Morningstar - Q3 2021 - 82

Investors
Bank Boom
Banks have rebounded, but select
opportunities remain.
SECTOR RAP
Laura Lallos
During the pandemic, Morningstar equity
analysts made their biggest call on banks in over
10 years-and it played out well. In a recent
Financial Services Observer,1
Morningstar senior
equity analyst Eric Compton explained why
they see the sector as fairly valued today and
already pricing in a series of future rate
hikes. He also noted that selective investors can
still find individual opportunities.
I spoke with Compton on the state of the
sector, current opportunities, and how
Morningstar differentiates its analysis. Our
discussion reflects performance and
valuations as of June 30.
Laura Lallos: Can you give a recap of how your
postpandemic call on banks played out?
Eric Compton is a senior
equity analyst with Morningstar
Research Services LLC.
concern was about credit and capital for the banks.
Would they survive or blow up again?
Since then, a lot of that uncertainty has
abated. The economy has generally fared well
enough to prevent major credit losses. In fact, we
have seen almost no normalization of credit
costs. But that was not a given. There were a lot of
forgiveness or deferral systems set up in
response to the pandemic that had never been
done in that way on that scale before. Those
balances were high enough that if they started to
go bad, it could have been a serious issue.
Credit costs have come in below everyone's
expectations. There's certainly been a lot
of economic pain for a lot of people. But from the
banks' perspective, the economy has been
good enough to keep credit costs quite low, and
they have done quite well from a credit and
capital perspective. If anything, they have excess
capital at this point. Now, with increasing
vaccination rates, the economy is reopening and
GDP growth is back. Fee income related to
spending and other activity-related fees that had
been depressed are coming back now.
Compton: The pandemic was obviously
a unique situation, with a lot of uncertainty.
Any time there is potential economic
damage, there will be questions around whether
the financial system is strong enough to
handle it. When unemployment goes from some
of the best it's been in decades to numbers
that make the recession of 2008 look not that bad,
it's pretty jarring. Back then, the primary
Coincidentally, during the pandemic, a lot
of trading and capital markets and investmentbanking-related
fees and revenue did very
well. Larger banks were almost countercyclical,
and those lines of business are still doing
quite well. A lot of signs now are positive for the
banks, and the banks have done better than
anyone could have hoped. We thought the banks
would be able to handle the pandemic-driven
downturn, and they did. It was a good call.
Shifting to more recent results, we were more
bullish on credit than consensus, and Q1
earnings came in better than even we expected.
There has been essentially no pickup in credit
losses. For example, everyone's paying down their
credit cards. Almost no one is defaulting.
Everyone's a lot more positive after Q1, and we're
now more in line with consensus.
Lallos: I just interviewed Barney Frank (Ten Questions,
Page 96), so I'm curious: How much of this positive
outcome owes to the Dodd-Frank Act?
Compton: We have definitely seen a strengthening
of the financial system due to the post-financialcrisis
regulation, and Dodd-Frank was the
major player in that. One of the biggest changes
is that capital levels have gotten much higher.
The magnitude of things that need to go
bad is much higher now, and that increases the
stability of the system.
During the last crisis, as long as you didn't
own mortgage-backed securities, you probably
missed a lot of the pain. But the pandemic
was so broad that it shut down almost the whole
economy. It's hard to diversify away from
that. But even with that heightened risk, when
I was looking through credit metrics I could
not find a corollary to, say, Citigroup C in 2007,
where potentially toxic exposures were very large
compared to capital. This time around, when
you look at capital levels, the scenarios you have
to run to make things really fall apart are much
more severe.
Lallos: Why isn't the mortgage lending boom cause for
concern this time around?
Compton: Any time you hear about the housing
market heating up, everyone gets a little
worried because of the history there. But with the
regulations, this time's a little bit different.
Banks aren't doing adjustable-rate mortgages that
are all going to reset at untenable rates at
the same time a couple years in the future. The
products in general are less risky. The overall size
of the subprime market is not increasing the
way it did during the lead-up to the financial crisis.
If anything, credit scores and such are even
1 Compton, E. 2021. " Banking Outlook 2021: Banks Have Survived the Pandemic, Now How Much Should You Pay for Them? " Morningstar Financial Services Observer, April.
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Morningstar - Q3 2021

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