U.S. Bank Stocks are Over-Reacting to Euro-Zone Exposure Concerns - Analyst

U.S. bank investors have been concerned about Euro-Zone exposure, but according to analysts at Wells Fargo today the market is over-reacting.

Recently updated (9/30) cross-board exposure data from U.S. banking regulators (FFIEC) showed that gross exposure of the largest 10 U.S. banks to the five most challenged Euro-zone economies totaled $226B at Q2 2011, up 13% quarter-over-quarter. However, the exposure as a percentage of total non-U.S. exposure is now a relatively modest 6%, up from slightly below 5% at the end of 2010.

Wells Fargo estimated that Morgan Stanley (NYSE: MS) has the highest universal/capital markets banks (UCMBs) exposure at 96% of Tier 1 common capital. However, they believe the exposure is "materially" overstated:

"We believe MS' exposure – similar to the exposures of other UCMBs – is materially overstated by the FFIEC data, as illustrated in Exhibit 5 on page 3, however. MS estimates its exposure to the peripheral European countries as of June 30 totaled approximately $5B – a figure 88% below the $42B estimated from the FFIEC data as of June 30. We note that in most cases the banks’ reported exposure to these five countries at the end of Q2 2011 is visibly below the figures estimated from the FFIEC data as of the same date. As well, the companies have been keenly aware of these exposures for well more than a year, suggesting potentially higher-risk exposures to counterparties in these countries have been reduced over that time, in our view. As a result, we believe the net exposures reported by MS and the other UCMBs are plausible values."

The firm said Bank of America (NYSE: BAC) is more exposed and Goldman Sachs (NYSE: GS) is least exposed of the peer group.

Despite the group exposure, "we do not believe losses on these exposures would drive a material change in the TBV of our UCMBs," the firm states. Still information remains sparse, the analyst cautions, which heightens investors concerns about this volatile situation.

Commenting on Morgan Stanley's exposure to France, the firm said it is quite manageable, and is more than discounted in the market:

"We have used MS' disclosure of its exposure to France to illustrate the differences between regulatory "exposure" and actual credit risk. We estimate MS' exposure to France is $2.4B before hedging benefits and $1.4B net of hedges. We believe MS' estimate of no net counterparty exposure to France excludes potential funding of currently unfunded corporate loans. We believe MS' exposure has been overly discounted by the market in recent weeks."

Wells Fargo also said the market's newest concern - derivatives - is also overblown:

"More recently, investors have become concerned about outstanding
derivatives positions of the UCMBs. According to the OCC, 97% of the notional
value of outstanding contracts is eliminated from bilateral netting and high
quality collateral held against counterparty risks. Losses typically do not exceed
20bps of net credit exposure. Specifically, MS' net credit exposure to derivatives
was 1% of Tier 1 common capital at Q2 2011, a level visibly below its peers."

The firm prefers JPMorgan (NYSE: JPM) and PNC (NYSE: PNC) for defense and Goldman Sachs as a more cyclical play.

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