After Moody’s cut credit ratings, regional banks are feeling the heat again. However, some smart analysts think there are select bargains in the trash bin.
By Jessica Nix, Forbes Staff
After a rough spring for banks following the collapse of Silicon Valley Bank and Signature Bank, more bad news is hitting the sector. Last week, Moody’s Investor Services, which provides credit ratings and risk analysis for stocks, cut the credit ratings of 10 small and mid-sized banks, citing higher costs and lower profits. By Tuesday morning, the Dow Jones fell by 400 points in response.
Moody’s actions are placing another strain on an already beaten-down sector. Regional banks stocks, as measured by iShares U.S. Regional Bank (IAT) ETF, are down 19% year-to-date versus a 16% gain for the S&P 500. However, veteran Wells Fargo banking analyst Michael Mayo notes that the Moody’s report is looking back on the past 15 months and following the trend of equity analysts who have lowered the average earnings estimate for banks by 20%. The Federal Reserve has already pushed up rates to stem inflation and signaled its willingness to raise rates again. It has also announced plans to raise capital requirements for large banks.
As the old saying goes on Wall Street, “buy the rumor, sell the news.” The same could apply in reverse: the bad news is out on banks, and it may be in fact a good time to buy the bargains.
“A majority of the concerns listed are already known,” Alexander Yokum, senior equity analyst at the independent research firm CFRA, agrees. Yokum added that since the spring, banks have strengthened measures to protect themselves from potential risk including increasing capital ratios and that the major concern for banks now is an unexpected surprise like a deepening recession.
Mike Mayo says the price discount on regional bank stocks from rising interest rates and the potential recession are overblown, but investors should still be cautious for increased regulation.
Regional Bank Stocks: Down But Not Out
Bank deposit runs at large regionals like Silicon Valley Bank and First Republic, starting in the March, have been a gut-punch to the entire regional bank sector . But higher rates can mean expanding net interest margins and savvy analysts say there are bargains out there.
Mayo prefers investing in larger national banks, a theme he calls “Goliath is winning,” since investors have more trust in the stability of larger banks. However, he says investors can take advantage of the price discount in regional banks from the current climate. When picking regional banks to invest in, Mayo says look for what he calls the four C’s: consistency of strategy and management, credit quality, controlling cost, and capital staying at a sound level.
“The longer your time frame, the more you're willing to wait, and deal with downward earnings revisions, the more likely you are to look at regional banks,” Mayo says.
Yokum likes PNC Financial Services (PNC) as his strong buy stock out of the top three largest regional banks: PNC, U.S. Bancorp, and Truist Bank. Despite being down 15% year-to date, PNC outperformed its stress test this past year and decreased its minimum capital ratios. Yokum says PNC has more capital as a buffer compared to its competitors. PNC also has less unrealized losses in comparison, and the Moody’s report pointed towards banks with larger unrealized losses as part of their reasoning for downgrades. Moody’s report issued a negative outlook warning for PNC.
Yokum added that PNC has a large loan to deposit ratio at 75%, giving the option to keep their net interest margins level or maintain deposits.
“They have optionality in a period where optionality is king,” Yokum says.
U.S. Bancorp (USB) and Fifth Third Bancorp (FITB) are two of Mayo’s picks for regional banks with consistent growth. Moody’s named both of Mayo’s picks in the recent report – Fifth Third was downgraded to a negative rating and U.S. Bancorp is under review. Fifth Third and U.S. Bancorp shares fell 4% and 5.2% respectively when the market opened on Tuesday.
Mayo says the two banks are still good picks for future growth because of credit markets reducing the risk of a potential recession and continued disinflation.
Yokum disagrees on U.S. Bancorp, saying he considers U.S. Bancorp as a hold because of the December acquisition of Union Bank that brought the capital levels lower and exposed the bank to potential risk with higher unrealized security losses.
However, Fifth Third, down 24% in the last six months, is another Yokum pick, citing their increasing deposits year after year. Fifth Third has a low loan to deposit ratio at 74%, meaning the bank has enough liquidity to cover any unforeseen event.
Commercial real estate loans are typically held by regional banks, which usually have 2-4% of their portfolio in commercial real estate, according to Yokum. Higher interest rates position banks to take a credit hit as demand for office space decreases. Fifth Third has lower exposure to changes in commercial office space with only 1.3% of its portfolio in office, according to Yokum.
“We’re not expecting them to have significant critical issues,” he says. “It's definitely a headwind that will likely hit a decent number of banks and we’re not expecting them to get hit too hard by that.”
Chris McGratty, head of U.S. bank research at the investment bank Keefe, Bruyette & Woods (KBW) says his strategy for looking at regional banks stocks would be to wait for investors to bring down expected earnings and watch for reserves to grow.
East West Bancorp (EWBC) is one of McGratty’s picks for a growth stock in the sector. The California based bank whose stock has gained 34% in the last three months, has reduced expectations for growth because of the economic environment with a large reserve of capital to weather the rest of 2023. By KBW’s analysis, East West will have a mid-teens return on tangible common equity, a rating on bank strength, by next year.
“Whatever the economy throws at East West, it will be fine. Their management teams have run the bank very conservatively for 15 years and they traded slightly forward tangible book,” McGratty says.
The California based bank primarily caters to Asian Americans, and it’s one of the few U.S. banks with a banking license in China.
“They have the tailwind that Asian Americans are a growing demographic,” Yokum says, also categorizing East West as a strong investment. “The product of customized service to understand China is very unique and that alone is an advantage in a homogenous market.”
In its recent second quarter report, East West reported a 21% increase in net income in the past year. Deposits are at an all time high, and the bank is still growing loans. According to Yokum, East West has outperformed the industry in deposits and loans and grown significantly over the past 10 years. Yokum’s only concern is East West’s 3% commercial real estate portfolio.
After the Moody’s ratings announcement, East West shares fell by 3%. East West was not mentioned as a bank Moody would reconsider their ranking.
McGratty’s second pick is New York Community Bank (NYCB), which bought Signature Bank from the Federal Deposit Insurance Corporation (FDIC) after its collapse in the spring. McGratty points to the bank’s liquid balance sheet and 7% yield as reasons for the bank’s strength. Net interest income increased by $345 million in the second quarter from the first quarter due to the acquisition. In the past year, net interest margins were up 69 basis points to 3.21%. Based primarily in New York with over 400 branches across the U.S, New York Community Bank is one of the largest multi-family portfolio lenders in the country.
Columbia Banking System (COLB), operator of Oregon’s Umpqua Bank, is McGratty’s final pick because of an improving dividend payout and its acquisition of Oregon’s Umpqua Holdings. The March acquisition created one of the largest banks in the Northwest with $50 billion in assets. Like New York Community Bank, Columbia offers a generous 6%-plus dividend yield plus it spots a low price earnings ratio of 7. Net interest margins increased from 3.88% in the second quarter of 2022 to 3.93% in the comparable quarter in 2023.
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