Banks Not Out of the Woods

Yesterday’s news that the Financial Accounting Standards Board (FASB) will “loosen” the mark-to-market rules that have led to widespread securities write-downs was received positively by investors. But are these changes the panacea that investors are expecting? Are banks now out of the woods with regard to capital adequacy? Should we be buying on this news or taking profits after the huge run-up over the past few weeks? Allow me to offer my two cents.

The financial stocks within the S&P 500 have rallied over 50% since the lows posted on March 6, 2009. The sharp bounce reflects a number of potentially positive developments, including better housing data, a modest rebound in retail sales, improvements in certain credit markets, a possible bottoming in certain manufacturing and consumer confidence metrics, and yes, the prospect of more liberal mark-to-market accounting standards. While these are all welcome developments, we remain most concerned about the one economic indicator that has the potential to most dramatically affect the near- to intermediate-term fate of the banks: unemployment.

This morning, the government reported a loss of 663,000 jobs in March, bringing total job losses to 3.7 million over the past six months and 5.1 million since the beginning of 2008. The unemployment rate now stands at 8.5% compared to 4.9% at the end of 2007. The loss of jobs at such a rapid pace creates numerous challenges for those in the business of making loans. Most obviously, delinquencies and losses on consumer loans such as credit card, auto, mortgage and student loans will continue surging as more consumers find themselves without a monthly paycheck. However, the derivative effects are also felt on the commercial side as high unemployment affects vacancy rates in commercial real estate and small businesses struggle to service their debt in the face of lower demand for their products and services. In a nutshell, we believe that while the risks associated with securities write-downs are now widely appreciated and discounted, the risks associated with higher loss rates on huge portfolios of consumer and commercial loans are less than appreciated. Outsized additions to loan loss reserves will continue to weigh down bank profitability while potentially leading to capital deficiencies at some of the weaker banks.

The modifications to mark-to-market accounting may indeed marginally improve the perilous situation now confronting the nation’s banks. Specifically, a reduction in securities write-downs that are required to be run through the income statement could modestly improve earnings and regulatory capital at some banks. However, the new rules do nothing to improve the metric upon which most investors are intently focused: Tangible Common Equity to Tangible Assets (TCE/TA). As long as investors remain focused on this metric as a gauge of capital adequacy, we believe there will be a limit to the upside in bank stocks.

We continue to tread very carefully when investing in financial services stocks, especially after this recent run-up. Financial stocks such as JP Morgan Chase and Goldman Sachs have dramatically outperformed the overall sector over the past several months because their balance sheets are in relatively good shape, they have largely avoided the pitfalls that have sunk other companies, and they are run by top-notch management. We believe investors would be wise to stick with quality as this once-in-a-century crisis continues to unfold. As we said have throughout this ugly bear market, now is not the time to be investing in companies with untried business models and untested management teams.

Peace,

Michael