The S&P Financials Index is up 75% from its low on March 6, 2008. The KBW Bank Index, which consists of 24 national money center and leading regional banking institutions, is up 84% over that same time frame. We are not terribly surprised by this move. On April 3 we wrote that the rally in financial stocks reflected a number of factors, 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 the prospect of more liberal mark-to-market accounting standards. At the same time, however, we also waved a flag of caution based on the fact that the unemployment continues to soar, with most pundits predicting that peak unemployment will not arrive until well into 2010. The 1Q bank earnings reports that have come in so far do little to allay our concerns. 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. As we contemplate investments within the financials industry today, we would continue to stick with well-managed and well-capitalized companies such as JP Morgan and Goldman Sachs.
We are always reluctant to make short-term trading calls. However, it strikes us that the euphoria over 1Q bank earnings is somewhat misplaced. The factors leading to first quarter outperformance (relative to drastically-reduced expectations) seem to be largely unsustainable. First and perhaps most obviously, the large money center banks with capital markets exposure benefited greatly from a sharp increase in trading-related profits. Banks such as JP Morgan, Citigroup, Bank of America, Goldman Sachs, and Morgan Stanley, among others, reported huge profits resulting from wide bid-ask spreads and increased volatility in fixed income markets. Second, the low interest rate environment, which is partially the product of government intervention, has led to another massive mortgage refinancing boom. Wells Fargo reported its best mortgage origination quarter since 2003, which resulted in a windfall of fees and gains on the sale of new mortgages. Other banks are enjoying similar benefits. And finally, we must constantly remind ourselves that the banks continue to operate with a huge amount of support from the federal government. The TARP capital injections and unsecured debt guarantees have dramatically reduced the banks’ cost of funds. This support has also eliminated the need (at least temporarily) for many banks to execute highly dilutive capital raises. The federal government support, as well as the benefits from trading and mortgage refinancing, cannot be expected to last indefinitely. Astute investors must determine which banks are best positioned to be profitable and thrive in the absence of these positive influences.
We also see some smaller factors that are positively affecting near-term performance for banks:
- Several banks (most notably Wells Fargo and Bank of America) appear to be benefiting from purchase accounting marks resulting from recent acquisitions. When a bank acquires another bank, it is required to mark the acquired assets, including loans, to market. These write-downs essentially act as a reserve for losses on acquired loans. Our concern is that this “reserve” is being used to mask underlying loan deterioration, leading to reduced transparency. Stated another way, it is highly difficult to figure out whether or not the acquirers overpaid or underpaid for their targets.
- We believe that seasonal factors, most importantly tax rebate checks, are creating the illusion that credit losses are close to peaking. Several banks have noted moderation in the rate of deterioration in certain loan loss ratios. But is this possible if unemployment is expected to continue rising through at least the end of the year?
- Some banks, including Wells Fargo, have already implemented the new mark-to-market accounting rules, leading to higher capital ratios than would otherwise have been the case. While we agree with the new rules, we do not believe this is a sustainable source of capital for banks.
The quality management teams are using these non-recurring windfalls to improve their financial health. Goldman Sachs tapped the equity markets for an additional $5 billion following its 1Q earnings release. JP Morgan and others used a large portion of its trading profits to fund loan loss reserves. However, other banks don’t appear to be willing to face the reality that this is the worst banking environment in decades. Continued housing price declines and job losses create unprecedented uncertainty over the ultimate peak level of loan losses. Bank managers should address this uncertainty through balance sheet fortification.
We remain cautious on the financials. The big wildcard for all banks is the ultimate peak level of unemployment. Will the unemployment level peak shy of 10% at the end of this year, or will we go peak out at 11% or higher in 2010? This is perhaps the most important question as it relates to the ‘investability’ of the banks at this time. Not coincidentally, stemming the tide of rising unemployment is a key objective of the stimulus package. But beyond unemployment, the peak of which is unknowable at this point, there are other systemic risks for the banks. Most importantly, housing price declines have the potential to cripple bank balance sheets for the indefinite future. We are most concerned about the following:
1) Despite some of the lowest mortgage rates in history, there remains a huge backlog of unsold homes both on the market and on bank balance sheets as a result of foreclosures. Clearing this inventory will require additional drops in housing prices;
2) Reports suggest that 20% of the existing mortgages are currently underwater (ie, the borrower owes more than the home is worth). If housing prices continue to decline, will more and more homeowners be incentivized to simply walk away, leaving the bank with the loss? What percentage of mortgages will be underwater when home prices ultimately trough?;
3) We remain very concerned about mortgage rate resets on a flood of option-ARM and Alt-A mortgages scheduled for the 2010-2011 time frame. According to John Maudlin’s April 10 newsletter, the amount of option-ARM and Alt-A mortgages resetting over 2010-2011 will be as large in scale as the sub-prime mortgages that reset over the 2007-2008 time frame;
4) Are artificially low mortgage rates (driven by government purchases of mortgage-back securities and Treasuries) responsible for an apparent stabilization in housing prices? If so, what is the price level at which demand meets supply without government intervention and support?
Recent comments by Treasury Secretary Geithner suggest the large majority of banks will be deemed well-capitalized following the stress tests. However, we think it is likely that some banks will be required to raise additional capital through either new stock offerings or TARP conversions. Paul Miller of Friedman, Billings, Ramsey has a research note out today in which he unveils his own personal stress test for the banks. Paul concludes that “if unemployment peaks at 10%, roughly consistent with the government’s stress test, most of the big banks will be able to earn through it. On the other hand, if unemployment is closer to 12%, which FBR believes is more realistic, their viability without additional capital is more questionable.” In fact, Paul’s numbers suggest each of the nine banks he analyzed would be dramatically undercapitalized at 12% unemployment. Is it any wonder why the Obama administration felt such an urgency to pass a stimulus bill to help minimize job losses? There certainly is a lot riding on this stimulus package.
In closing I would just like to mention that I will be appearing on CNBC tonight during the 8-9 pm hour. Please tune in if you would like to hear some commentary straight from the horse’s mouth. In addition, I wanted to note that Farr, Miller & Washington is aggressively pursuing a new business development professional who can help us capitalize on our strong performance track record. If you know of somebody who might be interested in speaking with us, please let me know.