Executive Summary

The pandemic has created an extraordinary risk/return trade-off for the shares of high quality U.S. banks. We believe there is the potential for decent returns for bank investors without improvement in the current environment, and the potential for enormous returns if the rate of change in the economy remains positive.

As we watch the markets heading back toward February highs, we note that returns have been driven by technology companies with sturdy balance sheets, defensive consumer staples, and health care. Travel, energy, and credit-exposed financials, among others, have had a bad year.

U.S. bank shares are, we believe, subdued by three causes of fear resulting from the global pandemic. The first and most significant cause for concern is the potential for loan losses in a dramatic, GFC-beating recession. The second is the fear that the Fed will mandate an added regulatory capital cushion in the current environment, resulting in dividend cuts and putting a lid on growth. Finally, there is the fear of a what a move into negative rates might spell for banks’ ongoing profitability. In this note, we outline the case for investing in high quality U.S. banks.1

Banking systems are built to absorb negative news. The ratio of bad to good news for banks is inherently skewed to the downside. For the vast majority of a bank’s assets, the return is capped at an agreed rate – and the actual outcome will be worse after taking into account the inevitable write-offs – while a bank’s liabilities are resolutely dependable and must be paid. However, elevated levels of bad news are only truly problematic for long-term shareholder returns if they necessitate dilutive capital raising, like that seen most recently during the Global Financial Crisis (GFC). It is from this perspective that we address the current fears for the banks; we conclude that the risk of large-scale dilution, for high quality banks such as U.S. Bancorp and Wells Fargo at least, is remote and that the prices on offer at the time of writing are attractive.

Fear of Loan Losses

Yes, there will be significant credit losses for the banks. Q2 will be grim. Whereas Wells Fargo and U.S. Bancorp have set loan loss reserves for low double-digit unemployment, initial pandemic data tells us this is probably not going to suffice. Financial markets have short memories, but not that short – we can understand why many investors’ first urge is to mutter “here we go again” and move on to other opportunities with less hair.

Our work on banks over the years tells us that the devil is in the detail. It’s not the credit losses that investors should fear per se – credit losses are an inevitable part of banking – but a mismatch between those losses and the ability to absorb them. We believe that this time around, for the higher quality banks at least, this is no rerun of the GFC. Why?