Why Big Banks Are Cheap

Big banks are cheap!

Bank of America (NYSE: BAC  ) trades at 0.6 time book value. JPMorgan Chase (NYSE: JPM  ) trades at one time book value. Citigroup (NYSE: C  ) , 0.8. Wells Fargo (NYSE: WFC  ) gets the highest bid at 1.4 times book value -- still well below historic averages.

Cheap!                                                                                        

Right?

Maybe. Valuations can be deceiving. There might be a good reason banks are cheap. A key business metric isn't exactly booming. It's dropping. Quickly: 

Source: Capital IQ, a division of Standard & Poor's. Note: Y-axis doesn't start at zero to better show change.

Banks profit when they lend money (responsibly). Investors bid up valuations when those profits grow. With loan books shrinking, it's little wonder investors aren't bullish on banks' profit growth.

So what's going on? Three big reasons loan books are on the decline.

1. Write-offs and runoffs 
When banks give up on your ability to repay a loan, they write you off figuratively and literally. The loans are removed from their books. Game over. That's a write-off. And when you pay off a loan, it's discharged from the bank's books. If the cash used to pay off a loan isn't immediately lent back out, loan books shrink. That's a runoff.

A good example of runoffs: The Federal Reserve has purchased trillions of dollars worth of Treasury securities over the past two years as part of its quantitative easing programs. Many have asked, How is the Fed going to sell all these bonds? Answer: It probably won't. It doesn't have to. It can just let them run off naturally. Same deal for banks.

2. They're just not that into you 
Banks are still adjusting to reality. The bubble years are being worked off. They aren't willing to lend as much as they did four years ago. This isn't because they're being stingy today. They were too kind in years past.

Banks are quick to add that they still want to make loans. Lots of them. They're ready now. But there's a qualifier. Banks are eager and prepared to make loans to borrowers with good credit. Fantastic credit, even. There simply aren't many of those borrowers out there. Businesses that have had credit lines pulled over the past few years have criticized banks for not lending enough. In reality, many of those businesses never should have been offered a loan to begin with.

3. You're just not that into them 
Consumers and businesses don't have the risk appetite they did in the past. When they do find the will to expand, they use more equity and less debt than they did before. Banks are lending less because we don't want to borrow as much. This has been the most overlooked factor in the banks-aren't-lending argument.

Thankfully, the tide is starting to turn a little. The most recent Fed Loan Officer Opinion Survey notes that demand is increasing for industrial loans and commercial real estate loans. This, though, comes after years of falling demand. Auto loan demand is also starting to pick up, but this, too, comes after years of demand pullbacks. Consumer loan demand is still weak -- and will likely stay that way as long as employment remains grim.

Managing expectations
If you're a regulator -- or someone who cares about banks being "too big to fail" -- this is all good news. Banks should shrink. They're too big to begin with; thank goodness they're cutting back. If you're an investor, though, watch out. With interest rates near historic lows and likely to rise, banks have their work cut out for them over the coming years. Add in shrinking loan books, and that struggle is exacerbated. There's a good chance that's why they look cheap.

Fool contributor Morgan Housel owns B of A preferred. Follow him on Twitter @TMFHousel. The Fool owns shares of Bank of America, JPMorgan Chase, and Wells Fargo. Through a separate Rising Star portfolio, the Fool is also short Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (13)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 25, 2011, at 1:07 PM, ronbeasley wrote:

    Its kind of amusing that so many people who don't understand banks feel compelled to write about them. The time to buy banks is when credit quality is improving, loan demand is starting to recover, capital and cash are abundant, and valuations are low.

    Would you rather listen to this guy, or pay attention to what Warren Buffett, Prem Watsa, David Tepper, John Paulson have been doing and saying? They all have huge positions in Wells Fargo, and all but one continued to add in the fourth quarter of 2010. Bruce Berkowitz, one of teh top mutual fund managers of teh past decade, has also loaded up on shares of banks. So you can follow the best, or get caught up in the misinformed gloom and doom.

    Wells Fargo is the largest holding in my personal and client portfolios.

    Ron Beasley

    www.rwbi.net

  • Report this Comment On April 25, 2011, at 5:21 PM, xetn wrote:

    Two observations about banks:

    "How would you like to get free money to invest, the interest on which is guaranteed by the government's taxation authority (and guns)?"

    (http://mises.org/daily/5223/Charting-the-Course-to-7-Gas)

    The main reason I see why banks are cheap is they have not yet truly addressed their huge stock of existing and pending REOs. When (if) they ever do, their balance sheets with show they are virtually worthless.

  • Report this Comment On April 25, 2011, at 5:29 PM, buffalonate wrote:

    I have been buying many large bank stocks the last few days because many are at 3 month lows. The tier 1 credit rating which is the best measure of the health of banks has been improving across the board. The American Bankers Association recently announced that loan defaults were down in all 8 categories. Every large bank I can think of reported profits last quarter so the risk is very minimal.

  • Report this Comment On April 25, 2011, at 6:11 PM, TMFHousel wrote:

    <<Every large bank I can think of reported profits last quarter so the risk is very minimal.>>

    Not that I'm predicting another meltdown, but this same logic could have been implemented in 2008. It didn't work well.

  • Report this Comment On April 25, 2011, at 10:54 PM, hogroamer wrote:

    The author is correct that the time to buy is when a stock is out of favor. Banks are cheap and as for the bank owned property, they are doing it the smart way. Holding it back so as not to decimate housing prices. Yes they are bargain basement now but the banks are pricing them at very attractive prices to attract multiple offers. They are clearing up the inventory and now lending to those that can REALLY afford it.

    I'm a holder of BAC and just bought a $300K house in FL for less than half price. Come on in the water's FINE!!!!

  • Report this Comment On April 25, 2011, at 10:59 PM, hogroamer wrote:

    <<Every large bank I can think of reported profits last quarter so the risk is very minimal.>>

    Not that I'm predicting another meltdown, but this same logic could have been implemented in 2008. It didn't work well.

    LOAN QUALITY IS MUCH HIGHER THAN IN THE "EASY MONEY" DAYS OF 2008, IT'S A DIFFERENT ENVIRONMENT.

  • Report this Comment On April 26, 2011, at 7:51 AM, dbtheonly wrote:

    xetn is right until & unless we can value the REO & CDS components, & figure out exactly who owns the loan for foreclosure purposes, the book values of the big banks, are more a matter of faith than accounting.

  • Report this Comment On April 26, 2011, at 9:33 AM, wasmick wrote:

    @xetn,

    Very interesting point, I'd love to see the data supporting this statement:

    "The main reason I see why banks are cheap is they have not yet truly addressed their huge stock of existing and pending REOs. When (if) they ever do, their balance sheets with show they are virtually worthless."

    I'm struggling with bank valuations and it would be a key data point to analyze. Can you link it?

  • Report this Comment On April 27, 2011, at 9:53 AM, wasmick wrote:

    @xetn: And strangely, I'm still waiting for the link......

    Color me surprised.

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