The Cheapest Bank Stocks Based on 'Normalized' Earnings: KBW

NEW YORK ( TheStreet) -- For truly long-term investors, Bank of America ( BAC) and JPMorgan Chase ( JPM) are the best bargains among big banks, according to KBW analyst Christopher Mutascio.

For several years, analysts and investors have been considering large banks' potential "normalized earnings" as a tool in making long-term stock picks. The credit crisis, of course, caused a few years of outsized loan losses to hammer industry earnings. In the aftermath of the crisis, the release of loan loss reserves has boosted results, but that activity can't go on forever.

The industry is also being held back by slow loan demand in many important categories. And the volume of mortgage loan applications is slowing from last year's record pace, as fewer borrowers refinance and rising long-term rates lower affordability for some potential homebuyers.

Margin Squeeze

Another major factor holding back the normalization of bank earnings is record-low short-term interest rates. The Federal Reserve has kept the short-term federal funds rate in a range of zero to 0.25% since late 2008, and the Federal Open Market Committee has repeatedly said that this "highly accommodative" policy would be appropriate at least until the U.S. unemployment rate fell below 6.5%. June's unemployment rate was 7.6% and the Bureau of Labor Statistics will announce the rate for July on Friday.

Barring an unexpected rise in inflation, the federal funds rate could easily stay in this range for another year. Banks have lowered their funding costs over the past few years, but that hasn't been enough to keep their net interest margins from being squeezed.

Long-term rates have been rising over the past several months, in anticipation of a curtailment of the Federal Reserve's monthly purchases of $85 billion in long-term securities, which has been meant to hold long-term rates down. The market yield on 10-Year U.S. Treasury bonds rose to 2.63% on Tuesday from 1.70% at the end of April.

But second-quarter net interest margins for most large banks continued to decline. What the banks need for margin expansion is a parallel rise in rates, which can only happen when the federal funds rate is increased.

The Federal Open Market Committee completes its two-day meeting Wednesday, which will be followed by a policy statement at 2 p.m. EDT. Investors will be looking for any change in language confirming whether the central bank's bond-buying may be reduced, as early as September.

Looking Ahead to 2016

Mutascio on Tuesday published a report that included 2016 earnings estimates for large-cap banks covered by KBW under three interest rate scenarios. All three scenarios assume the banks' efficiency ratios and loan loss provision ratios "migrate to 20-year medians."

The first scenario assumes no expansion of net interest margins (NIM) from second-quarter levels. Bank of America's NIM was a relatively low 2.44%, although it expanded from 2.43% in the first quarter and 2.21% during the second quarter of 2012. JPMorgan Chase reported a core second-quarter NIM of 2.20%, narrowing from 2.37% the previous quarter and 2.47% a year earlier.

The second scenario is the "most optimistic, with substantial NIM expansion," while the third scenario "generally assumes the midpoint between the current and 20-year median NIMs."

Under the third "midpoint" scenario, KBW estimates Bank of America will earn $1.85 a share during 2016, with JPMorgan Chase expected to earn $6.30 a share.

Based on Tuesday's closing price of $14.52, Bank of America's shares were trading for just 7.9 times Mutascio's 2016 EPS estimate under the third scenario. JPMorgan Chase was the second cheapest on that basis, with shares closing at $55.33, or 8.8 times KBW's 2016 EPS estimate.

Each of the nation's two largest banks has special circumstances holding the shares back in the eyes of investors. Despite making so much progress working through its legacy mortgage problems mainly springing from the purchase of Countrywide Financial in 2008, Bank of America still had unresolved mortgage repurchase claims against the company totaling $16.648 billion as of June 30. That was down from $17.135 billion the previous quarter, mainly because of the bank's settlement with bond insurer MBIA ( MBI).

JPMorgan Chase faces a number of regulatory investigations, after on Tuesday agreeing to settle Federal Energy Regulatory Commission charges of market manipulation for $410 million. According to a New York Times DealBook report on Wednesday, JPMorgan's "new and conciliatory approach" to settling with regulators may not be completely successful, as "government officials, stung by the bank's past displays of hubris, may drive up the price of settlements or resist the overtures altogether." JPMorgan's "hubris" includes continued success in making boatloads of money. The bank brought home record earnings in 2012 of $21.3 billion, or $5.20 a share, despite taking at least $6.2 billion in losses from the "London Whale" hedge trading losses.

On the other end of the spectrum for KBW's 2016 EPS estimates, KeyCorp ( KEY) comes out as the most expensive bank. The Cleveland lender's shares closed at $12.20 Tuesday, which was 12.6 times KBW's 2016 EPS estimate of 97 cents a share, under the third scenario for net interest margin expansion.

-- Written by Philip van Doorn in Jupiter, Fla.

>Contact by Email.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

More from Stocks

Why The FANG Stocks' Dominance May Not Be So Bad For The Market

Why The FANG Stocks' Dominance May Not Be So Bad For The Market

Danica Patrick's Final Race at 2018 Indianapolis 500: What She Thinks About Cars

Danica Patrick's Final Race at 2018 Indianapolis 500: What She Thinks About Cars

At End of May, Investors Signalling They May Stay Away

At End of May, Investors Signalling They May Stay Away

Inside Carnival's Mind Blowing New Horizon Cruise Ship (Video)

Inside Carnival's Mind Blowing New Horizon Cruise Ship (Video)

Neel Kashkari: The Heart of Our Financial System Is More Radioactive Than Ever

Neel Kashkari: The Heart of Our Financial System Is More Radioactive Than Ever