going to affect U.S. banks. If we see these big banks in Europe running into problems, obviously it's not good for the global economy and not good for U.S. banks. But U.S. banks can probably work through it in the short run.

Guziec: Is the distress in Europe creating any investment opportunities that we can identify?

Sinegal: It's certainly causing investment opportunities in U.S. banks, in terms of banks being underpriced in the United States because of contagion fear.

Guziec: So, if we were to summarize the current state of the market as of Aug. 11, distress in Europe is causing potential contagion fear in the United States, which is possibly creating some deals among the banking stocks.

Davis: Some banks had really big problems and have made significant progress toward cleaning them up and that have fairly simple business plans that are priced attractively in Europe. I don't think that share prices are necessarily going to improve until the Europe problem is solved more generally, but if they don't have much exposure to it, they'll probably be OK. Examples might be Commerzbank CRZBY in Germany and Lloyds LYG in the U.K. Those are both banks that have both made pretty good progress toward cleaning up their books. Something would have to happen that's not on investors' radar right now to really hurt them.

Sinegal: Financial institutions are always something of a black box, and it's important for investors to decide where on the spectrum they're comfortable taking risk.

Davis: And to be somewhat diversified. You'd hate to put all of your retirement savings into even a really good bank, like Wells Fargo WFC, because something could always be lurking.

Philip Guziec, CFA, is a derivatives strategist for Morningstar and co-editor of Morningstar OptionInvestor online newsletter and research service.

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