Behind-The-Scenes Banks Still Strong

I recently read over an S&P banking industry survey from 2006 to try and gauge if there were any indications that savvy investors could have picked up on to predict just how serious the housing meltdown would become. Here is what the survey said about mortgage volume trends at the time:

"With the refi boom behind us, we expect commercial banks with sizable mortgage portfolios to return to historically normalized earnings growth. We believe that, among banks focused on consumer lending, those relatively diversified loan portfolios, full consumer product lines, and strong sales cultures are better positioned to compete in a post-mortgage environment."

The analyst, like the vast majority of us, didn't see the extent to which historically low mortgage rates, unsustainable home price appreciation, and the securitization of related securities with now-obvious credit weakness would turn snowball into the perhaps the biggest credit crisis ever. Back in 2006 the key worries were the extent to which Hurricane Katrina and bankruptcy reform would affect the banking industry, but the overall conclusion was that credit quality remained strong.

On the other hand, the analyst did identify those firms that were likely to successfully compete in the post-mortgage environment. Bank of America (NYSE:BAC) has stood tall with a solid consumer business, as have JPMorgan (NYSE:JPM) and US Bancorp (NYSE:USB) given their diversified geographic reach and product lines. Of course these firms bested the competition by avoiding significant exposure to the most toxic securities and derivatives created during the housing frenzy. (To learn more about these securities, read Behind The Scenes Of Your Mortgage .)

Custodial Banks Still Strong
Another group that looks to have held up well are the large custodial banks, including Bank of New York Mellon (NYSE:BK), Northern Trust (Nasdaq:NTRS) and State Street (NYSE:STT). These players specialize in providing back-office functions to other financial firms, such as those related to trading, securities settlement and lending, financial statement reporting and other items such as foreign exchange and cash management services. These are industry leaders and Bank of New York Mellon is the largest of the three with about $23 trillion in assets under custody, followed by State Street (over $15 trillion) and Northern Trust (just under $4 trillion).

These firms are also among the largest asset managers in the world. State Street boasts close to $2 trillion in assets under management (AUM); Bank of New York Mellon has just over $1 trillion, and Northern Trust has approximately $750 billion. Overall this means that the majority of income stems from fee income, which is generally less risky, earning a spread between the assets they lent and borrowed, which must be accounted for on the balance sheet and represent more traditional banking activities. The custody firms do operate these lending businesses though, which I'll come back to below, and their businesses are still quite dependent on the health of the overall financial services industry.

Trust Northern Trust
I recently spoke with Thomas McCrohan at Janney Montgomery Securities, who counts these custody banks among his active coverage as a sell-side analyst. He pointed out that JPMorgan and Citigroup (NYSE:C) also have sizable back-office operations, although their other banking activities make them much more diversified money center banks.

In terms of the purer-play custodial banks, McCrohan is most comfortable with Northern Trust given its very conservative reputation. It is among the least levered banks and has a well-regarded asset management franchise. Logically this means that Northern's stock price has held up well lately. It is currently trading at about 15-times forward earnings and sports a price to book ratio of close to 3.

State Street stands out as the riskiest among its peers given uncertainty over its balance sheet and overall credit quality. There is concern an off-balance sheet conduit may have to be brought back on the books. That leaves Bank of New York Mellon in the middle, with some credit concerns that are being offset by a reasonable valuation (10-times forward earnings multiple, 1.2 price-to-book ratio) and further cost-cutting potential from the recent merger of Bank of New York and Mellon.

Bottom Line
McCrohan remains largely neutral on these names, a warranted position given it's not certain how the volatile financial markets will affect the custodial banks. A recent Wall Street Journal Article highlighted a squeeze in lucrative securities lending fees as securities issued by the likes of Lehman Brothers and Wachovia plummet in value and freeze up the credit markets. This has already caused Northern Trust to take a pretax charge to cover investors. Reasonable valuations are definitely offsetting these concerns, as are the strong balance sheets for a number of these players and long-term appeal of their business models.

Add it all up and it may make sense to at least nibble on these stocks in preparation for when the industry can return to normal levels and profits start rolling in again.

To read more on this topic, check out Special Feature: Subprime Mortgage Meltdown.