US Universal Banks: Investors are Over-Discounting Tail Risk

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September 10, 2013

US Universal Banks: Investors are Over-Discounting Tail Risk

  • Investors in financials are over-discounting tail risk particularly for universal banks. Despite the rally since summer 2012, the price-to-book ratio for the S&P financials sector index is 50% of that for the S&P; the equivalent average ratio for the US universal banks is just 35% (with JPM above at 43%, BAC below at 29%, and C at close to the average).
    • Until November 2007, the ratio for universal banks had dipped below 50% only in 1994 (when surprise Fed tightening came ahead of the April liquidation of Askins Capital and December bankruptcy of Orange County and “tequila crisis” devaluation of the Mexican peso), and 1998 (when surprise sovereign default by Russia in August came ahead of the recapitalization of LTCM in September).
  • Today’s 35% ratio for universal banks suggests meaningfully higher systemic risk than the crisis periods of either 1994 or 1998 when the ratio hit lows of 46% and 48% in April and October respectively (see Exhibit). This is despite the fact that universal banks are meaningfully bettercapitalized today: the average equity/assets ratio for the three of them is 10% versus 7% going into 1994 and 1998.
    • While average returns for the US universal banks will be lower than the mid-to-high teens from 1993 through 2006, they will be more dependable because of higher capital requirements, more intense supervision, and credible resolution regimes.
  • A dependable 10-12% return-on-equity with a payout ratio of 50-60% (consistent with growth in the balance sheet of 4-6%) could command valuations of 1.2-1.5 times book, versus the current price-to-book ratios of 1.0x, 0.8x, and 0.7x for JPM, C, and BAC respectively.

Exhibit: Universal Bank and Financials Valuations (price-to-book relative to S&P500)


Despite a 60% increase in the S&P financials sector index since the height of concerns about European sovereign debt in the summer of 2011, and an increase in the price-to-book value from 80% to 120% (see Exhibit 1), financials are still trading at low relative valuation levels.

Exhibit 1: Price-to-Book Value for S&P Financials Sector Index versus S&P500

Specifically, the price-to-book value for the sector index is 50% of that for the S&P500 versus a 20-year average of just under 65% (see Exhibit 2). The relative price-to-book value fell below 60% in November 2007 as capital-adequacy concerns related to the mortgage-crisis were reflected in downgrades of Citigroup, and has not moved above the level since. Aside from during the technology bubble in early 2000, the only other occasions when the ratio fell below 60% were in 1994 when surprise tightening by the Fed was followed by the fire-sale liquidation of Askin Capital in April, the bankruptcy of Orange County in December, and the “tequila” crisis in Mexico after peso devaluation in December; and in 1998 when the August sovereign debt default by Russia came ahead of the September recapitalization of Long Term Capital Management.

Exhibit 2: Financials Valuation Relative to S&P500 using Price/Book versus Short-Term Interest Rates

The relative valuations of the universal banks are meaningfully lower than even the financials index (see Exhibit 3) with the price-to-book ratios relative to the S&P500 being an average of 35% (with specific ratios of 43%, 33%, and 29% respectively for JPM, C, and BAC).

Exhibit 3: Universal Bank and Financials Valuations (price-to-book relative to S&P500)

We provide this history to illustrate that the present valuation of financials is indicative of greater concerns around systemic risk than in 1994 when highly-levered interest-rate bets were unwound (e.g. Askin Capital, Procter & Gamble, Orange County) and in 1998 when highly-levered credit bets were unwound (e.g. LTCM). This is despite the fact that banks are meaningfully better positioned to manage systemic events than on either of those two occasions. For FDIC-reporting banks in aggregate, the equity/assets ratio is now 11.2% compared with 8% in 1993 and 8.3% in 1997; the universal banks are more levered, particularly JPM (see Exhibit 4).

Exhibit 4: Leverage (equity-to-assets) Ratio for FDIC-reporting banks and Universal Banks

Of course, the average equity/assets ratio for the universal banks at 10% in 2007 was much higher going into the mortgage crisis than in 1994 and 1998, and that did not protect investors. The reason was the sheer scale of the failure of risk management at Citigroup which lost 20% of its equity in 2008. However, this is a true outlier; the only year in our data sample which goes back to 1991 (see Exhibit 5) when either BAC or JPM had negative earnings was 2010 when BAC reported a return-on-equity of minus 1%.

Exhibit 5: Long-Run Return-on-Equity for US Universal Banks

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