Bank Stocks Get Hit by Dimon’s ‘Cockroach’ Hint. It’s Time to Buy.

Bank of America is stock to consider playing. The bank has solid earnings and confidence in its outlook. (FREDERIC J. BROWN/AFP via Getty Images)

Key Points

• JPMorgan CEO Jamie Dimon’s “cockroach” comment about bad credit weighed heavy on bank stocks. The SPDR S&P Bank ETF dropped 6% on private credit worries.
• US banks have committed about $95 billion in loans to private credit funds, which is not considered a systemic risk given over $2 trillion in equity.
• Bank of America is highlighted as a strong value, trading at a 10%+ price-to-earnings discount to peers, with potential for growth.

JPMorgan’s Jamie Dimon raised a red flag—he used the word “cockroach”—about the bad credit that a handful of banks face. Bank stocks fell hard.

The selloff came just after all of the big banks had just posted solid earnings and confirmed that everything was under control, which underpins the case for buying the stocks.

In this case, an investors’ head—not his or her heart or stomach—should rule. The U.S. banking system is in good hands right now.

The SPDR S&P Bank Exchange-Traded Fund, home to the large U.S. investment banks and super regional lenders, has dropped about 6% from Tuesday’s close. Most of the drop came Thursday, when the focus sharpened on bank loans made to two companies that have declared bankruptcy, auto lender Tricolor Auto Group and auto parts maker First Brands. Lenders Jefferies and Zions Bancorp took hefty losses.

Dimon raised the issue on JPMorgan’s earnings call, which kicked off this earnings season: “When you see one cockroach, there’s probably more.”

The fear is that private credit is becoming a problem. Tricolor isn’t a private credit fund, but its businesses was built on the same idea: Borrow money from banks, lend it to borrowers who don’t have access to bank financing—for a high yield. Plus, these bonds don’t trade in the public market so their prices don’t swing day to day and they don’t have to reveal much information to the public.

For these very reasons, investors have poured trillions of dollars over the past few years into private credit funds, which lend to small and midsize businesses that can’t raise capital from banks.

All the revelations about the companies that went under put an exclamation point on just how opaque—and risky—private credit is and bared the ultimate risk: Other businesses with poor credit will fail to repay the credit funds, translating into large losses for banks.

The fact, though, is that U.S. banks as a whole aren’t extremely exposed to private credit. They had committed about $95 billion of loans to private credit funds, according to a study from the Federal Reserve published this May.

That amount is spread across several banks, so no single large bank is taking much risk. The total sum is also not exorbitant, given that all U.S. banks have a total balance sheet equity of over $2 trillion today. Put simply, banks have plenty of capital to cover potential losses related to private credit.

The issue is that private credit assets are growing every year, which means the amount that banks lend to these investment vehicles will also increase. But the scale of all of this is so small today that, if it ever creates a problem for the financial system, it won’t happen soon.

“We do not believe the private credit lenders are a systemic risk to the U.S. economy or banking system,” said Gerard Cassidy, a RBC bank stock analyst.

So for U.S. banks overall, balance sheets, bad credit expense, and earnings all look fine.

The private credit market “is not a thesis changer when it comes to financials,” said Jason Ware, chief investment officer of Albion Financial Group, which is maintaining its stockholdings in U.S. financial institutions.

The bank ETF, analysts forecast, can grow aggregate revenue 9% annually over the coming two calendar years, according to FactSet. The drivers: a growing economy, which increases loan volumes; a pickup in corporate transactions; and rising trading revenue on the back of rising markets.

Earnings per share can grow 14% because profit margins can increase as banks increasingly use artificial intelligence to target business opportunities.

That can push the stocks higher, especially because they’re now reflecting risk that won’t materialize soon. At the very least, these names can recover the ground they’ve just lost as the market sees no evidence that the financial system is currently at risk.

One name to consider is Bank of America, which remains down almost 2% from Wednesday’s close. It’s participating in the revenue and margin trends of the broader industry, and beat third-quarter sales and earnings estimates.

BofA also signaled confidence in its outlook, increasing the low end of its fourth-quarter net interest income guidance by $100 million to $15.6 billion.

And the earnings estimates could rise. Analysts forecast $15.61 billion in fourth-quarter net interest income, which represents a bit more than half of total revenue, while the high-end of management’s guidance is $15.7 billion. If the company keeps surpassing expectations, analyst should lift their forecasts.

As the bank proves to the market that it remains on a path of growth, the forward price/earnings multiple of just over 10 times can rise close to the bank fund’s over 13 times.

“Bank of America represents strong relative value…trading at a 10%+ P/E discount to peers,” wrrote Christopher McGratty, Keefe, Bruyette & Woods analyst.

This is one of those moments to buy when others are worried.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com