Outside of the financial crisis, the last time oil prices dropped as sharply as they have recently, they triggered a wave of bank failures. Could this happen again? Learn what's different now, and why investors should pay special attention to some of the banks with heavy energy sector exposure.
We may not know when or how the Fed will raise interest rates, but there's little doubt it will happen eventually. Foolish banking specialist John Maxfield explains some of the effects the measure can be expected to have on debtors, creditors, and international markets when it does come.
A full transcript follows the video.
Kristine Harjes: Falling oil prices and that nagging suspicion that interest rates are going to rise; what could possibly go wrong? This is Industry Focus.
Hello Fools, welcome to the financials edition of Industry Focus. Kristine Harjes here, along with our senior banking specialist, John Maxfield.
We have got lots to talk about today; a lot of buzz lately around whether or not the Fed is going to raise interest rates, how much, how soon, will the world end as a result? We're going to shed some light on that situation in a little bit.
But first, let's look at the big story in banking right now, which is energy prices. I'm going to turn it over to John and let him take the wheel on this one. John, how are falling oil prices affecting the financial sector right now?
John Maxfield: This is something that we talked about a few weeks ago, Kristine. It's my opinion that the fall in oil prices over the last six months -- it's been pretty dramatic, around 50% -- will be the biggest story not only in the energy markets in 2015, but also in the banking industry in 2015.
I say that for the simple reason that if you go back and look at the last time -- other than in the midst of the financial crisis -- the last time oil prices fell to this degree, this quickly, that was in the 1980s and we saw a wave of bank failures throughout the energy (unclear) states.
In fact, I was just reading a book about that time period, written by a former FDIC chairman. The FDIC is, of course, responsible for going in and picking up the pieces after something like this happens.
He said that every single major bank that was based in Texas and Oklahoma at the time, failed; so you can get a sense for why bank analysts and bankers and bank investors would be concerned about that.
Now, that's not as big a concern this time around because this time a lot of the big banks in the country are much better diversified. You don't have as many regional banks that are focused specifically in oil or energy related assets as you did back then, because back then banks in many states weren't allowed to have branches, and almost universally they were not allowed to bank over inter-state lines.
When you're thinking about the issue of lower energy prices, that's how that plays into the banking sector on a million-mile-up level.
Harjes: It seems like since then there's been a lot of learning from the mistakes, so that's definitely a good thing. Can you fill us in on some banks that maybe didn't learn their lesson quite as well? Who's really heavily exposed to the oil industry, that we should look out for?
Maxfield: One way to look at this is to go through various banks and to look at their loan portfolios, and to look at the percentage of that portfolio that is allocated to energy-related loans.
Let's just talk about some of the big banks that have large energy exposure. You have MidSouth Bancorp (NYSE:MSL), 20% of its loan portfolio is energy related. BOK Financial (NASDAQ:BOKF), 19% of its loan portfolio is energy-related. Cullen/Frost (NYSE:CFR), which is a big bank down in the Texas area, 15% of its total loan portfolio is exposed to the energy sector.
When you think about that, there are some banks -- and some of these banks are large, but they're nothing like your $2 trillion JPMorgans (NYSE:JPM), or $1.5 trillion Wells Fargos (NYSE:WFC) or anything like that -- but these are still significant players in those areas.
If you're either a current or a prospective investor in a bank like this, then the question is first, how will they perform through this cycle? There are a number of ways that you can determine that.
My recommendation would be to look back on how they've performed through cycles in the past. If they'd made it through multiple serious energy cycles then you have a better likelihood, or it seems more reasonable to conclude, that they'll make it through this one as well.
Let's talk about BOK Financial. These guys have 19% of their total loans in the energy sector, but if you go and you look at their loans, you'll find a number of different things that should put investors at ease.
The first is that they've seen this many, many, many times because they're focused in that area. One of the things that they've done to combat the credit risk when you have volatility in the oil market is that they've moved away from oil services providers, in terms of providing loans to them, and now they provide principally loans to the actual companies that own the oil and bring it out of the ground.
That's beneficial because with an oil services company, let's say something goes south. What do you collateralize those loans with? Maybe some equipment or stuff like that, but a lot of that equipment is worth pennies on the dollar of its actual stated value.
Whereas, if you're loaning money to the oil companies themselves, you can collateralize that with the oil that's in the ground, and we know that that is worth something. It may not be worth as much now, but over time it will increase in value. I think that's probably a safe thing to assume.
Again, you want to look at how they've done in past credit cycles, and then how they have positioned themselves in the current cycle to make it through it.
Harjes: So you can't just look at a single metric of exposure to the energy industry. It's more about the variety of exposure and what might be a riskier play, such as the energy services companies, versus something that's a safer way of exposing to the energy industry.
Maxfield: That's exactly right, and let me just interject a couple points. First is that, to be completely transparent -- and I'm somebody who looks and studies banks all day, almost every day -- it is really difficult to get a clean picture on what a bank's exposure is and what's going to happen to that bank when they go through any type of cycle.
All of this, you're just making the best possible guess that you can make. That's why you need to really rely on history to see, does this group of banks have a pattern of making it through things in the past, that they know how to do it and they've proven that in the past, and you can rest more assured that they'll be able to do so again.
You have to approach this type of thing with a lot of humility, as an investor, and recognize that not only are you not in a position to know everything, but that the things that you probably won't be able to determine are probably the things that will be the most detrimental to any particular bank.
Harjes: Yes, that's a great point. Do you think that listening to the words and wisdom of these companies' executives could offer any additional insight?
Maxfield: I love that question, because when you think about a bank and the statements that its executives make, and you read through the transcripts or you listen to the conference calls of all these different banks, one of the things that you'll find is that they all say the same thing.
What you have to do is parse out the banks that are just saying things, from the banks that are backing those words up with actions. That's where the historical performance comes into play.
On top of that, a bank fundamentally is about confidence. If the investors in a bank lose confidence -- and I don't mean just your equity investors. I mean your debt investors, principally -- your depositors, your warehouse loan providers, things like that.
If they lose confidence in the bank, they'll start pulling their loans out, and that creates a liquidity crisis for the bank, and a bank can fail from a liquidity crisis. In fact, that's typically how they fail, as opposed to simply a solvency issue.
So bank CEOs and bank CFOs can't get on the conference call ... even if there's really bad news, they've got to be very careful about how they present that bad news, in order to stop a loss of confidence and thereby trigger a liquidity crisis for them.
You can almost look at it and think these CEOs, to a certain extent, have a fiduciary duty to ... I don't want to use too strong a word, but they almost have the fiduciary duty to lie about their current condition at any one point in time, because if they over-emphasize it, that could lead to failure.
You have to take the actual words with a grain of salt, and really look at the historical performance over time.
Harjes: Good to know. That's something to watch out for.
I'm going to pivot the conversation a little bit. I'm wondering now, what sort of buying opportunities have presented themselves as a result of all this aftermath with falling oil prices?
Maxfield: Great question. If you look at some of those banks that I mentioned, and there's a list of banks that buy exposure to the oil industry, all of their stocks are down over the past year, relative to the KBW Bank Index, which tracks the main banks in the country, which is up over the past year.
There are buying opportunities in there, because a lot of these stocks have fallen, and some of these banks are going to make it through just fine.
The question is, you're going to want to go through and look at, let's say your BOK Financial. It's down 6% over the last year, whereas KBW Bank Index is up 6%. When you consider that they have a history of making it through these cycles over time, on a relative basis that looks like a buy.
I'm not saying that it is, because you'd have to really dig into the numbers to feel comfortable about that, but there are certainly opportunities that come about when you have things like this happen in the market, and the smart investors, I can assure you, are looking at these banks that are taking hits to their stock prices, but are probably going to make it through this just fine.
Harjes: What about some of the big bargain-hunters, the major players in the financial space? Are you seeing a lot of movement on their part, into these banks, trying to scoop them up at these discounted rates?
Maxfield: Yes, there have been a number of different reports out recently about institutional investors moving into this space. I think one of the big ones was KKR (NYSE:KKR), which is a private equity firm, and other firms like that.
When you see these guys moving in -- because they have trained themselves to not be afraid when the market goes down, like most investors are, and to not be too euphoric when the market goes up -- so when you see them making moves like this, it is worth taking note of those moves, and maybe thinking about mimicking them in some way, shape, or form if you're in a position to do so, and if your risk tolerance is consistent with that.
Harjes: Right, of course. Great insight on an issue that's definitely been getting a lot of attention lately, and definitely also something that investors will want to keep an eye on.
Let's turn our attention over to the previously mentioned issue of interest rates. Speculation of rates rising sooner than later seems to be everywhere. What's your take, John? Is the Fed going to raise interest rates this year?
Maxfield: Well, we know the Fed is going to raise interest rates. We know that for sure, because interest rates are really low, and there's been a lot of conversation about them raising interest rates.
The problem is that we just don't know when that's going to happen. If we're expecting a Japan-type situation -- where the Federal Reserve over there has been trying to push up inflation, but it has failed since the '90s -- if we're stuck in that situation, called a liquidity trap, then it could be years or decades before interest rates really move up to any type of considerable degree.
I personally don't think that's going to happen in the United States, but you never know for sure. There are a number of reasons for that; our demographics are a lot better than Japan's, a lot of money floods into us from the rest of the world, which makes capital cheap here, which then is able to push inflation forward much faster than it would in Japan, and a variety of different reasons.
But trying to predict whether the Fed is going to raise them this particular year is, in my opinion -- and I would say that most financial professionals would probably agree with this -- is largely a fool's errand, because we just don't know. We don't know what data they're looking at, we don't know the exact targets they're shooting at in various sectors of the economy.
You can operate, just assuming that interest rates are going to go up at some point, but trying to pinpoint if it's going to happen this year or next year is probably something that you shouldn't factor into any type of investment strategy.
Harjes: That is a wise answer, and very true. Let's say, however, if interest rates were to rise this year, what would be the impact?
Just to keep things structured -- I don't want our interest rate speculation running too wild here -- let's break it down into two categories, debtors and creditors. If the Fed raises interest rates soon, what will be the effect, first off on debtors?
Maxfield: The effect on debtors will be that their borrowing cost goes up. I have a 30-year fixed-rate mortgage. That's not going to impact my 30-year fixed-rate mortgage.
Who that will impact are the commercial loan borrowers, because a lot of those loans are structured so that they float based upon either a benchmark interest rate in Europe, LIBOR, or they float based upon a benchmark here in the United States, the Fed Funds Rate, or some other short-term interest rate. Those will go up, so that will drive down profitability in the corporate sector.
Now, most large corporations, it will only impact them on the margin. However, there are some corporations and some types of businesses that an impact on the margin will be enough to tip them into the abyss, if you will.
Those are companies that previously went through leveraged buyouts. Let's say you have ABC Corp and it had a subsidiary, XYZ Corp, and that subsidiary decided to detach from ABC Corp and go private. Let's say a private equity firm took that private.
What that private equity firm is going to do is ... when you buy a house, you collateralize the loan to purchase the house, with the house itself. That's what private equity firms do when they buy companies. They buy a company, but they buy it with debt that's collateralized by the company.
What that means is that that company emerges from that with a ton of debt on its balance sheet, an inordinate amount of debt on its balance sheet, so any increase in interest rates for those types of companies is a very problematic thing. Over the past few years, we've seen a ton of action in the leveraged buyout industry, so you're going to want to watch any company that has exposure to that industry.
Banks aren't as big an issue here, but what are a big issue are business development corporations, because they specialize in debt that is kicked out of a leveraged buyout transaction.
We've seen a lot of the stocks in the Prospect Capital Corporation (NASDAQ:PSEC) and other companies in the BDC area, their stocks have taken considerable hits over the last year. That's the reason that has happened, and the pain has really only just begun for that sector of the financial industry.
Harjes: Very interesting. Let's look at the other end of the spectrum, creditors. What will be the impact of rising interest rates on creditors?
Maxfield: Creditors, it's interesting. When we're talking about creditors, let's focus our conversation on banks. There are a number of different impacts to a bank, when you see interest rates either go up or down.
Just speaking from a very general perspective, if the Federal Reserve feels comfortable raising short term interest rates, that's a good sign, economically, because it means that things are improving.
Maybe we're seeing an uptick in inflation. We know that unemployment has come way down, under 6%, so that would just be a good thing because typically economic activity will come along with that.
A lot of these banks have exposure to the payment sector, so as economic activity picks up, activity in the payment sector picks up. As activity in the payment sector picks up, non-interest income will pick up at these banks, so that's a very positive thing.
Another positive impact of higher interest rates for creditors is the point I made earlier; the interest rates on loans to the commercial borrowers -- which makes up the lion's share of most portfolios at commercial banks -- the loan payments on those will increase, but it will increase the net interest income of these banks, and particularly banks that have a lot of debt, that use core deposits; that's retail deposits that don't pay interest rates.
Banks that use those to fund their assets, they will see a dramatic increase in their net interest income.
Now, on the bad side of this, one thing that's kind of a truism in finance is that when interest rates go up, the value of fixed income securities goes down. I'm talking about basically bonds here, for all intents and purposes.
When you look at a bank's balance sheet, a large share of the assets they hold are fixed income securities, so we will see the value of those take a hit on bank balance sheets. Now, it will be partially offset each quarter by an uptick in that interest income and some non-interest income.
I think it was last year when Bank of America's (NYSE:BAC) CFO estimated that it would take them between two and three years for the positive benefits of an increase in interest rates to offset the diminution in their asset values, so it will be a mixed picture, but on net it's certainly a good thing if we see interest rates going in that direction.
Harjes: Great. Let's turn a little bit toward international markets. Just how far might the spillover effects reach?
Maxfield: In international markets, my guess is that it would have a pretty significant impact, and I say it for this reason.
When interest rates increase in a country, or in an economy, and particularly in an economy like the United States -- we're not like a South or Central American country, where they have a history of rapid inflation over and over and over again. Investors have a lot of confidence in the U.S. dollar.
What happens is you make U.S.-based assets more valuable because the yield on those assets goes up, so that draws money in from the rest of the world. What you'll see is capital flight from China, Europe, South and Central America, into the rest of the world. It will cause that.
We've seen in the past that when you have that capital flight, when that comes in, that then gives banks and other types of credit companies the firepower to make more loans. For the United States, bringing that capital in is on net probably a good thing.
But for other countries who will see capital flight, it's definitely a bad thing because the dollar will be more powerful at that point than those other currencies.
Harjes: I think it's safe to say that all the hype around this issue is pretty warranted?
Maxfield: Yes, absolutely. You have to remember, we're still operating in the shadow of the greatest financial crisis since the Great Depression, and when you look at all the financial metrics that you're still seeing the impacts of this on -- and on the top of that list are interest rates -- so seeing how everybody adjusts as we come out of this, this is a very big thing in the financial market.
Harjes: Of course, yes. Even though nobody can really say with certainty what the Fed's next move will be, it certainly seems like the potential for its actions to ripple throughout the U.S. economy, and the world economy as well, is certainly present. In any case, the Fed's actions over the next year will certainly be a worthwhile story to watch.
With that, let's wrap this up. John, thanks so much for your time today, and thanks everyone for tuning in. Until next time, be sure to check out Fool.com for more great insight and analysis from John and our other Foolish contributors, for all of your investing curiosities and needs. And of course, Fool on!
John Maxfield has no position in any stocks mentioned. Kristine Harjes has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, JPMorgan Chase, and Wells Fargo and has the following options: short April 2015 $57 calls on Wells Fargo and short April 2015 $52 puts on Wells Fargo. 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.