Saturday, September 19, 2009

Update on bank investment thesis: WFC, USB, Lloyds TSB

The banking sector is undergoing a tremendous amount of stress and change, with parameters that fall beyond our earlier investment thesis for banks WFC and USB and Lloyds TSB (UK). It is necessary to reconsider the investment thesis for banks, and incorporate these latest data points.

Broadly the following macro changes have to be factored into the investment thesis:
  1. The macro environment is turning out much worse than expected. This will drive losses and loan defaults are likely to increase to outlier levels unless some form of government guarantee or intervention takes place. The chart of loan resets (below) suggest that more pain is to come as the wave of Alt A and Prime loan resets hit.

  2. The probability of the macro ecosystem changing is rising: regulators and/or the market may make it difficult for banks to sell their loans. If this persists, then banks will likely have lower ROAs because they will have to hold loans on the balance sheet. This could lead to a fundamental downward revaluation of bank equities.

For WFC and Lloyds TSB specifically, their investment merits need to be re-evaluated. WFC's acquisition of Wachovia and Lloyds TSB's acquisition of HBOS has created a great amount of uncertainty:
  1. How much bad assets are there sitting on the acquired bank's books? WFC and Lloyds TSB have good credit underwriting and a good loan book; it can only be hoped that their acquisitions have equally good loan portfolios.

  2. Both WFC and Lloyds TSB have a good business model, and are able to price their products at a premium. HBOS on the other hand, has traditionally relied on low prices to win business. Wachovia is in the middle of the road, not relying on low prices, but not able to command premium prices either. This suggests that the customer bases of acquirer and acquiree are very different, and that their business models are also very different. Whether these can be integrated is a large unknown.
Monthly Mortgage Rate Resets Chart: