Financials were the top performer in the S&P 500 for the first quarter. Since financials represent approximately 15% of the index, their performance has an important effect on the health of the stock market. The large banks, which are a major component of the sector, have been under considerable pressure since the beginning of the credit crisis. However, their stock prices have enjoyed a recent resurgence. What should we expect from this important element of the economy?
From the beginning of the meltdown in subprime loans, through the collapse of the real estate market, to the present concerns in the euro-zone – banks have been at the center of the crisis. The fundamental problem, of course, was the buildup of debt over a thirty year period. The credit crisis is a result of having reached unsustainable levels of debt. We are now in the painful process of reducing that debt to historical norms. In order to have a healthy economy, all sectors will have to participate: individuals, companies, financial intermediaries, and – yes – even the government. As the focal point of public ire, governmental scrutiny and regulation, and this month’s commentary, we will take a look at the various factors affecting the deleveraging process of the banking industry.
In the early 1980s, interest rates reached very high levels to curtail inflation. As inflation receded and interest rates started to fall, borrowers found credit increasingly affordable. Although monthly payments remained the same, borrowers could take on more and more debt. Banks increased their debt to equity ratios to accommodate the loan demand. Regulations restricting banks from investment banking activities were eased and, then, eliminated. Investment banking was traditionally a brokerage and underwriting business. But with this new activity came a trading culture. Banks began to securitize loans so that they could do more business. Likewise, some set up off-balance sheet vehicles to gain flexibility and less regulatory supervision. Proprietary trading became an attractive avenue to increased profits. All of these activities, which reached their zenith just before the credit bubble burst, are now under regulatory review.
Banks can reduce their leverage ratios by reducing their loans, increasing their capital, or through some combination of the two. As we will see, there are a number of innovative ways to address this issue. In the United States, banks were quick to write down bad real estate loans (which depletes capital) and to issue new equity (which increases capital). They also became more selective in their lending criteria. Off-balance sheet vehicles have been closed, and proprietary trading has been largely suspended. However, many challenges remain.
Lawsuits by federal and state regulators have and will continue to exact a toll on the banks. The National Credit Union Administration, in conjunction with others, has sued Goldman Sachs for potentially $2.6 billion in mortgage related legal losses. Last year, it settled with Citigroup and Deutsche Bank for $166 million for bad mortgage backed securities sold to credit unions. Massachusetts fined State Street Corp. $5 million for failing to tell investors that a hedge fund manager that helped pick the assets in a collateralized debt obligation also bet against it. There are many examples, but the largest settlement to date was for $25 billion reached in February among Ally Financial, BofA, Citibank, JPMorgan Chase, and Wells Fargo over robo-signing. With the robo-signing suit behind them, these banks will now start foreclosure proceedings, putting further pressure on the real estate market. Although the banks have set up reserves for these loans, should real estate decline appreciably from here, there will be additional loan losses and economic repercussions
European banks, like Banco Santander, are legitimately selling parts of businesses to raise capital. Interestingly, Banca Monte del Paschi di Siena is examining the possibility of writing down goodwill, allowing it to forgo paying interest on government bonds and, therefore, increasing its capital. Spain and Portugal are buying “contingent convertibles” as a way of increasing bank equity without increasing government deficits. The problems in Europe are large and complicated. Countries like Spain, Italy and Portugal have limited access to capital markets, and the European Central Bank (ECB) is restricted by its charter in how much it can lend to member countries. These countries need funding to rollover their debts, as do their banks. They sell their debt to their banks, which then use it as collateral to obtain loans from the ECB. Although this charade is intended to calm the markets and to allow for lending to the private sector, it has allowed US banks and other investment vehicles to reduce their exposure. Nonetheless, US banks are not immune from problems in the euro-zone, which are far from being resolved.
The Bank for International Settlements has identified 29 Systemically Important Financial Institutions, suggesting that they hold an additional 1% to 2.5% in capital. The Federal Reserve has accepted the recommendations and, empowered by Dodd Frank, may include important nonbanks, such as GE Capital and AIG.
It will probably take another 5 years for banks to delever as they continue to face losses from foreclosures, declining revenue opportunities as activities such as proprietary trading are stripped away, and they are slowly reduced to spread lending. Banks are guiding analysts to expect returns on equity of 12% compared to earlier expectations of 20%. Likewise, return on assets has declined by about one third. Recent favorable earnings have come from releases of reserves against bad loans. The decline in loan loss reserves accounts for about one third of the earnings reported by Citigroup. Those reversals cannot be repeated indefinitely, and may have to be increased in the next recession.
Despite the mixed reputation of the securities rating agencies, their ratings of banks matter because they affect funding costs. Late last year, S&P lowered ratings on 15 of the world’s largest banks. Moody’s has placed many of these same banks on review for possible downgrades because they are facing “more fragile funding conditions, wider credit spreads, increased regulatory burdens, and more difficult operating conditions.” While it is certainly encouraging to see the financials performing better, we couldn’t agree more.