Investing in Banks: Take the Long View

Motley Fool analyst Matt Koppenheffer sits down with Rick Engdahl for a side-of-desk interview about banks. Are they really that hard to understand? Can the big banks be trusted? Join us for a discussion on banks from Citigroup (C -1.09%) to Wells Fargo (WFC -1.11%), as well as some of the smaller players.

In this video segment, Matt sheds some light on the mortgage-backed security market and what makes it tick. He also offers his thoughts on the Fed's next move and what investors should keep in mind when looking at banks in today's changing economy.

A full transcript follows the video.

Rick Engdahl: You had mentioned that the mortgage rates had gone up sharply earlier this year, in anticipation of the Fed's actions.

That's always been a little gray area for me, is what drives those rates up and down? Is it just that anticipation, or is it the demand because of all the refis? What's actually driving those rates? Is it a supply side thing, or a demand side thing?

Matt Koppenheffer: It's really just classic supply/demand actions. Basically, when the expectations are that the Fed continues to be in there, buying mortgage bonds in particular -- they're in there buying mortgage bonds -- that'll keep the price around a certain level and that builds in a certain expectation, so buyers can feel free to go in there and buy, and expect that, "It'll stay around this, and this is what I can expect from my investment."

But when you suddenly have the change of view, that X date -- it's not happening yet, that the Fed's stopping purchasing but if you expect, "Well, maybe by the end of this year, maybe early next year the Fed stops buying" -- and you take out tens of billions of dollars of monthly demand in the mortgage-backed security market, well all of a sudden the supply/demand of that will push down prices and push up rates.

If you're in the mortgage-backed security market today thinking about, "Should I buy this given security?" and you're looking out to maybe Q1 of next year and thinking, "Well, prices are going to start to fall there," you start pricing that in and figuring out, "If I think that's going to happen here, then I don't want to be buying at this price, I want to be buying at this price, minus whatever."

You start to see a little bit of demand start to creep out because of the expectations people have. It's sort of that kind of activity on the margins that are starting to push prices down and push rates up a little bit now.

It's all this guessing about what the Fed's going to do.

Rick: Do you have any particular guesses? What does the future of the mortgage market look like to you?

Matt: Higher...

Rick: Coupling onto that question of where do you see things going, how does that influence your investment theses, going into banks?

Matt: That's an interesting question, because that dynamic will have a big impact on banks over the next two to three, maybe even five years.

I personally -- this will be foot-in-mouth, probably, looking back on it -- but I think by the end of 2014, we will be at the 6.5% unemployment rate, or better. I'm an optimist. I'm bullish. I think that the economy, although it's not moving a lot right now, is repairing faster than people are giving it credit for.

I think we're going to see that build up and I think we're going to see that start to play out faster than people are expecting, so I think the employment market is going to improve in the next couple of years, more than people think.

That's going to impact what the Fed does, it's going to impact what happens to mortgage rates, and that's going to have a big impact on banks.

However, when I think about the investing question I generally want to think even bigger picture than that. That's a shorter-term dynamic. That's, how are the given banks going to handle the short-term fluctuations in the market?

They're dealing with many different cyclical industries, so when you take an X-ray to a J.P. Morgan  or a Bank of America, you've got the mortgage type business, you've got the commercial lending business, you've got investment banking business. All of these are basically riding the waves of the economy in a little bit of a different way, but you're going to see that no matter what.

You can try... anybody can be my guest and try to guess what the economy is going to do on a year-to-year basis. That's a very, very, very hard game and I don't bother doing that.

What I'd rather do is say, "What are the banks that have the best businesses, that have a long-term strategy, that have strong brands, that have good management, that are basically going to make the most of when the cycle is doing well, and are going to protect the bank and protect investors the best when the cycle goes down?"

On that downcycle kind of question, I can roll out the classic Warren Buffett quote of, "When the tide goes out, you see who's swimming naked." Rewind to 2008-2009, particularly in the banking sector, we got a great view of exactly who had no swim trunks on.

When I think about the investing question, you have to be ready in a cyclical industry like this, I think. If you're a Foolish investor thinking in terms of 10 years, 15 years, 20 years for your investments, you're less concerned about where are we in this, in the economy, and more about, "What's this business that I'm investing in?"