Are Your Bank Stocks Safe?

By Hightower Omaha on February 9, 2024

February 9, 2024

The regional bank stocks are taking a hit again as investors react to a troubling earnings report from one of the larger ones, New York Community Bancorp (NYCB). That stock is down 64% since January 29, contributing to a 12.5% slide in the SPDR S&P Regional Banking ETF (KRE) over the same time frame. The major concern with the NYCB earnings report was that the bank took a huge provision for loan losses that was well above all estimates. The company said the provision was largely the result of two commercial real estate loans that are in danger of defaulting. Management also mentioned the bank’s rapid growth over the past year+ as a factor contributing to the disappointing report. The company acquired Flagstar Bancorp in late 2022 as well as some of the assets and deposits from the failed Signature Bancorp in 2023. Those acquisitions put the bank over $100 billion in assets, a level that triggers more stringent capital, liquidity and stress testing requirements. 

But if investors’ balance sheet concerns with NYCB are really confined to just two loans and the increased regulatory scrutiny resulting from its growth (which is something investors should have already known about), why would the stock plummet by nearly two-thirds? Is there something else going on we should be worried about? 

Investor concerns about NYCB reflect the broader concerns about the sector as a whole. Extreme interest rate increases and a long overdue turn in the credit cycle, particularly for commercial real estate, are leading some investors to deem the sector “uninvestable.” So should we all be dumping our bank stocks for fear of another banking crisis? Not necessarily. There could be opportunities during this period of rampant fear if we can get comfortable with a few fundamental issues.

How diversified is the bank?

The more diversified the better in this environment. And this means diversity of the bank’s loan portfolio as well as diversity of revenue. Nearly 60% of NYCB’s loans are commercial real estate loans, which includes a huge chunk of multi-family loans concentrated in the New York area where there are rent controls. At the same time, non-interest income (also called fee income) represented just 15% of NYCB’s total net revenue in 2023. That is a low number for a bank of NYCB’s size, leaving the bank heavily dependent on the spread between the interest earned on assets, like loans and securities, and the interest paid on deposits (and other liabilities).    

How well has management navigated the extreme volatility in interest rates?

The huge increase in interest rates last year caused a double-whammy for banks. The value of their loan and securities portfolios declined while depositors left in droves in search of a higher return on their deposits. The drop in asset values caused sharp declines in the capital bases of many banks, and net interest margins were severely impacted by the increase in funding costs. The failures of both Signature Bancorp and Silicon Valley Bank in 2023 were the result of management’s inability to plan for a rate increase of the magnitude we saw. There are many other banks reckoning with the damage those interest-rate increases caused. At best, the headwind will be a drag on earnings for a while. At worst, equity capital could decline materially causing a need to raise fresh capital.   

How “sticky” is the bank’s deposit base?

Both Silicon Valley Bank and Signature Bank were also crippled by massive withdrawals by their depositors. Both had a large chunk of deposits that were over the FDIC insurance limit of $250,000. When customers of these banks realized their deposits could be lost, they had no other choice but to join the “run on the bank.” Regulators have since established precedent that deposits over $250,000 will be covered, but there is no guarantee going forward. Therefore, investors should favor banks with a high percentage of deposits under the $250,000 limit. But depositors are also leaving banks in droves in search of higher interest rates, forcing the banks to increase deposit rates or let the deposits go. Bank investors should look for banks whose depositors are less rate-sensitive for one reason or another, helping those banks keep interest costs low. And finally, there are ways for banks to hedge the impact of higher interest rates, which could insulate them from some of the impact. 

How well capitalized is the bank?

Finally, investors should favor banks that have adequate capital not only today but also in the (likely) event that regulators impose stricter capital and liquidity requirements in the future. Furthermore, the assessment of a bank’s capital adequacy obviously has to include an assessment of the bank’s loan quality and reserve adequacy as well. High capital ratios today don’t mean much if much of that capital is at risk of being wiped out by huge losses on commercial real estate loans, for example. And as we saw with most banks last year, capital can also fall materially as a result of losses on securities portfolios due to the rapid rise in interest rates. 

It is likely that periodic bouts of volatility will continue to plague the banking sector as its constituent companies navigate an extreme turn in the commercial real estate credit cycle and extreme volatility in interest rates. Now is a time to differentiate between those banks that can manage through this cycle and those that could be severely crippled. Generally speaking, larger banks will fare better because of their greater diversification and stickier deposit bases. But that won’t necessarily be true across the board. NYCB has assets of over $100 billion, and it has shown the perils of inadequate diversification and too-rapid growth. In a nutshell, you need to do your homework before investing in banks right now, but there are opportunities to be had for the diligent and disciplined.

Peace,

Michael