Bank stocks have had a bad rap. Since the Global Financial Crisis (GFC), they’ve been associated with poor controls and questionable practices that resulted in significant loan losses. Now another crisis is stoking fears that widespread economic damage and a long, winding recovery will once again translate to extreme loan losses that erode banks’ profitability.
But banks today appear structurally different compared to a decade ago. In the period leading up to the financial crisis, banks were undercapitalized. They needed to raise defensive equity—which diluted shareholders’ stakes—in order to shore up balance sheets devastated by charge-offs. Today, banks seem well capitalized and profitable. Yet despite being in much better financial shape, a “once bitten, twice shy” mentality persists.
While we expect banks to withstand pandemic-driven credit defaults—some of which may approach levels seen during the GFC—there are three overlooked differences. First, banks entered this crisis on firmer financial footing, with capital ratios 98% higher than in 2007. Second, loan mix matters. For instance, large banks tend to have diverse loan books that lean toward credit card lending and servicing large businesses, whereas most community banks are mortgage heavy. Since the GFC, some investors dislike mortgages. But in reality, community banks—with their current loan mixes—have historically experienced about half the loan losses of their larger counterparts. Finally, fees from administering loans from the Paycheck Protection Program (PPP) represent a massive boon to bank earnings, particularly for community banks.
The Market is pricing in a replay of the GFC…
Despite these advantages, the market appears to be pricing in a replay of the GFC. The price to tangible book value (P/TBV) multiple of community banks—a measure of a bank’s worth should it need to liquidate—sits at a historically low level of 0.80x, a 20% discount to actual tangible book values. Why the haircut? Because investors consider book values overstated and poised to drop. That makes them unwilling to pay higher prices.
Community bank stocks have traded at these levels only once before, during the GFC. In other recessions, the trough valuation multiple for the sector stood at 1.05x versus the sector’s historical average of 1.21x (or 1.33x, excluding the GFC period) (Display).
…But this is not the GFC all over again
Those concerns may be unfounded. Following a decade of heavy-handed regulation and de-risking—including the incorporation of rigorous stress-testing at the core of their risk and capital management processes—banks appear fundamentally sound. Each year, the Fed oversees stress tests on the largest banks, informing their capital return budgets. As a result, the US banking industry enters this crisis sitting on an 80-year high level of capital. And common equity ratios, which measure a bank’s actual capital on hand to cover potential losses, hover at levels twice those preceding the GFC (Display).
These healthy balance sheets underpin the federal government’s and bank regulators’ confidence that banks are strong enough to serve as a core solution to this crisis—as evidenced by their crucial role disbursing PPP stimulus. This stands in stark contrast to the GFC when banks were a big part of the problem.
Profitability is the differentiator
The GFC represents the only cycle since the 1930s when US banks did not remain profitable. This time around, we expect the industry to produce positive earnings, even while banks experience elevated loan losses. During its recent test, the Federal Reserve revealed that even under a “severely adverse” scenario, the largest US banks would nearly break even—despite significant loan and trading losses—and would remain very well capitalized. In this severe stress test, the Fed modeled loan losses on par with those during the GFC.
But this test failed to recognize several catalysts for community banks. First, it omitted any benefit from the PPP or other relief programs. Also excluded? Accretive actions—such as mergers and acquisitions (M&A) and share buybacks—which can drive strong returns for these smaller banks. Together, these underappreciated catalysts can propel earnings growth well beyond market expectations. The question is: By how much?
Stay tuned for the next installment in our series, “What’s the Market Missing with Community Banks?”
- Michael Howard
- Chief Investment Officer—Financial Services Opportunities (FSO)
- Todd Buechs
- National Director, Core Fixed Income & Alternative Credit—Investment Strategies Group