Jeff Davis, CFA, is a veteranbank analyst. The views and opinions expressed in this piece are those of theauthor and do not necessarily represent the views of S&P Global MarketIntelligence or Mercer Capital, where he is the managing director of the financialinstitutions group.
Banksare supposed to be boring. The second-quarter earnings reports for the largebanks that reported as of July 18 did not disappoint in that regard. There werenot any meaningful surprises. I doubtthe super-regional banks will surprise either. Credit is in good shape for the time being. Energy-related reserve building is (or nearlyis) over, unless oil prices dive again. Incremental NIM pressure remains following a reprieve in the firstquarter after the December rate hike. The one surprise was better-than-expected fixed-income results, buttrading conditions were good. Brexitincreased volatility while the trend during much of the quarter was bullish, astreasury yields declined and credit spreads narrowed.
Withlittle revenue growth beyond periodic bursts of trading activity, I see thedominant investing theme for the large-cap banks as an income play. I occasionally hear the bank income themereferred to as a shareholder ATM. That is a stretch because a turn in thecredit cycle will nix large-scale buyback activity. If it is bad enough, dividends will betrimmed too. Bank distributions for common shareholders are hardly aperpetuity. Nevertheless, there issomething to be said for a more acquiescent Fed for the time being.
Basedupon data from SNL Financial, large-bank distributions ranged between roughly40% and 80% of earnings in 2015, with 20% to 35% in the form of dividends andthe balance via buybacks. A few such asCapital One FinancialCorp. and Bank of NewYork Mellon Corp. were higher, while laggards and should seedistribution increase to around peer levels based upon the recent approval oftheir 2016 CCAR submissions. BB&T Corp. is set to return more capital to its shareholdersvia buybacks, rather than other banks' shareholders, as it takes a break fromM&A for the time being.
Returningexcess capital, rather than sitting on it and perhaps eventually blowing it bymaking marginal loans and acquisitions, is a shareholder friendly outcome.Distributions in a near zero-rate environment fit well with the zeitgeist ofour times. With P/E ratios based upon2016 estimates in the vicinity of 10x to 14x, the earnings yield approximates7% to 10% for the large banks. The yieldto shareholders is 6% to 8%, assuming an 80% distribution rate. Earnings that are not distributed build bookvalue. Aside from the issue of whetherbanks at times may be overpaying for repurchases, I think the math is not badwith the ten-year yielding less than 2%.
Thezeitgeist of an era eventually ends, however. Sometimes a new distinct era emerges, other times it fades to somethingthat is ill-defined. The unanswerablequestion for the current era of excess capital and high distributions is: Howlong will it last before the inevitable credit cycle reappears? If it is yearsaway, the large banks may absorb a sizable amount of their share base before itends, although not so ironically at much higher prices than issuances occurredin the years immediately after the financial crisis. If the view is the cycle will turn next year,then going up capital structure to invest in the banks' preferred and sub debtfor less income will make sense.
Icould make an argument that if the focus is income (or high distributions) aslong as there is little revenue and earnings growth, then a synthetic bankportfolio consisting of investments in BDCs, residential mortgage REITs andcommercial mortgage REITs could make more sense. Mortgage REITs and BDCs as broad assetclasses sport dividend yields in the vicinity of 10%. As a business model proposition, REITs andBDCs are disadvantaged vis-à-vis banks given the absence of cheap, stabledeposit funding and (much) fee income; however, traditional REITs and BDCs donot pay income taxes as pass-through entities provided at least 90% of taxableincome is distributed. That is a hugeincome advantage in a low-rate environment, though the credit risk profile ofBDCs and commercial banks is hardly the same.
Noteveryone likes BDCs as a quasi-bank substitute due to high external managementfees, investment underperformance and corporate governance issues among someBDCs; however, returns to BDC shareholders would improve if the rhetoricalquestion put forth by a credit investor I heard at a conference comes tofruition in which he predicted few BDCs (as currently structured) would surviveif Vanguard GroupInc. launched a viable low-fee BDC.