In the wake of credit rating downgrades by Moody’s, regional banks find themselves once again grappling with a challenging environment. Despite this, astute analysts believe that hidden gems can be uncovered within this turmoil. After a turbulent period following the collapses of Silicon Valley Bank and Signature Bank, the sector is facing fresh setbacks. Moody’s Investor Services, renowned for credit ratings and risk evaluations, recently lowered credit ratings for 10 mid-sized banks, attributing the decision to escalating costs and diminishing profits. In response, the Dow Jones plummeted by 400 points, underscoring the profound impact of Moody’s actions.
Moody’s actions are exacerbating the already beleaguered state of the banking sector. As indicated by the iShares U.S. Regional Bank (IAT) ETF, regional bank stocks have plunged by 19% year-to-date, in stark contrast to the S&P 500’s 16% gains. Nevertheless, Wells Fargo’s seasoned banking analyst, Michael Mayo, emphasizes that Moody’s report reflects a retrospective analysis spanning 15 months, aligning with equity analysts who have downgraded average earnings projections for banks by 20%. The Federal Reserve has taken steps to elevate rates to counter inflation and has signaled readiness for further increases. It has also announced intentions to heighten capital prerequisites for major banks.
In the realm of Wall Street, the adage “buy the rumor, sell the news” is familiar. In reverse, this could signify that the current slump in bank news could, paradoxically, offer an opportunity to seize undervalued assets. Alexander Yokum, a senior equity analyst at CFRA, an independent research firm, concurs that many of the concerns are pre-existing. Yokum highlights that since spring, banks have bolstered risk mitigation measures, including augmented capital ratios. As Yokum underscores, the primary concern for banks is an unforeseen shock, such as a deepening recession.
Although the discount on regional bank stocks due to rising interest rates and the looming specter of a recession might seem overstated to Mike Mayo, he urges investors to maintain vigilance against amplified regulation.
Resilience Amidst Challenges: Prospects for Regional Bank Stocks
The resonance of bank collapses, such as those at Silicon Valley Bank and the First Republic, has resonated throughout the regional banking sector since March. Yet, higher interest rates can translate into broader net interest margins, offering a glimmer of hope. While Mayo advocates for investments in prominent national banks, he coined the theme “Goliath is winning,” signifying investor trust in larger banks’ stability. Nonetheless, he underscores the potential value of regional banks in the current climate. Mayo outlines a fourfold criterion when selecting regional banks: strategic and managerial consistency, credit quality, cost management, and robust capital retention.
Mayo asserts that the longer one’s investment horizon and tolerance for downward earnings adjustments are, the more attractive regional banks become. In line with this sentiment, Yokum designates PNC Financial Services (PNC) as his top “strong buy” among the three major regional banks: PNC, U.S. Bancorp, and Truist Bank. Despite a year-to-date decline of 15%, PNC weathered its stress test and lowered its minimum capital ratios. Notably, PNC boasts more substantial capital buffers compared to its counterparts. Moreover, PNC’s minimized unrealized losses enhance its position, as opposed to banks saddled with larger unrealized losses, as indicated in Moody’s downgrades.
Yokum points to PNC’s robust 75% loan-to-deposit ratio, affording the flexibility to maintain net interest margins or safeguard deposits. He emphasizes PNC’s strategic advantage in a climate that prioritizes optionality.
On the other hand, Mayo identifies U.S. Bancorp (USB) and Fifth Third Bancorp (FITB) as strong contenders for sustained growth. Moody’s recent report mentioned both banks: Fifth Third faced a downgrade to a negative rating, and U.S. Bancorp is under review. These announcements led to market declines of 4% and 5.2% for Fifth Third and U.S. Bancorp, respectively.
Mayo’s optimism for these banks stems from credit market dynamics that reduce recession risk and ongoing disinflation. However, Yokum holds a differing perspective on U.S. Bancorp, categorizing it as a hold. This assessment stems from the Union Bank acquisition in December, which lowered capital levels and exposed the bank to potential risks through heightened unrealized security losses. Meanwhile, Fifth Third, despite a 24% dip in the past six months, garners Yokum’s favor due to its consistent deposit growth. With a modest 74% loan-to-deposit ratio, Fifth Third ensures sufficient liquidity to weather unforeseen developments.
Strategic Insights and Picks for the Future
The realm of commercial real estate loans predominantly belongs to regional banks, which allocate approximately 2–4% of their portfolio to this sector. Yokum highlights that elevated interest rates could trigger credit challenges as office space demand wanes. However, Fifth Third’s exposure to office space alterations is limited, with only 1.3% of its portfolio dedicated to this segment.
Chris McGratty, head of U.S. bank research at Keefe, Bruyette & Woods (KBW), advocates a watchful stance. He recommends waiting for investors to revise earnings expectations downward and monitoring reserve growth. East West Bancorp (EWBC) captures McGratty’s attention as a growth stock contender. Despite a 34% surge in the past three months, the California-based bank has tempered growth forecasts in response to the economic environment. Thanks to a substantial capital reserve, East West is positioned to navigate 2023 adeptly. As per KBW’s evaluation, East West is slated for a mid-teens return on tangible common equity by the upcoming year.
Beyond its financial resilience, East West’s niche catering to Asian Americans stands as a compelling factor. It holds a unique advantage in understanding and serving the growing demographic of Asian Americans.
In Q2, East West reported a 21% net income increase over the past year, accompanied by record-high deposits and sustained loan growth. Over the last decade, East West has outpaced industry growth in deposits and loans. Despite these achievements, Yokum remains cautious due to the bank’s 3% exposure to commercial real estate. Post-Moody’s rating announcement, East West experienced a 3% share drop, but it escaped Moody’s reassessment.
Seizing Opportunities: Promising Prospects in Regional Banks
McGratty’s second selection is New York Community Bank (NYCB), which acquired Signature Bank from the FDIC post-collapse. McGratty cites the bank’s liquid balance sheet and 7% yield as underpinning its strength. The acquisition led to a $345 million upswing in net interest income in Q2, and net interest margins grew 69 basis points to 3.21% over the year. Operating primarily in New York with over 400 branches nationwide, NYCB ranks among the largest multi-family portfolio lenders in the U.S.
Columbia Banking System (COLB), the operator of Oregon’s Umpqua Bank, clinches McGratty’s final spot. The acquisition of Oregon’s Umpqua Holdings in March propelled Columbia to become one of the Northwest’s largest banks, boasting $50 billion in assets. Similar to NYCB, Columbia presents an attractive dividend yield of over 6%, combined with a low price-earnings ratio of 7. Over the year, net interest margins increased from 3.88% to 3.93%.
In the ever-evolving banking landscape, challenging times have unveiled opportunities. The path ahead for regional banks involves navigating headwinds while capitalizing on their unique strengths. As analysts advocate a cautious but strategic approach, the prospect of revitalization in the sector remains promising.