As a disclaimer, all banks are inherently risky. They typically use substantial leverage and a small miscalculation in risk can erase a large portion of the equity in any financial company. This was definitely the fear during the panic and what ultimately caused the failure of Lehman Brothers and Bear Stearns. If confidence is lost in any financial institution it is basically game over. With that out of the way let's dive in.
Bank of New York Mellon (BK)
I took a look at this stock after I heard that Warren Buffett took a position in it during Q3. There are many reasons why BK is attractive but let me list a few. It is now one of five banks in the world with a triple A rating from S&P after the unwarranted downgrade of Royal Bank of Canada. It has very high (and excessive) capital levels, and much lower credit exposure. It currently sells at a little more than 1.1 times book value can earn in excess of 16% on common equity. Expect BK to substantially raise their dividend and buybacks once the government controls are removed.
Goldman Sachs (GS) and Morgan Stanley (MS)
Both of these investment banks are selling at reasonable values and both have strong franchises. Specifically, Goldman sells for 1.3 times book and Morgan Stanley for 0.9. Furthermore, Goldman sells for 1.46 times and Morgan Stanley for 1.0 times tangible book value. Goldman has historically earned higher returns on common equity at around 20% per annum while Morgan Stanley in the 16% range.
Morgan Stanley obviously sells a little cheaper but it doesn’t have as strong of capital levels as Goldman. Reputationally, Goldman is much stronger and has managed themselves much better before and during the recession. Reputation is key in any of these franchises. I know some will point out that the investment banking industry faces some strong headwinds and possibly more regulation. I have no doubt that the investment banking business has learned a few things about risk during the past few years as well. Lastly, the market share off all these institutions have gone up post Lehman Brothers, and perhaps due to reputational damage at Bear Stearns (now a part of JP Morgan).
Despite the risks Goldman and to a lesser extent Morgan Stanley, will do well going forward. Buffett has a significant stake in Goldman so that does reduce some capital risk their. Morgan Stanley doesn't have that kind of financial backing to rest upon, but as we all know the US Government will not allow either of these firms to fail.
Conclusion and Previous Recommendations
In conclusion, I will add that I still believe Wells Fargo (WFC) is cheap. The bank is well capitalized, has the strongest banking franchise in the business, and industry leading net interest margins. I am thoroughly excited with my purchase WFC shares in Q3 and plan on holding them for a very long time. It is rare that you can buy shares in such a great business for the prices they are currently selling for. I believe management at Wells Fargo is outstanding and really understands how to go to market. Did you know that Wells Fargo has a Chief Reputation Officer?
General Electric (GE), another company with financial division that has been under duress during the crisis but they just announced their second dividend increase in six months. GE Capital is working on the problem loans but is still has a strong business. It is capable of earning 3 times their current earnings rate. I have no doubt that GE Capital has also increase market share in some strategic areas. The exit of Textron Financial from the commercial finance of manufactured equipment is one example.
I think is should be clear that the financial sector while beaten up during the crisis, still has a way to go in the recover. Thing have forever changed, but in many ways for the better. Early next year we should see the government allow several of the stronger banks increase dividends and increase buybacks. This will give legs to the next move higher in a number of financial companies.
Disclosure: Long WFC & GE.