Aside from the market volatility of the past several days, last week's signal from the Federal Reserve that it could tighten the money spigot later this year also had another expected effect: Interest rates have started to inch higher.
While higher interest are commonly viewed as bad for stocks, that's not completely accurate especially when it comes to banks. As I've argued before, higher interest could actually turn out to be a catalyst for banking stocks if higher rates lead to an expansion in the net interest margin.
As a hypothetical exercise, the average 30- year fixed mortgage rate is now 4%, up from say 3.5% six months ago. A bank with $10 billion in new loans will enjoy an additional $50 million in net income, thanks to the 50-basis point increase in net margin.
You can do the math and appreciate the potential if mortgage rates go to 5% and we are talking about tens of billions of dollars in lending. Deposit rates historically don't go up as quickly as lending rates, so rising interest likely lead to expanding net margins. Of course, loan volume matters as well.
Banks find themselves in an interesting position. Many investors have forgotten the Troubled Asset Relief Program warrants that were issued to Uncle Sam back during the recession. They were then sold to the public, and now trade freely. These warrants are simply super long call options. They will do well -- perhaps extremely well -- over the coming years if bank stocks move higher.
My favorite warrant is the Bank of America (BAC) Class A warrant (BAC-WTA on Yahoo! Finance), which allows you to buy shares of BofA at $13.30 anytime before Jan. 16, 2019. The warrant trades for $5.50 while BofA trades for just under $13.
If you can articulate a scenario where BofA shares could trade for $20 or more in the next two years, the warrants could trade for at least $11. That is $6.40 intrinsic value plus $4 to $5 in time value. The higher BofA shares go, the bigger the warrant payout. A $30 BofA share price, or 1.5x book value, would make the warrants worth $16.40 plus any time-value premium. That is a 200% return or higher.
Capital One Financial (COF) has warrants (COF-WT) that allow you to buy shares of COF at $42.13 until November 2018. Capital One currently trades for $61 a share. The warrants are currently trading for $23.30.
AIG (AIG) warrants (AIG.WT) have a strike price of $45 and trade for $18. The warrants expire in January 2021. AIG shares trade for $43.75. Wells Fargo (WFC), Warren Buffett's favorite bank, has warrants expiring October 2018 with a strike price of $34.01. The warrants are trading for $13 while WFC shares trade for $40.
Goldman Sachs (GS) is widely known as the smartest bank in the business. They also issued TARP warrants, which were then sold to the public. What of the warrants now? Goldman bought them all back a couple of years ago.
