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Quarter-End Insights

Financial Services: Housing Market Still on the Worry List

Bargains are still hard to find in financial services, as the U.S. mortgage market is stuck in limbo and housing bubble concerns rise in Canada.

Stephen Ellis
  • The financial services sector appears to be fairly valued. The overall industry trades at a price to fair value ratio of 1.02, which suggests bargains are limited. The cheapest subsector is Latin American banks at a price to fair value ratio of 0.88, while the most overvalued subsectors are regional U.S. banks, saving and cooperative banks, and Asian banks, with price to fair value ratios of 1.09.
  • The U.S. mortgage market continues to be in limbo. With Fannie Mae and Freddie Mac in the process of being wound down, better positioned banks will need to focus on developing long-term advantages in the market through economies of scale, low funding costs, underwriting quality, revenue generation ability, and operating efficiency. Regional banks with significant mortgage exposure are most susceptible to market share losses as they lack the scale or cost advantages needed to maintain share in a more heavily regulated market.
  • The Canadian housing bubble is another source of concern. While we have numerous concerns, we highlight three of the major areas: housing affordability, the impact of immigration, and the Canadian government's ability to create a soft landing for the Canadian housing market.

 

Bargains continue to be challenging to find in the financial services industry, and we broadly see the space as fairly valued today. In today's market, we think careful stock-picking will be rewarded, and highlight three top picks,  Apollo Global Management (APO),  Synchrony Financial (SYF), and  Standard Chartered PLC (STAN).

In the U.S., the mortgage market continues to be in limbo. Mortgage origination, servicing, and investment activities account for a significant portion of assets and revenue at U.S. banks, yet the mortgage market has been in limbo for over half a decade. Government involvement is at an all-time high, with the Federal Reserve supporting the mortgage market by purchasing securities guaranteed by the Treasury. Virtually no politicians, regulators, or market participants are happy with Fannie Mae and Freddie Mac--now operating in conservatorship--but the two organizations dominate the mortgage industry. Several proposals for reform are in progress, but each option is an experiment that would have uncertain outcomes for the U.S. economy and homeownership. We think the wind-down of Fannie and Freddie will be the biggest change the financial system has experienced in half a century.

Mortgage servicers, which typically earn only a few basis points annually on the loans they service, have little room to maneuver around new regulations. The combination of higher capital costs and a litany of new procedural requirements ensure that banks will be able to serve only the simplest of accounts, and those that offer other revenue-generating opportunities.

Originators have more room to adjust their business models in a changing market, and we expect technology-related expenses to increase as firms cut head count in response to declining volumes. However, gain on sale margins are likely to decline as Fannie Mae and Freddie Mac decline in importance and low-cost competitors increasingly win market share.

Overall, we think a more competitive--and less subsidized--market will result in a barbelling of market share and profits. In servicing, scale will grow in importance for basic functions, producing an advantage for the largest banks. Capital- and effort-intensive functions are likely to move outside the banking system, where less-regulated firms have an advantage. Similarly, origination will continue to be profitable at massive banks that can spread fixed costs over a large volume of similar loans, though low-cost online competitors are likely to gain share, especially from medium-size firms lacking economies of scale.

In Canada, we remain concerned about the housing bubble, and highlight several key troublesome areas. Bulls argue that housing is still affordable in Canada, and the market is balanced. However, affordability changes drastically if interest rates revert toward historical means. Over the past 30 years, mortgage rates have declined in nearly every month compared with rates five years prior. This means that most Canadians have seen continually lower mortgage payments. In this environment, home affordability has expanded.

Canadian housing bulls also suggest that immigration of people into Canada, particularly wealthy Asians from China and other Pacific Rim countries, has been the cause of home pricing inflation. However, although some of the price increases have been attributed to wealthy foreign buyers, especially Asians seeking quick citizenship into Canada, this has been a very small percentage of immigrants. Wealthy Asians may have had a localized impact on some housing markets, but it would be unfair to attribute the increase in pricing only to net immigration.

Finally, housing bulls suggest that the Canadian government and its agencies have been taking steps to create a soft landing for Canadian home pricing. For example, the increase in mortgage insurance premiums will increase mortgage payments without burdening the mortgage payer. We note that despite the actions of its government entities, Canadian home prices have continued to increase and are up more than 27% since 2009. Although the intention of the government agencies and officials is laudable, the impact upon market pricing has been negligible, in our opinion. 

Top Financial Services Sector Picks

Star Rating Fair Value
Estimate 		Economic
Moat 		Fair Value
Uncertainty 		Consider
Buying
Apollo Global Management $40.00 Narrow High $24.00
Synchrony Financial $33.00 Narrow High $19.80
Standard Chartered 1630 GBX Narrow High 978 GBX
Data as of 09-16-2014

 Apollo Global Management (APO)
Apollo is a global alternative asset manager with over $160 billion in assets under management deployed across private equity, credit, and real estate strategies. Notably, Apollo manages AUM for Athene, a fixed annuity provider, which provides Apollo with a $60 billion-plus source of permanent capital. We believe the market is overly focused on the short-term health of the IPO market and the near-term pace of realizations, and overlooking the strong growth prospects Apollo has within credit, thanks to regulators forcing banks to sell illiquid and risky assets to Apollo at a discount. 

 Synchrony Financial (SYF)
Formerly General Electric Capital Retail Finance, Synchrony provides a range of credit products through programs established with a diverse group of national and regional retailers, local merchants, manufacturers, industry associations, and health-care providers, which the company refers to as its "partners."  We think Synchrony has built strong switching costs around its ecosystem of partners, and as a result, earns high yields and high margins in its credit card business.  Our fair value estimate implies a 2015 multiple of 10.3 times earnings. While the market appears concerned about credit quality with Synchrony, we think the company prices its yield to compensate for any additional risk in its granular retail card portfolio. 

 Standard Chartered PLC (STAN)
We think that the market's excessive focus on the slowdown in Standard Chartered's near-term growth has created an opportunity for long-term investors to buy into the name at an attractive valuation. We expect revenue growth to be under 6% in 2014 as the company pulls back in South Korea, compared with an average of 14% since 2007. However, we think that the narrow-moat trade bank's competitive advantages, built on its huge low-cost deposit base and network across fast-growing markets, remain intact. Moreover, we think Standard Chartered has managed its exposure to a slowdown in China well: Its direct exposure to mainland China is less than 5% of total assets, and its exposure to commercial real estate (the segment that typically shows the biggest losses in a property bubble bust) in Hong Kong and Singapore combined is less than 15% of shareholders' equity (as of June 30, 2013). We think that the bank will continue to out-earn its cost of equity, even in this more difficult environment, and that its market price, at 1.1 times book value and 11.9 times forward P/E, looks compelling.

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