Since the beginning of 2013, we have been hearing a whole range of positive opinions about the housing recovery, which is also a big sign indicating the gradual revival of the overall U.S. economy. While the housing recovery is still stable, the world of refinancing is seeing a declining trend because of increasing rates. The sizable increase in rates has prevented borrowers from entering into refinancing agreements, which has driven down the business of huge mortgage lenders like Citigroup (C) and Bank of America (BAC).
It is not new for the companies facing a slowdown in business to go for job cuts as an exercise to manage expenditures. Recently, Citigroup announced the closure of its Danville office and dismissed approximately 120 people as per reports. This is clearly indicative of the fact that the huge banking giant is facing a decline in mortgage business. Though the business of Citigroup encompasses various services, the recent development in its refinancing and mortgage business would give a considerable blow to its revenues.
Citigroup received more assistance than any other bank from the federal government after the sub-prime crisis in 2008. A few days back, the Federal Deposit Insurance Corp (FDIC) announced the sale of the last of its interests in the company, as reported by Reuters. The federal government has made a total return of around $13 billion on its bailout funds and its decision to exit suggests a robust turnaround in Citicorp's overall operations. Though the stock rallied only around 2% after this news, it still reflects positive investor sentiment.
While we are on the 2008 crisis page, I would like to highlight that one of the main reasons for the failure of big banks was bad lending practices. Once the crisis was over and the government was bailing out a number of banks, regulators decided to impose stringent rules on capital requirements so as to monitor lending practices.
While Citicorp's management admitted a level of uncertainty about the new rules, the company's Tier 1 common ratio increased to 10% under Basel III norms. Going ahead, regulatory capital maintenance will have a considerable impact on overall operations of banks and will be a crucial component while analyzing banking stocks. For Bank of America, risk-weighted assets under Basel III were $1.31 trillion, $43 billion lower than quarter one, 2013 because of an improvement in the composition as well as overall credit quality on the books.
In July 2013, Bank of America's second quarter performance beat Street estimates by a reasonable margin because of an improvement in credit quality, robust expense reduction and healthy presence across a diverse range of customers. The stock has gained approximately 53% over the last year as a result of a healthy recovery in the overall economy and is currently trading in the range of $14.50-$15. A good number of analysts have suggested this to be a good entry point considering the fact that Bank of America is trading cheap at a PBV ratio of 0.73 as compared to its peers and the industry average.
In the last year, Citigroup delivered an increase of 47.04% (assuming that the dividends are reinvested) in total returns as compared to the S&P 500's total return, which was up by 17.05% over the last year. It goes without saying that the company has created reasonable value for its shareholders by way of huge price appreciation and consistent dividends. However, the big fall of 2008 still lingers in the minds of investors due to which they are skeptical about investing in banking stocks.
Apart from healthy results and well-regulated policies, big banks like Citigroup and Bank of America need to regain the confidence of investors by strengthening their brand image. The Fed's decision to taper off its QE program could well be the beginning of happy times for the banks as interest rates would go up, thereby fetching better margins in the core business of lending. Additionally, the improvement in the U.S. economy would fuel a greater demand for loans that would only increase the magnitude of gains.
While I agree with analysts on this being a good time to invest in companies like bank of America and Citicorp, it would be wise for investors who do not have a healthy risk appetite to wait for the markets to absorb the effects of big regulatory reforms and major policy decisions ahead.