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* |
Adjusted P/BV |
|---|---|---|
|
Bank of America |
14.3 9.3 |
0.59 0.55 |
|
Citigroup |
14.5 9.5 |
0.75 0.70 |
|
JPMorgan Chase |
13.2 8.6 |
1.06 1.00 |
|
US Bancorp |
17.7 11.5 |
1.84 1.73 |
|
Wells Fargo |
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 ."
