The KBW bank stock index is down 16% through the first three weeks of 2016, and down 23% since July 2015. The bank index decline is more dramatic than that of the broader S&P 500, which has fallen just 6% during the start of the year and 9% since July 2015.
The precipitous drop in bank share prices could be seen as surprising, since recent earnings announcements have been relatively uneventful. But the fall in the banking index is more understandable when one considers the impact of a changing credit cycle on asset quality and earnings. Signs point to lower asset quality, with banks not prepared to manage the bumpy road ahead.
In the years following the crisis, banks – supported by an accommodative monetary policy – increased commitments to higher-risk asset categories, including real estate, corporate, energy and emerging markets. Low default rates, narrowing credit spreads and rising asset prices encouraged banks to loosen underwriting standards in search of revenues during the upswing in the credit cycle.
But potential credit problems began surfacing last year. These included a flattening yield curve, rising high yield credit spreads, increasing corporate leverage and falling secondary market loan prices. The federal bank regulators expressed concern in their Shared National Credit Report and Fitch expects higher 2016 loan default rates. Nonbank credit investors, including hedge funds and collateralized loan obligation funds, experienced significant losses and redemptions last year. The spike in losses led one large fund, Third Avenue, to suspend withdrawals.
Bank financial results for the fourth quarter are largely silent on this concern. This is not surprising since opaque bank financial statements are lagging, rather than leading, indicators of asset quality issues. For example, only recently have banks started increasing energy loan reserves despite the secondary market prices for many of these credits falling below 50% of par, according to Thompson Reuters. Instead, institutions are engaging in "extend and pretend" to postpone loss recognition. Moreover, investors are concerned that asset quality issues extend beyond the energy sector into other high risk exposures, according to a Credit Suisse analyst note this month on credit quality. The concern is reflected in higher uncertainty discounts applied to bank earnings.
To be fair, any direct asset problems have not shown up on bank balance sheets. But investors are displaying signs of doubt about institutions' stock price compared with their asset values. Return on equity at many banks continues to lag their cost of equity, and the problem will worsen as the credit cycle becomes more unfavorable. Share prices relative to book value, or the total nominal value of a bank's assets, are low at banks of different sizes. JPMorgan Chase's stock price is trading at an 8% discount relative to its book value. The ratio is flat at BB&T, but KeyCorp is trading at an 11% discount while Wintrust is trading at a 10% discount. The problem is worse at banks like Citigroup and Bank of America, which have discounts as high as 40%.
The low ratios indicate these banks lack franchise value let alone growth potential. Institutions might be gaining more value if they took a more conservative approach consistently applying credit underwriting standards based on a clearly articulated risk appetite and enhanced risk disclosures. But if banks have elevated charge-offs in their future, that won't help earnings. Absent actions that signal tangible value potential – such as increased cash dividends - we can expect shareholder activism to grow as activists seek to close the growing value gap.
Activist investors are typically drawn to institutions with low returns that demonstrate caution and therefore a potential to gain value by reinvesting earnings in underperforming activities. They are challenging the strategic direction of banks based on continued poor performance. Unfortunately, for some banks, curtailing growth or reducing dividends may not be enough; spinoffs, divestments and outright sales may be needed. The problem cannot be covered over by moving up the credit risk curve or making overpriced acquisitions.
As Warren Buffett says you can only tell who was swimming naked when the tide goes out. The tide in this case may be the worsening credit cycle.
J.V. Rizzi is a banking industry consultant and investor.