Thursday, April 26, 2012

Are Large Cap Bank Stocks Undervalued?

As will be explored in this post, a major determinant of large capitalization banking stocks is the direction of housing prices.

US centered large cap banking stocks appear undervalued by many measures in late April, 2012. Citigroup is selling at 0.53 net book value and approximately 0.66 net tangible book value, Bank of America is selling at 0.41 net book and approximately 0.50 net tangible book value, and even the generally well respected JP Morgan is selling at 0.91 net book value.

In comparison, in southern Europe, banking stocks are currently in a declining trend, but appear even more compelling to from a valuation standpoint, at first glace: Italy's largest bank, Unicredit is selling at 0.11 net book value (falling over 30% in one day in January 2012), Spain's Banco Santander is selling at 0.59 net book value (falling approximately 25% from march 2012 to April 2012) - even as Banco Santander has a compelling market position in one of the hottest emerging markets, Brazil.

The first step to analyzing large capitalization banking stocks is to note that the earnings power of the banking franchises - potentially massive due to the incredible size of the bank's balance sheets -- can be completely diluted to the current shareholder by loan losses. This is to say, if there are loan losses of sufficient size, then the loss taken by the bank will result low equity to asset ratios (as the loss flows to equity) which necessitates the bank to raise more capital. As the share price tends to plummet with high realized loan losses, the bank will have to sell very high numbers of shares to bring capital ratios back to acceptable levels. So one could say that there are three main factors should be discussed in order to analyze current banking valuation for the shareholder:

1. Earnings power of the banking franchises,

2. Current required write downs from loan losses and

3. Potential future increases for loan losses (or, alternatively, reversal of estimates for loan losses) in future time periods.

On point 3 above, the major determining factor of additional losses beyond current estimates are the direction of housing prices. This is to say, if housing prices go up, then it is possible that current estimates of loan losses on the books will be lower, significantly adding to shareholder value.

The previous post in this blog has argued that housing prices are a larger contributor to GDP than commonly calculated by economists, and therefore will impact not just real estate but other commercial activity and loans, without government and central bank stimulus. Note that, as Warren Buffett stated in bis assessment of investment in banking, realized write downs may be "gained back" if assets recover in value (assuming banks have already taken the full loss, then any gain above that loss will add to earnings). That is to say, if the asset prices of problem loans increases, a firm may "write up" its problem assets, in the most optimistic scenario. In the third part of this post, housing prices are theorized to be driven in the first stage up by "a large scale injection of money" into the economy by one or more of the following forces: large scale investment from positive views of future growth of the economy, additional earnings from exports, and/or monetary expansion.

It is assessed that in the US only large scale investment is moderately possible over the next few years based on computer technology or some other potentially now-unrealized technology (always possible in an innovative economy such as the US, that a new technology can appear over a short time span, such as the Internet in the mid 1990's, or the automobile in the 1910 to 1920's, etc), therefore the recovery in housing prices and the recover in banking stocks is tepid at best.

Bank of America Analyzed as an Example of Value in the Large Cap US Banking Stock Universe:
Bank of America is one of the largest mega-banks in the world, ranked as the number #3 banking institution worldwide in terms of total assets at the end of 2010 with approximately $2.1 Trillion of assets. The simplifying assumption here is that the earnings power of BofA can be expressed as a net interest margin plus fee income as a percentage of total assets. Many analysts will estimate the earnings power of a bank by its divisions -- depending on how the bank divides its reportable segments into real estate lending, commercial lending, trading, credit card services, trading, investment banking etc -- then add up this earnings power on a segment by segment basis. A difficulty of using a segment approach is that such an approach takes emphasis off total loan losses, and treats the divisions as fully separable. I have read one analysis that stated card services, for example, would be worth by itself "more that the entire market capitalization of Bank of America." (and therefore BofA is a buy since the other divisions must be worth at least zero). However, in reality the Bank cannot spin off the credit card division as an entirely separate company: credit card holders will be deposit holders of the bank, deposits are used for funding of all divisions of the bank, if the bank losses depositors then credit card market share will go down.

So one could say, credit cards will report through the entire banking operation which must absorb credit losses. One could say, that each segment will be linked to the overall operations and asset levels of the Bank as a whole, although in different ways for example the trading division will be linked by the borrowing credit of the bank through the acquisition of trading assets, etc for the other segments of the bank. (with the possible exception of the investment bank, which could be potentially separated out from the overall bank). At the end of 2011, a full $311Bn of BofA's total assets were invested in debt securities (secondary market, a low interest rate) and $120Bn were in cash and equivalents -- the rest were in commercial and real estate loans of $900Bn, trading assets ($176Bn, perhaps a majority from the trading division at the acquired Merrill Lynch) and reserves deposited at the Federal Reserve, which earns a small interest margin, and other assets such as property and equipment. The vast majority of assets are therefore accruing income (one could say, of course, why otherwise would these be "assets"?) the tricky part is assigning fee income to the balance sheet.

In 2011, the total net interest income of BofA was approximately $45Bn - representing a slight net interest margin of only approximately 50 bps on interest bearing assets. Fee Service and fee income was higher at approximately $58Bn before loan losses, with the majority of fees coming from credit card, deposit account, brokerage and investment banking fees. One could say , again that the majority of fee and service income is linked to total assets (with the possible exception of investment banking fee income). All personal and other expenses were approximately $60Bn in 2011 for BofA, and tax rates are assumed to remain constant at 38%. If one assumes that interest rate conditions remain similar going forward for at least the next couple of years then net interest and fee income appears to be approximately 50 bps total, then the revenue power of Bank of America is approximately $120Bn ($2Trillion times 0.60%), minus $60Bn in expenses to yield $40Bn in pre-tax income, and $24.8Bn in net income.

Note! This net interest spread of only 50 bps total on both interest and fee income is very, very low -- most banks report net interest margins in normal times in excess of 200 bps and certain banks, such as WestAmerica in Northern California have net interest margins of over 400 bps. If, conceivably, BofA could get their overall retun on assets around 200 bps then the earnings power would be massive, around $210Billion of net income per year (before loan losses). This is the power of having $2Trillion of assets, potentially -- and this is the hope that many analysts point to when they state BofA is undervalued -- however there are several complicating factors.

Potential Loan Losses at Bank of America: BofA's real estate portfolio consisted of approximately $83Bn of home residential and equity loans with Loan to Values above 100% at December 31, 2011, and $47Bn (not indicated if included in the above 100% LTV category above) of home loans with FICO scores of less than 620, according to page 186 of their 2011 10-K. An additional $11.5Bn of credit card balances are outstanding to consumers with FICO scores of less than 620. At total of approximately $94BN-$130Bn of loans in the real estate and credit card category appear at risk if housing prices and the economy continue to deteriorate.

Of course, not the entire amount of the potentially problem loans would be written off, but some percentage, and my point is that this percentage would increase with continued declining house prices and a (however likely) potentiality of a double dip recession. BofA has a combined approximately $24.5Bn of "receivable criticized" commercial loans according to page 186 of their 2011 10-k. Again, the full amount will likely not be written off in future years, but some percentage depending on the strength of the economy. Some percentage of the approximately $70Bn of goodwill from the acquisitions of Merrill Lynch and Countrywide should be written off, if the economy and house prices deteriorates further.

What have other analysts estimated as the potential credit losses at Bank of America? Current CEO of the publication the BusinessInsider, Henry Blodget estimated loan and goodwill loans of between $100Bn and $200Bn, citing certain percentages of of home equity, commercial and goodwill to be written down, citing various sources, including bloggers and bank analysts, including a hedge fund which was short BofA stock. The analysis seems to have gotten under the skin of the Bank, as the Bank issued a statement denying Blodget's article within 24 hours of it being published in late August. I am not going to speculate whether or not Blodget's analysis is correct or not, but rather that the ultimate credit loss by Bank of America, and by extension many of the large cap banking stocks, will be driven by the direction of house prices and, as house prices impact GDP to a larger extent than commonly supposed by economists and analysts. It should be noted that Warren Buffett, in stating his reasons for his purchase of $5Bn worth of preferred shares in Bank of America in late August, stated that he thought that housing prices were going to improve thereby giving a boost to the economy on Buffett's appearance on Charlie Rose. It is to housing prices that we now turn.

Thesis: Housing Prices Cycles Theorized to be Driven by "Macro-Scale Injections of Money into the Economy
A huge number of studies have looked at housing prices, mainly from the standpoint of supply and demand. Factors that impact demand are household income, and by extension employment rates and population growth, availability and interest charged on mortgage financing, cultural dimensions of housing demand (whether the population prefers houses to apartments, number of occupants per unit, etc). Supply is calculated by the existing housing stock and additions to the housing stock provided by surveys of homebuilders, economists and government officials.

One observation -- that does not appear to be in most of the existing studies on house prices -- is that household income levels and growth will be impacted, in part, by a relation with housing prices, in a self-reinforcing manner. As housing appreciates in price, the economy will strengthen and more people will be employed and earn income, which can then be used to purchase housing. Economists disagree on the exact magnitude of the relations between housing prices and GDP and household income, but mainly agree that a relation does exist. A self reinforcing relation can also occur with financing and housing, in so far that financing will be more available and lower cost in a period of steadily rising house prices, all other factors equal, which supports house prices and vis-versa. The opposite can occur in a period of declining house prices -- financing is more difficult to get and at higher cost driving down demand for housing and therefore housing prices.

The "Chicken and Egg" Problem in Determining Housing Prices and Demand Factors: As such, as the forecast for household income will depend in part on housing prices, we have a "chicken and egg" problem in forecasting house prices. This is to ask: what first causes housing prices to appreciate, in the first stage, is it disposable income rising first or housing prices rising first? Once housing prices establish an upward trend (for some reason) then they will impact household income, but in the first time period, what drives up disposable income or does disposable income go up first or housing prices go up first? Well, it seems using common sense, in the first stage disposable, income will go up, which then goes towards supporting housing prices then house prices can "self-reinforce" disposable income. The author of this post would propose that in order to get the housing price cycle started upwards -- and, critically to stop house price declines from continuing -- that some large "macro-injection" of money into the economy is needed, to increase disposable income and therefore begin the housing price-reinforcement cycle.

Three Types of Macro-Injections to Begin Housing Price Appreciation Cycles: An excellent chart of the long term (since 1890) prices of houses in both the United States and Australia is presented here. Data is from Nigel Stapledon in Australia and Robert Shiller in the US, and is inflation adjusted. One can see a few interesting trends, house prices in both countries were relatively flat from 1890 to 1945, then increased dramatically from 1946 to 1950 as the solders came back from WW2, and a wave of optimism swept both countries (the Japanese defeated for Australia, the Germans and Japanese defeated for the US). Investment in the United States took off from 1950 to the late 1960's, (data to be provided) driven by business optimism in the US. An interesting divergence in the housing prices of both countries appears in the 1970's -- the US's house prices kept up with (high) inflation, while Australia's house prices increased at a significantly higher rate -- an increase in Australia of approximately 50% from 1970 to 1975 while the US housing prices remained flat.

It is theorized that Australia benefited from the increase in metal and coal prices during this period while the United States did not to the same degree, which drove housing prices higher in Australia verses the US. House prices remained relatively flat in both countries indexed to inflation through 1980 to 2000 then took off way above trend from 2000 to 2006 in the US and from 2000 to 2010 for Australia. It is proposed here that the driver of house prices was different in the two countries -- in the US it was "an injection of money" from loose monetary policy (interest rates declining from 6% levels in 1999 to 1% levels in 2002) while in Australia the injection of money stemmed from export earnings. Next steps in this post (as it is becoming very lengthy) is to determine the amount of additional capital needed as a percentage of GDP and/or the housing stock to supply continuation of housing price increases.

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