Yes, short-term rates are zero. Yes, the yield curve is flat. Yes, a recession appears imminent and some have already declared we are in one. However, banks have simply gotten too cheap to ignore. Many bank’s shares are trading at or below tangible book value. While we believe that most banks are undervalued, Capital One (COF) is at the top of the list.
We view the risk/reward to be one of the most attractive out of the banks we follow, due to its balance sheet. Capital One’s loan book is primarily comprised of credit card loans (roughly 50% are credit cards, the other 50% is roughly an even split between other consumer lending and commercial lending). Given the uncertainty around mortgages caused by forbearance, we believe that credit card focused lenders, like Capital One, are the safer play.
Forbearance Brings Uncertainty Toward Mortgage Lending
The government granted homeowners that are experiencing a financial hardship due to COVID-19 a right to forbearance. Some lenders are simply delaying payments until the end of the forbearance period, others are modifying the loan to tack on the extra payments at the end of the loan. Regardless, forbearance has put major strain on lenders and servicers, particularly servicers, as they are still on the hook to deliver the monthly payments. The government has not addressed the issue, and there’s no guarantee that they will. As a result, we view banks that have meaningful exposure to real estate servicing as a riskier play than those that don’t.
When a bank prices loans, they price them based on risk. For example, let’s say that a 30-year fixed mortgage has a rate of 4%. Included in that 4% yield is a cost in the form of interest rate risk (let’s just say 1.00%), credit risk (let’s say 0.25%), options risk (let’s say 0.50%), and liquidity risk (let’s say 0.05%). After all of these risks are accounted for, the bank is earning 2.20% on a risk-adjusted basis.
Credit card yields, on the other hand, are much higher. As of the end of 2019, Capital One’s effective rate was 12.5%. Included in that yield is again interest rate risk (let’s say 0.50%), credit risk (let’s say 3.50%), and liquidity risk (let’s say 0.50%). After these risks are accounted for, the bank is earning 8.00% on a risk-adjusted basis.
All this to say, is that the risk of not receiving monthly payments due to forbearance is not fully priced into the mortgage. Additionally, although realized credit costs are not likely to trend higher due to forbearance, many consumers will still be left to pay the lump sum at the end of the period. This will likely be an issue for many, especially if they didn’t have the savings to cover one or two months of their mortgage.
Credit cards will likely see an uptick in charge-offs. According to the Federal Reserve Bank of St. Louis, charge-offs on credit cards for the top 100 banks reached as high as 10.6% during the fourth quarter of 2009. If we do continue down this recessionary path, defaults on credit cards are an almost certainty. There is still exposure to credit card holders that do not own a home, and therefore cannot take advantage of mortgage forbearance.
However, we don’t see charge-offs on credit cards reaching financial crisis levels, primarily due to mortgage forbearance. If homeowners don’t have to pay their mortgage, this prioritizes the servicing of their other debt. Additionally, some lenders are approving forbearance with no questions asked. Some consumers may not have necessarily lost their job directly to Covid-19, however, they may take this as an opportunity to focus on their debt that cannot be pushed out into the future.
The Issue With Leverage
We wrote about this in our last article, but credit cards loans require more capital to be held against the loan than a mortgage due to higher unexpected losses. Back to the risk-adjusted return comparison between mortgages and credit cards: the 8.00% is way better than the 2.20%, but that is before leverage. Unexpected losses are generally much higher than credit cards, so credit cards require a larger capital buffer. As a result, banks that have a larger concentration in credit card loans and other unsecured debt are less leveraged than mortgage-focused banks. This allows banks to generate comparable returns on equity.
Leverage is great when times are good. This becomes a problem once unexpected losses begin to accumulate.
Let us just say that we don’t view this as a repeat of the financial crisis. Banks are much more prepared than they were ten years ago. They are more capitalized, have access to ample liquidity from the Fed, and are generally much healthier than compared to pre-crisis levels. However, as we stare a recession in the face, we tend to gravitate towards banks with less leverage.
The Bottom Line
Once again, we view banks in general to be undervalued. Given the valuation that most banks are receiving, the market is expecting significant losses. Our opinion is that many investors are looking to the financial crisis as guidance. We don’t view this to be a similar event. But given the uncertainty of the situation, we prefer credit card oriented banks like Capital One over other mortgage-heavy banks.
Mortgage forbearance will likely lead to credit card charge-offs performing better than past recessions. Further, Capital One has less leverage than other large banks due to their balance sheet, which will likely be an advantage in the near-term future. With Capital One’s shares trading at roughly half to tangible book, we view this to be a great buying opportunity.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in COF over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.