The past six weeks have been miserable for financial stocks, especially those that focus on mortgages. While Wells Fargo (NYSE:WFC) is one of the premier banks in the U.S., it has heavy mortgage exposure. If we are heading into a recession, we will see an increase in nonperforming assets that will drive writedowns. Even banks that aren’t big in residential mortgages will experience an uptick in delinquencies in their commercial real estate books and other consumer loans. Where can a financial sector investor hide out until the dust settles?
Bank of New York Mellon (NYSE:BK) is a vastly different bank than Wells Fargo or most traditional banks. The Bank of New York Mellon was established by Alexander Hamilton in the 18th century and is one of the oldest trust banks in the U.S. As a trust bank, it gets most of its income from fees, not from the traditional business of “borrowing short and lending long” which means taking deposits and making loans. This means it has much less exposure to deteriorating credit in the U.S. economy.
Fee income drives the business
Bank of New York Mellon (BNYM) has two major businesses: investment services and investment management. The investment services business primarily involves custody, or the holding assets on behalf of other parties. At the end of 2019, the company held over $37 trillion in assets in custody. Typical customers would be mutual funds or pension funds that keep their portfolio at BNYM and pay the bank fees for this service. Custody gives BNYM the ability to lend out securities, which is another big business. If you short a stock, say Apple, you borrow that stock from a custody bank like BNYM, which might be holding it for an index fund or mutual fund. You sell that stock in the market and pay a securities lending fee. When you cover your short, you return the stock back to the security lender. BNYM is one of the leaders in agency and treasury lending. Another big part of investment services is Pershing, a trade clearinghouse. Clearing means handling the mechanics of a trade, making sure that the buyer gets the securities and the seller gets the money. Investment services also has several other businesses, including American depositary receipts for foreign stocks, exchange-traded fund management, and plain vanilla corporate treasury management services.
The other business for BNYM is investment management. Here, the bank has $1.9 trillion in assets under management. The asset management business has eight separate asset management firms specializing in different asset classes and investment strategies. This arm also runs mutual funds and money market funds. The wealth management business provides personal banking, wealth and estate planning, and custody services.
Earnings and returns
BNYM earned $4.51 per share last year and paid a per-share dividend of $1.81. This gives the company a P/E of 7.7 and a dividend yield of 3.4%. Return on assets last year was 1.2%, and return on equity came in at 11.4%. Some of the company’s fee income is dependent on asset prices, so it is possible that the drop in the stock markets over the past quarter will have some effect. Note that the bond market has rallied, however, which will offset some of the declines. The company does in fact have a loan and securities portfolio for investment, so it isn’t immune to credit risk. However, fees accounted for 80% of revenue last year. So, while it will see some deterioration in the corporate credit portfolio income, it won’t be as affected as a traditional bank.
Bank of New York Mellon will sidestep the mortgage mess
Just about every bank that retains mortgages will be hit by the forbearance issue. Under the CARES Act, borrowers who are affected by the COVID-19 coronavirus situation may receive forbearance on their mortgage for up to a year. Mortgage servicers are pretty much required to give it to them. This has two big effects on a bank. First, the bank doesn’t get the principal and interest payments it is owed on time. Second, the mortgage servicing asset takes a writedown. The writedown of mortgage servicing rights will be evident in the March 31 end-of-quarter results for most banks. From the chatter in the marketplace, servicing values are down anywhere from 50% to 70%. Traditional banks, which service their own mortgage portfolio, have this issue. BNYM does have a mortgage portfolio for its private banking business, but these mortgages are for the uber-wealthy, who are unlikely to need forbearance.
We will get a taste of what has happened to the banks when they start reporting first-quarter earnings next week. In the first week after the CARES Act was passed, mortgage servicer and lender Mr. Cooper granted 86,000 forbearance requests, which represented about 2.5% of its portfolio. Bank earnings are going to be impacted by this. If you are interested in a bank that will be able to largely sidestep these issues, Bank of New York Mellon is worth a look.