Most of the larger banks have reported fourth quarter earnings already, and we must admit the results were better than we had anticipated.
In general, the growth in problem loans declined, capital and reserve ratios strengthened, low-cost deposits continued to grow at a robust pace, and earnings largely surpassed estimates. Absent the bucket of cold water that President Obama threw on the sector when he announced new regulatory initiatives late last week, the 4Q results may have actually strengthened the resolve of those that believe we are nearing a peak in credit losses for this painful cycle. So while we at Farr, Miller & Washington remain non-believers for now (which we will explain further below), let's examine some of the factors that have many people believing that the days of outsized loan write-offs at the banks are nearly over.
On the consumer side, most banks reported an improvement in credit card metrics and a decline in early-stage delinquencies across a number of consumer loan categories. At the same time, the data suggested that problem loans in the residential real estate category are growing at a slower pace than they had in previous quarters. Why is this important? It is important
because a decline in the rate of increase in problem assets is a precondition to an eventual decrease in problem assets. Moreover, historical data suggest that bank stocks perform very well once the rate of increase in problem assets starts to decline. Essentially, investors are anticipating the return of normalized levels of credit losses well in advance of the actual improvement. They do this because as loss rates decline, banks are able to drop their large vault of accumulated loss reserves to the bottom line. Therefore, earnings growth can be very strong and bank stocks can do very well during this stage in the credit cycle. However, we would stress that it remains highly unclear as to whether or not we are indeed nearing peak loss rates for the cycle.
On the commercial side, credit metrics continue to come in much better than many had feared. The warnings that commercial real estate would be the "next shoe to drop" have thus far been largely unfounded. While losses and problem assets continue to grow, the rate of growth in problem assets declined signficantly in the fourth quarter and the situation is nowhere near the fiasco that many had predicted (at least not yet). Furthermore, management commentary regarding the sale of some problem assests suggest that the secondary market for problem loans is open for business again. This is also a positive.
As we continue to work through the cycle, one thing that is unambiguous is that bank balance sheets have improved dramatically over the past several quarters due to large capital raises and huge additions to loan loss reserves. Moreover, many of the banks have already repaid TARP and the resulting dilution is well known. The balance sheet strengthening is important because it offers protection in the event that losses come in much higher than the consensus expects. However, it is also important because if loss rates are indeed beginning to peak, there is a huge amount of reserves that can be dropped to the bottom line, resulting in outsized growth in book value. Under this scenario, bank stocks would likely perform very well.
So why aren't we banging the table on bank stocks?
We continue to believe that the apparent stabilization in credit quality may be a head fake. We continue to believe that a second leg down in housing may be in the offing based on the removal of key stimulus initiatives. Recent home sales data suggest that the $8,000 tax credits played a huge role in stimulating demand for housing at the lower end of the spectrum. At the same time, the Fed has kept mortgage rates artificially low by purchasing enormous quantities of mortgage-backed securities. Third, as much as 95% of new mortgage loans are now guaranteed by the government through Fannie Mae, Freddie Mac or low-down-payment FHA loans. What will happen when the government removes this support? The private banking sector is clearly not fighting over new mortgage loans, and housing demand will clearly subside when tax credits expire and mortgage rates rise by 50 or 100 basis points (or more). Lower demand for housing and reduced access to credit will mean further home price declines, more foreclosures, and another round of write-downs at the banks.
On the commercial side, we believe the reason for the better-than-expected credit performance within commercial real estate is that bank regulators have provided the banks with flexibility to work with borrowers such that losses will be spread out over a much longer period of time (years instead of quarters). So rather than allocating more capital and reserving for losses on underwater, restructured CRE loans, banks can now modify terms without having to take such measures. This Japanese-style flexibility essentially amounts to kicking the can down the road as these losses will have to be recognized sooner or later. The problem will grow with time.
The bottom line is that we remain cautious on banks as a group.
Bank earnings are highly levered to the health of the economy, and we do not think there is much to sustain the pace of recent economic growth once the government steps out of the way. Having said that, we at Farr, Miller & Washington are long-term investors. We buy great companies for reasonable prices with the idea that they will be able to outperform the market over an economic cycle (3-5 years). Therefore, the recent sell-off in bank stocks due to the regulatory uncertainty may in fact provide us with an opportunity to add to our positions in two banks we believe are well positioned to withstand the storms we see on the horizon. However, we will remain underweight in financials until we see more definitive signs of an end to this miserable credit cycle.
Finally, we would note that the BKX bank index (an index of 24 large bank stocks) has been flat since August while the overall market has trended higher.
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Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.