166 Trillion Reasons Why Bank Stocks Are So Cheap

My continuing search for sectors of the stock market that are trading cheaply and offer the potential for gain has led me to a controversial slice of the market: bank stocks.

Looking at the "Big Four" in the U.S. banking sector, it's easy to conclude that the sector is undervalued...

But that conclusion may be a bit misleading.

Make no mistake - by traditional measures banks look cheap, and their stocks could do fine until the next financial crisis.

But that's the problem. Looking at banks that way ignores the elephant on their balance sheets, and the potential damage to our portfolios.

Here's what's really driving this critical economic sector into a "buyer beware" investment category...

Beware This Financial "Weapon of Mass Destruction"

Disappointing fourth-quarter earnings reports led to a sharp sell-off in big bank stocks thus far in 2015.

As of January 17, the group was already down 11% year to date, compared to a 3% drop in the S&P 500. The big four U.S. banks - Bank of America Corp. (NYSE: BAC), Citigroup, Inc. (NYSE: C), JPMorgan Chase & Co. (NYSE: JPM), and Wells Fargo & Co. (NYSE: WFC) - are trading at an average P/E multiple of roughly 12x, compared to a 16x multiple for the broader market.

But these bank stocks are cheap for a reason. Banks are different than industrial companies - their balance sheets are enormously leveraged, complex, and opaque, and they contain all kinds of hidden landmines.

And when those landmines are triggered, the fallout could be catastrophic.

By way of an example, consider a little story about a hedge fund that just blew up - Everest Capital's Global Fund.

According to Bloomberg Businessweek, after earning 14.1% in 2014, this fund had $830 million in assets as of the end of last year. But it literally vaporized last week after the Swiss National Bank surprised markets by removing the peg of the Swiss franc against the euro.

The fund lost 100% of its money because it was overexposed to a single financial instrument and was too leveraged. That is precisely the same kind of risk that is facing the large U.S. banks - they are overexposed to derivatives in amounts that could wipe out their shareholders' equity overnight.

It's a tale, and warning, worth telling: the most alarming aspect of the big banks' balance sheets are the hundreds of trillions - yes, that's trillions with a capital "T" - of derivatives contracts that sit on their books.

In the next financial crisis, these weapons of mass financial destruction could wipe out shareholders in the blink of an eye....

The Absolute Value of Risk Is Too Big to Ignore

Indeed, the biggest reason to avoid investing in banks is the one that nobody wants to talk about.

JPMorgan Chase, Citigroup, and Bank of America sit on top of huge derivatives books that dwarf their capital bases.

As of June 2014, the last date for which data was available, JPMorgan Chase, Citigroup, and Bank of America, respectively, had $68, $61 and $37 trillion of derivatives contracts on their balance sheets. This compared to shareholders' equity of $227.3 billion at JPM, $213 billion at C, and $237.4 billion at BAC (these are billions with a "b").

In other words, the volume of derivatives is about 300 times larger than the bank capital supporting them.

In the event of another financial crisis in which the counterparties on these contracts decide they are unable or unwilling to meet their obligations, these banks would be wiped out and the government would be forced to bail them out - again.

The only question would be whether politicians would be willing to again bail out shareholders.  That's not a bet I would want to make.  It's going to be expensive enough to bail out insured depositors, to say nothing of the $4 trillion of uninsured deposits that are also at risk.

In December, Congress agreed to allow the banks to leave these derivatives inside the bank subsidiaries that are insured by the FDIC, leaving depositors exposed to losses.

Wall Street, which is completely conflicted in having its analysts recommend the stocks of its own industry, wants to pretend that derivatives are not a risk.

Instead, analysts are arguing that things are going to get better for the banks. To some extent they have a point. The regulatory assault that has extracted tens of billions of dollars of legal costs from JPM, C, and BAC is likely nearing an end.

Even if the banks continue to run up ten-figure legal bills for the next couple of years, these costs are going to wind down sooner or later.

Furthermore, one has to believe that sooner or later bank managements will start learning from their mistakes. While these behemoths are extremely difficult to manage, there is little chance that JPMorgan will swallow another London Whale (where it lost over $6 billion risking its capital trading credit default swaps on high-yield bond indexes), or that Bank of America will buy another subprime mortgage company like Countrywide Credit. Regulation has turned these institutions into quasi-public utilities whose opportunities to take foolish risks has been significantly limited.

Nonetheless, to quote George W. Bush, one should never "misunderestimate" the ability of banks to find the next lending disaster or, for that matter, to cause it. Right now, for example, banks are creating tens of billions of dollars of subprime auto loans that, while unlikely to pose a systemic risk, are likely to lead to big write-offs in the years ahead.

There are other reasons why bank stocks are lagging the market: They are struggling to generate top-line growth; their net interest margins are under pressure, especially with a flattening yield curve; they are going to have trouble reversing credit reserves; rising macroeconomic volatility could hurt results in the year ahead, including the consequences of weak oil prices; and they continue to operate as ATMs for government regulators to the tune of billions of dollars a year.

While government regulation has significantly strengthened bank balance sheets and liquidity, it has also severely crimped their ability to make money. They may also be in line for new taxes and fees as politicians hunt for revenues in the years ahead.

This Is Our Play in the Banking Sector

With so much risk attached to the banking sector, what's driving investors to purchase bank stocks?

The large banks are focused on returning capital to shareholders after years of fighting with regulators over the right to do so.

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The four largest banks are a tale of two cities - JPMorgan and Wells Fargo & Co. (NYSE: WFC) have much higher payout ratios than Bank of America and Citigroup due to the latter's much-publicized legal and balance sheet troubles.

Bank of America and Citigroup are still tainted by the mistakes they made during the financial crisis, and the fact that the government had to bail them out. They flunked the first set of stress tests that were designed to determine whether they were healthy enough to start paying dividends again. Only recently were they approved to start paying dividends again.

As a result, while JPMorgan and Wells Fargo have payout ratios (dividends plus stock buybacks) of 60% and 95%, respectively, Bank of America and Citigroup have much lower payout ratios of only 46% and 40%, respectively.

In fact, both Bank of America and Citigroup's quarterly dividends are still a paltry $0.08 per share, which represents a 20% payout ratio in Bank of America's case, and a miniscule 6% payout ratio in Citigroup's case. The government has refused to allow these companies to return more capital to their shareholders, reflecting the low esteem in which their management are still held by regulators and politicians.

The good news is that these payouts are likely to increase from these low levels as they continue to strengthen their balance sheets, which bodes well for their stock prices. JPMorgan and Wells Fargo pay higher $0.45 and $0.40 per share quarterly dividends since they have fared better in government stress tests.

These potential positives could move bank stocks up over the course of the next few years, but they are really beside the point. There are better places to look for value than companies that are hiding neutron bombs inside their balance sheets.

Unless you are willing to bet that there will not be another financial crisis, you should limit your exposure to banks to deposits that are insured by the government. Any amounts above that are at risk.

About the Author

Prominent money manager. Has built  top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.

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