Financial Services: Bank Worries Are Overdone

Morningstar's view is that the decline in oil prices is likely to prove a short-term phenomenon. With U.S. producers drastically reducing spending in 2015, production growth is set to meaningfully slow this year and could even decline in 2016 if prices remain weak. Our longer-term expectation of continued global demand growth leads us to believe that Brent oil prices will again be around $75 per barrel by 2018. It's our view that this is the minimum price necessary to ensure adequate supply over the medium to long term.

However, we acknowledge that future prices, as well as producer behavior across markets, can be difficult to accurately predict. Although prices rebounded quickly after their sharp fall in 2009, in other times, banks have not been so lucky. We therefore believe it is prudent to consider what bank-level loan losses might look like in a stress scenario in which energy prices remain depressed for a prolonged period. We therefore estimate potential losses for both a stress-case and worst-case scenario.

In our stress case, we assume that banks experience 5% losses on energy loans, that 10% of energy commitments are drawn and that banks experience a similar 5% loss rate on these, that banks lose 50% of oil-related investment banking revenue, and that losses on Russian assets hit 15%. In this scenario, we estimate that, on average, covered banks with known exposure to energy or Russia would experience losses of 1.7% of common equity. We're comforted by the results of this scenario, which project that even the most exposed bank, Societe Generale, would experience manageable losses of 5.1% of common equity.

Our worst-case estimates are also drawn from the historical record, but instead of assuming that banks experience average losses, we assume that all banks experience losses in line with the much more extreme historical examples. In this scenario, we assume that energy losses reach 25% of loans, that 50% of commitments are drawn and that these, too, experience 25% losses, that banks lose 100% of oil-related investment banking revenue, and that Russian losses hit 50% of assets. In our worst-case scenario, we estimate that the same set of banks would, on average, see more painful losses, averaging 8.7% of common equity. It is only in this extreme scenario that we project that any covered banks would experience losses severe enough to cause capital shortfalls: We project that 10 banks (Barclays, BOK Financial, Comerica, Commerzbank, Cullen/Frost,

), Royal Bank of Canada, Societe Generale, Standard Chartered, and Zions) could see losses of greater than 10% of common equity. Reassuringly, however, the remainder of the banks are projected to see manageable losses averaging 4.2% of common equity.

Apollo Global Management

APO

Apollo is a global alternative asset manager with about $160 billion in assets under management deployed across private equity, credit, and real estate strategies. Notably, it manages AUM for Athene, a fixed-annuity provider, which provides Apollo with a $60 billion-plus source of permanent capital. We believe the market is overly focused on the short-term health of the IPO market and the near-term pace of realizations, and is overlooking the strong growth prospects Apollo has in credit, thanks to regulators forcing banks to sell illiquid and risky assets to the firm at a discount.

Lloyds Banking Group

LYG

We think Lloyds has finally turned the corner. In 2014, it reported its first annual profit in five years, declared a dividend (its first since 2008), and outearned its 10% cost of equity, with an underlying 13.6% return on required equity. We expect results to continue to improve: Net interest margins will strengthen as noncore operations run down, and shareholders will finally see the benefit of Lloyds' strong competitive position in the United Kingdom's profitable retail banking market.

Banco Santander Brasil

BSBR

We think Santander Brasil is undervalued because investors are overly focused on headline profitability metrics that do not capture the true earnings power of the company. In our view, Santander Brasil holds a strong competitive position in the highly concentrated Brazilian banking market with a narrow economic moat. We expect that the negative accounting impact from goodwill and excess capital will fade, and over the long term, investors will come to realize the bank's true earnings power.

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