Will the US Banks Be Walloped in the Future, Relative from Now?

30% of my portfolio is allocated to US small-cap value-weighted ETFs. Whichever small-cap value ETF you choose, a large proportion of the allocation will be towards the financial sector.

I think perhaps that is one of the reasons why values tend to suffer going into a recession.

The recession is not here yet, but there is much negativity abound. We hear of commercial loan crises due to the sudden rise in interest rates or how undercapitalized banks could be going into a recession.

The stock market is a machine that consistently factors in available information and adjusts the price of the market. Based on some people’s observations, they try to price in what will happen in six months.

I wonder given the negativity how much has been priced into the current decline. There is also a question of whether we will have a soft or a hard landing.

I would think the market has not priced in much or that there wasn’t much soft landing in the past.

I would probably need to brace for some really shitty drawdowns.

Not everyone holds a similar view to me. Well, some people can be more positive about some banks.

I came across a couple of articles from Andrew Walker, who writes at Yet Another Value Blog:

• Banks banks banks (redux)
• Banks banks banks (redux) follow-up

Andrew previously worked as an analyst in various private equity and hedge funds, which helped him build up his bottom-up analysis skills.

He fleshes out much of his thoughts in those two articles and it will be better to read his thoughts compare than repeat them here.

In summary, here are some takeaways:

1. The idea is to buy banks that trade below their tangible book value if you want something safer. That is, if their underlying balance sheet is worth that amount of tangible book value and there are no nasty surprises.
2. Citizens Financial Group CEO mentioned in May that if you are able to buy banks at tangible book or even below a bit, historically, you would have made a killing. (Andrew provided some numbers and some of you value-tilted investors may want to see the numbers of CFG)
3. Some banks have held-to-maturity (HTM) debts that is sitting on their balance sheet at cost. But these debts have unrealized losses (if the bank sell them off today). If they are sold today, it will wipe off a chunk of the tangible book value, which will make a previously cheap looking company suddenly more expensive. If you look, you can find banks that do not have that big of a HTM problem and because they have less of this “baggage”, they might be a cheaper stock or stocks to buy.
4. Given that most banks are trading around their tangible book value, Andrew thinks that certain things such as the looming commercial real estate crisis, banks die if the economy rolls into recession and defaults rise, or being murder by high interest rates, may have already been baked into the price.
5. Andrew brings up the point that last year, 100% of the economist think we will be in the recession this year. But that didn’t happen and we could argue that the banks have enough lead time to do what they must to prepare for it, like build up their reserves against loans, increasing their capital.
6. The banks also have adequate time to prepare for higher interest rates, and they might have shore up capital to get ready for that event.
7. The banks may not have that big of an exposure to commercial real estate, and even if they do, they would have recorded the losses in previous quarters. For them to still record even more losses would take even more catastrophic events.
8. Most banks have underwritten their portfolios like they are already experiencing a recession. A few banks have been under the assumption that a recession will hit first half of 2023.
9. Andrew also addresses the concern that the rise in interest rates will destroy banks’ earnings. When the yield curve was inverted, that hurt the banks more but the curve is rapidly uninverting. When the curve was inverted the cost they have to pay on the deposit is higher than what they loan out and Andrew noticed that the majority of the interest on deposits came up to 50-60 bps more. As the curve uninverts, they can loan at 1% more while the deposit rates are still at 50-60 bps.
10. It is easy for us to forget that the best investments are typically made during rocky environments. This rule applies to both buying stocks and making loans. Some banks are overcapitalized and can take advantage from those weaker banks.

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