One of the indicators of profitability and earnings that investors in bank stocks watch most closely is the net interest margin, which is interest income minus interest expense.
Net interest margin in the U.S. banking system has been declining for the past three years, as the Federal Reserve has increased quantitative easing and has withdrawn longer-duration debt from the publicly available capital markets. This has affected banks of all sizes pretty evenly. Net interest margin at the top four is currently about 3.10%, and at the smallest local banks it is about 3.50%.
Some banks, however, have larger margins, and unsurprisingly, three of the four largest publicly traded ones with the highest NIM are those that are focused on credit cards: Discover Financial Services (DFS) at 8.6%, Capital One Financial (COF) at 6.5% and American Express (AXP) at 5.4%.
Interestingly, Bank United (BKU), the 82nd-largest U.S. bank, which has the third-highest NIM, 6.1%, of all publicly traded banks, carries no credit card assets. I will address Bank United specifically in a separate column.
Discover Financial Services, the 28th-largest bank in the U.S., has by far the highest NIM of all publicly traded banks. This is directly related to the fact that it has the highest concentration of assets in credit card loans, at about 80% of its portfolio. The remaining 20%, however, consists of other kinds of consumer loans.
Besides concentration risk, another issue for investors to be aware of is that Discover has not increased its credit card assets in three years. Instead, it has increased its book of other consumer loans. The company appears to be trying to diversify into longer-term, fixed-rate consumer loan products to offset the potential for losses in the credit card space in the event that interest rates continue to move higher in the U.S. Although this prudent, Discover is late in doing so in comparison with Capital One.
Capital One, the sixth-largest U.S. bank, is by far the most diversified of the three, with about 40% of its portfolio in credit cards, 20% in residential mortgages, 15% in auto loans, 10% in commercial and industrial loans, 10% in commercial and multifamily real estate and 5% miscellaneous.
Net interest margin at Capital One has decreased from about 8% to 6.5% over the past three years as the company has moved aggressively to diversify into mortgages and auto loans and as a result created an asset portfolio closer to those of the money centers. But impressively, Capital One has been able to maintain NIM at 6.5% while the Big Four money centers are at 2.4% for JPMorgan (JPM), 3.35% at Bank of America (BAC), 3.46% at Citigroup (C) and 3.50% at Wells Fargo (WFC).
American Express, the 29th-largest bank in the U.S., is highly concentrated like Discover, with about 65% in credit cards and 35% in commercial and industrial. Unlike Capital One and Discover, however, American Express has not substantially diversified and instead taken a "damn the torpedoes, full speed ahead" route with regard to its credit card assets.
In the last three years, American Express' book of credit card loans has increased in value from about $22 billion to $34 billion -- a 55% increase. The only hedge to its credit card concentration has been to increase its commercial and industrial loans, the only other type of loan it carries, from about $13 billion to $17 billion.
Although Capital One has also increased its credit card loan assets by about 50% in the same period of time, it has increased its exposure to other kinds of loan assets even more quickly.
From an equity standpoint, besides having the most diversified portfolio, Capital One also offers investors the lowest price-to-earnings ratio of the three, at about 9x, and the highest dividend, at 1.8%.
The P/E and dividend at American Express are about 18x and 1.2%, while at Discover they are 11x and 1.6%.
These are all good companies, and although the risk associated with potential defaults on credit cards if interest rates rise is greater than at other banks, Capital One offers the best value for investors at this point.