NEW YORK ( TheStreet) -- Now is the time for long-term investors to consider building positions in heavily discounted bank stocks.
Following last week's decent showing for bank stocks in the wake of ratings downgrades by Moody's Investor Service, increasing clarity on banks' enhanced regulatory capital requirements, continued U.S. economic reports showing a growth slowdown, and signs that European leaders could muddle their way through saving the common currency, heavily discounted high-volume bank stocks may be able to begin recovering to levels reached earlier this year.
The KBW Bank Index (I:BKX) closed at 45.09 Friday, up 1% for the week and up 14.5% year-to-date, however, the index was down 10% from its closing high of $50.26 on March 26.
For the investment banks, the ratings downgrades announced by Moody's act as something of a "reset" for Morgan Stanley (MS - Get Report) and Goldman Sachs (GS), especially after the ratings firm surprised investors -- and apparently even Morgan Stanley -- with a two-notch downgrade, instead of the expected three-notch downgrade.
With investor jitters continuing for Morgan Stanley over weak second-quarter revenue prospects in a tepid economy, even Deutsche Bank analyst Michael Carrier -- who sees 41% upside for the shares, based on a $20 price target and Friday's closing price of $14.14 -- rates the shares a "Hold." So why should investors consider Morgan Stanley? One reason is that the shares of this profitable investment bank trade for just over half their reported March 31 tangible book value of $27.37. The company is also very strongly capitalized, with a Basel I Tier 1 common capital ratio of 13.3% as of March 31, increasing dramatically from 12.7% the previous quarter and 8.9% a year earlier. Under Basel III, allowable Tier 1 capital will be reduced, while risk-weighted assets will increase, pushing the Tier 1 common ratio down, but banks have until January 2019 to achieve full compliance with the new capital standards, and Morgan Stanley estimated in its first-quarter 10-Q filing that "its pro forma Tier 1 common capital ratio under Basel III will be in a range between 8% and 10% by the end of 2012." With a minimum Tier 1 common equity ratio requirement of 7.5%, plus a possible 2.5% capital buffer required as a "systemically important financial institution," Morgan Stanley could conceivably comply with the enhanced capital requirements by the end of this year, or five-years before the fully phase-in of Basel III requirements. Under new regulatory guidance for "advanced banks," Citigroup analyst Keith Horowitz on Thursday estimated that Morgan Stanley's pro forma Basel III Tier 1 common equity ratio would be 8.5%, which is within the range of 8% to 9% that Morgan Stanley CEO James Gorman recently estimated. That's considerably higher than Citi's estimates for JPMorgan Chase , Goldman Sachs , Bank of America and Wells Fargo , although, of course, several of those names have been posting higher recent returns on equity than Morgan Stanley. JPMorgan Chase analyst Vivek Juneja on June 11 estimated that Citigroup's (C - Get Report) "Tier 1 common ratio under Basel 3 likely to exceed 8% by the end of 2012."
While lowering its long-term debt rating for Morgan Stanley to Baa1 from A2 last week, because of concerns over "(i) the firm's commitment to the global capital market business, on which it relies heavily for earnings; (ii) its historically high level of earnings volatility; and (iii) the problems in risk management and controls the firm suffered during the crisis," Moody's said on Thursday that its concerns were partially mitigated by "(i) the firm's gradually increasing "shock absorbers" in the form of earnings from other more stable businesses (albeit still below that of most peers); (ii) its reduced risk appetite, improved liquidity profile and stronger capital position; and (iii) enhancements to risk management, internal processes and controls." Morgan Stanley's shares are trading at an historically low six times the consensus 2013 earnings estimate of $2.24 a share, among analysts polled by Thomson Reuters. The consensus 2012 EPS estimate is $1.39. Goldman Sachs is also trading at relatively low valuations. The shares closed at $93.63 Friday, or 0.8 times their reported March 31 tangible book value of March 31 tangible book value of $123.94, and for 7.5 times the consensus 2013 EPS estimate of $12.83. The consensus 2012 EPS estimate is $11.22. Carrier sees 44% upside for Goldman, based on Friday's closing price and his price target of $135, rating the shares a "Buy." Looking at other large-cap bank holding companies, there are six high-volume components of the KBW Bank Index that traded below tangible book value as of Friday's close, according to Thomson Reuters Bank insight. Here they are, in descending order by valuation to their reported March 31 book value: