In the post-election market, the big banks have been winners. Goldman Sachs (GS) and Morgan Stanley (MS) have both surged around 30 percent since early November. As Dow components, they’ve helped the index close in on 20,000 for the first time.
But let’s not be so quick when it comes to the big banks. They still face some huge problems. The biggest, most important, and most overlooked problem is that they’re in just as bad shape—and in some cases worse shape—than they were before the outbreak of the Great Recession nine years ago.
Back then, the issue that brought the banks down came from subprime lending. Remember those days? The riskiest loans were considered “contained.” The problem was supposed to be solved. Some of those risky loans were expected to end up being troublesome to the bank, but they were well-compensated for the initial risk.
Sure, at first. But the problem was that the subprime loans weren’t contained. They had been sliced and diced. Or, in Wall Street speak, “securitized” into various other products. Investors in mortgages were getting pieces of different loans, some riskier than others. And ratings agencies, unable to understand the complexity of these issues, gave their stamp of approval.
Well, subprime housing isn’t what it used to be, but it’s coming back. While traditional mortgages are already pretty affordable with interest rates so low, the return of interest-only loans are coming back. And self-employed folks, who don’t have a W2 form for a loan officer to review, are finally starting to get mortgages again after some lean years indeed.
But today’s housing market isn’t the bigger problem. Subprime auto loans, that is to say, car loans to the riskiest borrowers with the lowest credit scores, are at record highs and rising. Defaults on those loans are at 20-year highs. A car is a bit different than a house. While a houses’ price can vary, and, yes, even drop, a car drops in value… and keeps dropping. At some point, it’ll be worth nothing but parts and maybe the gas in the tank. Defaulting on an auto loan after a few years leaves the borrower on the hook for an asset that’s significantly depreciated.
And that’s just one market. While there’s no category for subprime student loans, that’s one area where individuals have racked up the debt like crazy. But if you’re lending to a student who defaults, you’re out of luck. You can’t suck their acquired knowledge out of their brain. There’s no asset to seize. That’s why student loans have higher interest rates and can’t be discharged in a bankruptcy.
This brings us back around to the big banks. They’re still up to their less-than-stellar lending activity. But with a new presidential administration on the horizon, and likely the most pro-business one since the Coolidge administration, this time is different. A new wave of mergers could occur, particularly if large multi-national companies can get tax break on repatriating all the cash they hold in their overseas subsidiaries.
Right now, bringing that money back comes at a hefty fine of around 40%; higher than what most individuals will pay in total federal, state and local taxes.
But what will bringing that money back really accomplish? At the moment, companies are using their excess cash flow to engage in what I call “financial engineering.” They’ll raise dividends, buy back shares, and otherwise work to push their stock higher with short-term activity, rather than engage in improving the business for the long haul. That’s a danger that the biggest companies in the market face right now.
What’s the solution? Take a smaller approach. In the banking sector, that means avoiding the big names, which have already had a huge post-election run. The banking system may look flawed when you consider the firms with a Wall Street presence. But banks running out of Main Street are faring far better.
There’s still a lot of skepticism in the banking system thanks to the Great Recession. And it affects all banks, big and small. While stocks in general are still hitting new highs, companies like Citigroup (C) and Bank of America (BAC) are still about 50 percent below their 2007 peaks. Their dividends got slashed, and investors remain soaked. But hey, it only took Microsoft (MSFT) 16 years to go from its tech bubble peak to new highs. By that logic, these banks need another eight years to give investors a positive return.
But the smaller banks, which aren’t engaging in the subprime or student loan space, are in far better shape. They’re still in the business of real banking—making loans to people in their community—and keeping those loans on the book. If they don’t outsource those loans the way the big banks do, they’re responsible for all the danger.
What’s more, many banks today still trade under their book value, even in the post-election rally. Book value is a conservative way of valuing a bank that looks at how shares are trading relative to the value of all the bank’s loans. In theory, if the bank were to liquidate its loans in an orderly fashion, the bank could close up shop and pay out cash to shareholders at book value.
Sometimes there’s a premium to that value and sometimes there’s a discount. Today, there are still plenty of discounts, which reflects pessimism about a bank’s entire book of business. In some cases, some discount makes sense, but for the smaller banks? Not so much.
Even better, the smaller banks tend to get gobbled up by the bigger banks over time. When that buyout offer is announced, quick double-digit gains can be acquired.
The easiest way to play the sector is with an ETF like the SPDR S&P Regional Bank ETF (KRE). But it’s run up along with the big banks year-to-date. Your best bet might not be a bank that I’ve even heard of. It might be your local bank, if it’s publicly traded. Next time you’re there, think about your bank not as a customer, but as a potential business you could be a fractional owner of.
Andrew Packer is a Senior Financial Editor with Newsmax Media. He currently writes the Insider Hotline investment advisory, serves as investment director for the Financial Braintrust, and is managing editor of Financial Intelligence Report.
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