2023 has been the year of bad news for many banks. Despite the conventional wisdom that rising interest rates is good for banks, the extreme move higher over the past couple of years by the Fed to fight inflation has worked backwards. The housing business has ground to a halt, and depositors are looking for higher yield. As a result, banks are facing probably the toughest operating environment they've seen since the Global Financial Crisis over a dozen years ago.
We've seen numerous banks have their credit ratings downgraded by both Moody's (MCO 0.25%) and S&P Global (SPGI 0.07%). Bank regulators are now proposing additional regulations for many larger banks that will increase their costs at a time they're already facing pressures on their bottom lines.
All of this has sent bank stocks down. The S&P Banks Select Industry Index is down 14% in 2023, while the S&P 500 has gained over 17% at this writing. Plenty of investors are either selling or avoiding bank stocks all together.
Never one to blindly follow the conventional wisdom, this investor has zigged while others are zagging. As of the end of August, 14.9% of my invested wealth is in bank stocks; moreover the vast majority of those investments were made in March and May of this year, based on my thesis that the banks I've chosen to own are positioned for years of success, and the discounted prices I was able to pay made them far too attractive to miss.
Genius, or giant mistake? Let's take a closer look.
Here are the banks I bought
| Bank Name | P/E Ratio | Price to Book Value |
|---|---|---|
| Axos Financial (AX 0.21%) | 8.45 | 1.35 |
| Bank of America (BAC -0.21%) | 8.2 | 0.89 |
| Bank of N.T. Butterfield (NTB -0.18%) | 5.98 | 1.5 |
| Central Pacific Financial (CPF -3.08%) | 6.8 | 0.96 |
| Live Oak Bancshares (LOB -3.21%) | 23.1 | 1.7 |
| M&T Bank Corp (MTB -0.35%) | 7.4 | 0.87 |
| PNC Financial (PNC -0.12%) | 8.3 | 0.98 |
| SoFi Technologies (SOFI 3.69%) | n/a | 1.57 |
| Truist Financial Corp (TFC 0.53%) | 7.1 | 0.72 |
Here's the real problem with banks right now
We mentioned the conventional wisdom above: Rising interest rates = bigger profits for banks. When interest rates move higher gradually, that's true. Banks are pretty good at passing higher rates along to borrowers faster than they raise the yields paid on depositors.
The past couple of years have been something very different. Raging and persistent inflation -- who remembers when it was only transitory? -- forced the Federal Reserve to take drastic steps, moving interest rates to levels we haven't seen in nearly a decade and a half. And while it seems to be having the Fed's desired affect, cooling down rampant inflation, it's also had a chilling effect on housing and real estate financing, something that many banks rely on for interest income.
Overnight Federal Funds Rate data by YCharts
This happened, of course, after everyone and all their cousins either bought a house or refinanced their mortgage at sub-3% interest rates, leaving a lot of banks with many billions of dollars in either ultra-low-yielding mortgages on their books, and deposit customers seeing online savings and money market yields of 4% and higher. To put it bluntly, many banks are seeing their margins get squeezed.
As a result, plenty of banks are likely to see their earnings and returns suffer in the years to come. They are essentially stuck with these cheap loans, the market for new higher-yield mortgages has dried up, and depositors want more yield.
The ratings agencies aren't the only ones who see the struggles coming. Federal bank regulators recently proposed new rules that would increase capital requirements for many banks with over $100 billion in assets that don't already have to comply with the additional regulations for so-called G-SIPs (the "too big to fail" banks). These requirements would add additional expense to these banks, as they would have to take on additional debt to raise more capital to cover deposits in a failure event.
And we haven't even talked about the commercial real estate environment that many regional and midsize banks will have to deal with...
Why buy banks in this environment?
There are a lot of reasons to expect banks to earn below-average returns in the years ahead. How long depends on what happens with interest rates, but most banks are encumbered with some degree of low-yield loans that they would have to take huge losses on to sell, and many have sizable commercial real estate exposure, including office buildings that have lost a lot of value.
But banks are not a ticking time bomb as we saw during the Global Financial Crisis 14 years ago. There are problems, sure, but by and large the regulations in place have resulted in well-capitalized banks, and depositor confidence -- at least in the banks still standing after this Spring -- has remained quite high.
In other words, it seems like a situation where the sentiment has sent many bank stock prices down more than the material risk. And when that happens, that's when you should buy bank stocks -- that's exactly what I did. At the discounted valuations some banks still trade at, you can more than make up for weaker returns with incredibly attractive valuations.
Should you invest in bank stocks, too?
Whether value or growth, there are still opportunities in banks. Three in particular that are built to grow in this environment are SoFi, Axos, and Live Oak, which I discuss in this video. If it's value you're seeking, many big banks trade for single-digit earnings multiples and discounts to their book value because of those low-yield loans and the concerns described above.
Could things get worse? Sure. A recession is still a near-term risk. But thinking long-term -- as I am with my 15% investment -- I believe today's prices will prove to be wonderful prices to have paid when we look back in five years.
