|
Published: November 24, 2009
In February 2009, I reviewed the operations
of the 12 largest U.S. banks, and concluded most of them were
sound.
In fact, I told Money Morning readers that the soundest were at
that point excellent investment opportunities.
Judging by the performance of the Financial Select Sector SPDR
(NYSE: XLF) Exchange-Traded Fund since that time, one
thing is clear: If you’d followed my advice you would have more
than doubled your money.
Yes, the market’s up, too, but not to that degree -- so it’s
reasonable to say that I feel a quiet satisfaction over my early
analysis of that troubled sector.
A Tough Act to Follow
Unfortunately, the U.S. banking-sector outlook for 2010 is not
so rosy. Not only would you be buying at roughly double the
price of February, but the sector’s prospects are considerably
grimmer than they were just a few months back.
I didn’t get everything right in February. You can quibble only
slightly with my ratings of banks: For instance, State Street
Corp. (NYSE: STT) has been nothing like the solid player I
predicted at the time, while Capital One Financial Corp. (NYSE: COF) has had less difficulty with its credit-card portfolio than
I expected.
Overall, however, I was mostly right.
What I got wrong was my advice to readers to buy the shares in
the top-quality banks: You actually would have fared better by
investing in the lousy ones. Instead of the +100% you would have
reaped by following my strategy, you could have made roughly +90%
by now on Bank of America Corp. (NYSE: BAC), which I had
dismissed as a “zombie,” and about +210% on the “walking wounded”
Capital One.
And if you’d waited until early March -- when true despair ruled
-- you could have earned even more on the king of the “zombies:”
Citigroup Inc. (NYSE: C).
Bad banks turned out to be the better investment than good banks
for two reasons:
First, the government has intervened heavily in the banking
sector, even since February. The “stress tests” were carefully
designed so that everybody would pass, while the public
investment in Citigroup was converted from preferred stock into
equity on what looked like very favorable terms. Little or
nothing has been done to break up the largest banks that had
caused the problem; indeed, the only sanction on them has been
for a “Pay Czar” to step in and limit the pay of their 25 top
executives. Conversely, the good banks like U.S. Bancorp (NYSE:
USB) and BB&T Corp (NYSE: BBT) were forced by the threat of
state intervention to raise new equity to repay TARP money, and to cut their dividends, neither
of them things they would have done in a free market.
And second, the other factor helping banks that I did not expect
in February was the continuation of very low interest rates and
the ongoing federal “stimulus.” The U.S. Federal Reserve has
purchased $2 trillion of U.S. Treasuries, mortgage bonds and
agency bonds.
The Obama administration has continued its initiatives, too,
such as the $8,000 tax subsidy to first-time homebuyers. This
has helped bad banks more than good banks, because the
housing-loan and mortgage-bond “books” of the bad banks were in
far worse shape.
However, it has enabled all banks to make money simply by
borrowing short-term money at a cost close to zero and lending
it out to consumers and business at rates often in double
digits.
The biggest beneficiary has been Goldman Sachs Group Inc. (NYSE:
GS), which has enjoyed a trading bonanza, and which is now
intending to pay out record bonuses on the basis of profits made
using cheap, taxpayer-provided capital.
No Room for a New Year Encore?
Going forward into 2010, these factors stop being so positive.
First, it’s most unlikely that the Fed will keep interest rates
at such low levels in 2010. Commodity and oil prices have soared
during 2009 because of the low interest rates, and at some point
these escalating prices will translate into real inflationary
pressures -- even down to the consumer level.
When this happens, interest rates will have to go up. That will
have three effects on bank profits -- all of them bad.
- First it will reduce the huge trading profits that the likes
of Goldman Sachs, Citigroup and Bank of America (which owns
Merrill Lynch) have been making.
- Second, it will reduce the profitability of borrowing
short-term and lending longer-term -- indeed the banks that have
invested in bonds with the interest rates un-hedged will even
incur capital losses.
- Third, and last, the higher interest rates will tend to reduce
the prices of assets such as houses and commercial real estate,
thus causing larger bad debts.
The government’s stress test earlier this year was based on a
“worst case” U.S. economic scenario of 10.5% unemployment in
2010 and a 29% decline in U.S. house prices from the beginning
of 2009.
Housing prices are now showing signs of having bottomed out only
about 8%-10% below their December 2008 level. That’s good.
However, the U.S. unemployment rate in October rose by +0.4% to
reach 10.2%, and there must be a substantial chance in the new
year that the U.S. jobless rate will blow through both the
stress test’s hypothetical level of 10.5% and the November 1982
postwar record of 10.8%. Combine that with a possible further
decline in home prices if interest rates rise, and investors
could be looking at some real trouble for the balance sheets of
consumer-oriented banking institutions.
Since unemployment has never risen above 10.8% in the postwar
period (and its duration above 10% was only 10 months in the
rough 1982-83 downturn) the U.S. consumer-credit system is not
“stress-tested” for such high unemployment rates.
Losses could be huge.
Of course, the government will very likely bail out the banks
again if they get in more trouble. However, shareholders would
probably be pretty badly penalized in that event, since
politicians would likely conclude that investors should bear
more of the cost for zapping taxpayers twice in two years.
That brings me to the other possibility, of punitive legislation
against the banks -- or some kind of “insurance premium” on
those deemed “too big to fail.” I’m talking about premiums in
addition to those that banks already pay to the Federal Deposit
Insurance Corp.
There is considerable political momentum behind this: The news
of the record Goldman Sachs bonuses and soaring bank
remuneration -- coming at a time when the Fed is running
policies specially designed for U.S. financial institutions to
repair their capital and resume ordinary lending -- is pretty
compelling. It’s not as if the banks were increasing their
lending with the money they are being given; bank loans are
currently running $600 billion below year-ago levels even as
banks have nearly $2 trillion in excess reserves with the Fed.
Personally I would favor a “Tobin tax,” a small tax on each
transaction in bond, stock commodity and foreign-exchange
markets. This would need to be imposed by global agreement, but
could be levied on a country-by-country basis (you don’t want to
give global institutions a separate source of revenue, heaven
forbid!).
Tobin taxes would fall most heavily on the very big conventional
banks, as well as on the trading-oriented investment banks. They
would hit especially hard the “fast-trading” business
initiatives, in which investment banks profit from their inside
knowledge of money flows.
That’s all to the good; the “fast trading” business -- and much
of trading in general -- appears to me to be pure rent
extraction in which traders make money without providing
anything of value to others. As a veteran banker myself, I can
say with certainty that this is not true of most traditional
banking and investment banking business, however.
Whatever tax the politicians decide to go with would strike both
directly and deeply at bank profitability. If designed badly,
this tax could also hurt the relatively innocent regional banks.
There is also new talk of breaking up the biggest banks to stop
them being “too big to fail” -- again probably bad news for
shareholders in the short-term.
With markets, loan losses and the government all likely to hurt
banks in 2010 -- especially in the year’s second half -- banks
are not a savvy investment play right now.
However, there may come a period -- perhaps in late spring -- at
which the overall stock market sees all the problems and again
fails to distinguish properly between the badly run or scamming
behemoths, and the valuable and well-run regional franchises.
At that point, selected banks will again be a “Buy.”
Perhaps -- as we saw last February -- it will even once again be
possible to double your money.
After all, risk does have its advantages!
-- Martin Hutchinson
Contributing Editor
Money
Morning |
