Banks Blindsided by a Housing Double-Dip

An economic slowdown, followed by the nationwide decline in home prices that finally burst the housing and credit bubbles, ushered in the financial crisis. While the market seems already to have forgotten this nasty episode, this week's news that the housing market is now double-dipping brings back uncomfortable memories.

The banking sector is particularly vulnerable to a decline in home prices. Earlier this year, the top five banks looked cheap on the basis of their price multiples -- but in light of this new information, is that still the case?

$80 billion in potential losses
To get a rough estimate of this new housing slump's impact on banks, why not go straight to a report that Standard & Poor's published only last week? Here's one of S&P's key conclusions:

At $70 billion to $80 billion, total losses in a double-dip scenario would equal approximately 30% to 35% of projected pre-tax operating income before any provision for losses. This is a sizable potential risk for the U.S. banking sector, though we note that these losses likely would be spread over several quarters.

S&P's loss estimates are based on the assumption of a "hypothetical" double-dip in housing, in which prices fall 15% between May and the end of 2012. For reference, this week's release of the S&P Case-Shiller house price index showed a drop of 4.2% in the first quarter of 2011. That decline more than erased any gain off the 2009 low, leaving the index at its lowest level since 2002.

My assumptions
Let's look at the impact of these hypothetical losses on the valuations of the top five U.S. commercial banks. Standard & Poor's doesn't make all of its assumptions explicit, so I'm going to make a few of my own:

  • The top five banks experience loss rates that are consistent with those of the industry as a whole.
  • Losses represent 35% of projected pre-tax income before any provision for losses.
  • The losses occur in the second half of the year through 2012. Losses are distributed equally over these six quarters.

Under those assumptions, here is how the valuations shake out:

Company

Adjusted P/E*
Current P/E

Adjusted P/BV
Current P/BV

Bank of America (NYSE: BAC  ) 14.3
9.3
0.59
0.55
Citigroup (NYSE: C  ) 14.5
9.5
0.75
0.70
JPMorgan Chase (NYSE: JPM  ) 13.2
8.6
1.06
1.00
US Bancorp (NYSE: USB  ) 17.7
11.5
1.84
1.73
Wells Fargo (NYSE: WFC  ) 15.2
9.9
1.30
1.22
Equal-weight average 15.0
9.7
1.11
1.04

*Based on next 12 months' EPS estimates. Source: Author's calculations based on data from Standard & Poor's.

If this scenario came to pass, the price-to-earnings multiple for the group would rise from less than 10 to 15. In the pre-crisis era, 15 times earnings to own the biggest banks in the country may not have sounded unreasonable. In the current environment, which requires banks to hold greater amounts of capital to support their balance sheets, it is not clear that this valuation would leave investors with any significant margin of safety.

Still, this scenario is not a certainty. S&P's chief economist put its odds at 20% -- albeit before any double-dip had been confirmed. Today, those odds might be higher.

Large banks are in the doghouse
On May 26, I wrote that the stocks of the five largest banks are likely to remain "in dead water" for 12-24 months. Any rerating of their shares would depend on revenue growth -- which will be hard to come by in this economy. As Doug Cliggott, U.S. equity strategist at Credit Suisse, told Bloomberg Television recently:

Financials are likely to struggle, maybe for a couple more years. ... There's very little organic revenue growth. ... When you look at the level of loans on bank balance sheets relative to GDP, they're still at an extraordinary high level, so we think as balance sheets normalize relative to the size of the economy, you're just not going to be able to get revenue growth.

The hits just keep on coming
Between the housing double-dip and yesterday's announcement from Moody's that it may downgrade B of A, Citi, and Wells Fargo -- which would likely raise their funding cost -- these banks can't seem to catch a break. The current environment is clearly unfavorable for banks in general, and for this group in particular. If you're thinking of picking up this basket of stocks now, first make sure that these banks will offer you a wide margin of safety to compensate for increased uncertainty. Then, be prepared to be very patient.

These banks may be "too big to fail," but we've got "Too Small to Fail -- 2 Small Caps the Government Won't Let Go Broke."

Fool contributor Alex Dumortier holds no position in any company mentioned. Click here to see his holdings and a short bio. You can follow him on Twitter. The Motley Fool owns shares of Wells Fargo and JPMorgan Chase. The Fool owns shares of and has opened a short position on 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 (7) | Recommend This Article (2)

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 June 03, 2011, at 4:13 PM, ronbeasley wrote:

    It is just this kind of thinking that is providing incredibly attractive opportunites in bank shares. Opinions that are contrary to fact are running rampant. The CEO's of Wells Fargo and JP Morgan Chase are both seeing a gradually stregthening housing market. Noted NY Times columnist Floyd Norris recently wrote an in depth analysis of the components of the housing price index, showing how the surface numbers make things look far worse than they are.

    The best investors out there, Warren Buffett, Prem Watsa, Bruce Berkowitz and others, have steadily added to their bank holdings.Yet we are still bombared with idiotic opinions about a "housing double dip", which doesn't exist, and inane financial projections.. Shame on the Motley Fool for publishing this stuff. I thought you were trying to help investors.

    Ron Beasley

    www.rwbi.net

  • Report this Comment On June 03, 2011, at 10:13 PM, WayneGorsek wrote:

    Watch the HBO movie Too Big to Fail based on the book, it is highly accurate. Anyone investing in bank stocks would have a better shot playing craps in Las Vegas! I do not trust these bank's balance sheets, what are the assets really worth if liquidated today in the worst housing market in our history? What these banks did to the taxpayer by unloading massive toxic bad loans onto Fannie and Freddie and our inept and corrupt Govt backing them with trillions of dollars of taxpayer money is criminal.

    Wayne Gorsek

  • Report this Comment On June 04, 2011, at 11:59 PM, thehynie wrote:

    The analysis is short-sighted. This scenario hardly makes a dent in book value, and the P/E impact is a one-time impact, meaning there would be very little change to normalized earnings over a five year period.

    In analyzing a one-time event like this, it might be better to look at the new price/book ratio and compare it to that of the recent highs. One would see that the recent highs would represent a much higher p/b than the projected. That could be viewed as the opportunity in the stocks.

  • Report this Comment On June 05, 2011, at 9:28 AM, Purpleboarder wrote:

    @ RonBeasley..

    ......"Yet we are still bombared with idiotic opinions about a "housing double dip", which doesn't exist, and inane financial projections.."

    So you disagree the housing market is in the process of a 'double-dip'? Until wages increase, and unemployment drastically decreases, how in the world are we going to clear the current glut of new/existing homes? No jobs and no wage increases = no housing recovery. It's that simple. I haven't even touched on inflation and increased energy/gas costs hitting the average consumer.

    What/who is going to represent the organic growth in the Real Estate market that you are counting on to avoid this 'double-dip' scenario in the house market? I am truly interested in your opinion.

  • Report this Comment On June 05, 2011, at 5:28 PM, ETFsRule wrote:

    Wow, RonBeasley is clueless. Just look at vacancy rates and you can see there is still a huge oversupply in the housing market. House prices will continue to drop for at least the next couple of years.

    http://research.stlouisfed.org/fredgraph.png?g=IX

  • Report this Comment On June 06, 2011, at 12:04 AM, HectorLemans wrote:

    "...these banks can't seem to catch a break. The current environment is clearly unfavorable for banks in general, and for this group in particular."

    Those poor banks. I'm getting less than 1% interest on my savings account and they still can't make money. Almost makes me want to put them out of their misery...permanently.

  • Report this Comment On June 06, 2011, at 12:53 AM, xetn wrote:

    I don't believe the banks have been blindsited. I think they have intentionally hidden the facts by not initiating foreclosure due to the electronic mortgage transfers and the lack of proper documentation.

    Another aspect is the pending nearly 1 million homes that are subject to foreclosure in the next few months.

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