Are Big Banks Still at Risk?

Victor is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Profitable growth in the financial sector depends on a rebound in economic growth and rising interest rates. I will analyse three of the four largest banks in the US: Wells Fargo (NYSE: WFC), Bank of America (NYSE: BAC), and J.P. Morgan Chase (NYSE: JPM). They all face the same macroeconomic risks as the rest of the sector. Specifically, continued deleveraging, historically low interest rates and a lack of loan demand. Furthermore, their status as globally important financial institutions will force them to hold quite a bit more capital, which could reduce their flexibility with respect to business investments and consequently depress returns.

Wells Fargo's competitive advantages are still intact

Wells Fargo specializes in community and wholesale banking, wealth, brokerage and retirement. It is also a major player in the residential mortgage market, servicing $1.8 trillion in loans. After acquiring Wachovia in 2008, the firm doubled in size.

Wells Fargo's competitive advantages are still intact. Management has developed a base of $1 trillion in deposits, providing a low-cost source of funds for the company's operations, about 20% more cheaply than its closest competitor. Core deposits grew more than $51 billion over the past year. This, together with a successful expense reduction program provides an exceptionally difficult to match level of profitability by peers.

The company has also started returning its growing earnings to shareholders via both dividends and share repurchases. The company generates ROE at 13.3%, significantly higher than the industry average 9.8%. This implies that the company reinvests its earnings more efficiently than its industry peers. Moreover, Wells Fargo is relatively not a large derivatives dealer. This greatly diminishes complex risk exposures and vulnerability to regulatory changes to the derivative business.

The valuation on a P/E basis looks attractive. The shares currently trade at 10.7 times, at a 14% discount to the the industry average. Additionally, a higher interest rate environment in the future would help Wells Fargo’s margins improve. This is consistent with a long-term buy recommendation on the stock.

A return to a reasonable level of profitability will take time

Bank of America acquired all the outstanding shares of ABN AMRO North America Holding Company in 2007, Countrywide Financial in 2008 and Merrill Lynch in 2009. Its strong consumer and commercial banking franchise, significant credit card operations and growing asset management business could profit from the growth of the global capital markets and steepening of the yield curve.

Expenses are elevated due to the bank's massive troubled mortgage business. There is still pressure on deposit re-pricing, lower loan levels and derivative positions, which are dragging down its net interest income. In addition, direct and indirect exposure to Europe could significantly impact the bank’s financials if the crisis prolongs any further. Bank of America also remains focused on managing capital levels efficiently to meet Basel 3. Under the New BAC program, it plans to reduce risk-weighted assets and focus on corporate borrowers and U.S. retail clients as well as strengthen its investment banking. If successful, the plan could result in a smaller Bank of America, but one with a wider economic moat. Actually, since 2010, the company has completed the closure of more than 29 non-core assets to strengthen its capital position.

Increased regulatory burden is expected to reduce the company’s flexibility with respect to its business investments. With a valuation at 14.7 times its earnings, 18% above the industry average, a long-term neutral recommendation is consistent on its shares.

JPMorgan earnings on track

J.P. Morgan Chase, with operations in more than 60 countries, completed in 2008 the acquisition of Bear Stearns Companies and the banking operations of Washington Mutual Bank.

JPMorgan announced net income to increase to approximately $27.5 billion by 2014. These estimations are optimistically driven by cost-cutting programs, assumption of lower litigation costs and an increase in interest rates. The company will be eliminating overall 19,000 jobs by the end of 2014. JPMorgan’s credit quality continues to normalize due to an improving trend in delinquency rates and net charge-offs and loan balance also increased because of an improving lending activity in its wholesale businesses. It seems as the company will be improving profitability subject to what happens in the market.

Competing with Wells Fargo, the company aims to be the industry's best deposit franchise. Total deposits surged 7% YOY to $1.2 trillion in the 1Q 2013. Additionally, JPMorgan will be able to leverage its strong deposit base when interest rates finally rise.

JPMorgan currently trades at 9.4 times its earnings, a 25% discount to competitors’ mean valuation. JPMorgan’s intention to buy back shares from the second quarter of 2013 onwards will boost investors’ confidence in the stock. However, it doesn’t look like an outperforming stock in the market and so for this reasons I recommend to hold.

Bottom line

Even though the macroeconomic environment will influence results, an extended period of (1) deleveraging, combined with (2) an extended low interest rates environment and (3) greater scrutiny from regulators, could dramatically reduce profitability for any of these banks. While Bank of America and J.P. Morgan Chase do not offer convincing reasons for a buy recommendation, Wells Fargo is expected to deliver strong growth figures in the future. Technical analysis can also help analyse possible outcomes. I recommend investors to read this blog post which describes why it is important to pay attention to it.

Victor Selva has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, JPMorgan Chase & Co., and Wells Fargo. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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