By now, I'm sure that everyone is aware of the carnage in the banking sector. In both the United States and Europe, bank stocks are under tremendous pressure. Especially American regional banks are getting hit hard, triggered by the failure of SVB Financial Group (SIVB).
One of the stocks I avoided in the past was KeyCorp (NYSE:KEY), a giant among the Midwest's regional banks. Now, this bank's stock price is one of the casualties, falling more than 40% from its 2023 highs.
In this article, we'll discuss this tricky situation and assess why it may or may not make sense to add the KEY ticker to a (dividend) portfolio.
So, let's get to it!
Regional Banks: Armageddon Or Buying Opportunity?
Year-to-date, the S&P 500 (SP500) is up roughly 1%. Regional banks (KRE) are down 25%. Cleveland, Ohio-based KeyCorp is down more than 30%.
These numbers are wild and caused by the failure of Silicon Valley Bank, or at least by the underlying forces that caused this California-based bank to fail.
While that bank had benefited like no other bank from the massive surge in startup funding in California, it hadn't done its homework. Especially when founders and customers heard that SVB was selling $21 billion of securities from its portfolio because some startups were ripping cash out of the bank, alarm bells went off.
It also didn't help that 93% of the bank's $161 billion deposits were uninsured while the bank did not hedge sufficiently against interest rate risks.
SVB was swimming in money, as it had far more deposits than loans. Hence, the bank bought government bonds instead, which have fixed interest rates. When the Fed started to raise rates, these bonds lost value.
As Bloomberg puts it:
In a higher-interest-rate environment they didn’t have money anymore. So they withdrew their deposits, so you had to sell those securities at a loss to pay them back. Now you have lost money and look financially shaky, so customers get spooked and withdraw more money, so you sell more securities, so you book more losses, oops oops oops.
Ok, so SVB messed up. But why do other banks need to suffer?
For starters, there was a fear that the SVB situation could trigger a bank run. After all, banking is mainly built on trust. Without trust, it doesn't work. Even if a bank is as solid as a rock, the moment most of its clients come rushing for their deposits, its business model collapses.
Following SVB's collapse, regulators also shut down New York's Signature Bank, which had been considered a crypto-friendly bank, highlighting the urgency of efforts to backstop the nation's banking system. Before these events, U.S. bank stocks were under pressure as KeyCorp warned about mounting pressure to pay savers more. As interest rates rise, depositors can switch to banks offering higher rates, which can lead banks to either raise their own rates, cutting into profits or face the prospect of potential funding issues.
With that said, while the full guarantee of SVB deposits did cause the market to refrain from further breaking down, we're now dealing with a new wave of headlines as Swiss-based Credit Suisse Group AG (CS) is suffering.
The Swiss bank, with five times more deposits than SVB, fell up to 28% on Wednesday (3/15) after its Saudi Arabian investors made clear that they would not provide more liquidity.
According to Bloomberg:
“Markets are very sensitive to the negative news flow after the surprise of seeing a US bank disappear from one day to the other,” said Francois Lavier, head of financial debt strategies at Lazard Freres Gestion. “In a context where market sentiment is already weakened, not much is needed to weaken it even further.”
Societe Generale SA and BNP Paribas SA fell more than 10%. The combined market value lost among European banks was more than $60 billion on Wednesday.
With that said, there's a case to be made that we're not in a Great Financial Crisis situation. Banks have much more capital, the housing market isn't imploding, and we are getting close to the end of the hiking cycle.
In a note to clients, ACG Analytics wrote that the recent banking collapse is not expected to lead to any major systemic changes, nor is it likely to result in new banking reforms being passed by Congress anytime soon. Instead, most of the policy response is expected to come from regulators, led by Federal Reserve Vice Chairman for Banking Supervision Michael Barr's review of bank capital, which is likely to recommend higher capital requirements.
The fallout from the collapse will also likely include adjustments in FDIC insurance rates, which have been announced to pay for the new joint deposit backstop. The question on everyone's mind is whether this represents the Fed hiking rates until something breaks or if it was simply an isolated incident that the Fed will address in its ongoing efforts to maintain price stability.
While the situation is concerning, experts believe that the U.S. financial industry is robust enough to weather this storm, and the Fed will take appropriate action to mitigate any potential risks to the broader economy.
In other words, there is a case to be made that banks are attractively valued at these prices.
What To Make Of KeyCorp?
The other day, someone asked me what I look for in a regional bank. I answered that a big part of my research is based on finding an edge. Something that makes a bank special. Especially when it comes to geographic locations. I own one regional bank: Huntington Bancshares Incorporated (HBAN), which is also located in the Midwest. That decision wasn't just based on being attractively valued in 2020, but also because I'm bullish on the Midwest. Supply chain re-shoring is likely to shine new light on the Midwest's capabilities in manufacturing and related activities.
Both HBAN and KEY are major players when it comes to financing these activities.
As of 4Q22, KEY had 50% commercial loan exposure in the industrial sector. This translates to roughly $60 billion. Just 18% of total loans were consumer mortgages. Home equity and direct consumer loans were just 12% (combined).
In its commercial portfolio, the company focuses on industry verticals like consumers, industrials, healthcare, technology, energy, and real estate. In other words, it finances the big picture while reducing exposure to construction and other issues that hurt the company during the Great Financial Crisis.
In its consumer portfolio, the company focuses on high-quality mortgages with an average FICO score of 761. Its consumer loan portfolio has an average FICO of 772.
In its investment portfolio, the company mainly holds fixed-rate GNMA and GSE-backed MBS and CMOs. These are bundled fixed-rate (government-backed) mortgages. This $47.4 billion investment portfolio yielded $1.9% in 4Q22.
KeyCorp also has more than $40 billion in hedges. $28 billion of these hedges consist of interest rate swaps, where players exchange fixed against floating rates with counterparties.
Moreover, the credit quality of its loans remained high. According to its earnings call, the company has seen an increase in activity moving onto its balance sheet, with a record $136 billion of capital raised for clients in 2022, of which 23% was retained on its balance sheet. This is above their long-term average of 18%. Despite this, credit quality remained strong during the quarter, with net charge-offs as a percentage of average loans at 14 basis points.
The number of non-performing loans decreased in 4Q22, and delinquencies, criticized, and classified loans remained near historically low levels.
That said, in December 2022, I wrote the following:
I believe that KEY has more room to fall due to elevated credit risks that (I believe) are not yet entirely priced in.
Well, as we just discussed, that's exactly what happened.
Now, bullish voices are becoming louder again.
As reported by Seeking Alpha, Baird came out making the case that KeyCorp's valuation is too compelling to ignore.
[...] the recent weakness provides a good entry point for the stock, he said, as it's trading at ~4.3x preprovision net revenue, a more than 30% discount to its historical average. "KEY is one of the few regionals that is poised to grow NII (net interest income) over the coming quarters as rate hedged come off," he said.
In addition, "we believe the bank's risk-reduction measures taken in recent years will result in manageable credit costs as trends normalize," George wrote.
These comments make sense, as Chairman and CEO Chris Gorman said in the 4Q22 earnings call. He made the case that the company would continue to benefit from its balance sheet and interest rate positioning in the coming years. They have been deliberate and intentional in managing their interest rate risk with a longer-term perspective, which has resulted in less current benefit but a significant upside in the next two years. As swaps and short-term treasuries mature and reprice, the company anticipates an annualized net interest income benefit of $1.1 billion if they were to reprice existing short-term treasuries and swaps. Needless to say, as rates have come down, the current benefit will likely be lower.
Overall, the company's strategic approach to interest rate risk management should position them well to take advantage of opportunities in the market and generate strong returns for their investors in the years to come.
That said, KeyCorp stock is now trading at just 1.3x tangible book. That's well below the three-year median. Moreover, this is based on a tangible book value of roughly $8 billion. Prior to 2022, that number was consistently higher than $11 billion. In other words, a sustainable economic recovery would make KEY even more undervalued. In that scenario, the company is trading below 1x tangible book. The dividend yield is now 7.0%, which is a more than decent premium.
So, unless we're about to enter a new Great Financial Crisis, KEY is trading at a very attractive valuation.
Furthermore, I often make the case that regional banks are boring. It's hard to find a regional bank with an edge and long-term growth is often slow. Hence, investors need to use opportunities like the current one to buy banking exposure. I bought my HBAN position in 2020. If I didn't have any exposure, I would be buying KEY at these levels. This week, I added a bit to my HBAN position. The only reason why I did not buy KEY is that I am not looking to own more than one regional bank in a 22-stock portfolio. I'm also preserving some cash for investments in dividend-growth stocks (as discussed in this article).
Words Of Caution
While I believe that the long-term risk/reward for KeyCorp is favorable, we're in a situation of panic. Banking stocks can fall further, especially if the Credit Suisse situation gets out of hand. So, please be aware of that. Do not go overweight in regional banks.
In this article, we discussed KeyCorp, one of my favorite Midwest-based regional banks. Like all of its peers, the bank's stock price is suffering from the market sell-off, fueled by the SIVB disaster.
The good news is that KeyCorp is a solid bank. It has hedged its interest rate risks, a solid client base, and a valuation that makes the current stock price look very attractive.
Going forward, I believe that KeyCorp shares have a lot of upside potential if the economy rebounds. The question is how much pain we have to experience until that happens.
So, while I do like the long-term risk/reward, investors need to remain cautious. We're not out of the woods yet.
This article was written by
Welcome to my Seeking Alpha profile!I'm a buy-side financial markets analyst specializing in dividend opportunities, with a keen focus on major economic developments related to supply chains, infrastructure, and commodities. My articles provide insightful analysis and actionable investment ideas, with a particular emphasis on dividend growth opportunities. I aim to keep you informed of the latest macroeconomic trends and significant market developments through engaging content. Feel free to reach out to me via DMs or find me on Twitter (@Growth_Value_) for more insights.Thank you for visiting my profile!
Disclosure: I/we have a beneficial long position in the shares of HBAN either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Not financial advice