Exposure to sub-prime borrowers is a common phenomenon in the financial realm. Ideally, sub-prime borrowers are people who have gone for loans they cannot afford. For instance, someone might have taken a mortgage for a house that is way beyond his means by using adjustable rates. Despite the monthly payments, the affected individuals are not able to meet the payments as stipulated. Such scenarios often make people think critically before investing in bank shares. Does exposure to such risks directly influence the share prices of these institutions?
Understand how banks operate
Before answering such a sensitive question, it is important for anyone to understand how huge commercial banks operate. Essentially, banks take deposits from its customers. Such deposits might come in form of savings, checking accounts, certificates of deposits and other products. The banks take such funds and lend them to other people in need of loans.
Initially, bank profits were dependent on the margins of the interest the bank pays to depositors and the profits they make on loans. However, today, successful banks have developed hybrid models in which they earn profits from other ventures such as processing of credit cards, merchant payments, mutual funds, annuities, overdraft charges, insurance brokerage and any other thing you can imagine.
Every time a loan is originated in the books, the bank pays the cash to the borrower and establishes an asset for the loan. Subsequently, the bank creates a reserve on its entire loan portfolio to take care of expected losses. For instance, they can assume that 1% of loans will default and create a reserve for the same. If indeed such a thing happens, they would have prepared well for the shock.
Are bank stocks worthy purchases?
Well, miscalculations are possible. The rate of default might be higher than previously estimated by the bank. As such, the decision to invest in a bank’s stock depends hugely on the quality of underlying loans. So, have in mind the CBA share price is going to depend on the quality of its loans. If you are going to buy its stocks, you must have an idea of such issues.
Just like the other stocks, you will also have to asses other factors such as P/E ratio. It is possible for a bank to be overvalued despite its unhealthy loan records. You don’t want to sit on a time bomb such as that. Definitely, you will also want to look at the dividends of the stocks. For instance, if it pays 5% dividends, what is the likelihood that it will be able to sustain such rates for the 3-5 years in the volatile interest rate market?
Choosing the right stock to invest in is not an easy affair. It requires due diligence. If you want to invest in the shares of a bank, you must loom far beyond the factors you consider when investing in other stocks. The quality of underlying loans greatly matters. Do not sink while thinking you are going for a major bargain.