'Too Big to Fail' Gets Even Bigger

NEW YORK (TheStreet) -- Most people concerned over bank bailouts and the risk to the economy and taxpayers from "too big to fail" banks may not realize that despite the best intentions, new regulations are keeping the big banks from shrinking.

Stock valuations for the six largest U.S. banks are rather low, with the group trading for an average of 9.6 times consensus 2015 earnings estimates, based on Friday's closing prices.

Looking at the remaining 284 banks for which consensus 2015 earnings estimates are available from Thomson Reuters Bank Insight, the ones with market capitalization above $5 billion trade for an average of 13.3 times forward earnings estimates, while the names with market caps between $1 billion and $5 billion trade for 15.3 times forward earnings and the banks with less than $1 billion in market capitalization trade for 16.1 times forward earnings.

That's a pretty clear pattern. The smaller banks, on average, are more profitable than the big ones, and investors prefer names with solid growth opportunities.

Meanwhile, most of the big guys keep getting bigger. Here's a quick look at the nation's six largest banks' asset growth, or shrinkage since the end of 2006, before any hint of the U.S. real estate collapse, along with forward P/E ratios and returns on equity:

JPMorgan Chase (JPM) had total assets of $2.416 trillion as of Dec. 31, increasing from $2.359 trillion a year earlier and $1.352 trillion at the end of 2006. The asset growth included the government-brokered acquisitions of Bear Stearns and the failed Washington Mutual in 2008. JPMorgan's return on average tangible common equity (ROTCE) was 11.92% during 2013, declining from 14.72% in 2012, according to Thomson Reuters Bank Insight. The 2013 results were lowered by a third-quarter net loss, when the company set aside $7.2 billion, after taxes for litigation reserves, ahead of $17.5 billion in residential mortgage backed securities settlements with government authorities and private investors in the fourth quarter. The company's fourth-quarter results were lowered by $1.1 billion after tax from legal expenses, which included the bank's deferred prosecution agreement with the Department of Justice over its role in the Bernard Madoff Ponzi scheme. JPM's shares closed at $57.61 Friday and traded for 9.1 times the consensus 2015 EPS estimate of $6.35.

Bank of America (BAC) had $2.102 trillion in assets as of Dec. 31, down 5% from a year earlier, but up from $1.456 trillion at the end of 2006. The bank acquired Countrywide Financial and Merrill Lynch during 2008. Bank of America's ROTCE was 7.94% in 2013, increasing from 2.96% in 2012. Bank of America's shares closed at $156.29 Friday and traded for10.1 times the consensus 2015 EPS estimate of $1.62.

Citigroup (C) had $1.881 trillion in total assets as of Dec, 31, increasing 1% from a year earlier, but declining slightly from the end of 2006. The bank's 2013 ROTCE was 8.2%, improving from 4.8% in 2012. Citi's shares closed at $48.26 Friday and traded for 8.4 times the consensus 2015 EPS estimate of $5.76. That makes Citigroup one of the cheapest U.S. bank stocks, regardless of company size.

Wells Fargo (WFC) had $1.527 trillion in total assets as of Dec. 31, increasing from $1.423 trillion the previous year and $482 billion at the end of 2006. The company more than doubled in size at the end of 2008 through its acquisition of the beleaguered Wachovia, trumping a previous offer from Citi, which had been personally brokered by former Federal Deposit Insurance Corp. chairman Sheila Bair, with the Federal Reserve also providing support, according to Federal Open Market Meeting Transcripts released on Friday. Wells Fargo's ROTCE was a very impressive 17.48% during 2013, increasing from 16.70% in 2012. Wells Fargo's stock closed at $45.60 Friday and traded for 10.7 times the consensus 2015 EPS estimate of $4.25.

Goldman Sachs (GS) had $912 billion in total assets as of Dec. 31, down 3% from the previous year and up 9% since the end of 2006. Goldman reported a 2013 return on average common shareholders' equity of 11.0%, improving from 10.0% in 2012. Goldman's stock closed at $164.50 Friday and traded for 9.6 times the consensus 2015 EPS estimate of $17.07.

Morgan Stanley (MS) had $832 billion in total assets as of Dec 31, increasing 7% from a year earlier, but declining 26% from $1.123 trillion at the end of the company's fiscal 2006. Morgan Stanley in 2007 and 2008 went through a major balance sheet restructuring, which included the spinoff of Discover Financial Services (DFS). The bank reported returns on average common equity, excluding debit valuation adjustments, of 5.1% for 2013 and 2012. Morgan Stanley's stock closed at $29.62 and traded for 9.9 times the consensus 2015 EPS estimate of $2.98.

So two of the "big six" saw their total assets decline during 2013, and three of the six saw massive balance-sheet growth since the end of 2006.

Meanwhile, only three were likely to have achieved high enough returns on equity during 2013 to cover their cost of capital.

KBW analyst Fred Cannon in a note to clients on Sunday wrote that the cost of capital is "generally thought to be 9 to 12 percent for banks."

Cannon very effectively summed up the current distortion created by the much higher standards for capital strength brought about by the Basel III agreement, as well as several additional requirements announced recently by U.S regulators:

Further, theory and practice dictate that if a company can't invest above its cost of capital, that capital should be returned to shareholders. However, if capital is trapped at a bank because of regulation, that theory no longer is effective. As a result, the hurdle rate for investments falls to zero, that is the bank should make any investment that returns above a zero cost of capital in order to continue to build capital. This effectively increases the incentive for banks to remain large.

The large bank holding companies eventually will more than exceed all of the capital requirements under Basel III, as well as those of the Federal Reserve, and other stringent requirements from the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency for their underlining bank subsidiaries.

But for the next several years, as the big banks continue to build their capital ratios while going through annual stress tests and capital plan reviews by the Federal Reserve, investors cannot expect major initiatives to raise returns on equity through divestiture or relatively large deployments of capital through share buybacks or dividend increases.

The big banks have no choice but to remain very big, for several more years.

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

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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.

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