by Shah Gilani, Money Morning
Special Report from Money Morning
Bank stocks had a great run higher, but they started to sell off last week and into this week. Investors are practically fleeing America’s biggest, most profitable bank shares.
I’ll come right out and say it: Those investors are making a huge, expensive mistake, and I hope you’re not one of them.
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Because the real story is, right now is the best time to buy banks. Investors are leaving billions on the table, if you can believe it (and you should). They’re running scared from some of the year’s biggest upside.
The profits are right there for the taking, so let’s go…
Why Investors Are Running Right Now
Bank shareholders are bailing out because they’re scared. They’re terrified because they think they’re facing the expiration of an exemption the Federal Reserve worked out for big banks last year.
That one-year exemption basically gave banks a pass on having to count U.S. Treasuries in the calculation of banks’ supplementary leverage ratio (SLR). This exemption is currently set to expire next week, on March 31, 2021.
Banks, unsurprisingly, have stringent reserve requirements that got a lot more stringent after the disastrous financial crisis of 2008. One additional calculation forced on them is the SLR, which requires banks to count all their “assets” when calculating how leveraged their capital is against those holdings.
As far as assets go, U.S. Treasuries and junk bonds have the same “weight” in SLR calculations.
When the pandemic started to hammer the markets and the economy last March, the Fed decided to exempt Treasury holdings at big banks from being incorporated in their SLR calculations. That way, banks would be less constrained in their reserve requirements and could lend more money out into the economy where money was needed.
Not having to add government bills, notes, and bonds in their SLR calculations allowed banks to add huge amounts of those assets at precisely the same time they knew the Fed was going to do everything in its power to lower rates.
Since lowering rates increases the price of bonds, the huge addition of Treasuries to banks’ balance sheets, combined with the exemption afforded them, guaranteed them some tidy profits as the Fed drove rates down.
Banks stocks have been huge beneficiaries of the recovering economy, and part of the so-called “rotation” into cyclical stocks. Investors saw the steepening yield curve as another positive for banks.
A rising yield curve means rates on the short end of the yield curve are very low, but the further out you go on the maturity spectrum, rates tend to rise, sometimes steeply – meaning greater net interest margin (NIM), for banks. NIM is the spread banks make when they borrow cheaply on the low end of the interest rate curve and lend money out at higher rates for longer periods of time.
The much-anticipated Fed statement last week about projections and decisions made in its quarterly two-day Federal Open Market Committee (FOMC) get-together said nothing about the soon-to-expire SLR exemption.
Compounding that lack of clarity, in the press conference that followed the Fed’s statement, Chair Jerome Powell refused to answer a question about the expiring exemption, instead saying there would be an “announcement coming.”
Investors took that as bad news – and started net selling bank stocks.
And sure enough, on Friday, March 19, the Fed said it was letting the exemption expire on its original expiration date, March 31, 2021. And that sparked some hard selling of big-name bank stocks.
Sellers’ Big Mistake: Rising Rates Aren’t a Bad Thing
Investors aren’t thinking big enough; their short-sighted thinking is that banks won’t be as profitable if they must calculate Treasuries back in their SLR requirements. Along those lines of faulty reasoning, they figure banks have to reserve against all the bills, notes, and bonds they bought, so they’ll have to sell excess holdings to get their reserve requirements down.
But they’ve got it all wrong; rising rates aren’t really a bad thing.
The big picture for banks is painted by the Fed. And given the Fed’s concern and coddling of big banks (which all own a piece of the Fed, by the way), there’s no way the Fed is going to suddenly impact bank liquidity or profitability.
Of course, the Fed’s been talking to banks, monitoring their holdings, and hinting they’ll have to start including Treasuries back in their SLR calculations. There’s no way the Fed would tolerate big banks unloading tens or, collectively, hundreds of billions of dollars’ worth of Treasuries into an unreceptive market and push rates a lot higher.
That would be “disorderly,” – with a capital “D” – which the Fed chair vowed to not let happen if it looked like rates were going to spike in such a way. So, they wouldn’t purposely force a disorderly dumping of bonds by banks that would spike rates and freak out bond as well as equity markets.
That doesn’t mean there won’t be any net selling of Treasuries by banks; it just means that selling won’t be disorderly to the point of causing rates to spike a lot higher.
Based on my analysis, rates are going higher anyway. And that’s not a bad thing. In fact, it’s especially good for banks and bank stocks, and here’s why.
If rates rise because of growing pains, it means the economy – which we’d all agree was knocked for a loop last year – is growing above trend. Rising rates would be natural, and indicative of healthy demand for money and credit, the better to expand and consume more. As long as rate increases are orderly, economic participants can adjust to them.
As for banks, remember: A steepening yield curve, which is what happens when rates on the longer end of the maturity curve rise, means fatter net interest margin – meaning their profitability on loans.
Another bullish break for banks was somewhat hidden in what the Fed said about the expiring SLR exemption. The Fed said it would be taking another look at the effects it has on liquidity and markets.
I’ll tell you exactly what that means.
It means the Fed is going to change how it weighs Treasuries in SLR calculations. After all, it makes no sense that Treasury holdings have the same weight as much riskier junk bonds. Lowering the weight of Treasuries in certain calculations is going to happen, for several reasons. I’m going to get into those in the next few days, but for now, it’s enough to say that it’ll have gigantic implications.
For banks, the implications are obvious: They’ll be able to hold more Treasuries and reserve less against them, which will add to their profitability.
Here’s What Smart Investors Should Do
So, you can now see that the sell-off on big bank names is a big mistake.
Be that as it may, there’s a lot of profit lying there on the table for folks who know what’s really happening. This ongoing dip is a golden opportunity to get into bank stocks. Take your pick: Bank of America Corp. (NYSE: BAC), Citigroup Inc. (NYSE: C), or Wells Fargo & Co. (NYSE: WFC).
I think the Financial Select Sector SPDR Fund (NYSEArca: XLF) looks particularly attractive right now. You can get it for a (relative) song at $33.50. XLF holds all those banks and many more, which is great for upside and a bonus if you’re trying to keep it simple.
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