October 19, 2023 | Premium Service | Are bank stocks cheap? Banks are certainly inexpensive compared with other sectors and have been for a long time. Banks trade for single digit price-to-earnings multiples. Residential mortgage REITs at least trade in the low teens in terms of P/Es. We recall the judgment of Kevin O’Leary on CNBC a few years back: “Banks are dead money.” Indeed, today many banks are book insolvent thanks to the Federal Open Market Committee, but that is mostly an earnings problem.
This week we had caught up with Ralph DelGuidice, who has contributed to this blog in the past, about the world of banks. As we discuss below, commercial banks have a number of ways to deal with impaired assets that are not readily apparent to equity investors. But the large universal banks that ply the capital markets and make use of essentially infinite leverage in the derivatives markets also face a number of serious challenges ahead.
If you think of all of the low-coupon debt and loans sitting in the portfolios of large banks, these assets are going to be with us for years, even decades, to come. But is that bearish for commercial banks? That depends on whether we are talking about banks that make loans and take retail deposits vs banks that trade the markets and manage assets, real and borrowed.
The former group is currently under downward pressure due to fears about credit, while the latter are still benefiting from the lift they experienced during COVID and zero interest rates -- for now. The latter group of dealer banks, joined by some of the larger hedge funds, use leverage that is proportional to what the system allows, to paraphrase Ralph.
Two words: centralized clearing. In a world where derivatives dealers and their customers must actually own the Treasury collateral they use in centrally cleared trades, the use of leverage will be significantly reduced. Systemic risk and dealer earnings will decline. The chart below shows some of the mind-boggling gross derivatives positions of the larger dealers and Peer Group 1.