COVID-19 ushered in the real possibility of widespread loan defaults, liquidity issues, ballooning credit card debt (as banks hold the liability), and stressed mortgages. To exacerbate these COVID-19 impacts, a delicate balance between interest rates, Federal Reserve actions, potential yield curve inversion, and liquidity must be reached. The customer side of the business continues to be worrisome as the duration of this crisis continues to drag on with no signs of slowing. A segment of the consumer base is faced with lost wages and the real possibility of not being able to meet their financial obligations (i.e., car payments, mortgage payments, etc.), which will unquestionably have a negative impact on revenue and earnings for banks. The financial cohort is in a difficult space as the broader economic backdrop continues to dictate whether these stocks can appreciate higher. The initial shock of the COVID-19 pandemic resulted in the market capitalizations of many large banks to be cut by ~50%. Some of the largest banking institutions such as Citi (C), Goldman Sachs (GS), JPMorgan (JPM), and Bank of America (BAC) were sold off in the most aggressive manner since the Financial Crisis a decade earlier. As COVID-19 continues to drag in both spread and duration, share buybacks have now been halted, and dividend payouts arrested. The stability of dividend payouts is now in question as uncertainty continues to cloud this sector. Moving forward, how durable are the major financial names at these depressed levels, are the banks investable in light of the COVID-19 backdrop?
Recent Federal Reserve Stress Tests
The Federal Reserve put new restrictions on the banking sector after the results from the annual stress test found that several banks could get too close to minimum capital levels in potential scenarios tied to the COVID-19 pandemic. The largest banking institutions will be required to suspend share buybacks and arrest dividend payments at their current level for Q3 of 2020. For the first time in the 10 year history of these stress tests, banks are now required to resubmit their payout plans again later this year. This move is indicative of the unique and unprecedented landscape of the COVID-19 pandemic.
The biggest banks already said they would voluntarily suspend share repurchases, which made up roughly 70% of capital payouts for the industry. What remained were the dividends except for Wells Fargo (WFC), which is struggling to restore profits after its scandals. Worst case scenario modeling puts the unemployment level peaking up to 19.5% and could result in up to $700 billion in loan losses for the 34 banks that take part in the annual stress tests. The industry’s aggregate capital ratios could fall from 12% at the end of 2019 to as low as 7.7%. This necessary capital is defined as the difference between a bank’s assets and liabilities, which serves as a buffer to absorb these potential losses.
The COVID-19 Impact
COVID-19 has materialized into the black swan event that only comes along on the scale of decades. This COVID-19 induced sell-off has been the worst since the Great Depression in terms of breadth and velocity of the sell-off. This health crisis has crushed stocks and decimated entire industries. The S&P 500, Nasdaq, and Dow Jones indices shed approximately a third of their market capitalization in late March.
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The longer the COVID-19 economic shut down persists, the higher the unemployment will rise. More companies will run the risk of liquidity issues, access to capital, and potential bankruptcy. On the consumer side, massive unemployment will negatively impact the ability to pay mortgages, rents, student loans, and auto loans. Consumer demand will plummet as a function of rising unemployment. In the backdrop of all these destabilizing financial conditions are the large financial institutions. The banks underpin all the lines of credit and liabilities which appear to be in jeopardy after the COVID-19 pandemic.
Banks Were Healthy Prior To COVID-19
The most recent annual stress test results came back overwhelmingly positive for the financials. 18 of the most prominent institutions operating in the U.S. had to show they can survive an economic downturn while maintaining the ability to make loans and continue paying out dividends. That hinges on a bank’s capital. Every bank won approval to boost shareholder payouts under the capital plans they submitted. Collectively, the results showed a resilient banking industry compared to the financial crisis a decade ago, when the government had to bail out lenders. The banks have more than doubled the capital it has to absorb losses to about $800 billion, per the Federal Reserve.
The big banks, specifically JP Morgan (JPM), Bank of America (BAC), Goldman Sachs (GS), and Citigroup (C), were coming off of record profits and revenue across the board. All of these solid numbers from the big banks were expected to continue until COVID-19 hit. Based on the aforementioned stress test results, the Federal Reserve is committed to having a healthy and robust banking industry to support a variety of economic scenarios given the COVID-19 backdrop.
Are Financials Investable?
The banks are far stronger than they were during the 2008 Financial Crisis and have rigorous annual stress tests that maintain fiscal disciple. Banks are well capitalized and working with clients and consumers on payment deferrals if impacted by COVID-19. The banks can assist in providing a financial bridge to those businesses and consumers negatively impacted by COVID-19 as a stop-gap measure. As this pandemic passes and economic activity rebounds, the banks will present value at these oversold and depressed levels. JP Morgan (JPM), Bank of America (BAC), Goldman Sachs (GS), and Citigroup (C) have lost a significant amount of market capitalization as a result of the COVID-19 impact and present compelling investment opportunities. Their strong cash positions and healthy balance sheets are allowing dividends to continue as the economy transitions away through the COVID-19 damage.
The COVID-19 pandemic has undoubtedly had a negative impact on economic activity worldwide. COVID-19 has ushered in the real possibility of widespread loan defaults, liquidity issues, ballooning credit card debt, and stressed mortgages. To exacerbate these COVID-19 realizations, a delicate balance between interest rates, Federal Reserve actions, and potential yield curve inversion must be reached. Despite this overwhelmingly negative backdrop, massive fiscal and monetary policies are being adopted quickly to blunt this economic fallout that amounts to trillions in total stimulus. The banks are far stronger than they were during the 2008 Financial Crisis and have rigorous annual stress tests to show they can survive an economic downturn while maintaining the ability to make loans and continue paying out dividends. Dividends are being held steady, and share buybacks have been discontinued across the board to maintain healthy balance sheets. Some of the biggest banks, specifically Citi (C), Goldman Sachs (GS), JPMorgan (JPM), and Bank of America (BAC), were coming off of record profits and record revenue across the board before COVID-19. The banks are much more resilient and capitalized with unprecedented government stimulus coming into the fold. As the economy slowly reopens, these banks will likely appreciate higher and retrace previous highs while maintaining their dividend payouts. Many of the banks present compelling investment opportunities at these depressed levels.
Disclosure: The author holds shares in AAL, AAPL, AMC, AMZN, AXP, DIA, GOOGL, JPM, KSS, MA, MSFT, QQQ, SPY and USO. However, he may engage in options trading in any of the underlying securities. The author has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses. The author is the founder of www.stockoptionsdad.com where options are a bet on where stocks won’t go, not where they will. Where high probability options trading for consistent income and risk mitigation thrives in both bull and bear markets. For more engaging, short duration options based content, visit stockoptionsdad’s YouTube channel.