Market Analysis

Underestimated Financials

Years after the financial crisis, investors are still ignoring Financials’ improving health—but that’s not necessarily bad.

Source: John Moore/Getty Images.

Five years after Lehman Brothers collapsed, investors still seem skittish over US Financials. Revenues are growing nicely, balance sheets are flush with cash, net interest margins are widening and regulatory clouds are clearing. Yet many just can’t shake the ghosts of 2008—they see banks that are still “too big to fail,” foreclosures still on the market and even some “toxic assets” still on the books. In our view, this is a good sign sentiment on the sector remains too dour—likely creating a small tailwind for Financials moving forward.

It’s true some banks are still big—if anything, they’ve become even bigger, as depositors have flocked to institutions they perceive as the highest quality. It’s easy to see why. All the big banks have raised significant capital, cleaned up their balance sheets, repaid bailout loans and started turning profits. When the Fed announced the biggest will face extra-tough capital requirements in July, markets largely yawned—ordinarily it would be a headwind, but the banks are already nearly there on their own. Banks can fill the small shortfall by retaining earnings over the next few years. Furthermore, bank size isn’t inherently a risk—regulators bailed out small banks in 2008, too. For the big banks today, what matters are healthy balance sheets and diverse revenue streams.

One underappreciated reason balance sheets are in better shape today: With housing improving, many supposedly toxic assets are losing their toxicity. They’re starting to gain back their value. Some securitized mortgages are nearly all the way back to pre-crash levels as home values have recovered and homeowners have refinanced. Some institutions that bought them on the cheap have even been able to make a profit! This suggests they weren’t as toxic as feared. Yes, market values fell in the housing bubble’s wake, but they’ve still generated income for the banks that held on, and now that values are being written up, they’re no longer a huge drag on the bottom line. If ever you doubted mark-to-market accounting was misapplied to these illiquid, thinly traded assets, this is pretty strong evidence otherwise.

Housing’s recovery is helping Financials in other ways, too. Thanks to rising home and commercial real estate prices, banks are selling more of the foreclosed properties they’ve held on their books (and writing up the values of those remaining). Realized losses are far smaller than initially anticipated—some properties have even turned profitable! As a result, banks’ distressed real estate portfolios are shrinking—another positive for balance sheets.

Even the Treasury has made out ok, with a nearly $10 billion profit on its “bad banks” bailouts and investments. Yet lately, news has centered on the 113 banks still on the government’s dime—even though a whopping $2.7 billion is tied up there. Profits to-date swamp the remaining liabilities—not what you’d expect if banks were as bad off as feared.

This and other positives are largely underappreciated—great for stocks, which grow on the gap between reality and expectations. That US Financials seem to be outpacing expectations suggests the sector has plenty of room to rise. Few folks fathom banks are cash rich and, despite ongoing quantitative easing (QE), still managing to lend more. And with yield spreads widening lately, higher loan revenues look likely. Once QE ends, they should rise further. QE flattens the yield curve, pressuring banks’ net interest margins—banks borrow short and lend long. Slimmer margins disincentivize lending. Once QE ends, long rates should rise, fattening margins and enticing banks to lend more.

Yet, folks fear the opposite—they suspect rising rates will whack banks’ trading revenues in Q3, making Q2’s rip-roaring earnings growth impossible to match. And, well, a repeat is pretty improbable—Q2’s 28.1% y/y earnings growth was largely a function of some big one-off loses in 2012, which made the comps easy to beat. But earnings and revenue can still be just fine looking forward.

Overall, with sentiment surrounding US Financials still broadly too dour, the potential for reality to beat expectations appears high. Looking ahead, the sector should feel a nice tailwind as folks gradually realize how strong it is.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.