Susan Jubinsky: Let me talk about Morningstar's new view on regional banks in light of what's going on with New York Community Bank. The stock is currently in a steep decline. I'll update our viewers here.
David Sekera: At the end of January, New York Community Bank reported a big fourth-quarter net loss. There were a few reasons for the loss. First, the one that everyone was concerned about was the increase in loan loss reserves, especially in office and multifamily. Not surprisingly, for a company like New York Community Bank, a lot of the loan loss reserves are concentrated in New York, but they also had to increase their capital levels to meet stringent regulatory standards.
We also saw their core profitability itself decline amid all of this. The bank cut their dividend to $0.05 per share to allow them to accumulate capital over time. In addition to the stock price plummeting since this earnings report, I also noted that the company's bonds (they have several outstanding bonds maturing in November 2028) have also fallen from trading in the mid 90s to $0.77 per share. Doing some quick math, this equates to a yield of about 15.3%. So these bonds are now trading in distressed debt territory as well. To put this in context for those of you who don't know how bonds are traded, these bonds are no longer trading on what I would consider a yield basis, they are actually trading on a dollar basis.
When traders consider how to trade these bonds, they are thinking in probability-weighted terms of whether the bank will survive, whether these bonds will be repaid in full at maturity, or, if the bank fails, whether the bonds will trade according to the expected recovery value of the failed bank.
Dziubinski: Morningstar equity analysts don't officially cover the New York City bank, but can you walk our viewers through what the likely outcomes are for the bank?
Sekera: There are only three possible outcomes here. First, New York Community Bank may be able to hang on until it can generate enough revenue to cover its losses and rebuild its capital to the necessary levels. If it doesn't lose a ton of deposits and can generate enough revenue to cover its commercial real estate losses and rebuild its capital, it may be able to survive in its current form.
NYCB is particularly at risk. We shouldn't take the entire banking industry too seriously.
Second, I think it's entirely possible that there will be a large capital injection. A large investor could come in and do a large capital injection through preferred stock or subordinated debt investments. The real objective here is to instill enough confidence in depositors and investors to keep this bank afloat.
But depending on how it's structured, it could be very dilutive to existing shareholders. And third, it could go bankrupt. So if it experiences a significant outflow of deposits in the short term and loses its ability to self-fund, the FDIC could step in and shut it down and take it into administration.
Jubinski: Among the regional banks that Morningstar covers, which banks have the most exposure to commercial real estate, and do you think they are at risk?
Sekera: As you say, we don't cover New York Community Bank, but our team of analysts has looked very closely at what's going on here for any implications to other regional banks that we cover, and our view is that New York Community Bank was just in a very high-risk situation.
“New York Community Bank has significantly more exposure to commercial real estate than any other bank we cover. It also experienced a more severe deterioration in core profitability compared to the banks we cover. Accordingly, while many of the banks we cover are facing pressure on their profits, New York Community Bank is facing much greater pressure than the other banks we cover.”
Looking at the coverage of the banks we've covered here, the two I want to look at are Zions ZION and M&T Bank MTB, which have the highest exposure to commercial real estate relative to the amount of capital they have, and they also have a very high exposure to office space.
But we're not as concerned about that as we are with the commercial real estate exposure that we see at New York Community Bank. If you look at the numbers here, on a relative basis, their exposure is about half of their capital. And if you look at the office loans, they're much less relative to their capital than what we saw at New York Community Bank.
Dziubinski: In summary, Morningstar believes this is primarily an issue for New York Community Bank, and we don't expect it to spread to other regional banks that we cover, even those with a little more exposure to commercial real estate. So, Dave, is this a buying opportunity for regional banks today?
Sekera: I agree. There's certainly the potential for more volatility in the short term depending on how New York Community Bank does. But as you said, a lot of other regional banks have also fallen in the last two weeks. Zions was actually the biggest loser, down 10.8%.
And this is a stock I might avoid. This is a four-star rated stock, it's trading 28% below fair value, but it doesn't have an economic moat. This is still the riskiest stock. It has the highest exposure to commercial real estate, it has high exposure to office.
First among our favorite banks that fell is U.S. Bank (ticker: USB). The stock is down 6.5%. It's a 4-star rated stock and is trading at a 23% discount. This is our go-to name in the regional bank space. It's the only stock we rate as having a wide economic moat and we also rate it as having moderate uncertainty.
And two other stocks that investors might want to look at are Comerica (ticker: CMA) and Truist Bank (ticker: TFC), both of which are 4-star rated stocks, and both of which are banks that we rate as economically favorable.
Now, Comerica has high exposure to commercial real estate but pretty low exposure to office space. And Truist has moderate exposure to commercial real estate but low exposure to office. But Truist has a lot of losses on its held-to-maturity book. So, again, those two stocks are probably a little bit riskier. But at the four-star level, I think you can buy them at a pretty safe margin given their intrinsic value.
This is an excerpt from the February 12, 2024 episode of Monday Morning Markets with Morningstar's Dave Sekera. Watch the full episode of “2 Stocks to Buy, 1 Stock to Watch, and 2 Stocks to Sell After Earnings Releases.” A list of previous episodes can be found here.