Big banks are cheap!
Bank of America
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.
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.