February 8, 2017

Dan Loeb Gets A Little Too Bullish On Bank Stocks

by Breakingviews

Dan Loeb is getting too bullish on banks. In his latest letter to investors in Third Point, the high-profile hedge-fund manager argues that a combination of rate hikes and operating leverage will jack up returns for U.S. lenders and investment banks before any tax cuts or regulation take effect.

Yet Loeb makes some feisty assumptions to arrive at his belief that returns on equity could increase over the next two years by between 2 and 4.5 percentage points. At the high end of the range, that means JPMorgan and Goldman Sachs could be cranking out returns on equity of around 15 percent, while even laggards like Bank of America and Citigroup would finally cover their cost of capital, at around 10 percent.

He’s right that banks have spare lending capacity: the industry has lent out just 79 percent of its deposits, according to data last month from the Federal Reserve. The country’s largest bank by market value, JPMorgan, has a loans-to-deposits ratio at just 65 percent. That’s a lot of lending firepower that could be more profitably deployed.

But the more rates rise, the greater the danger that customers withdraw a decent amount of deposits and put them into higher-yielding assets. Moreover, new rules require the biggest banks to keep a larger slug of cash and liquid securities to hand than before the crisis.

It is also worth questioning Loeb’s link between higher rates and fatter earnings. U.S. Federal Reserve changes to monetary policy show little correlation with American banks’ net interest margin developments over the last 30 years, according to consulting firm Opimas. And though a steepening yield curve could help in some ways, it could also reduce the value of big fixed-income portfolios – and there are always some banks on the wrong side of trades.

A final rosy assumption is that shareholders will get a better deal than employees. It’s true that some compensation ratios were very low last quarter – JPMorgan only set aside a fifth of revenue for its investment bankers. But that was to help get its ROE over the 10 percent hurdle. The more core earnings improve, the less such tricks, which Goldman has also employed at times, will be necessary.

The prospect of tax cuts and rate hikes has already helped boost bank stocks 24 percent since the election, giving Loeb a decent return. And the Trump administration’s desire to cut regulation may help more – though that may take some time. The future of American lenders is brighter now that it has been since before the 2008 crisis – just not as bright as he expects.

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