In investing it is always essential to constantly reassess one’s investment thesis to ensure that the facts still remain the same as they were when the position was initiated. At T&T Capital Management we regularly are updating our assumptions as earnings and markets developments dictate. The major risks of the problems in Europe are primarily psychological and hypothetical. If we lived in a world where central banks restricted liquidity in the face of frozen capital markets, the anxieties about counterparty risk would be a lot more worrisome than they are currently. That is a primary differentiator since the Great Depression in that central banks realized that they are responsible for providing liquidity when markets freeze. There will certainly be losses related to a severe recession in Europe and a likely Greece exit from the E.U.. European banks aren’t nearly as attractive due to their strong likelihood of needing to raise capital under challenging conditions, high leverage, and large exposures to peripheral Europe. U.S. financials are in a completely different place yet trade for a similar valuation. It is obvious that the market is acting irrationally in relation to these companies so the key is to relax, be patient, and buy in the face of this extreme pessimism. Below are 5 reason that support my argument. I’m certainly open for any factual arguments refuting our investment thesis but I’ve read many “bear reports” and aside from short term technical mumbo jumbo, I haven’t seen anything compelling that would warrant these discounts to tangible book.
1) The large U.S. banks have significant exposures to U.S. mortgages and credit card which have all shown consistent improvements in credit metrics over the last several years. The housing market is picking up steam and has bottomed which will have extremely positive impacts on earnings. The reason the “Great Recession” was so damaging to the U.S. banks was because it involved the U.S. mortgage and housing markets where prices declined 20-50% depending on the region. The European crisis will not have nearly the same impact on U.S. banks earnings or capital because the exposures are far more limited. Most of the banks have provided their exposure and even in extremely stressed conditions I wouldn’t expect more than a few billion in losses which would be offset by earnings in their core businesses.
2) As a consequence of the “Great Recession” the large banks raised unprecedented amounts of capital. They actually have double the capital, double the liquidity, and less leverage than in 2008. These measures will insulate the banks from dilutive equity issuances and allow the banks room to be aggressive when attractive opportunities present themselves.
3) The European crisis has been going on for 3 years now beginning when Greece announced that they had far more debt than originally reported. This has allowed the U.S. banks to offload and hedge risk. Greek exposure has generally been written off completely so the main threats to the banks would be contagion risk relating to other peripheral countries or institutions.
4) The ECB has provided an amazing amount of liquidity through two LTRO maneuvers. As the crisis deepens it is likely that they could do another one and if it got bad enough I’d expect the Federal Reserve to step in at some capacity. Since policymakers have been so destructive over the last several years any positive changes could have large upside implications. For example the issuance of Euro bonds combined with continued fat cutting of government budgets would likely have a significant impact on solving these problems. I’d also expect a TARP-like program for the European banks to boost capital and reduce leverage. While this will be dilutive for European banks it will also reduce counterparty exposure considerably which is a major overhang.
5) The most important reason U.S . financials are likely to go higher is due to the ridiculous prices they are selling at. 3 of the 5 largest banks are trading at around 50% of tangible equity or liquidation value. In addition all 5 banks are highly profitable with margins increasing from trough levels. The banks are already aggressively cutting costs, and the worst of the legal problems and regulatory changes are done, or soon to be done. This along with the increased capital will gradually enable these companies to buy back stock and pay dividends which will likely close the valuation discount.
INVESTING IN THE FINANCIAL MARKETS INVOLVES RISKS. OPTIONS ARE NOT SUITABLE FOR ALL INVESTORS.