The Bear Case
While Bulls might be inclined to evaluate a bank’s profitability over the normal course of doing business, looking at things like credit quality, loan quality, growth and interest margins, if the last several years have shown anything, they’ve shown the fallacy of evaluating bank stocks based on “normal” times.
Investors taking the long view need to understand that returns on bank stocks are more likely to be dictated by irregular and sometimes cataclysmic (i.e. the bailout out of Citigroup Inc.) events.
For example, the KBW Bank Index, tracker of 24 of the nation’s biggest banks, showed a total return on bank stocks of 328% between 1993 and into the first half of 2007. But across nearly two years thereafter, those stocks lost 84% of their value before bottoming out in early 2009 at 33% below the level in 1993. History is full of such scenarios, some more severe than others, ranging from the Panic of 1873 to the Great Depression.
Many analysts recommend evaluating a bank’s financial strength and ability to thrive even in tough economic times by looking at its efficiency ratio —the percent of a bank’s revenue eaten up by operating expenses. (Bank of America has a high one.)
Those with high efficiency ratios are going to have substandard returns for investors. Aside from better profits for shareholders, a low efficiency ratio also means a bank has a lot more leeway for lowering interest rates or surviving troubled times. And the better rates a bank can offer, the better (i.e. more creditworthy) clientele it can attract. A solid financial performer should also be a lending institution with a healthy portfolio of non-interest income, namely fee-based income.
The real no-brainer, however, is to look at how the bank performed in the last downturn. Invest in one that not only didn’t need a bailout but one that didn’t take major risks for the sake of short-term versus long-term gains. That alone takes Bank of America and Citigroup off the list for smart investors.
And while Bank of America’s book of business may look a bit stronger these days given the massive weight of lawsuits under which it has staggered since the financial crisis, it’s still weak when compared to players like Wells Fargo.
The Charlotte-based bank reported 2014 third-quarter losses in the amount of $232 million or $.0.04 per share. Those losses have been due in part to litigation expenses, including its recent $5.3 billion settlement with the Department of Justice. That litigation wiped out, at least from an investor standpoint, any benefit to what Bank of America’s Chief Executive Officer Brian Moynihan called “improved profitability in most of our businesses relative to the year-ago quarter.”Since the financial crisis began, Bank of America has spent over $70 billion to handle legal matters.
Bank of America isn’t alone, however.
JPMorgan Chase also said anticipated legal issues in the months ahead could cost the bank up to $6 billion, eating into its profit margin.
Banks have also been compromised of late by rising interest rates, which have led to a significantly reduced demand for refinancings. The nation’s biggest home lender, Wells Fargo, had mortgage and refinancing originations drop by $65 billion in the second quarter of 2014 compared to a year earlier.
And there’s no denying that bank stocks have been bouncing around a good bit, never a good sign, since it increases the likelihood investors will buy high and sell low. In fact, some analysts say Bank of America’s stock is twice as volatile as the S&P 500.
Meanwhile, Citigroup Inc. doesn’t look like a good bet either. Its net income for the third quarter of 2013 presented a fair showing of $.3.4 billion, or $1.07 per diluted share, a slight increase from a year earlier when it posted net income of $3.2 billion, $1 per share. The bank has yet to pass Federal Reserve stress tests, having shown an inability to adequately project revenue and losses in the event of a significant economic downturn.
While the bank has certainly climbed a good ways out of the hole it was in in 2008, when it accepted a $45 billion bailout from the federal government, it remains on less than solid footing for an investor without an appetite for risk.
Because banks tend to be heavily leveraged, even in our stricter regulatory climate, even a little drop in asset values can cause insolvency. Before you invest in big bank stocks, consider not how the financial institution is performing now but how likely it is to weather an economic crisis (and another will come eventually) with aplomb in the future.
The Bull Case
While investors may have been turned off by many of the big banks’ delinquent loan portfolios, those loans have been rapidly sliding off the books, as financial firms have sought to sell off nonperformers. Bank of America has been especially aggressive, having sold off more than $1 trillion in nonperforming loans in the last five years. In the third quarter of 2014, the bank had 221,000 delinquent loans in its portfolio, a drop of 44% from a year earlier. Bank of America has said it anticipates “normal” delinquent loan levels by 2016.
According to the Office of the Comptroller of the Currency, the nation’s seven biggest banks have all seen noteworthy improvements in delinquent loan balances. Nationwide about 5.2% of residential mortgages remained seriously delinquent at the close of the third quarter of 2014, compared to 5.5% a year earlier.
Wells Fargo’s Chief Risk Officer Mike Loughlin said in a third-quarter statement to shareholders, “Credit quality continued to trend positively in the third quarter as loan losses remained at historic lows, nonperforming assets continued to decrease, delinquency rates were stable, and we continued to originate high quality loans.”
It’s a trend among all the big banks right now.
They are all also nearing the end of years of litigation woes. While Bears may caution against investing in financial institutions dogged by lawsuits, it looks like the worst is over.
Litigation is, in fact, the main reason for Bank of America’s poor showing in the third quarter of 2014. In fact, with so much litigation behind it, the banks’ investors can now breathe a sigh of relief and, most likely, look for profits in the quarters to come. The same is true for JPMorgan Chase, which reached a $13 million settlement with the Justice Department and Citigroup, which settled in September for a $7 billion DOJ fine.
Many analysts claim Bank of America is a pretty safe investment bet given its stable operating performance. And the bank has really ramped up its wealth management activities, posting over $3 billion in revenue in that segment in the second quarter of last year and $4.7 billion in revenue in the third quarter.
Yes, Bank of America only generated a 4% return on equity in 2013, but plenty of analysts think the bank’s poor showing has been the result of five years of legal drama, which is now winding down. In the long-term, they say, the bank should easily generate double-digit return, meaning trading at book value or higher is a reasonably safe bet.
However, if you’re still skittish, then look to Wells Fargo and JPMorgan, which are both paying dividends at nearly 3%. If you’re going to invest in big banks and aren’t sure about making a long-term commitment, it may be best to skip over Bank of America for now and go with the current bigger income-earners, Wells Fargo and JPMorgan. Bank of America is for long-term investors.
Wells Fargo, which is currently the most profitable U.S. bank, posted $5.7 billion in net income for the third quarter of 2014, up 3% from the third quarter of 2014, according to the company’s latest financial report.
Diluted earnings per share stood at $1.02, a 3% increase, and the banks efficiency ratio stood at 57.7%, a 140 basis points improvement. Wells Fargo reported third quarter return on equity of 13%. For the first nine months of 2014, earnings per share averaged $3.08. On a trailing 12-month basis, the bank has paid out 33% of its profits in dividends, compared to about 18% (a 1.2% yield) for Bank of America.
Wells is also well-capitalized with a reported Tier 1 capital ratio of 11.6% as of Sept. 20, 2014. The bank has passed the Federal Reserve’s stress tests with flying colors, meaning it’s well-poised to weather a recession.
The nation’s largest home lender, Wells Fargo has also seen substantial growth in both loans and deposits with $833.2 billion of loans by the end of the third quarter of 2014, an increase of $31.1 billion from a year earlier. And total average deposits were up 10%. The bank’s nonperforming assets have dropped 15%.
In a statement to shareholders, Wells Fargo Chairman and CEO John Stumpf said, “The company’s third-quarter results demonstrated strength in the fundamental drivers of our long-term growth. Loan and deposit growth was strong and diversified across both commercial and consumer businesses. Capital levels increased even as we returned more capital to shareholders through higher dividends and share repurchases from a year ago.”
The bank’s CFO, John Shrewsberry, attributed Wells Fargo’s strong position to the firm’s “diversified business model.”
Another clear bet is JPMorgan Chase, which posted net income of $5.6 billion, or $1.36 per share, in the third quarter of 2014. A year earlier, the nation’s biggest bank was looking at a $380 million loss, or $0.17 per share loss. JPMorgan has been especially aggressive of late in acquiring non-interest income and boasts 8% wallet share in its Global Investment Banking sector. The bank also holds a Common Equity Tier 1 ratio of 10.1% as of the close of the third quarter of last year.
Chairman and CEO Jamie Dimon said in a third-quarter report to shareholders, “Consumer & Community Banking deposit growth led the nation as the FDIC reported Chase No. 1 in deposit growth for the third consecutive year.” JPMorgan’s deposits climbed 8.8% compared to the average market growth rate of 3.2%.
And while mortgage originations dropped 48% for JPMorgan from a year earlier, the third quarter did see origination gains of 26% when compared to the previous quarter.
All in all, the big banks are poised for growth and increasing revenue in the long-term.
Editor’s note: Bull vs. Bear is a non-positional column designed to present both “bull” and “bear” cases surrounding a publicly traded stock representative of the U.S. housing economy. Analysis focuses primarily on macro economic factors, and the column is designed to allow investors to choose for themselves which case presented makes the most sense for their own investment objectives. HousingWire does not recommend any specific investments.
