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Low Interest Rates Aren't the Biggest Problem Facing Banks

The financial sector has been one of the slowest areas of the stock market to recover from the COVID-19 pandemic. While the S&P 500 is now up by 7% for the year, the financial sector is still down by about 18%. It's a common misconception that banks are performing poorly because low interest rates are hurting profitability. And while this certainly doesn't help, it isn't the primary reason bank stocks are still down, as Fool.com contributor Matt Frankel, CFP, explains to Motley Fool analyst Jason Moser in this short video.

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Jason Moser: But the banks that we typically focus on, as these earning reports start rolling out, Matt, we talk about Wells Fargo (NYSE: WFC); we talk about Bank of America (NYSE: BAC), which I know you're a big fan of; Goldman Sachs (NYSE: GS), another one we talk a lot about on the show. What are some of the things that you're looking for from these banks as these reports start rolling out this week?

Matt Frankel: Well, one, just as a general theme, it's not as much about interest rates right now as it is about loan losses. Banks can make money in low interest environments. I mean, if you go for an auto loan at, say, Wells Fargo right now, it's not going to be 0%, it's going to be, you know, you're still going to pay them 3%, 4%, 5% interest depending on your credit. So, they can still make money in a low interest environment.

Remember, rates were around 0% from the end of the financial crisis for the next, what, six or seven years, and banks were making money. So, that's not the big issue, the issue is how will the economic fallout from the COVID pandemic impact loan losses.

Just in the second quarter alone, I'll start with Wells Fargo. In the second quarter alone, Wells Fargo set aside over $8 billion in anticipation of loan losses. Now, at the time, remember, the $600 unemployment boost was still in effect. Pretty much everyone thought that would be extended in some form; yet to be done. So, that $8 billion might not be enough if things go wrong. Unemployment has decreased quicker than we would have anticipated, but at the same time, the help coming to the people who are unemployed has gone away.

So, the real key thing to watch, especially with Wells Fargo, which Wells Fargo is purely a commercial bank for the most part, they have a small investment banking operation, but for the most part they make money off of consumers and businesses. So, watch the loan loss ratio. I think their net charge-off rate was 0.46% in the second quarter; that's a key number to watch and see how it ticks up in the third quarter, because now we're going to really start seeing what the economic effects of the pandemic have been. There are some effects, but it's a question of just how bad it's going to happen.

And remember, Wells Fargo was the only of the big banks to slash their dividend recently. They need profits to bring it back. I think that the formula has to do with the last four quarters of earnings. Wells Fargo produced a pretty big loss in the second quarter. So, I mean, normally I don't pay that much attention to the bottom-line number, but in Well Fargo's case, it's kind of important, because it's where their dividends come from. And now more than ever, now they really have to be able to justify their dividends. So, that's Wells Fargo, what I'm watching.

Jason Moser has no position in any of the stocks mentioned. Matthew Frankel, CFP owns shares of Bank of America, Goldman Sachs, and Wells Fargo and has the following options: short January 2021 $23 puts on Bank of America and short November 2020 $22.5 puts on Wells Fargo. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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