Since this is our first newsletter, we’ll start by explaining why we’re doing this and what our readers can expect going forward. We hope you’ll give us feedback on what you like, what you don’t like, and what else we should consider as we fine-tune the product. Also, expect shorter issues in the future following this initial introduction!
We’re doing this for a couple reasons:
To provide a platform to comment on industry developments and connect with a broader audience in more of a real-time format. Also, we miss aspects of our former careers as research analysts and this helps us scratch the itch, without the burdens of stock ratings, price targets, and EPS estimates.
What you can expect:
With that said, let’s jump in
Bullish on bank stocks, but still navigating some rough terrain
Why is everyone so skittish? A little context…
Microsoft (MSFT) Stock Price vs Operating EPS
The 2008 crisis was a similarly devastating event for banks, but in our view, the sector healed itself over the next decade. Underwriting and service quality improved, new rules were established after a period of lax regulation, and incentives were better aligned. A well-deserved redemption period awaited during the 2020’s, but instead has evolved into a state of near-constant panic, brought on not by a flawed approach to risk management as in 2008, but rather by the pandemic and its destabilizing aftermath. Banks unfortunately have had a front-row seat, with every spasm, no matter how idiosyncratic, leading investors to dive back into the bunker, restarting the clock on the “show me” aspect of the sector’s recovery.
So we get the pushback, but consider the following:
Like the Microsoft example above, banks have created value that has gone unrewarded in the market. Since 2017, banks have grown tangible book value by 40%, or 6.7% annually, in line with the LT average, and yet, the bank stock index (KRE) is down 19%. Similarly, P/E multiples for banks have contracted, while the broader market multiple has significantly expanded, by -4 and +5 multiple points, respectively.
Stock Performance Vs. TBV Growth Since 2017
CRE risk hysteria triggered by NYCB is overstated, but stock overhang will linger for now.
Risks around CRE have been circulating since rates headed higher but were exacerbated by the disclosures from New York Community Bank in late January. Late last year, the Wall Street Journal published an article noting that the bank sector’s exposure to commercial real estate was $3.6 trillion, including about $623 bil. of CMBS and loans to non-bank lenders.
The market has treated announcements like NYCB’s as an indictment of the entire $3.6 trillion CRE exposure. The sub-asset classes of CRE are office, multifamily, retail, and industrial. NYCB’s credit issues fell into the office and multifamily segments, where there is no denying that there are issues but…it’s complicated!
Not all office exposure is created equal... In the office segment, behavior has changed what the future looks like since COVID, with large metro area office towers experiencing higher vacancy rates due to changing workplace norms. As loans mature, higher rates create challenges for refinancing property that is now worth less, and muted deal activity inhibits price discovery.
…and the same is true of multifamily. NYCB’s issues here relate to the rent-regulated multifamily segment in NYC, to which it is the largest lender of any bank. The idiosyncrasies of the entire NYCB situation are well-known, but less discussed is that specific concerns around multifamily are also quite likely idiosyncratic to metro New York. In 2019, the state passed the New York Housing Stability & Tenant Protection Act, limiting the ability of landlords to raise rents in line with inflation, higher rates, and financing costs. Even in California, regulations were relaxed at the end of 2023 to allow more flexibility on price increases for rent-regulated apartments. Other NYC-exposed banks report to us that rental rates are up about 30% since COVID on traditional multifamily – in other words, higher rental income is helping to absorb the impact of inflation and higher rates. So again, even within New York, let alone the rest of the country, NYCB’s issues aren’t an indictment of the broader multifamily market.
A few other points to consider as it relates to CRE armageddon fears, much of which we attribute to what we call 2008 PTSD:
In the near-term, it’s likely that these counterpoints won’t matter very much as it relates to the stocks, as the NYCB news unleashed a genie that will prove difficult to stuff back into the bottle. But it’s just not accurate to suggest that $3.6 trillion of CRE exposure is at risk because a bank in New York City took some losses on downtown office real estate and rent-regulated multifamily.
While we don’t foresee announcements of the same size and scale ($100 bil.+ asset banks) as NYCB, any stumbles by smaller banks will be seized upon as further validation of CRE armageddon fears. So while we’re confident that risks to the system and the vast majority of banks is significantly overstated, as it was following the failure of Silicon Valley Bank last year, potential risk to the stocks remains acute, and at the very least, further extends the timeline to “normalization” in this post-COVID world. For bank investors, this backdrop creates frustration and risk…but also tremendous opportunity.
Bank stock observations:
Biggest still seems best, at least for awhile longer. The four largest bank stocks were all up last year, led by JPM. Heading into this year, these stocks still seemed attractive, but more for company-specific reasons. Wells Fargo seemed closer to escaping regulatory purgatory; Citi was poised to continue its “bad to better” transformation; and JPMorgan seemed deserving of a stock re-rating on par with great companies in other sectors. As a group, they all seemed likely to benefit from proposed capital rules perhaps being watered down, leading to increased capital return, and undemanding valuations, historically speaking. Moreover, with the back-up in rates and increased likelihood of “higher for longer”, anticipated NII headwinds are dissipating, as earnings guidance that was previously based on 6 rate cuts will likely prove too conservative, while increased concern about CRE impacts these companies less. Interestingly, amidst the NYCB hullabaloo, big bank stocks have quietly broken out, with JPM now trading at an all-time high, and WFC and C trading at post-March 2023 highs.
Preferreds still screening attractive. Bank preferred stocks have set back a bit recently on the NYCB news and the back-up in rates after a strong rally post the irrational fears of systemic risk last year. With the announced Fed pivot and irrational fears taking hold (again, but this time on CRE credit), preferred stocks, many of which are still trading at deep discounts with upper single to low double-digit yields, seem attractive. Moreover, we suspect that most fixed-to-floating rate preferreds resetting this year (to low double-digit coupons) aren’t likely to be redeemed amidst the current market turmoil and ahead of the finalization of new capital rules.
Thinking through the potential trouble spots. While we think broader credit fears are overblown, the sector isn’t devoid of potential land mines. As evidenced by NYCB, a cheap valuation won’t insulate a stock following a dividend cut brought on by credit concerns and a reduced earnings outlook. For smaller banks too, share liquidity can present an extraordinary challenge in this regard. AOCI also presents headwinds to TBV growth and TCE optics as rates back up. We don’t think these issues are widespread, but the profile of a bank that’s liability sensitive in a higher-for-longer rate scenario, with heavy CRE exposure, a CECL-induced reserve that sits below peers, and a high dividend payout ratio is potentially problematic if a credit blip calls into question the sustainability of the dividend.
Topics for future newsletter issues:
Disclosures:
Of the individual stocks mentioned, our investment fund currently has long positions in Wells Fargo & Co., JPMorgan Chase & Co., and Citigroup Inc. The author(s) has long-standing long positions in Microsoft Corp. Citigroup Inc., and JPMorgan Chase & Co. in his personal investment account.
The information in this newsletter does not constitute an offer to sell or a solicitation of an offer to buy any security. This information does not purport to be complete, is subject to change, and is qualified in its entirety by the definitive offering documents related to any private fund managed by GenOpp Capital Management LP. All time-sensitive references are made as of the date set forth above, unless otherwise expressly indicated, and there is no obligation to update any such reference. The delivery of this information does not imply that the information is correct and no representation or warranty is made as to the accuracy of any information contained herein. This information is not a recommendation to buy any security and does not constitute any form of legal, tax, investment, or other adv