The fundamentals of US banks suggest the present downturn should be very different from the Global Financial Crisis. We believe the current market environment presents the best opportunity in decades to invest in the US banking sector.
In the first quarter of 2020, US banks’ share prices declined by 52%, the fastest drawdown in the sector in history. The broad US equity markets have recovered their losses and are currently trading at all-time highs, but as of September 2020, banks are still down 37% - this dislocation presents a unique buying opportunity.
While pandemic-driven market volatility and panic selling brought back memories of the 2007–2009 Global Financial Crisis, the fundamentals suggest this downturn should be very different. Indeed, we believe the current market environment presents the best opportunity in decades to invest in US banks. A patient investor can earn substantial profits owning the sector at current levels.
US banks have four characteristics that underpin this view:
1. Robust loan portfolios with less credit risk than prior recessions
2. Strong capital
3. Low valuations
4. Resilient interest margins
Robust Loan Portfolios with Less Credit Risk than Prior Recessions
The loan portfolios of US banks are robust, and the market misperceives their credit risk. To provide more liquidity to the economy at the onset of the COVID-19 lockdowns, US regulators allowed banks to offer customers payment deferrals without penalizing or forcing them to set aside additional capital against these loans.
Banks reached out to their borrowers and offered up to six months of interest and/or principal payment relief, regardless of their current circumstances. Some borrowers took the offer because their businesses were directly impacted by lockdowns, and they couldn’t afford to pay. Others were managing well through the downturn but amidst a great deal of uncertainty, accepted relief as a short-term insurance policy.
At one point in June 2020, 16% of loans on US bank balance sheets were not paying according to initial terms. If this amount of loans had gone into foreclosure, even with a 50% recovery rate, losses would have wiped out the equity capital of the banking sector. Faced with this potential prospect, investors were understandably reticent to own bank stocks throughout the summer.
We took a different view.
After talking to a large number of bank management teams over the summer, we walked away with the understanding that the vast majority of loan deferrals were opportunistically taken, and the borrowers would resume paying at the end of their three- to six-month grace periods.
Indeed, loan deferrals among US banks have declined steadily from a peak of 16% in June to 3% in October. This declining trend should continue with deferrals settling between 2–4% by the end of 2020. This will represent the true stock of bad loans from the pandemic-induced recession of 2020.
Assuming a 50% recovery rate on these loans, write-offs should amount to 1–2%. For comparison, losses in the 2001 recession were 1% and the losses in the Global Financial Crisis were 4%.
US banks have the highest levels of capital for the past 80 years. After the Global Financial Crisis, regulators in the United States were laser-focused on putting safeguards in place to ensure banks would not stoke another systemic economic crisis.
Regulators stress-tested major banks annually and forced them to build capital. In the United States, banks entered the 2008 recession with thin levels of capital – around 6% – and 4% in aggregate loan losses quickly burned though that capital. As a result, many banks failed or had to issue hundreds of billions of dollars in equity dilution.
Due to the ownership dilution, even established market leaders like Citigroup experienced 80–90% price declines from which their stocks never recovered previous highs. Today, on the other hand, banks sit on 9% capital, 50% higher than in the prior recession.
Even if a similar amount of losses were to materialize this time around, banks would not need to issue new capital. In fact, as we explained above, we believe losses will be 1–2%, leaving the current share count for banks very stable.
US bank valuations today are the second cheapest in the last 35 years. Investors are understandably concerned about the global recession currently underway and have pared cyclical stocks from portfolios given their depressed earnings this year.
Banks now trade at 1.0 time their price-to-tangible book value, a valuation that has only been observed once before, at the bottom of the Global Financial Crisis.
With the understanding that banks will not need to issue new capital, we believe they will perform very strongly coming out of this recession, as the market starts to look forward to normalized earnings beyond 2020.
A typical bank will experience nearly a 50% decline in earnings during 2020, but by 2023, it should return to the same levels of earning as in 2019. The stock price should follow, and in many cases, we would expect bank stocks to double in price if 2019 valuations are recaptured.
Resilient Interest Margins
In March, US Treasury yields dropped below 1% across the entire yield curve for the first time in history and raised concerns that “US banks were turning Japanese.” Having dealt with negative interest rates for years, European and Japanese banks earn low returns of 5–7% on equity (ROEs) compared to 13–15% ROEs for US banks.
If US rates stay low or turn negative as in Europe and Japan, investors assume that the profitability of US banks would converge to the levels of their European and Japanese counterparts. We don’t share this view as there are some important structural differences to keep in mind between US banking institutions, and those in Europe and Japan. These differences are important drivers of profitability.
For example, US banks do not hold the lowest risk (and lowest yielding) loans on their balance sheets. Conforming residential mortgages are securitized with guarantees from US agencies Fannie Mae and Freddie Mac, and US municipalities raise capital in the bond market. As a result, US bank-lending spreads (and margins) are structurally higher than in Europe and Japan.
During the 70 years following World War II, US banks have consistently earned a risk-adjusted margin of 2.5% through a variety of interest-rate, economic and geopolitical environments. Meanwhile, European and Japanese banks have struggled to earn a 1% lending margin even when rates were positive.
We now own shares in 25 US banks and as part of our investment analysis, we re-priced their balance sheets to reflect the current rate environment. If these banks run off higher-rate legacy loans and re-price their entire balance sheets to current rate levels, they will still generate net interest margins (NIMs) of 3% before provisions for credit loss, while risk-adjusted NIMs (after normalized provisions) will remain in the vicinity of 2.5% or more, enabling them to comfortably produce double-digit returns on equity.
Banks are under-owned by institutional investors
Our current constructive view of US banks stands in sharp contrast with the positioning of large mutual and other institutional funds that have cut their ownership of the sector to the lowest level in a decade.
Our data only go back 10 years, but anecdotally we often hear about the lack of conviction from long-only mutual fund investors who may be the most under-weight the banking space in a generation. There are many catalysts that could trigger a rotation back into the sector, including the development of a viable vaccine for COVID-19 or a sudden increase in inflation expectations (concomitant with curve steepening) as a result of central bank accommodation and fiscal stimulus.
We can only speculate which driver will tip the scales and drive a re-rating of the sector, but at some point in the next two years, as US banks recover their pre-pandemic level of profitability, institutional flows will be re-allocated back to the space and drive meaningful share price appreciation in US banks.
If interest rates do not move from current levels and stay below 1% across the entire yield curve, we believe US banks will recover their pre-COVID-19 earnings (and prices) by 2023. That would give investors significant upside from current levels. And if rates move higher and the yield curve steepens, the upside from current levels will be extraordinary.