What to Make of the Short-Sale Thesis Against U.S. Bancorp

Recently, HoldCo Asset Management, a respected investor in the banking industry, issued a scathing short-sale report on U.S. Bancorp (USB 2.56%), calling the fifth-largest bank by assets in the U.S. "the unsafest and unsoundest of them all." The crux of the report is that U.S. Bancorp is poorly capitalized and is likely to have to raise capital and potentially even cut its strong dividend in the near future.

U.S. Bancorp has typically been considered one of the strongest-performing banks in the industry and has generated an average return on equity of close to 15% since 2010. The bank is also viewed as a conservative underwriter of credit, so the report likely caught many investors by surprise. Let's take a deeper dive into the report and discuss what to make of it.

Examining the report

Since the banking crisis in March, investors have been looking closely at banks' balance sheets. One of the things that has been under a microscope is bank bond portfolios, because many banks invested heavily in U.S. Treasury bills and mortgage-backed securities when interest rates were low. Now, many of these portfolios are deeply underwater as interest rates have soared, and U.S. Bancorp definitely has a lot of unrealized losses on its books.

If these bonds ever had to be sold while they were trading at a loss, they would wipe out a substantial amount of shareholder equity. However, if U.S. Bancorp can hold them to maturity, it would recoup the losses. And as the Federal Reserve slows its interest rate hikes, the unrealized losses should decline over time as well.

Currently, super-regional banks such as U.S. Bancorp do not have to include the unrealized losses on the bonds that they intend to sell before maturity in their regulatory capital calculations. But given everything that has happened, there is talk that regulators will look to change this.

And with U.S. Bancorp approaching $700 billion in assets, it is poised to become a Category II bank, meaning it will eventually have to start incorporating these unrealized losses into its regulatory capital calculations anyway.

U.S. Bancorp's common equity tier 1 (CET1) capital ratio, which measures a bank's core capital expressed as a percentage of its risk-weighted assets (RWA) such as loans, came in at 8.5% at the end of the first quarter, which is much lower than its peers. In early 2022, U.S. Bancorp had a better CET1 ratio of roughly 9.8%, but it had to use significant capital when it purchased Union Bank.

If the unrealized losses from bonds held for sale were applied to U.S. Bancorp's capital levels, along with the bank's full reserves for potential loan losses, U.S. Bancorp's CET1 ratio would fall to 5.8%, which is well below the bank's 7% CET1 requirement. HoldCo also believes that the bank's CET1 requirement is set to increase after the Federal Reserve's stress testing this year. Furthermore, it notes that the bank has one of the highest dividend payout ratios in the industry.

With the Biden appointee Michael Barr, a well-known supporter of higher capital requirements, now serving as the vice chairman for supervision at the Fed, HoldCo believes banks are headed for stricter regulatory capital treatment. All of this leads HoldCo to believe that a capital raise and a dividend cut could be coming for the bank sooner than many think.

U.S. Bancorp's response

On its recent earnings call, U.S. Bancorp had an opportunity to answer questions from analysts regarding issues raised in the report.

When asked about the need for a capital raise, Chief Executive Officer Andy Cecere said "that is not part of our thinking as we sit today." Cecere also noted that "dividend growth continues to be a priority" and that "our expectation is we would have continued growth in the dividend."

The bank did, however, pause share repurchases. But after the recent failures of Silicon Valley Bank and Signature Bank roiled the banking industry, a lot of banks have done the same.

One main reason U.S. Bancorp feels confident is that while the acquisition of Union Bank did consume capital, it will also lead to more earnings accretion, which will help to build capital. Cecere said he expects the Union acquisition to add 20 to 25 basis points (with 100 basis points equaling 1 percentage point) per quarter, which is why he expects the bank's CET1 to be above 9% by year-end.

Also, unrealized bond losses should shrink if the Fed pauses its rate-hiking campaign. If rates go higher than expected, management said, it has added certain hedging instruments to reduce the impact.

Management also expects to optimize RWA by limiting balance-sheet growth or selling certain smaller, noncore businesses. Lowering the RWA, the denominator in the CET1 calculation, is one way for a bank to increase its CET1 ratio.

Lastly, management said that it doesn't expect to be classified as a Category II bank -- and therefore need to apply unrealized securities losses -- to capital until at least the end of 2024.

Should investors be worried?

There are definitely risks here. For one, deposit pricing and credit quality (and therefore earnings) are still quite uncertain, and U.S. Bancorp might not get the earnings accretion it needs to boost its CET1 to more than 9%. 

Also, the Fed's Barr is a bit of a wild card. While it seems unlikely that there wouldn't be a phase-in period, if the Fed takes some kind of more-immediate action regarding U.S. Bancorp's bank classification -- or if its stress-test results come in much worse than anticipated -- that could also spell trouble for the bank. Based on what I've heard bank CEOs say, there does seem to be a great deal of uncertainty about what stress-test results will look like in June.

However, CET1 capital requirements for next year won't take effect until October, so U.S. Bancorp could still very well be nearing a 9% CET1 ratio by then, which should allow it to meet any new and more-immediate capital requirements.

The bank should also be able to control some of its fate with RWA optimization. I also believe that any new regulations would need to be phased in over time, which would allow the bank to get capital to appropriate levels. Personally, I think it's a bad look for the Fed if it forces U.S. Bancorp to raise capital when the Fed approved the very thing -- the Union Bank acquisition -- that lowered the bank's capital only last October.

Given that U.S. Bancorp's stock is already down about 25% this year, HoldCo might very well have already made money depending on when it sold short. I find the need for a forced capital raise and dividend cut unlikely, but not necessarily impossible.

The outlook for buybacks anytime soon, however, doesn't look great. I don't believe there is any urgent need to sell the stock, but I do feel as if the market will be more receptive once U.S. Bancorp's CET1 ratio rises back to 9%.