After U.S. taxpayers bailed out the nation’s banks from financial disaster during 2009, bank stocks have enjoyed a good run, with Standard & Poor’s Financial Index returning 177 percent from its all-time low of 81.9 on March 6, 2009, to its close of 220.1 on March 25 of this year.
With several financial pundits claiming that many countries around the globe are in danger of falling back into a recession later this year, some investors are concerned that bank stocks have seen their highs and that those stocks will pull back sharply during the months ahead. In contrast, my research indicates just the opposite.
Of utmost importance, the most-recent readings on leading economic indicators for the United States, the euro zone, Brazil, China, India, and numerous other nations suggest that those countries’ economies will continue to improve and expand at healthy rates the remainder of this year.
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Meanwhile, large U.S. banks, such as Bank of America (BAC), Wells Fargo (WFC), and Citigroup (C) substantially improved their financial condition during the past two years by shedding unprofitable operations, reducing the sizes of their workforces, and merging with stronger banks.
In addition, most U.S. banks have raised large sums of money in an effort to improve their capital base, increasing the assets that back their loan portfolios. Because of those actions, many U.S. banks now have risk-based capital ratios that substantially exceed the Federal Reserve’s minimum risk-based capital requirements.
For those of you who aren’t familiar with the term “risk-based capital ratio,” that ratio refers to a financial institution’s total risk-based capital in comparison to its risk-weighted assets. Total risk-based capital includes the book value of a company’s common stock, retained earnings, preferred stock, and subordinated debt; risk-weighted assets refer to the book value of a company’s assets. Assets such as cash are considered to be risk-free, while certain types of loans are considered to be somewhat risky and potentially uncollectable.
Separately, banks are now in a better position to substantially increase their profits. That’s because the difference between the interest rates that banks charge to lend to households and businesses — their primary source of profits — and the interest rates that they pay to borrow funds — their primary costs of operating — diverged sharply over the past two years.
For example, commercial banks currently charge their best business customers, on average, an interest rate of around 3.25 percent, while they pay their depositors, on average, an interest rate of around 0.38 percent on six-month Certificates of Deposit (CDs). Hence, the spread between banks’ lending and borrowing rates is currently 2.87 percent. In comparison, the difference between bank lending and borrowing rates was a negative 0.88 percent during October 2008.
Meanwhile, U.S. households and businesses are in a much better position than they were a few years ago to take out loans. That’s because the debt of U.S. households relative to their after-tax incomes is currently at the lowest level since April 1998, while the solvency ratios of U.S. corporations are near the highest levels in more than seven years.
In light of the fact that U.S. banks substantially reduced their lending standards during the past 12 months, there’s a good chance that U.S. households and businesses will soon begin to increase their bank borrowings and that the profits of most U.S. banks will continue to increase during the months ahead.
Although banks that generate a large portion of their profits from home lending activities, such as Bank of America (BAC) and Wells Fargo (WFC), will likely continue to face some significant hurdles throughout the remainder of this year, there’s a good chance that banks that generate a large portion of their profits from investment banking activities and from making loans to businesses will perform well during the coming months.
Two such banks are JPMorgan (JPM) and Citigroup (C). JPMorgan substantially grew its earnings per share at very fast rates during each of the past four quarters, while Citigroup earned a profit during each of the past four quarters after losing large sums of money in 2009.
Meanwhile, investors who would like to invest in a diversified portfolio of bank stocks might want to consider the SPDR KBW Bank ETF (KBE), which holds the equities of 24 U.S. money center banks and regional financial institutions.
Although stocks of companies that operate in the financial sector of the U.S. economy were among the worst-performing stocks during the four weeks ended March 25, 2011, primarily as a result of investors' concerns about the financial exposure of those companies to Japan and Europe, the longer-term outlook for those companies appears to be firmly intact.
In regard to the very near-term, the S&P 500 Financial Index has held above a key price-support level and its 200-day moving average, and price-momentum indicators suggest that the stocks of commercial banks and investment banks have fallen to oversold levels.
Meanwhile, more companies have gone public this year, and more money has been raised by investment banks this year for initial public offerings of stock, than during the first three months of last year. That trend obviously bodes favorably for the profit outlook and longer-term direction of investment banking stocks.
About the Author: David Frazier
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