U.S. banks were at the epicenter of the Great Recession resulting from their exposures to housing, mortgage-backed securities and corporate credit. Significant loan losses, bank fraud and credit downgrades impaired bank capital, prompting the U.S. government and regulators to take action. The U.S. Treasury, Federal Reserve and banking regulators shored up bank capital levels, adopted quantitative easing and increased regulation and oversight.
U.S. banks are safer today than they were 10 years ago. First, fairly lax rules and regulations have been replaced with closer oversight and new rules for leverage and liquidity including stress tests. Second, banks have, by necessity, increased their internal controls and have dedicated billions in personnel and technology to these efforts. For example, J.P. Morgan has one of out of every seven employees working in its internal control, regulatory and compliance efforts. Third, more demanding capital requirements lead to debt and equity capital infusions increasing equity cushions. Banks are now better capitalized, and the financial system is likely more resilient to certain macroeconomic risks.
The strength of high quality banking models and the uniqueness of bank capital structures make middle-tier hybrid securities an attractive investment opportunity. Middle-tier hybrid securities sit between low yielding senior debt and higher risk equity in the bank capital structure.
Floating rate preferred stocks, subordinated debt and trust preferred securities are examples of middle-tier securities. These securities have attractive coupons (typically 5-8%), unique maturity structures and advantaged regulatory treatment. For example, subordinated debt receives equity capital treatment at the holding company level. We highlight these securities because they have been essentially de-risked and they sit above the first loss position of equities in the capital structure.
A year ago, investors were bullish on banks as beneficiaries of corporate tax cuts, higher interest rates and lower loan losses. Now, investors are concerned that a slower economy and an inverted yield curve will lower profits. Bank stocks have fallen by about 22% on average this year, lagging the S&P 500 very sharply, and are trading well below historical price multiples. Prices of middle-tier securities have also declined (to a lesser extent), despite the fact that these securities have a completely different risk-return profile. The current weak sentiment toward banks has marked down prices below par or call prices. If we are right, it’s a classic “baby being thrown out with the bath water” scenario.
What we like about this contrarian investment opportunity is that it does not require loan growth or high profitability, it simply requires that selected U.S. banks remain solvent and that regulatory capital policies remain in place.
We believe there are under-appreciated opportunities in middle-tier securities of community banks, regional banks and the large U.S. banks such as Bank of America, J.P. Morgan, Citigroup and Wells Fargo. Risk in bank loans include credit risk, interest rate risk, and liquidity risk.
Floyd Tyler, CFA is the President of Preserver Partners, LLC, an SEC-registered, alternative asset manager of private funds and a liquid alternative mutual fund, Preserver Alternative Opportunities Fund (PAOIX). He holds a Bachelor of Business Administration in Economics from The University of Tennessee, a Master of Science from Carnegie Mellon University and a Ph.D. in Finance from The Florida State University.
The information provided herein represents the opinion of the portfolio manager and is not intended to be a forecast of future events, or investment advice. It is not a solicitation to invest in any investment product. It is intended for informational purposes only. Past performance is not a guarantee of future results. Inherent in any investment is potential for loss. Risk in bank loans include credit risk, interest rate risk, and liquidity risk.