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Tough Environment for Banks, but Stocks Look Cheap

Jeremy Glaser

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. Bank stocks had one of their worst trends since the height of the financial crisis over the last week. I'm here today with the Morningstar's associate director of banks, Jim Sinegal to take a look at what's happening.

Jim, thanks for joining me today.

Jim Sinegal: Thanks for having me.

Glaser: So, can you just give us an overview of why are the banks selling off so strongly, and even more than the broader market?

Sinegal: I think there are a few reasons. I think, number one, perhaps, obviously, in some ways, maybe not so obviously in other ways, was the Standard & Poor's downgrade of the U.S. government debt. I think the major fear there originally was that it would have effects on banks' operations. I don't think that's a big problem. What I do think is the implications of the cut on government spending. I think S&P said that the government had cut spending and less than S&P had wanted it to.

There is a lot of political pressure to cut spending. Something I've been telling people, I think the market is Keynesian and definitely did not like the idea of government spending cuts. I think that's why Treasuries were up; I think that's why the stock market was down. And those deflationary pressures are really bad for banks and as compared to the market in general.

I think the second reason obviously is the legal risks have kind of come to the forefront again. BofA looked like it had reached the settlement on mortgage putbacks. Now AIG is suing BofA. The New York Attorney General is after BofA. So, a lot of these mortgages issues that investor thought were put in the past or maybe not as far behind as we thought.

Glaser: So, we certainly have been talking about bad loans and the mortgages in particular for it seems like a few years now; it has been a few years now. Have most of banks really put this behind them? I mean is this just we're hearing a few little, a lawsuit here or lawsuit there or is this still really a large systemic problem that investors in the sector need to be focused on?

Sinegal: I don't think it's a major problem for a lot of the banks. I think that for Bank of America for instance, it's a major problem, because they assume so many liabilities or potential liabilities with the Countrywide acquisition. BofA paid a few dollars, and it got many, many billions of dollars in potential legal liabilities for what they paid. It's a big problem for the firm.

With some of the smaller regionals that weren't mortgage originators, I think a lot of their bad loans are off their balance sheets. The loans made in '04 or '05, they've either charged off or been replaced by new loans, made in 2009 and 2010, and they had much more conservative underwriting standards. So I think for a lot of the smaller banks, a bad loans aren't nearly the problem they were a few years ago.

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Glaser: So are you worried we're going to go back to those days of 2008 where there were capital raises and banks really needing to show up their capital, or are do you think that most of banks are comfortable with their capital levels right now?

Sinegal: I think most banks are comfortable with their capital levels. I think if you look at the absolute levels, they're 2 to 3 times higher than what they were at the depths of the previous crisis. Again, reserves are higher, and the number of bad loans is nowhere near as large as it was. So I don't think that's a concern. I think the concern in the banking sector is more macroeconomic in nature, and just that it's going to be a deflationary environment, an environment of low loan growth, low interest margins, and increased credit losses. It's just not good for bank profits.

Glaser: So, it's another good question about normalized earnings power. We've been talking a lot about, how we're waiting for banks to get back to that normal to really show their full earnings power. When is that going to happen?

Sinegal: That's a great question. I think it's uncertain. I don't think it's going to happen for quite some time. With the Fed statement, that it looks like interest rates are going to be low for the next couple of years, that's something that's a big headwind for the banks. A lot of the banks are kind of waiting to make new loans until interest rates get higher. The low, flat yield curve is not good for bank earnings. So, it looks like it could be some time before we see a lot of improvement.

That said, with the drop in stock prices a lot of that we think is priced into some of the bank names now. So, even if earnings don't improve a lot, you're paying, in a lot of cases, single-digit multiples on 2011 earnings, which even if things don't get a lot better, it's still not that bad of deal.

Glaser: Before the crisis a lot of investors brought bank stocks for the yield and dividends obviously went away and are now slowly starting to come back. Do you see any good yield plays within the banks right now?

Sinegal: With yield plays, there aren't a ton. There are a few regional banks with attractive yields. A bank like Valley National Bank, I think, was yielding in the neighborhood of 6%. It's a really high-quality bank and a name we liked a lot. We don't think the stock is cheap on a price-to-fair value basis, but for investors looking for yield, a bank like that could be really attractive.

Glaser: Are there any other names that maybe don't have great yields right now, but that you think might be able to get through this potential slowdown and still give investors a good return?

Sinegal: I think it's probably won't surprise you that I'm going to recommend a lot of the highest-quality names, banks like, Wells Fargo, U.S. Bank, and PNC. Those are really well-managed banks, very profitable banks already, and the stock prices have fallen enough to make them really attractive plays in our view. Another name that might be more surprising is, we've been taking a closer look at Citigroup. It briefly hit 5 stars Monday. It might be out of that territory now, but that's a bank that raised a ton of capital, and it has a lot of good things going for it.

It's shrinking their business as opposed to a bank like BofA that is still trying to integrate all of these acquisitions. It has a strong emerging-markets tailwind. If credit growth is a major problem in the U.S., Citigroup is really the only U.S. bank that could benefit from growth elsewhere in the world. So, it has a lot more going for them now than it did in the depths of the crisis. It still has, I guess, enough of a poor reputation that the stock is getting really cheap.

Glaser: Jim, thanks for your thoughts, today.

Sinegal: You're welcome. Thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser.