Investors have been warming up to bank stocks in a big way. The KBW Bank Index jumped 50% over the past two years, and a brightening economy suggests further good times ahead for the industry.
Yet looks are deceiving. A series of regulatory changes actually portend tougher days ahead.
Wells Fargo & Co. (NYSE: WFC), which has been repeatedly cited by Warren Buffett as America’s best-run bank, should buck the head-winds. Frankly, it’s the only bank stock you should have in your portfolio right now.
Still Tweaking The Regulations
Dodd-Frank regulation is the most comprehensive reform of the banking industry since the Great Depression. It’s so detailed that only 220 of the 398 required rules have been finalized.
The move away from institutional credit ratings for risk-based capital will mean larger due diligence departments for banks of all sizes. One local bank surveyed by the Washington Post reported a seven-fold increase in its compliance team. Mergers between smaller banks are increasing to better handle the regulatory burden. And in the quarters ahead, the regulatory burden will only grow greater.
On top of existing regulations put in place by the Dodd-Frank legislation, January brings the implementation of the international Basel III requirements to U.S. banks. This requires banks to hold more funds in reserve, limiting the amount available for lending. The Board of Governors of the Federal Reserve approved U.S. rules for Basel III implementation in 2013 for implementation next year.
The soon-to-be-implemented Basel III rules will lead banks to increase their Tier 1 capital to a minimum 8.5%, from a current 4.0% minimum. (Tier 1 capital is composed of a bank’s common stock and disclosed reserves.) Minimum total capital requirements increase to 10.5% from 8% in January.
The inclusion of unrealized gains or losses to capital measurement imposes more volatility. This means that many banks will probably hold more capital than is necessary in order to avoid a shortfall.
The move to force banks to bolster their balance sheets comes at a bad time. Bank lending has failed to contribute much to economic growth over the past several years and may not give much of a boost to the economy in 2015 either, as capital bases are enhanced. Two key stats paint the picture: Consumer credit at depository institutions increased just 2.7% from the end of last year to August; and mortgage debt increased just 1.5% in the second quarter of 2014, compared to a year earlier.
Best In Class With Housing Tailwinds
Against higher regulatory burden, housing may become a bright spot for banks.
Though mortgage lending has yet to materially strengthen, home equity lines of credit (HELOC) jumped 17% in the third quarter. October home prices snapped a seven-month slowdown, increasing 6.1% -- prices rose in every state. Housing prices are within 10% of their prior peak in 27 states, and the increase in credit is a harbinger of homeowner confidence in higher prices.
Of the big banks, Wells Fargo has the biggest exposure to housing with 17.6% of the mortgage origination market in the United States. This is almost triple the next largest share of 6.3%, held by JPMorgan Chase & Co. (NYSE: JPM). First-time mortgages for family properties housing one-to-four people increased 9% in the first two quarters of this year.
In addition to holding the top spot for residential and commercial real estate loans, the bank is also number one in small business and auto loans. Wells Fargo's total loan portfolio grew by 3.7%, better than JP Morgan, Citigroup, Inc. (NYSE: C) and Bank of America Corp. (NYSE: BAC).
And the loans are performing well. The bank’s net charge-off rate, or the bank's declaration that the debt will not be repaid, fell every year of the last five and is now just 0.32% of loans.
Wells Fargo has a much smaller reliance on investment banking and other non-interest income products that may get hit under regulation. The bank had a common equity-to-Tier 1 capital ratio of 11.11% and total capital risk-to-assets ratio of 15.6% as of September, well above the requirements mandated in the new regulation.
Meanwhile, this well-run bank also sports solid value. Shares trade for 13.2 times trailing earnings, below the industry average of 15.6 times. Look for shares to rise 10% or more over the next year, to above $60, as the housing market slowly brightens. Investors also benefit from a steadily growing dividend, which currently yields 2.5%.
Risks To Consider: New regulations target banks with $10 billion or more in assets, but could limit lending and growth across the entire banking sector. While some banks may benefit from economic tailwinds, volatility may increase for all names in the sector.
Action To Take --> New regulatory burdens from Dodd-Frank and Basel III are set to start hitting banks soon and investors need to adjust their portfolios toward banks that can withstand higher capital requirements and staffing needs. Look to banks like Wells Fargo, which have limited exposure to non-interest income and may benefit from the continued recovery in housing.