Our Outlook for Bank Stocks
Bank fears reached a new crescendo in the first quarter.
Quarter-End Insights
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Due to mounting fears about credit losses and an increasingly harsh political climate, bank stocks' valuations compressed to new lows in the first quarter of 2009. Many of the best banks traded well below book value and the majority of lesser banks came to resemble penny stocks during the quarter as investors began to price in high probabilities on the most dire potential outcomes such as nationalization or receivership across the board.
While we concede the downside risk to the economy and the potential for the administration to come under pressure from constituents to reverse the present course, key decision makers have continued to signal that there will be "no more Lehmans" and that additional equity capital is available to systemically important financial institutions should the need arise. It should be noted that trading in nonguaranteed bank bonds and preferred stocks still reflects considerable fear on this front, despite assurances to the contrary.
Valuations by Industry
With the exception of some remaining investment banks like Morgan Stanley (MS) and Goldman Sachs (GS), most financial firms with credit risk on their balance sheet faced significant sell-offs during the first quarter, as evidenced in the chart below.
| Bank Industry Valuations | |||||
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| Star Rating | Price/Fair Value* | P/FV Three Months Prior | Change (%) | Uncertainty | |
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| Finance | 3.9 | 0.46 | 0.52 | -12% | 83% |
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| International Banks | 3.3 | 0.51 | 0.55 | -7% | 100% |
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| Regional Banks | 4.0 | 0.53 | 0.63 | -16% | 70% |
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| REITs | 3.6 | 0.63 | 0.78 | -19% | 84% |
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| Savings & Loans | 4.2 | 0.66 | 0.86 | -23% | 54% |
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| Securities | 3.0 | 0.82 | 0.73 | 12% | 87% |
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| Super Regional Banks | 4.6 | 0.35 | 0.69 | -49% | 90% |
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| Data as of 3-13-09. *Market-Weighted Harmonic Mean **Ranks the industry's fair value uncertainty (most uncertain =100) based on the aggregate market-weighted uncertainty ratings of all industries under coverage. |
For banks, sliding fourth-quarter earnings, bleak forward guidance, the U.S. Treasury's announcement regarding the initiation of a round of stress tests, and tougher political winds resulting from bailout fatigue all combined to pressure industry valuations to a degree not seen since the S&L crisis. While TARP capital infusions bolstered Tier 1 capital for all recipients, more and more banks began losing money--as reported during fourth-quarter earnings season--due to a combination of rising credit losses, stepped up provisioning, additional security write-downs, and reduced fee income. In light of this nasty combination of factors, bank analysts (and equity investors more broadly) changed their focus toward tangible equity capital, which takes the first hit from higher provisioning during this portion of the credit cycle.
We conducted our own version of a stress test to assess the largest banks' potential need for additional tangible common equity given our forecast for revenue over the next two years, combined with scenarios of varying severity regarding credit losses. The big-picture result showed that Citigroup (C) likely needed additional tangible common equity in most scenarios (following our stress test, the government obliged by offering to convert some previously issued preferred capital into common), while several large banks such as Bank of America (BAC), State Street (STT), PNC Financial (PNC), Suntrust , Fifth Third (FITB), and Keycorp (KEY) may need additional equity capital at a 10% cumulative loss rate, which would imply a substantially worse economic situation than we currently face. On a more encouraging note, we think several large banks could withstand a 10% cumulative loss rate based on current capital and provisioning levels, including JP Morgan (JPM), Well Fargo (WFC), Bank of New York Mellon (BK), US Bancorp (USB), Regions Financial (RF), and BB&T (BBT). Given the currently steep negative trajectory of the economy and the steady increase in loan losses across most every category, it is clear that this supercharged credit cycle will stress the entire banking industry to varying degrees based on underwriting quality, geography, product mix, and a variety of other factors.
Our Top Bank and REIT Picks
Given the extremely challenging and uncertain macro outlook, viewed in the context of global deleveraging by a substantial portion of households, corporations, and financial intermediaries, our stance reflects our judgment that investors should stick to high ground in the space. Our goal has been to recommend protection of capital by investing in firms that we think have a solid chance of surviving even the worst macro outcome, rather than attempting to shoot the lights out for the highest return from the most marginal players with the shakiest balance sheets, the very entities that will rally the most at some point--at least for those that barely survive the depths of this uber credit cycle.
| Top Bank and REIT Sector Picks | |||||
| | | | | |
| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Price/ | |
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| American Express |  | $54.00 | Wide | Very High | 0.26 |
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| City National |  | $64.00 | Narrow | High | 0.53 |
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| Host Hotels & Resort | | $15.00 | Narrow | Very High | 0.32 |
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| US Bancorp | | $31.00 | Wide | High | 0.52 |
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| Valley National Bancorp | | $19.00 | Narrow | Medium | 0.62 |
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| Data as of 3-25-09. |
American Express (AXP) is facing the worst loss cycle for credit cards since they emerged on the scene, which is only compounded by mistakes this particular firm made with outsized portfolio growth at the peak of the cycle. That said, its fee-based spend-centric model will help absorb the current pain and will continue to produce outsized earnings on the other side of this cycle.
City National is one of the best houses in a bad neighborhood. While California is facing a dreadful housing and employment market, we think that City National's solid underwriting and focus on affluent customers will help it pass this harrowing test, positioning the bank to survey and exploit the damage.
Although we expect sharp asset and rent deflation over the next few years in the hotel REIT space due to plummeting demand and excess supply, Host Hotels & Resorts (HST) should weather the storm much better than peers because of its stronger balance sheet and attractive property portfolio.
US Bancorp (USB) stands very near to the highest ground in the banking space. Not only does it benefit from a solid core franchise and underwriting culture, its fee-based businesses would allow this bank to endure much more pain than most of its peers could withstand.
Valley National Bancorp (VLY) has not faced a losing quarter since its inception in 1927. We think this bank's ultraconservative underwriting standards will meet the test posed by this sharp cycle as well.
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