Banks Survived Another Week—and the Biggest Ones Look Like Winners

First Republic shares fell Friday by almost 33%, to $23.03, after the bank suspended its dividend, while selling in a broad group of regional banks sent the
Invesco KBW Bank
exchange-traded fund (KBWB) to a new low for the year. The ETF fell 15% in the past week, and nearly 30% in the past two weeks, as concerns spread after the failure of
SVB Financial’s
Silicon Valley Bank and Signature Bank.

How should investors approach the new environment? Evercore ISI analyst Glenn Schorr thinks new regulatory rules could eventually lower banks’ return on equity by 10% t o 15%, and possible more for smaller banks. The industry has been earning 10% to 15% ROE. Bank stock-buyback activity could be muted this year.

Some of those negatives, however, are reflected in depressed stock prices and ample dividend yields throughout the industry. The KBW bank ETF is off 35% in the past year, and is trading back at 2016 levels. 

In the 12 months that followed both the 2008-09 financial crisis and the 2020 bank stock selloff, the KBW bank stock index rose by at least 75%. Investors can debate whether bank stocks have bottomed yet, but shares of the largest U.S. banks already reflect a lot of bad news.

Other potential winners, in addition to JPMorgan and Wells Fargo, include
Goldman Sachs Group
(GS) and
Morgan Stanley
(MS), which are structured as banks but have attractive franchises and do relatively little traditional banking.

The six biggest banks, which also include
Bank of America
(BAC) and
Citigroup
(C), carry dividend yields of 3% to 4.5%, which are safe. The stocks generally trade for 10 times 2023 earnings, or less. The even-higher dividend yields on regional banks also appear secure.

“The value proposition of the biggest banks has been enhanced,” says Schorr.

These banks’ attributes include product breadth, technology advantages, capital, size, and importance, all of which likely make them too big to fail. Deposits flowed into the largest banks in the past week, and that trend could continue.

“We love our regional banks. But in an environment where safety trumps all, it becomes harder and less profitable to be a smaller institution,” Schorr says.

Further industry consolidation seems inevitable. The U.S. still has more than 4,000 banks, while the United Kingdom and Canada each are dominated by just six institutions.

Regional banks have been advantaged relative to the largest banks due to their lower capital requirements and lighter regulation. That likely will change. “The markets don’t like uncertainty, and there is a lot of that now,” says
Barclays
analyst Jason Goldberg. 

Overall, U.S. banks are in good financial condition. They have low levels of problem loans, unlike in 2008-09. Regulators have succeeded in imposing standards that have forestalled loan and mortgage problems.

What the regulators didn’t anticipate were large losses in the banks’ bond investments. U.S. banks bought trillions of dollars worth of Treasury and agency mortgage securities in the past few years as interest rates fell to historically low levels. Those holdings showed losses of more than $620 billion at year end after a sharp selloff in the bond market last year. 

Regulators encouraged these investments in their capital rules for the banks, as such holdings carry minimal or no credit risk. But they have considerable interest-rate risk. In fighting the last war, so to speak, regulators didn’t anticipate the impact of higher rates on bond portfolios.

To bank critics, the huge bond losses show that the industry can’t seem to avoid big, periodic missteps. And with certain exceptions, bank shares haven’t been a way to beat the stock market. Bank indexes have underperformed the S&P 500 stock index over the past five, 10, and 20 years. Bank investment also can be asymmetric, given the possibility of huge losses or total wipeouts.

Berkshire Hathaway
(BRK.A, BRK.B) CEO Warren Buffett eliminated nearly all of the company’s exposure to the industry in recent years, with the exception of Bank of America. 

Bad investments in federal agency mortgage securities doomed Silicon Valley Bank, which regulators closed on March 10. Many big banks have large unrealized losses in a key category of their bond investments. 

Bank of America’s are the largest. The bank had a paper loss of $109 billion at year end on a $632 billion portfolio of mostly federal agency mortgage securities with maturities of over 10 years. They are carried using held-to-maturity accounting. The bank intends to hold its hold-to-maturity securities to maturity.. Those bonds carry an average rate of just 2%, way below current market rates on securities of 5%. 

Given the accounting treatment, the paper losses don’t depress the bank’s capital. But the losses are significant relative to Bank of America’s $175 billion of tangible equity at year-end 2022. 

JPMorgan was showing an unrealized loss of $36 billion on bond holdings at the end of 2022, compared with Wells Fargo at $41 billion, and Citigroup at $25 billion.

The table nearby shows the theoretical impact on a key bank capital ratio—Tier 1 common equity—if bond losses in the held-to-maturity category were reflected in that capital measure. The analysis from Barclays’ Goldberg shows that the impact among the largest banks would be greatest at Bank of America.

Bank of America’s supporters on Wall Street say the bank’s bond losses are offset by the rising value of its huge, low-cost deposit franchise of $1.9 trillion, including $1.4 trillion of retail deposits. Banks generally don’t put a value on their deposit franchise, but deposits are worth more as rates rise. Having 1% deposits is more valuable in a 4% rate world than in a 1% world.

Bank of America isn’t under pressure to sell any of those securities—sales would cause it to realize the losses—given its enormous liquidity. But they will weigh on its returns for years, particularly if the bank is forced to pay more than its current 1% for deposits. “These are money-good securities and there is no reason to sell them,” says Wells Fargo banking analyst Michael Mayo.

KBW analyst David Konrad wrote on Friday that the Fed “may begin to more closely look at held-to-maturity losses when addressing capital returns for banks.” That might not be good for Bank of America. The bank declined to comment.

For investors, it pays to stick with quality, and JPMorgan remains a standout. “JPMorgan is a big beneficiary of the current environment,” Goldberg says. “It’s the gold standard in the industry and has a fortress balance sheet. Customers increasingly will pay for a bank with a fortress balance sheet.”

At $126, JPMorgan shares trade for about 10 times 2023 estimated earnings and yield 3%.

Goldman Sachs is a top-notch trading and investment banking bank whose strengths have been obscured by the recent travails of its relatively small consumer business. 

Goldman tried to organize an equity rescue package for SVB before it collapsed. While that effort failed, it cost Goldman nothing, and the firm got the go-ahead to liquidate some $21 billion of bonds in SVB’s portfolio. That likely was a profitable trade.

“Buying Goldman Sachs around book value is a good idea,” Schorr says.

The stock, at $306, trades for a small premium to fourth-quarter book value of $304 a share. Goldman and Morgan Stanley have the highest capital ratios among their peers and a strong risk culture, with an emphasis on valuing securities at market, or mark-to-market in Wall Street parlance, not their ultimate value at maturity. Its bond losses in a held-to-maturity portfolio were just $1 billion at year-end 2022, by far the lowest in its peer group. 

While investment banking activity could be muted in the coming quarters, trading activity could be strong, and that is where Goldman excels. The stock trades for nine times projected 2023 earnings of $34 a share. The firm believes it can generate annual earnings of $45 a share or more in a better environment.

Morgan Stanley has successfully pivoted to wealth management under CEO James Gorman, and has been a standout. It is the only one of the top six banks to outperform the S&P 500 over the past five years. Citigroup, Wells Fargo, and Bank of America have all been in the red.  

Wealth management accounted for more than 40% of Morgan Stanley’s revenue and profits in 2022. The wealth management unit had pretax margins of about 30%.

Schorr likes the relatively stable fee-based revenue at Morgan Stanley, and the fact that two-thirds of its loan book is made up of loans to wealth management clients, often collateralized by investment portfolios. “I love the story,” he says.

Morgan Stanley stock, at $85, yields 3.5% and trades for 12 times projected 2023 earnings. That’s a premium to its peers but considerably below the market’s price/earnings multiple.

Wells Fargo remains a work in progress as the company contends with fallout from dubious lending and other business practices in the past. That led to a still-imposed regulatory cap on assets and a $3.7 billion settlement with government regulators in late 2022.

CEO Charlie Scharf called the settlement an “important milestone in our work to resolve historical issues.” Mark Stoeckle, manager of the
Adams Diversified Equity
fund, sees an opportunity for the bank to bring its cost structure in line with peers. 

Wells Fargo does mostly bread-and-butter deposit gathering and business and consumer lending. It has a relatively small wealth management business and little exposure to Wall Street. At $38, the stock trades for eight times projected 2023 earnings. It yields 3.1%. With a low dividend payout ratio, there is room for the dividend to rise in the coming years.

The biggest banks, and many smaller ones, could be buffeted in coming days and weeks as the troubles surrounding First Republic and other banks play out. But these giants are positioned to prosper over the longer term, and their shares are inexpensive.

Write to Andrew Bary at andrew.bary@barrons.com