What’s ahead in bank stocks?

Marty Mosby, a managing director at Guggenheim Securities, talks about what moves bank stocks, what banks could do to attract investors and how long it will take for real improvement in the outlook for banks.

Asset quality is improving. Profitability is up. Fewer banks are on the FDIC’s problem list. Yet, investors don’t seem to like bank stocks right now. Why?

We (Marty Mosby and fellow Guggenheim analysts Jeff Davis and David Darst) did some interesting research about this and we found, when the S&P 500 falls significantly, large cap bank stocks go down even more. When the S&P 500 goes up, large cap bank stocks go up even more. This holds true almost 80 percent of the time. Why? Bank stocks today represent a risk trade for investors. We have discussions about the (default) of the U.S. government and Europe on the edge of a financial crisis, and so you have the appetite for risk down significantly. That’s what’s driving bank stocks to underperform. Asset quality is getting better. Loan growth is starting to build. Regulatory oversight remains tough. But historically, you have had dividends and tangible book value as a source of support for bank stocks as the earnings deteriorate because of economic cycles. You haven’t had that this time. Going into 2010, the risk profile was pretty balanced, asset quality was getting better, we had done our capital raises and the U.S. economy was coming out of a recession. During that period of time, banks were starting to outperform the S&P 500. In April of 2010, things started to deteriorate. In 2010, Congress started to draft the Dodd-Frank bill and you had these lawsuits against the banks for their foreclosure processes. A lot of banks now are only paying a one-penny-per-share dividend, so you have the imbalance: Where is your risk reward? What is the return you get for taking on that risk?

You’re saying bank investors have been unhappy since April 2010 because they haven’t gotten dividends in bank stocks?

The dividends haven’t been there to make them happy even though the earnings power went away. Today, we have all these negative risks in the economy: the U.S. economy stalling, the yield curve flattening and therefore revenue for the balance sheet going down, the European debt crisis and investor lawsuits. There is very little to balance that. Investors are very uncertain about the U.S. economy and that’s why everyone exited bank stocks. 

What will change that trend?

If you could check off any of these boxes you will start to see a change. With the Basel III capital buffers, if the Federal Reserve comes out and says: “this is the amount of capital you will need, anyone with more than that can increase their dividend,” you will see some of those banks go and increase dividends. If we have these states’ attorneys general lawsuits against the banks cleared, if some of these investor lawsuits—the FHFA (Federal Housing Finance Agency) lawsuit, for example—goes away, we’ll see that issue resolved. If we start seeing revenue growth, that’s another tipping point.

When will those overhangs start to fade?

I think it will take a year and a half, and over that time, we’re going to start popping through these risks. We’ll wake up at the end of 2012 and see we’ll have made a lot of progress relative to these issues. As we get into fourth quarter of next year, there will be a number of banks who have already paid back (Troubled Asset Program Relief) money and will focus more on return to investors. We will see dividends go up. We only had a handful of banks like U.S. Bancorp and PNC Financial Services who were able to increase dividends. SunTrust Banks, First Horizon National Corp., Fifth Third Bancorp will start paying up.

What should bank directors and banks do?

I would focus on reducing my risk. I would want to make sure we’re resolving any of these issues as quickly as possible. I would talk to my management team about how we can get our dividend back up to a level where we can support a stock price, a level we think we should be valued at. How do we get our dividend at a price where we are generating about a 3 percent dividend yield? That’s what I would do.