In February, the president signed an executive order focusing on regulating the U.S. financial system, which may begin the process of reconsidering or potentially undoing parts of the Dodd-Frank Act.
In the 1978 classic film Superman, the superhero swoops down and saves the distressed Lois Lane, saying “Easy miss, I’ve got you,” with a winsome smile. A startled Lois replied, “You -- you’ve got me, who’s got you?”
We don’t blame her for being concerned. We think that even Superman deserved to have an independent check on his ability to save the world. While ratings are a powerful tool for markets (okay fine, more powerful than a locomotive), in our role as credit analysts, we do not simply rely on ratings agencies to save us from credit risks. We form our own opinions on industries and issuers, which may differ from the agencies in some cases. In this post, we take a closer look at the U.S. Banking sector and discuss why we think that U.S. banks are underrated.
Banks saw some of their darkest days during the Global Financial Crisis (GFC) and its aftermath. During the pre-crisis credit and housing market boom, bank debt levels swelled and capital ratios declined. When the GFC hit, U.S. banks were ill-prepared and were forced to raise capital. Shaky governance, weak risk management and poor regulatory oversight contributed to financial distress at banks. Banks paid massive litigation settlements to investors and governments.
However, in recent years, the industry picture has brightened. While headwinds certainly exist from low rates, capital market volatility and energy loan exposure, U.S. banks have increased deposits and maintain sizable excess liquidity. Litigation expense has declined from its peak in 2014, and capital relative to probable loan losses is at a 20-year high. New laws, such as the Volcker Rule and the Dodd-Frank Act, have reduced proprietary trading and created onerous capital surcharges for size and complexity. The beneficiaries of these risk controls have been the banks’ unsecured bondholders.
The market has taken note of this improvement in bank credit metrics. U.S. bank bonds have outperformed industrials in five of the last seven years. More recently, from May 2015 to March 2016, bank spreads traded tighter than industrial spreads. These market dynamics reflect improved capital ratios and risk management at banks, driven by a financial system cleanup after GFC.
But one important contingent has lagged the market in recognizing these improvements to bank fundamentals: Major ratings agencies and environmental, social and governance (ESG) research firms have been slow to upgrade bank ratings. In fact, large U.S. banks had higher credit ratings prior to the financial crisis – when leverage was notably higher and capital ratios were far weaker. Banks rated AA rated prior to the GFC are now placed in lower A or BBB categories by major ratings agencies. Similarly, some ESG research firms have gradually been lowering U.S. bank ESG ratings since 2010 and now rate U.S. banks well below global peers.
Looking closer at ESG research firms, they have a dimmer view of banks for a number of reasons. We observe that some U.S. banks receive very low ESG scores due partly to the high percentage of private credit in the U.S. economy. However, credit is widely available in the U.S. economy because of the importance of consumer spending. While higher-risk credit products exist in the U.S., it is important to remember that these risks are priced; risk-based pricing is in place to account for expected higher loan losses.
ESG firms analyze metrics they deem material for banks, such as board entrenchment, financial product safety and risk management, among others. In terms of board entrenchment, they consider board entrenchment at banks a negative. However, we believe that directors with strong expertise who have experienced various credit cycles may benefit boards.
ESG research firms also penalize regional banks for having weak financial product safety and they claim that U.S. bank lending practices are unsustainable. We think this ignores the fact that since 2011, loan write-offs and bank failures have declined by 67 percent and 91 percent, respectively. ESG research firms typically rate U.S. regional banks in line with – or even lower than – money center banks, even though regional banks typically experience far lower litigation settlements, regulatory censure and allegations of material ethical lapses.
We maintain independent views that are driven by rigorous fundamental research on sectors and individual bond issuers. This is particularly important given the uncertainty created by today’s U.S. election cycle, as some candidates are outlining plans to change the regulatory treatment of large banks. As a result of our research, we may have views that differ from ratings agencies and ESG research firms. We often discuss our assessments with various organizations that rate bond issuers, and we look forward to continuing conversations related to the Banking sector.
 See Financial Times, “Bank litigation costs hit $260bn – with $65bn more to come”, August 23, 2015.
 See company SEC filings and/or Bloomberg financial data for Bank of America, Citigroup, JPMorgan and Wells Fargo.
 See FDIC QBP Time Series Spreadsheets, https://www.fdic.gov/bank/analytical/qbp.
 See Barclays Live, annual total returns data for Invest. Grade: Intermediate Financial Institutions and Industrial Indices.
 Barclays U.S. Investment Grade Index, Intermediate Industrial Bonds, OAS; Barclays U.S. Investment Grade Index, Intermediate Financial Institutional Bonds, OAS, as of May 2, 2016.
 For example, Citigroup Inc. was rated Aa2/AA by Moody’s and S&P, respectively in 2007 and was rated Baa1/BBB+ at the end of 2015. This, despite the fact that Citigroup’s tangible common equity ratio improved from 2.7 percent to 10.5 percent over the same period.
 See MSCI Industry Report: Banks, June 30, 2015, page 4, MSCI ESG Research, Inc.
 See US Bancorp: Intangible Value Assessment (IVA), July, 29 2015, page 1, MSCI ESG Research, Inc.
 See MSCI ESG Research, Inc.; and FDIC, “Quarterly Income and Expense of FDIC-Insured Commercial Banks and Savings Institutions”, December 31, 2015; and FDIC, “Bank Failures in Brief”, https://www.fdic.gov/bank/historical/bank/.
DISCLAIMER: The material in this document is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Nothing in this document should be construed or relied upon as legal or financial advice. Any specific securities or portfolio characteristics listed above are for illustrative purposes and example only. They may not reflect actual investments in a client portfolio. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. This document may contain material directly taken from unaffiliated third party sources, including but not limited to federal and various state & local government documents, official financial reports, academic articles, and other public materials. If third party material is included, it is believed to be accurate, and reliable. However, none of the third party information should be relied upon without independent verification. All information contained in this document is current as of the date(s) indicated, and is subject to change without notice. No assurance can be given that any forward looking statements or estimates will prove accurate or profitable.