Listen: Street Talk | Episode 129: Investor Sees Inflection Point In Bank Stocks

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Joe Fenech

Nathan Stovall

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Nathan Stovall

Welcome to Street Talk S&P Global Market Intelligence podcast that offers listeners a deep dive into issues facing financial institutions in the investment community. I'm Nathan Stovall. And on this episode, we're talking about bank stocks, the sentiment toward the group, including concerns over margins in commercial real estate and ultimately whether or not it matches the fundamental environment. Coming back on the show to share their view on those issues and others is Joe Fenech, Chief Investment Officer at Gen Opp Capital Management. Joe, thanks for coming back on the show.

Joe Fenech

Nathan, good to talk to you. Good to be with you again.

Nathan Stovall

Joe, let's start at a high level of really what investor sentiment looks like towards the group. And it's been pretty downward, but we've seen it improve a little bit in the last few days. As you noted before we started this, it was kind of a dark tunnel, we're starting to see in the light. But I'm kind of curious of what you look at -- how you look at sentiment towards the group and what catalyst you see towards the sector.

Joe Fenech

Sure. So you're right. I think you hit it on the head, Nathan. It has been a long dark tunnel, but we're seeing the light at the end of it. I think we're in a new investment cycle for banks. And in the early stages of a new investment cycle, any new investment cycle, really, sentiment is going to lag the performance of the stocks, right, at least initially.

So even though it hasn't felt this way, I think, with some of the things that have happened over the last year or so, we're pretty confident that this bear market in bank stocks, this long bear market in bank stocks ended in May of last year. So it hasn't felt that way because most of the sectors continue to struggle with some things, right?

Margin pressure, you had a big regional bank earlier this year that was teetering before private equity stepped in. You've had a lot of hammering over commercial real estate. But look at the fact -- the fact of the matter here is that the bank stock index is up nearly 40%, in line with the S&P 500 since last May. So the stock is always bottom first, but the sentiment doesn't improve until the bad news starts to turn more positive. And we think we're, right now, at that inflection point where that bad news starts to turn more positive.

So I'd maybe point you to a few recent developments. So I think when the retrospective of the cycle is written, it's not the bottoming of the stocks last May that's going to get the attention, I think it's the recap this year of New York Community Bank. So here you have, I think, by far the most challenged of the big regionals, and in comes one of the savviest investors and Steve Mnuchin to step in without government assistance to rescue it.

So smart money comes in to save the sector's biggest potential problem, at the same time, the largest banks in the country are as healthy and as well capitalized as they've been in several decades. So that right there, I think, draws the line in the sand that says, really, there's no systemic credit problem because you're not going to have a major credit problem without the involvement of the two biggest sale banks. And one of the biggest problem in that next largest group of banks was just recapitalized by private equity.

So that event reminds me very much of the recap of BankUnited back in '09. If you remember, Nathan, the stocks bottomed first in March of '09, and then a few months later, you have John Kanas and Carlyle recapping BankUnited. And then that paves the way for the recap of the sector and sentiment slowly got better from there. This time around, the sector doesn't need to be recapped like it did then, but I think the Mnuchin investment will have a comparable effect to the Kanas-BankUnited investment back then.

So that's number one. Number two, I think we're at an inflection point for margin pressure for the industry. So we can talk more about this in a bit. But from a very high level, bank balance sheets today were built during a different time. Bank balance sheets today, I think, really reflect decisions that were made when interest rates were near zero, and the threat was that rates would go negative.

Obviously, rates have gone the other way. There's a painful adjustment process that goes along with that. But for the vast majority of banks, that headwind is going to ease, if not this quarter then next, and then it's going to turn into what I think will be a multiyear margin tailwind for the industry. So I think those are the newsworthy turning points, right? But then the specific catalysts like things beginning to get priced in as we speak, is firming up the visibility to that first rate cut, right?

So the gap between long and short-term interest rates is narrowing. The yield curve has been inverted for quite a while. But from where we sit today, just one rate cut is going to flatten out the curve. And I think that's the trigger for this group to really move higher. And investor sentiment, I think, is going to track that stock performance, but on a lag, and that will provide additional fuel to the fire, right? So just some high-level thoughts. I know we're going to get more into the details of all that, but that's kind of how we see things from a high level, Nathan.

Nathan Stovall

Sure. And I want to pick upon the margin piece, but going back to the NYCB recap and the comparison you made to BankUnited, one of the things that I have noted to people is if you look at where the capital markets were, they were kind of closed for a lot of regional and community banks. And then that deal gets done. And to your point, that's one of the -- that might have been the most troubled institution in that group.

So to me, I've always touted that as a really positive market, the capital was coming into the sector. And you've seen some deals come through since then, too. I know you didn't point to that, but I think that, that's a positive marker towards the group, too, in terms of sort of drawing a line in the sand and saying that we're moving forward from here.

Joe Fenech

I think you're exactly right. So like last year, even though the stocks, we think, technically bottomed in May of 2023, new capital didn't come rushing in the door, right, to save some of the other institutions that were teetering at the time. The market healed some of them, and we just kind of limped along. So I think you're right. You kind of need that high-profile private equity investor. No one more qualified on that front than a Steve Mnuchin, right?

And you had something similar happen with John Kanas, right? When John Kanas stepped in with Carlyle to recap BankUnited, that was sort of the all-clear for the recap of the sector. So the sector doesn't need to be recapped this time around, but I think, sort of, the effect is kind of the same, if you will.

Question and Answer

Nathan Stovall

Sure, sure. We can get back to that later in terms of it could be offset this time, but let's talk about the margin piece a little bit and the idea of margins bottoming. We've been waiting for that for some time. The question is, do rates have to decline, do they have to decline materially for it to see improvement? And I feel like I heard you say no in your mind, that some of this is simply time that we need to see those lower-yielding assets that were sitting on books turnover. Is that what you were getting at?

Joe Fenech

Yes. Yes. So I think that, that visibility to that first rate cut, that will help catalyze the stocks, but I don't think you need it necessarily for NIMs to bottom out, but it would definitely help, don't get me wrong. But let me maybe lay out where I think things sit for the vast majority of banks out there.

So I talked earlier about this balance sheet adjustment process that's taken place, right? Let's say that rates just stabilize right where they are today. The pressure on the funding side maybe persist for another quarter or two, but then it also stabilizes, right? You're already seeing that. The challenge for banks in this adjustment process has been these longer-term fixed rate loans and securities that will reprice higher, but over a longer period of time.

So take a well-managed, well-respected medium-sized regional bank like SouthState, right? They have $8 billion of fixed rate assets that will reprice higher in the 2% to 3% range. At 2%, that's $160 million benefit on a $40 billion balance sheet. So that's a 40 basis point improvement right there in net interest margin just from those fixed rate assets repricing over the time.

So what are the risks to that playing out, right? Rates could move higher, which would further pressure the funding side and at some point, credit could crack, right? So those are risks. But your question was, do we need lower rates to help NIMS? And I think the answer is no, you just need rate stabilization.

And so if you think about it, smaller banks tend to have higher concentrations of longer-term fixed rate loans and securities, right? And if you stratify banks by size, the valuations are almost perfectly correlated to this sort of phenomenon, meaning the largest banks who are the most asset-sensitive, have had the best fundamental performance, those stocks trade right now at the highest valuations. And it literally stair steps down to where the smallest banks trade at the lowest valuations.

And this, I think, is one of the main reasons why. So there's a lot of moving parts to that analysis. But the main point is that we're right now at that inflection point with this enormous headwind of the past few years begins to transform into what I think is like a multiyear tailwind now for margins.

Nathan Stovall

Sure. And to that last point about valuation, I mean maybe oversimplifying it, but regional and community banks in particular, make 75%, 80% of the revenues on spread, right? So if that's a negative story, okay, we're not going to trade the group at a great multiple. We've seen that. I'm not saying it's just fine, but just that's what we're seeing. If this suddenly is no longer a headwind, then that has to be a positive for that portion of the group, right?

Joe Fenech

Yes, it's a disproportionate positive to the smaller banks, and this goes back to my earlier point about the correlation of valuation. So fee revenues have really started to pick up over the last couple of quarters. The larger banks derive significantly more of the revenue, as you know, from noninterest income relative to the small banks. So I don't think it's a coincidence that to this point, the banks that are less reliant on NII have been on the relative advantage, and those stocks trade at higher multiples.

And that's another contributing factor to this wide disparity in trading multiples between larger and smaller banks. So to the extent that you see NII stabilization and eventually growth, it's going to be a catalyst. And I think that valuation gap between large and small, which is about as wide as I've ever seen it in my career, that valuation gap should narrow from here.

Nathan Stovall

And we've seen some of that in the last week, few days where I've seen some folks on the sell side attributing it to not even so much a massive change in the fundamental environment, but that trade unwinding -- maybe not completely unwinding, but easing a little bit where you're heavily favoring the big guys because of this dynamic.

Joe Fenech

That's right. And the big guys tended to be the largest banks, especially a little more asset-sensitive or a lot more asset sensitive, right? So as we get to that inflection point on rates, you're going to naturally see that rotation within the group. The small banks on average, very small banks before this week were trading at book value and the largest banks were trading at about 1.6x book, and that includes Citigroup, which trades at 70 and brings that multiple down. So again, that multiple disparity has never been as wide as we see it today.

Nathan Stovall

So I want to shift to CRE. I feel like we're getting so many questions. I'm sure you have lots of thoughts here. And it's been an overhang for the group. I've made the case that I feel like there's a lot of lazy discussion on this, particularly from folks who are not in bank land. Everybody has decided they know every single CRE loan that a bank makes and that the risk is massive.

And ultimately, I'm just saying that we've made the case there's not enough nuance here. Not every CRE loan is created equal. Not every balance sheet is created equal. Not every market is created equal, and definitely not every subcategory. Do you think that's fair? Do you agree that there's not enough nuance in that discussion?

Joe Fenech

Absolutely agree. So as I said earlier, let's just talk of major credit problems similar to OH, just completely off the table. You can't have a major credit event with help the involvement of the largest banks. Those banks are as healthy as they've ever been, and at the same time, private equities just recapitalize the biggest problem by far among the next tier of large regional banks. So with that context, let's dig into the CRE thing a bit more.

So it seems as though every time there's been a stumble like with New York Community Bank earlier this year, the Wall Street Journal runs the headline that references $3.6 trillion of commercial real estate loans on bank balance sheets. The issue I have is in, like you said, treating that entire 3.6 trillion as a monolith, right? It's some sort of giant proxy for risk.

That $3.6 trillion consists of all the subsectors of CRE, multifamily, industrial, retail and office. So let's, right up front, acknowledge the problem in office that primarily relates to the changes in how people work, right, post-COVID, particularly in the big metros. We see pockets of issues here and there in multifamily, but nothing alarming and nothing overly concerning in industrial or retail.

So it's primarily an office real estate problem. And if you look at research from the Fed, it shows that the larger the office space, the higher the default probability. So it's the larger office towers in the major metros. The big banks have most of this exposure not because of bad underwriting, right, because these are larger credits that even in the best of times, don't tend to fit the risk parameters and they're too big for the small guys.

So if you take a Wells Fargo, Nathan, for two quarters now, they've said that this 11% reserve they have against the office book is sufficient to deal with the problem. In other words, they're not going to be adding to that reserve. Other big regionals haven't gone so far as to say the reserves have topped out, but their reserve against their office book also sits in the high single-digit, low double-digit range.

So Wells Fargo has every incentive that tell the truth and not drag their heels on this issue. It's a single-digit percentage of their overall loan book. They've got a mountain of capital. They've got strong and improving earnings. So there isn't any incentive to drag this out like there might be for a small bank that has a higher concentration of office loans that can't afford the earnings hit to take the reserve to where it needs to be. But Wells Fargo does.

So if you assume their statements are accurate, let's now assume everyone has no reserves today on office real estate exposure and you set everyone's reserves to match Wells' at 11%. We don't have total office exposure for the industry, but if you look at the top 100 banks, that's a very, very manageable and absorbable hit.

And then you consider and I like -- I tell this story a lot, we have a bank in our portfolio in Wisconsin. They've got 40 office loans, no delinquencies, and their comment to us was that the largest building in the cities that they operate in is about as tall as a grain silo, right?

And when you stop to think about it, about 80% of the country looks like the cities that this bank operates in. So the bottom line is that the scale of the problem in no way aligns with the amount of hand wringing that's taking place in the investment community.

And so when New York Community Bank has issues with rent-regulated apartment lending in New York City, where a law was passed in 2019, freezing rents in rent stabilized buildings just before you get in this period of big inflation, it just makes no sense to run a headline conflating that to the $3.6 trillion of total commercial real estate exposure that sits on bank balance sheets around the country.

Nathan Stovall

Right. And so not only is it not $3.6 trillion when we talk about this poster child that they like to paint, that the folks who don't live in the space likes to paint the post-trial problems that is real. It's a fraction of it. And then to your point, the fraction that is there isn't even owned by the regional community banks because they don't have the balance sheet capacity. Even if they wanted to do it, they can't do those credits.

So a lot of them not only exist with the big guys, but exists with CMBS or they're tied up with CMBS or their insurers or credit funds or whoever. So it's not -- that's just the office piece, but it's not really -- we're not talking about actually who has the risk here.

And something else I heard you say, if you think about what have we seen, have we seen anything that really makes us feel better about this, it's that you're actually seeing the guys who do own this reserve pretty aggressively, and those reserves are not moving. We have seen delinquencies rise, but they haven't felt like they needed to lift those reserves beyond those initial builds.

Joe Fenech

Yes. So take like a Citizens Bank, for instance, CFG, right? Similar reserve on office to Wells Fargo. They're about 10%. They've already taken 6% cum losses to date, right? So you effectively got a 16% cum loss rate through the cycle on office, which -- and what they said is that assumes a 71% decline in office property values, right?

You start to think about the bulkiness of these reserves for, lack of a better term, right? If the big banks are right, all you do is set everybody's reserve to that 10%, 11% range. And when you do that, you see that the scale of the problem is in no way big enough to sort of create or justify the angst and the hand wringing that's going on about this topic.

Nathan Stovall

Sure, sure. And I'll talk about different -- or I'll ask about different asset classes, too, but one of the cases that I've kind of made is, okay, we do have a maturity wall here. And there's two points in there. One, yes, the rates are significantly higher, but the asset, you need to do the homework and think about what the subcategories are there and where they're located and all different kinds of things.

But even if there's problems, I've been in the camp that this is an earnings problem and where most of these guys are trading, they're trading -- I don't know if you'd agree with this, but it feels like they're trading like there's holes in their balance sheet. And it doesn't feel like, and it doesn't seem like you think that that's the case.

Joe Fenech

Well, the vast majority of banks no. I'm not going to say there aren't one-off issues out there, and I think we'll continue to see some of those. But again, if you're talking about a sector-wide problem and discounting the entire sector, I don't think that's appropriate, right?

And where are the biggest -- where the meat of the problem sits is, again, with the biggest banks, that are best equipped with the earnings power they have and the capital they have to deal with the problem. And it's a low single-digit percentage of total loans at the banks where this is the biggest problem.

Nathan Stovall

And the other thing, too, I don't know how you think about this, but we have seen extensions we have seen sort of pushed out over time. And maybe that doesn't sound very positive, but again, it allows them to work through it over time opposed to this idea that I feel like you see all these headlines that everything is coming due this quarter and then yet it gets kicked out a little bit further.

I've kind of made the case that I feel like that if there is an issue here, it's not the issue they're presenting, but it's going to play out over a much longer period of time than a quarter or even many quarters. that it's not this huge waterfall event like it's been presented. I don't know if you agree with that or not.

Joe Fenech

Yes. That's right. But I'm saying in a worst-case scenario, even if it was a waterfall event and everyone's reserve has to go to 11% in one quarter, right, to deal with the problem, the scale of this office problem is not sufficient to cause sort of mass recapitalizations around the industry, if that makes sense, right?

So then you layer in the fact of what you said that no one is going to have to go to 11% reserve tomorrow in terms of the small banks, that this is going to play out over time and it becomes even more absorbable. But I'm saying that even in the worst-case scenario, you go to 11% tomorrow for the whole sector, it's an absorbable and manageable problem.

Nathan Stovall

So you've just laid out where you think the most bearish guys are wrong. Maybe said differently, I mean, I would ask you what you think they're missing. You've kind of laid that out. They're missing that this is not as big as of a threat and that it's not going to happen as quickly or in a short period of time, and there's other tailwinds from the margin side.

Maybe asked differently, what do you think it takes to get them to understand that this is not just the '08 playbook? Because it feels like that's what they're going back, is that they're like, oh, we've seen this before. Same thing 15 years ago. We know there's going to be this massive rate defaults and you've seen people who've been saying we're going to see hundreds of failures and things like that. It doesn't really feel like that to me. Do you need to see just quarters of that not happening to kind of get them to understand that, that's not the case?

Joe Fenech

Yes. And there's a couple of data points and recent developments, I think, that kind of further that. So I think every quarter, to your point, that goes by where this notion of CRE arm again, doesn't come to pass, and if we can bridge that gap to the first couple of rate cuts, that helps to provide some relief on that front. Also, I think in retrospect, 2024, in the second half of 2024 is going to prove to be the year of peak concern on this issue. And from there, it increasingly moves to a rearview mirror level of concern.

So to me, it's really just a question of the passage of time without seeing problems on the scale of what we saw earlier this year with New York Community. Having said that, I think there's probably a handful more situations like we've seen recently with some smaller-sized banks or maybe regulators push banks with outsized CRE concentrations to raise some form of capital. Maybe a small bank here or there is caught with an outsized exposure and there's a dividend cut.

But the angst and the discounting of the entire sector relative to the scale of the problem, I think it's way overdone. And in terms of specific developments that have been positive, Washington Federal Bank out in the Pacific Northwest just recently completed the largest CRE bulk loan sale ever. They sold, I think, just under $3 billion of mostly multifamily loans to Bank of America at $0.92 on the dollar. And the discount was not due to credit. It was mostly attributable to interest rate marks.

And the CEO there, Brent Beardall, who I've known and respected him a long time, gave a pretty insightful interview on CNBC with his thoughts on why the whole CRE issue is overblown. I'd also point you to a recent M&A announcement made. SouthState, the bank I referenced earlier, conservative, extremely well managed is buying independent bank in Texas. IBTX -- 57% of the loan book at IBTX is commercial real estate.

So SouthState, I don't think buys a CRE-heavy bank like IBTX if management believes that the CRE crisis is right around the corner, right? So I think the data points are there for people that are willing to dive a little deeper beyond the headlines in the Wall Street Journal.

Nathan Stovall

Totally. And in those two points, the idea of it being a rate issue, those are two markers there. In the context of M&A, you have to mark a target balance sheet to mark. While Feds are taking the mark, no problem. SouthState too, they have the capital to take that mark. But if they really thought that it was a credit problem, they wouldn't be doing it to your point.

And I feel like we could see more clearing trades go if we see more M&A activity. And I'd love to get your thoughts on M&A really in closing. Like we've seen very few deals, a lot of it has to do with the required freight marks, some of it regulatory scrutiny. But it feels like the reasons to do deals are all still there.

The push for scale, the idea that you want to invest more technology and the fact that you might have some balance sheets that are challenged on the potential selling side simply because they have a lot of lower-yielding assets on their books. Do you think we get that pickup M&A activity? And if so, doesn't that have to be another catalyst for the group?

Joe Fenech

Yes. I think what's been interesting about the M&A we have seen, Nathan, is that you saw the deal in Michigan. You've seen IBTX. You saw the Heartlands transaction with UMBF. What's interesting is that through all the stuff we've been through the last four years, franchise value has been preserved. All those deals were over 1.5x tangible book.

So even through everything we've been through, that’s point number one, is that franchise value has been preserved. But I think the M&A wave this time, I think we're going to get it, but I think it's going to look different.

So Tim Spence, the CEO of Fifth Third who I think is terrific made a comment, I think, at a recent industry conference. He said that what OA cost us was not only reputational damage, but it cost us a generation of talent coming into the banking industry. And I hadn't thought about it that way, but he's exactly right, right?

If you're coming out of college anytime in those years after '08, who wants to work in an industry where you just had a financial crash, where the public and the politicians are just hammering you year after year. It just wasn't a sought after career for a long time, and I think we're paying for that now.

So there's a major succession issue in the industry. The average age of the Community Bank CEO today is 62. The boards, as you mentioned, tend to skew older than the management teams historically. We solved that challenge through M&A historically, but because of all the volatility over the past few years, there really hasn't been any M&A. So I think coming out of the cycle, you're going to have a whole lot of senior management teams that probably in a perfect world would have wanted to retire three, four years ago.

Now we are where we are, there isn't the talent in the organization to replace these people. At the same time, the regulatory environment such that there aren't enough approved buyers, right? So it's going to be really interesting to see how it all plays out. I think there's no doubt there's a pent-up demand for M&A and maybe as soon as later this year, it kicks off. But I just think it might look different than what we're used to seeing in the past.

Nathan Stovall

Sure. And with valuations being with what they are, you talk about franchise value holding up, but broadly, as we've talked about, you've got the bigger guys trading at higher valuations than smaller guys. That seems like a nice step for these deals -- for the math to work on these deals, like eventually when that does come. But to your point, if it's a smaller pool of buyers, maybe you don't see a rush out of the gate.

Joe Fenech

Yes. So I mean back to -- I really like SouthState Bank, and I think they've done a nice job. But let's look at the acquisition they just did. You're doing -- you're getting access to great markets at a reasonable price. IBTX, I think, is trustworthy on credit. They just got a little upside down with too many long-term, low fixed rate loans. So to the extent that South State can rework that balance sheet and as time just heals up some of those rate-related issues, they've got a heck of a deal.

So I think there's going to be opportunities as an investor like that to own some of the smart acquirers coming out of the cycle. And then I think you can own the sellers, too, but again, I think you're going to have to take more of a rifle shot approach than we used to in the old days, right? I'm not as willing to own a company that underperforms fundamentally when the only upside I see is if the company chooses to sell itself, right?

I think if you want to play the takeout game, you need to be comfortable owning the stock if the company never sells. And if takeout as part of your rationale for owning it, I think you have to have a specific thesis around how that potentially comes about. In other words, okay, there's value and scarcity to this franchise. There are potentially multiple buyers with the appetite and capacity to pay. And if you're really honest with yourself and that exercise, I just think that exercise is going to weed out more candidates than it necessarily would have in prior M&A cycles.

Nathan Stovall

Certainly. Well, great thoughts. Certainly, I appreciate you sharing your views and I know our audience does us well. Joe, thanks so much for coming on the show.

Joe Fenech

It's great to talk to you as always, Nathan. Take care.