Regional Banks, Likely Winners in the Third Round of the Fed’s QE
Jay is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Sometimes I wonder what Andrew Mellon would think of today’s ever increasingly complex banking structures. A well-known banker in his time, Mr. Mellon might have wondered himself if all the additional setups within modern-day banks for securities trading, capital markets, wealth management, and beyond bear much meaning of the traditional banking that he knew. It’s not your grandfather’s banks any more, is it? To him, a bank is where you forge this simple and direct relationship with businesses and individual customers to help grow an enterprise or undertaking worthy of your involvement. Do any of today’s banks still operate in such an old-fashioned way? Well, regional banks may be among the last standing, and their traditional lending activities, normally a large part of their business, seem to be more aligned with the Fed’s proposed loan-buying program under QE3.
After turning to buying long-term Treasuries in QE2 from its originally purchasing mostly mortgage-backed securities in QE1, the Fed is now switching back in its current round of open-ended QE3 to target mortgage-backed securities again. In retrospect, much of the money that the Fed supplied through Treasury purchases in QE2 likely has gone to many of the large banks, especially those that trade with the Fed as primary dealers. More attuned to buying investment securities, those banks may have channeled little of the stimulus capital into lending activities--the Fed’s intended focus. Now with the Fed resuming purchasing mortgage debt, smaller regional banks focusing on mortgages and lending in general will have an easier time to replenish their lending capital at better rates, which likely helps raise their bottom line.
Leading the group of regional banks is decidedly Wells Fargo (NYSE: WFC), which has also overtaken Bank of America (NYSE: BAC) as the number one U.S. mortgage lender overall. Total gross loans at Bank of America has consistently declined over the five quarters since the start of the second quarter of 2011, while the same measure for Wells Fargo has been on an upward trend over the same period. Both Wells Fargo and Bank of America have an approximate three-to-one ratio of capital allocation between loans and investment securities. In other words, out of the total capital available for lending and investing, both banks have 75 percent of the capital devoted to lending activities and 25 percent used for purchasing investment securities.
Not surprisingly, interest and fees on loans for Wells Fargo also amounts to about 75 percent of the total bank interest income, consistent with the level of lending capital deployed. However, Bank of America has only close to 68 percent of its total bank interest income in the form of loan income and fees, lower than the 75 percent one would expect, with the balance being interest income from securities investments. This likely indicates that Bank of America’s loan business may have underperformed, compared to both its investment units and comparable lending business at Wells Fargo. Other large banks generally have less focus on lending and more on investing. For example, JP Morgan has a capital allocation ratio of 60 percent vs. 40 percent between lending and securities investing.
Other smaller regional banks such as Fifth Third Bancorp (NASDAQ: FITB) and SunTrust Banks (NYSE: STI) are even more focused on lending than securities investing. Both Fifth Third and SunTrust have over 80 percent of their primary operating capital allocated to lending; leaving fairly small portions of their capital used for securities purchases. As a result, a large chunk of their income is derived from interest and fees on loans. In fact, both Fifth Third and SunTrust have about 85 percent of their total bank interest income in the form of loan income and fees. While Fifth Third assigns only about 15 percent of its operating capital for non-lending investments, SunTrust has a slightly higher percentage in non-lending capital. This seems to suggest that lending operations may have been more efficient at SunTrust, because while having a smaller percentage in lending capital, it has the same percentage of interest and fees from loans as that for Fifth Third.
Banks that use most of their capital to provide loans and derive most of their income from lending usually are small regional banks, because large money-center banks and other bank holding companies often run various investment units and unlikely have highly focused lending operations. As banks have all seen their outstanding loan value getting closer to their pre-recession levels, those that rely on loan increases for growth will find the Fed’s implementing a new round of QE3 the most welcome news. In the current credit-easing environment, one task at hand for more traditional bank investors is to identify banks with most of their capital tied to lending operations against those with large portions of their earnings coming from investment activities.
To learn more about the most-talked-about bank out there, check out the Fool’s in-depth company report on Bank of America. The report details Bank of America’s prospects, including three reasons to buy and three reasons to sell. Just click here to get access.
JJtheArdent has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America, Fifth Third Bancorp, and Wells Fargo & Company and has the following options: short OCT 2012 $33.00 puts on Wells Fargo & Company and short OCT 2012 $36.00 calls on Wells Fargo & Company. Motley Fool newsletter services recommend Wells Fargo & Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.