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Quarter-End Insights

Our Outlook on Bank Stocks

Loan losses are likely to increase as economic activity slows.

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Bank stocks continued to tumble in the fourth quarter, as economic indicators worsened and credit markets ground to a halt. We see little reason for cheer in the new year, as we expect loan losses to rise further and bank earnings to remain significantly depressed. At the same time, we see the downturn as an opportunity to purchase shares of some high-quality, lower-risk banks.

For years, banks rapidly grew their loan portfolios and allowed lending to increase much faster than deposits--banks' traditional and safest form of funding. Instead, banks increasingly depended on debt markets and securitization to fund their lending operations. This system, which had shown signs of stress throughout 2007 and 2008, crumbled on the eve of the fourth quarter when the 158-year-old investment bank Lehman Brothers declared bankruptcy and sent both equity and debt markets into disarray. Investors fled risky assets, causing prices to tumble and liquidity to dry up, and took shelter in U.S. Treasuries. Banks around the world prepared to take billions in write-downs, forcing many to seek out new sources of equity capital. A week later, as the crisis deepened,  Goldman Sachs (GS) and  Morgan Stanley (MS), the last two large independent investment banks, declared that they would raise capital and become bank holding companies in order to restore their access to funding, thus confirming that the global banking system was undergoing sweeping changes.

As the fourth quarter dawned, the financial crisis was threatening to become a disastrous vicious cycle in which banks conserved capital by refusing to lend either to each other or to the private sector. This sudden loss of funding threatened to sharply increase bankruptcies, which would cause bank losses to increase and encourage the banks to further hoard capital. In response to this growing threat, Congress enacted the Emergency Economic Stabilization Act in early October, which created the Troubled Asset Relief Program (TARP). This program was initially intended buy up many of the risky assets that set off the financial crisis, but was soon converted to a plan in which the Treasury would buy stakes in U.S. banks in the form of preferred shares and warrants for common shares. Of the 74 domestic banks we cover, 54 have received at least preliminary approval to get a collective $178 billion of new capital, which increased their Tier 1 capital ratios--a critical measure of bank health--by an average of 3 percentage points and alleviated most near-term capital worries. Seven of the healthiest banks we cover, including  Hudson City (HCBK) and  Commerce (CBSH), have said that they do not intend to apply. We're most worried about three banks-- E*Trade (ETFC),  BankAtlantic (BBX), and  Hanmi (HAFC)--that have applied but have not yet been approved. We already had concerns about these banks' long-term viability and think that if the Treasury does not approve their applications they may soon be forced to shut down.

While the TARP program appears to have staved off the worst outcomes, we see the financial downturn as far from over. The news that the TARP program would not buy up risky assets after all sent prices plummeting, and we expect many banks to take large write-downs again in the fourth quarter. Moreover, we anticipate that bank loan losses will increase sharply in 2009 and to remain very high through at least 2010. So far, most of banks' loan losses have been related to residential real estate, but we expect losses to spill over into other categories, such as commercial and unsecured consumer lending, over the coming quarters as economic activity declines and unemployment increases. In our opinion, bank stock prices are likely to remain volatile for some time.

Valuations by Industry

 Bank Valuations
Segment

 Price/Fair Value*

Three Months
Prior
Change
(%)
Finance 0.52 0.70 -26
International Banks 0.55 0.72 -24
Regional Banks 0.63 0.82 -23

Savings & Loans 

0.86 1.04 -17

Securities 

0.73 0.94 -22

Super Regional Banks 

0.69 0.79 -13
Data as of 12-15-08. *Market-Weighted Harmonic Mean

In spite of all of this gloom and doom, we think the current environment offers an opportunity for investors to pick up shares of good companies at attractive prices. On average, finance companies and international banks offer the most attractive discounts to our fair values, but many of these are among the more risky companies we cover. We recommend that investors be alert for attractive discounts on the strongest of these companies, like  HSBC (HBC) and  American Express (AXP). Regional banks also have attractive price/fair value ratios, although some are fairly valued in our opinion, and do not offer investors a large margin of safety. For example,  Cullen/Frost (CFR) is rarely priced at a significant discount to our fair value, but we see value in  BB&T (BBT).

Bank Stocks for Your Radar

 Stocks to Watch--Banks
Company Star Rating Fair Value Estimate Economic
Moat
Fair Value Uncertainty

Consider
Buying

American Express (AXP) $58 Wide Medium $40.60
BB&T (BBT) $43 Narrow Medium $30.10
HSBC (HBC) $84 Wide High $42.00
Trustmark (TRMK) $25 Narrow Medium $17.50
US Bancorp (USB) $35 Wide Medium $24.50
Data as of 12-16-08.

 American Express (AXP) is temporarily suffering from increased loan losses but we expect its long-term return on equity to be near 30%, thanks to its lucrative payment network and the strong fee-income stream it garners.

 BB&T (BBT) is an efficient Southeastern bank that is gaining deposits, the best source of bank funding, at a time when others are losing them.

 HSBC (HBC) is the only global bank that has come through the financial crisis in reasonably good shape. It is likely to gain market share as competitors like  Citigroup (C) and  UBS (UBS) are forced to scale back.

 Trustmark's (TRMK) conservative strategy during the boom years has allowed it to maintain very low loan losses in its home market of Mississippi, despite the downturn.

 US Bancorp's (USB) prudent underwriting and steady fee income stream are allowing it to take advantage of the credit crisis by buying up deposits and branches from less-successful rivals.

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Erin Davis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.