BANK STOCKS:  HOW MUCH PAIN IS ENOUGH?

11/30/07

The question of the day for investors is when will bank stocks stop falling?  Notice we said “when,” not “if.”  Banks generally have a fundamental earnings base:  they have a base of deposits, on which they must pay interest, and a base of loans and securities, on which they collect interest.  The market works such that a bank will collect a higher interest rate on its loans than it pays out in deposits.  That “spread” between the two interest rates fluctuates throughout the business cycle, and largely depends upon the steepness of the treasury yield curve.  Currently that spread is fairly tight, so current earnings are somewhat below normal earnings power for banks.  Demand for deposits and loans generally grows over time as the economy grows, and we have little doubt that it will continue to do so.

Obviously the problem right now is credit quality.  Thanks to deteriorating credit metrics (such as delinquencies and defaults) in the mortgage market, banks have sharply increased their bad loan chargeoffs and loan loss reserves this year.  Reserves are now higher than they had been, and they should be, but there will come a time when chargeoffs settle back down to “normal” levels.  Why do we have faith that the mortgage business will someday improve?  3 reasons:

1.    Mortgage lenders have largely stopped lending to subprime borrowers, and have drastically reduced foolish lending standards, such as no down payments and interest-only ARMs.  Eventually, these tightened credit standards will result in above-average credit quality for the average mortgage. 

2.    We believe the U.S. economy will prove resilient to the credit crunch, and that job losses, which are normally the most important predictor of mortgage problems, will not be terrible.

3.    As a backstop, even in the event of recession, interest rates typically fall considerably, which acts as a self-correcting tonic for the economy.

The stock market is an unpredictable animal, but it might be constructive to look back at past credit crunches, including 1990 (S&L bailouts, last mortgage crisis, junk bonds), 1994 (major Fed tightening, Orange County default), 1998 (Asian/Russian economic crisis, LTCM), and 2000-02 (U.S. recession).  As we show below, Citigroup provides a useful example, if only because it is a financial supermarket that has had exposure to all recent financial crises.  The numbers are the drops in each of the past crises.  We are not advocating the purchase of Citi, but the stock has fallen hard, and its 6.7% dividend yield is tempting. 

We are hopeful that we are near the bottom in bank stocks, but are always worried about “catching the proverbial falling knife.”  As we know all too well, good news and bad news alike tend to get exaggerated by over-emotional investors.  But we do believe there will be a time when we look back at bank stocks and ask:  “remember how attractive those dividend yields were?”