Banking Stocks: Levered to The Economy, One Levered To The Hilt
Three years after the financial crisis, most banks still trade at levels that indicate risk in the shares. The largest banks are massive and complex organizations that make even the most astute investors head spin. So how do you evaluate the risks with these behemoths?
At a high level, the tangible common equity ratio (TCE) provides some clues on the solvency and leverage employed. It's like asking "how much can a bank's assets fall before the entire value of equity is wiped out?" For example, assume a bank with a TCE ratio of 7%. If the value of all of the banks assets fell by 7%, theoretically equity holders would be wiped out.
Since the financial crisis hit, most of the big banks have built up their equity positions and are much healthier to say take a $2 to $5 billion hit on a bad trade. You can see this in the chart below with exception of one, we're going to get to that.
The tangible common equity ratio compares the amount of equity to total assets. If you look at the TCE ratios above, it is easy to see that balance sheets have improved for the most part.
It pays to also consider the price to book value which provides a clear indication of the markets views on the health of the assets on the books. You see a much different picture here. Only Wells Fargo (WFC) trades above book value. Bank of America (C), Citigroup (C), Morgan Stanley (MS) and Deutsche Bank (DB) all trade for less than half of book value. Opportunity? Tough call.
Based on the TCE and price to book, investors view Wells Fargo as the strongest and Deutsche Bank the weakest.
The prospects for the banks as a whole remain levered to the economy. A resurgence in the economy will benefit the sector. Improved employment, GDP growth and rising housing prices are all welcomed. Another downturn and there will be more pain for the banks. Some more equipped to handle than others.
To that end, Deutsche Bank stands out as the largest bank by assets, most levered and trades at less than half book value. Moody's downgraded several German Banks today and is reviewing Deutsche Bank. From Moody's, "the ongoing rating review for Deutsche Bank AG and its subsidiaries will be concluded together with the reviews for other global firms with large capital markets operations." It is hard to say how the credit agencies will treat Deutsche Bank. However, the chart below may provide some clarity for investors.
As you can see below, markets are pricing in risk for the entire sector--just more so for Deutsche Bank shares and who could argue with that.