Tuesday, December 5, 2017

A Spike in Bank Stocks?

U.S. bank stocks have enjoyed a smooth, upward ride in recent weeks. What explains the rise?
Take a look at how bank stocks have soared in recent weeks:  Share prices at JPMorgan have climbed 10% since early November, 8% at PNC Financial, 8% at Regions, 9% at Citi, and even 8% at Wells Fargo, the big bank that has had its share of reputational and off-balance-sheet issues the past year and a half. Bank of America shares have inched up almost 2%. 

What spurs such a spike in share prices? And is this spike subject to a later freefall after the market has deciphered and digested the bundle of financial news that has caused the spike in the first place? Or have market values risen to a new plateau?

Equity analysts often compare market values to book values (MV/BV) and try to determine how much a bank's market value (from share prices) exceed book value (net assets on the balance sheet).  The more confident investors feel about the strength of the bank's balance sheet, the way the bank manages an array of credit and market risks, and the "sustainability" and "predictability" of earnings, the higher the market value (relative to book value).

The same group of banks above (except for Citi) now show MV/BV ratio in a 1.2-1.4 range.  Investors appear comfortable that banks are measuring and managing risks and will be able to generate a predictable level of satisfactory earnings. (Citi continues to lag in this metric, but it, too, has seen upturns in overall market value in the past year.)

Consider how just a short time ago (a year ago? two years ago?) banks barely reached beyond MV/BV=1, and many showed MV/BV less than 1.  When the ratio falls shy of 1, equity analysts will rationalize shareholders are better off if banks break themselves up and sell of divisions, sectors, and subsidiaries.  (Buy the shares at 80; sell the various assets at book value at 100, and reap gains.)

What explains the rise?

<1 a="" ago="" analysts="" and="" at="" bank="" banks="" better="" book="" broken="" but="" chorus="" consolidated.="" cried="" discount="" divisions="" equity="" feed="" in="" into="" is="" it="" less="" might="" more="" nbsp="" of="" off="" or="" outcry="" p="" pieces.="" separated="" shareholders="" shares="" so.="" sold="" some="" spurred="" still="" suggesting="" than="" that="" the="" this="" to="" trading="" two="" up="" value="" was="" way="" were="" who="" worth="" years="">Some say favorable tax treatment (under the proposed U.S. legislation) explains rises in value.  If banks pay less in taxes, then they certainly will have more cash available to increase dividend payouts and buy back stock.  Citi and Bank of America reported over $6 billion in tax provisions last year; JPMorgan, over $9 billion. Bank stock investors lust after the predictable flow of bank dividends, and any hints that dividends will continue to rise will certainly boost share prices today.

This undermines some of the purpose of updated tax legislation, where politicians contend companies will use tax savings to reinvest in company operations.  At banks, the presumption is that banks will retain the extra earnings to boost capital that will permit banks to increase loan portfolios.  There is no guarantee.  Banks may just as likely use the extra earnings to deliver gifts to shareholders (dividends, stock buy-backs).

Projected easing of tough bank regulation is also speculated. Bank industry leaders continue to argue that regulation straps them. (Some say new regulation strangles them, curtailing growth and discouraging innovation and expansion.)  Dodd-Frank won't disappear, but it could be tweaked in ways that permit banks to boost loan growth and engage more comfortably in certain types of securities and derivatives trading.  If so, share investors contemplate this might boost returns on capital and, therefore, share prices.

Achieving ideal returns on capital continue to be a challenge for banks. Regulation imposes capital requirements on most bank activities and operations. Reaching a 12-13% is challenge. Few banks have returns that eclipse that mark.  Even fewer have returns that exceed 15%.  (And this includes all banks--big and small, global and community). 

Bank investors appear to understand returns will likely hover in the 10-12% range and are comfortable with that as long as returns are stable and predictable (while risks are managed) and as long as returns are sufficient enough to pay dividends and conduct occasional stock buy-backs.  No rational, reasonable investor can expect bank performance to result in ROE> 20% year after year.

U.S. banks, in the aftermath of the financial crisis and complex bank regulation, seem by now to have adjusted to the new normal.  Making sure they are comfortably above all requirements, benchmarks and standards is a regular operating activity at banks.  Share investors may have acknowledged that by 2017, banks have adjusted well to compliance, requirements, and stress tests, even if they wish some of the rules could be loosened or would just go away. 

In 2017, U.S. banks fared well in the Federal Reserve's stress tests, a regulatory-administered examination that assesses whether a bank can survive a prolonged period of downtown and macro-economic stress.  Banks subject to the test geared up, invested in people and systems, and reorganized their balance sheets to ensure enough capital anchored balance sheets to pass these tests--despite their complaints they didn't get to see the Federal Reserve's inhouse models used to conduct the tests.

Stock investors would likely be concerned about unexpected risks in banks.  Much of that is borne in trading and investment banking.  Related revenues and earnings are volatile.  But many big banks have offset these activities with revenue generators (asset management, consumer banking, service businesses, e.g.) with predictable streams of income.  Some big banks (JPMorgan Chase, Bank of America, e.g.) still look for trading and investment-banking home runs, but they won't be saddled too much if those activities are dormant in certain periods.

Banks also continue to do a better job simplifying the disclosure of complex activities in earnings and on the balance sheet (including loan portfolios, trading risks, hedging programs, etc.).  Some investors might actually understand most pages in 200 pages of 10-K disclosure.  Risks--including credit, market, liquidity and operational risks--are thoroughly explained. Even risks related to collateral, reputation, and documentation are addressed. 

Banks, as well, have been better about loss reserves on the loan portfolio.  Loss reserves should equal to expected losses from a range of loans--consumer to corporate, secured and unsecured, domestic and abroad. If the bank observes signs of vulnerability or weakness in the portfolio, they appear to plan and reserve for losses more quickly and more conservatively. Where could there be weaknesses in current portfolios?  Perhaps some banks have excess concentrations in energy loans, real estate loans, or loans originated in vulnerable countries.  Perhaps banks are reconsidering loans extended to companies in other sectors (retail companies, technology companies, etc.). 

The fin-tech sector, including new-venture companies that for the past few years have threatened to blow up traditional banking, still poses as a challenge to conventional banks.  They operate slightly beyond the supervisory eye of regulators. (They don't take deposits. At least not yet.) Many banks have begun to respond to the challenge, rather than dismiss or neglect the important role of that sector.  Some banks have decided to establish partnerships, providing capital and access to customers (something fin-tech companies crave and need). 

Stock investors are likely comfortable that banks are developing reasonable strategies to whatever goes on at or whatever will come from fin-tech companies. 

With any sector of stocks, there's always something that looms that could threatened to cause values to plummet.  The great unknown. The uncertain, unplanned-for event. The threat that appears from the darkness.  Analysts try to predict what could be the firestorm that tears apart a bank's sturdy, sound balance sheet.

What could that be?  Insufficient cybersecurity risks? A global recession that sets upon the global economy from yet another house of cards (one incident leading to another to another until the economy is wrecked)?

For now, at least until yearend, some bank shareholders will say, let's enjoy this bundle of riches for the moment.

Tracy Williams

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