Lehman haunts banks cheapest to S&P 500 even as shares surge

Excess Capital

Even with tighter controls, faster earnings growth and a pickup in the economy may boost financial shares more than the rest of the market, according to Todd Wittgenstein, a Los Angeles-based fund manager at HighMark Capital Management Inc., which oversees about $19 billion. The enactment of regulation after years of negotiations will spur CEOs to deploy excess capital back to shareholders, he said.

“Right now they’re being priced as if it’s still Armageddon,” Wittgenstein said Sept. 12. “Financial services are like a coiled spring.”

Initial jobless claims reached the lowest level in seven years this month, manufacturing reached a two-year high and a report showed gross domestic product expanded faster in the second quarter. The U.S. economy will grow 2.7% next year and 3% in 2015, the most since 2005, according to the median of 81 forecasts compiled by Bloomberg.

The average ratio of tangible assets to tangible equity, a measure of leverage, is down to 12.8 for the six biggest American banks as of June 30, according to data compiled by Bloomberg. That compares with 27.5 at the end of 2007.

Restrained Valuation

That hasn’t translated into higher valuations.

Morgan Stanley has doubled equity and customer deposits to cut reliance on short-term borrowing, which accounted for more than half of its funding in 2008. The sixth-largest U.S. bank’s assets are 14 times its equity, as of the end of June, compared to 38 at the end of 2007. Shares of the New York-based company trade at 15.2 times reported profit, down from 24 times in 2008.

Goldman Sachs, based in New York, doubled earnings last quarter, beating analyst estimates for the seventh straight time, data compiled by Bloomberg show. The price-earnings ratio of 9.7 compares with 8.7 five years ago, even as Chief Financial Officer Harvey Schwartz said the firm is “very comfortable” with its ability to meet a proposed U.S. minimum ratio of capital to assets.

Sheila Bair, former chairwoman of the Federal Deposit Insurance Corp., has said financial institutions must do more to pare their debt.

Stress Tests

“Large financial institutions still have way too much leverage,” said Bair, who now leads the Systemic Risk Council, a nonpartisan group whose members include former Federal Reserve Chairman Paul Volcker and former Treasury Secretary Paul O’Neill, in a Sept. 11 interview with Bloomberg Television. “We have gotten more capital into these banks as a result of these stress tests, but we were starting from a very low base.”

While record-low interest rates have encouraged lending, they’ve reduced profits. Net interest margin, the difference between what lenders pay for deposits and charge for loans, was 3.06% last quarter, near the lowest on record, according to Federal Reserve data on U.S. banks with more than $15 billion in assets. The measure has fallen for 12 of the last 13 quarters.

The central bank has said it won’t raise its target for the Fed funds rate until U.S. unemployment, now at 7.3%, falls to 6.5%, as long as projected inflation doesn’t rise above 2.5%. Fed funds futures show a 63.3% probability that interest rates will stay between zero and 0.25% 12 months from now.

‘Different Environment’

Even with the highest projected per-share earnings growth among 10 industries, S&P 500 financial firms’ total net income is forecast to reach $183 billion this year, 20% below the total in 2006, data compiled by Bloomberg show.

“It is a different environment that they are operating in today versus then and likely this is what they will continue to operate in,” Walter Todd, who oversees about $950 million as chief investment officer of Greenwood Capital Associates LLC in Greenwood, South Carolina, said by phone Sept. 12. “By definition, returns on equity are going to be lower, and valuations won’t necessarily get back to those levels.”


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