This article is not focused on Roaring Blue Lion Capital’s proxy campaign against HomeStreet, Inc. Instead, it draws upon insights from the fund’s observations about the fundamental differences between mortgage banks and commercial banks.
Roaring Blue Lion’s November 2017 letter explains why commercial banks are valued at a premium over mortgage banks:
Earnings Stability: Mortgage banks' earnings are highly sensitive to interest rates and seasonal factors, leading to unpredictable earnings. In contrast, commercial banks have more stable and predictable earnings, which investors prefer.
Interest Rate Sensitivity: Mortgage banks are negatively impacted by rising interest rates, as higher rates reduce mortgage demand. Commercial banks, however, generally benefit from rising rates, improving their profitability.
Operational Efficiency: Mortgage banks tend to have high efficiency ratios (85-90%), while well-run commercial banks generally have efficiency ratios of 40-60%. As a result, every dollar of revenue in a commercial bank generates roughly 50 cents of pre-tax income, compared to 12.5 cents for a mortgage bank. Therefore, the leverage per dollar of revenue for a commercial bank can be four times greater than that of a mortgage bank.
Valuation: Mortgage banks typically have lower price-to-earnings (P/E) and price-to-tangible book value (P/TBV) multiples due to their earnings volatility, whereas commercial banks command higher multiples because of their stable earnings and profitability.
Rising Rate Environment: In times of rising interest rates, commercial banks tend to be more profitable, widening the valuation gap between them and mortgage banks.
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