Why the Big Banks Offer a Good Risk-to-reward Play

By George Leong for Investment Contrarians | Oct 15, 2012

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The sub-prime credit crisis that surfaced in 2008 drove Lehman Brothers to bankruptcy, caused significant upheaval, and drove the U.S. and global economy into a recession. The aftermath was a structural change to the way banks do business, specifically the amount of risk that is assumed by a bank via sophisticated strategies. So far, the change coined the “Volcker Rule,” set in place by economist and ex-Federal Reserve Chairman Paul Volcker, appears to be capping the speculative trades made by the banks, which is good.

Banks have altered the way they do business and have shown positive strides along the way. JPMorgan Chase & Co. (NYSE/JPM), the first of the major bank stocks to report earnings, blew away revenues and earnings estimates. Wells Fargo & Company (NYSE/WFC) beat on earnings but fell slightly short of estimates despite an eight percent year-over-year increase. In the case of JPMorgan, the recovery in the housing market and the demand for mortgages helped drive revenues. (Source: “Mortgage boom leads to profit surge for JPMorgan, Wells,” Yahoo! Finance, October 12, 2012.)

In my view, the results are fairly good for the two bank stocks, and they indicate that the banks are able to grow their business volumes across the board despite the mixed economic recovery in the U.S. And with the housing market and economy continuing to improve, I feel bank stocks will as well.

The majority of the big banks have paid back part or all of their government loans. Bank stocks are showing promise, and expectations are the third-quarter earnings season will provide some upside surprises. Of course, the impact from the stalled European economies is a wildcard.

The risk related to bank stocks has declined, but there are still issues that could hamper the ability of bank stocks to deliver. According to the Trepp Stress Test, about one out of eight bank stocks failed the stress test. (Source: “Trepp Capital Adequacy Stress Test Report–Q2 2012,” October 10, 2012.)

The chart of the Philadelphia Bank Index shows the upward move of bank stocks from the 2011 bottom. Banks staged a nice rally, but retrenched in March to May 2012 on the European bank concerns and Moody’s Investor Services downgrade of the sector. The group has since staged a rally back to above the 50- and 200-day moving averages (MAs).

Chart courtesy of www.StockCharts.com

Moody’s grew a bit wary of the big U.S. bank stocks, especially given their continued appetite for risk in trying to attain profits. The reality is that the big money for banks lies with investment banking and trading, and not personal and commercial banking.

The stocks with the greatest amount of risk are Bank of America Corporation (NYSE/BAC), Citigroup, Inc. (NYSE/C), Morgan Stanley (NYSE/MS), and The Royal Bank of Scotland Group plc (NYSE/RBS), according to Moody’s.

Moody’s expressed the concern that some of the bank stocks are vulnerable to risk in the global financial markets; we are talking about the U.S. banks holdings in European banks and the excess trading risk assumed in trying to make profits for shareholders.

The second riskiest group of bank stocks is comprised of The Goldman Sachs Group, Inc. (NYSE/GS), Deutsche Bank Aktiengesellschaft (NYSE/DB), and Credit Suisse Group AG (NYSE/CS).

And according to Moody’s, the most stable bank stocks include JPMorgan, HSBC Holdings plc (NYSE/HBC), and Royal Bank of Canada (NYSE/RY).

But there is promise; the Federal Reserve annual stress test in March showed that 15 of the 19 U.S. big bank stocks passed the stress test, compared to 2009, when half of the big banks failed. The four stocks that failed the stress test were Citigroup, Inc. (NYSE/C), SunTrust Banks, Inc. (NYSE/STI), MetLife, Inc. (NYSE/MET), and Ally Financial.

In spite of the risk that still exists in the bank group, the climate for bank stocks is much better and worthy of a look.

Tags: bank stocks, big banks, credit crisis, earnings season, Federal Reserve, Global economy, Recession