Unjustified Panic Creates Opportunities in U.S. Bank Stocks

Global bank stocks have been routed over the past several weeks because fears of energy-related credit losses, global deflation, and potential interbank contagion are increasingly weighing on the sector.

We think the dour outlook is premature for several reasons. First, exposure to the energy sector--both direct and indirect--is more than manageable. Below-investment-grade energy bonds are pricing in losses of roughly 30%, which would result in losses of only 2.5% of equity value, or only one quarter's worth of earnings for a bank otherwise achieving a 10% return on tangible common equity. Otherwise, most large U.S. bank balance sheets remain rock-solid, in our view. Underwriting standards, especially with respect to consumer loans, have been unusually conservative since 2008, and securities portfolios are now tilted toward short-term liquid assets rather than the idiosyncratic illiquid holdings that prevailed prior to the global financial crisis.

Furthermore, though declining long-term interest rates are problematic in the short-term, we expect lower mortgage rates--along with a sizable and aging population of millennials, easing credit standards, and a reasonably healthy employment market—to contribute to an eventual rebound of the housing market. Finally, counterparty risk and notional derivative exposures are at the top of investors’ minds. Here too, we believe fears are overblown. Net exposures to individual asset classes, events, or counterparties are relatively manageable-especially in the case of interest rates which make up a bulk of reported notional exposures.

Though capital worries are clearly affecting some global peers, we think insolvency fears are exaggerated from both a fundamental and practical perspective.

For longer-term investors, we think 2016 headwinds are fully priced in for

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