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Big Banks on the Mend – Part 1

Eight years ago, in response to the Great Recession, the federal government enacted legislation to create a more stringent financial regulatory process. The goal was to increase transparency and accountability for the nation’s largest financial entities. The result was the Dodd-Frank Act.

Many investors, especially those hailing from Main Street, blame the big banks for the financial crisis that the United States experienced from 2007-2009. Greed on Wall Street sparked controversy as toxic mortgages and excessive risk-taking nearly crippled the U.S. economy. 

Thankfully, after experiencing a 19 month of recession, we’ve more than recovered. However, a decade later, many investors are still hesitant to own bank stocks because of mistrust. 

Because of this, the big banks offer some of the best value in the stock market today. This mistrust and ire for the banks could be creating an opportunity for investors. 

Warren Buffett is famous for saying, “Be fearful when others are greedy, and greedy when others are fearful.” 

Big banks are trading with historically low price-to-book value multiples. On a price-to-earnings basis, they’re also trading at a deep discount to the broader market. These discounts represent fear in the market. 

The Trump administration has taken steps to remove some of the regulations from the financial system and growth in the sector is picking up. What’s more, during the last couple of years, capital returns to shareholders have grown nicely as well. It’s rare to find the combination of value, growth, and income all coming from the same sector.

As regulations are removed from the banking sector, some investors fear that history will repeat itself. Human beings are known for their greed. However, the capital requirements put on the banks are still much higher today than they were before and their balance sheets appear to be healthy.

Report Cards Are Due

The last two weeks of July are very important to investors interested in owning bank stocks. While regulation is being removed from the big banks, they still have to pass the annual stress tests. 

The Federal Reserve will announce the results to these tests required by Dodd-Frank in late July. These tests determine the dividends and share repurchase plans that the big banks are able to declare.   

This process is called the Comprehensive Capital Analysis Review, or CCAR for short. You’ve probably run across this acronym in the news lately. That phrase is quite a mouthful, but it essentially means that the Fed conducts tests to track the health of the big banks. Think of the CCAR as a report card for the financial services sector.

The Fed uses different theoretical adverse scenarios to track the capital levels of the big banks. Their hope in doing so is to protect consumers and prohibit another financial crisis. 

The Fed looks at things like changes in real gross domestic product (GDP) growth, unemployment rates, real estate prices and mortgage rates, U.S. stock market volatility, and the interest rates on various U.S. Treasury notes. Each of these scenarios uses 28 variables to determine bank health. 

It’s a complicated process, but thankfully the results looked good this year. Of the 18 largest financial institutions in the U.S., 15 of them were given a thumbs-up by the Fed to move forward with their capital return plans.

Since the positive results were posted, we’ve seen strong dividend increases and share buybacks announced. 

The U.S. subsidiary of Deutsche Bank (NYSE: DB) received the worst grade. Goldman Sachs (NYSE: GS) and Morgan Stanley (NYSE: MS) received “conditional non-objections” from regulators, which means that they are forced to leave their shareholder returns at roughly the same level as last year.

Tomorrow, I will discuss a handful of banks specifically, highlighting their fundamentals and the benefits of owning them from an income-oriented/dividend growth perspective.

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