Are TBTF Banks Out of Danger? The Market Doesn’t Think So
Down here it’s just winners and losers
And don’t get caught on the wrong side of that line
This will be a long post. Even with all the pictures above the fold.
It started with a finger exercise during my daughter’s swim team practice:
Just in case you thought I was picking on The Big C in my previous post, let us look at the other major financial institutions (Too Big to Fail, or TBTF, Banks) over the same time period.
The Remaining Investment Banks:
While Goldman Sachs—as with most of the other so-called Winners—shows a significant upturn and major gains since the beginning of 2009, Morgan Stanley’s appreciation has been rather less apparent. However, both have returned only to approximately the price they held during the interregnum (after Bear Stearns fell but while Lehman Brothers ignored the warning and decided not to right the ship).
The Mortgage Lending Leaders:
Both firms show an increase in stock performance beginning in Q1 of 2009. Wells Fargo had a precipitous dive after LEH filed bankruptcy, but recovered in a similar amount of time. JPMorganChase, having acquired Bear for either a song or too much money, remains below the level it reached during the interregnum, but solidly in the middle of its range since 2006.
The Consumers-as-Profit-Center (“Retail”) Banks:
As is apparent, Capital One’s stock decline was not precipitated by the proximate solvency crisis itself, but rather by the decline in earnings and profits, and deflation in wages, that was in full swing by early 2006. While Bank of America does not have that preamble, it sees a similar decline in its stock price from the middle of 2007. By the time the recession is officially declared, the trend has started. And while Bear’s fire sale to JPM causes a decline in bank stocks, it is not until LEH that BAC mirrors its competitors above. More like MS than GS, BAC’s recovery to less than one-half of its pre-recession trading price suggests that the market is less confident than management that the firm’s major issues are behind it.
But one thing abides. The market isn’t happy.
Even as we might divide this squad into Winners (GS, JPM, WFC), Losers (C, MS), and Also-Rans (COF, BAC), six of those seven (exception: JPM) appear to be viewed by the market as no stronger than they were during the interregnum, the time when everyone was waiting to see if the other shoe would drop.
There are certainly other reasons the stock price might be down: insider selling at the firms is at record or near-record levels, and sooner or later people will figure out that when insiders are selling at 82:1 levels is not the best time to buy. Their loans are down (post on that coming soon) while, as Linda notes at ataxingmatter:
A recent study suggests that big banks in the TBTF category now enjoy a significant cost-of-funds spread compared to other banks. That is, they can borrow money more cheaply, leading to greater ability to make profits, than can other banks, because of the implicit guarantee that the federal government will step in and save them because they are TBTF and pose a systemic risk. That advantage may amount to as much as 48% of the TBTF banks’ profits this year (or as ‘little’ as 9%, on very conservative assumptions). The government, by the way, gets nothing for this implicit guarantee–unlike a commercial guarantor, it is not being paid a regular premium for the service.
So maybe investors believe that this advantage will go away. (Or, as noted above, maybe investors have figured out that the Big Banks aren’t taking advantage of this opporunity, expecting that it will never go away.)
The one certainty is that, with all of their advantages (the refusal of the Administration to support cramdowns for non-investment properties, leading to perverted accounting that makes banks solvent and mortgageholders underwater at the same time on the same property; the continuing payment of interest on Reserves in a deflationary environment, which has created a perverse incentive for the TBTF Banks not to lend; charging their smaller competitors for the TBTF Banks’s failures by raising their FDIC contribution and collecting three years of it upfront after not having saved for a rainy day; having Administration economic policy run by Larry Summers, whose last foray into the financial markets was too embarassing even for him to explain (h/t Felix); Ben Bernanke having decided that doing only half his job should be enough (h/t Brad DeLong); and the general delusion that the banks are necessary to and helping with a recovery. And that’s off the top of my head.
As The Epicurean Dealmaker observed last week vin a post eeryone should read:
Chancellor [of the Exchequer Alistair] Darling could not have been clearer:
“I’m giving them a choice. They can use their profits to build up their capital base, but if they insist on paying substantial rewards, I’m determined to claw money back for the taxpayer,” he said.
[H]e plans to do this by making banks choose between their employees and their shareholders…
Economists have made this point repeatedly: the first priority of people who run a business should be their responsibility to their shareholders. (See Steve Randy Waldman’s post yesterday for a clear explanation. And then see the post he pulled from comments after that, which saves me the trouble of hoisting from another person’s comments again for the real ramifications of TARP and the bailout. Why do Megan McArdle and the Administration hate the troops?)
Paying large bonuses while the banks themselves remain near insolvency is bad for the shareholders. Goldman Effing Sachs realizes that, even if they didn’t quite go far enough.
Why do I believe the state of the TBTF Banks ranges from near insolvency (C, MS) to on the edge of insolvency? The market tells me so.
you might believe that the banks are out of trouble, but the fact that stock prices of banks are low is consistent with well understood facts about where we are in this cycle.
anyone paying attention knows that most banks (not just tbtf) are going to be taking large writeoffs for the next couple years from loans put on their books before 2008. anyone paying attention knows that the banks have not sufficiently provisioned for these writeoffs but are depending on large pre-provision profits in the next couple of years. this is the administration’s strategy and the strategy of the banking industry — see the stress tests for example. these factors are going to keep payments to shareholders (ie dividends) low for the next two or three years minimum, and that is depressing the stock price. and beyond that, nobody really wants to speculate – nobody has a clear picture of how profitable the banks are going to be in 2012 or 2013.
furthermore people expect that there could be more equity raised through new stock offerings for many of the big banks or that they could divest themselves of some businesses in order to get on a more solid footing. this expectation will also depress the stock price.
so there are other explanations besides ‘not out of danger’ for the lower stock prices.
you might believe that the banks are not out of trouble, but the fact that stock prices of banks are low is consistent with well understood facts about where we are in this cycle.
anyone paying attention knows that most banks (not just tbtf) are going to be taking large writeoffs for the next couple years from loans put on their books before 2008. anyone paying attention knows that the banks have not sufficiently provisioned for these writeoffs but are depending on large pre-provision profits in the next couple of years. this is the administration’s strategy and the strategy of the banking industry — see the stress tests for example. these factors are going to keep payments to shareholders (ie dividends) low for the next two or three years minimum, and that is depressing the stock price. and beyond that, nobody really wants to speculate – nobody has a clear picture of how profitable the banks are going to be in 2012 or 2013.
furthermore people expect that there could be more equity raised through new stock offerings for many of the big banks or that they could divest themselves of some businesses in order to get on a more solid footing. this expectation will also depress the stock price.
so there are other explanations besides ‘not out of danger’ for the lower stock prices.
This is quite funny, really. Harvard, far too smart for its own good. To think I used to be a colleague of Hannah Gray!
http://www.bloomberg.com/apps/news?pid=20601087&sid=axcFIC0N68k0
wallace gromit – Selling off assets at a fair value–that is, by contractual, consensual agreement–should not depress stock prices. (It also shouldn’t raise stock prices, though it often does.) And, while new stock issuance would be dilutive–ask any of us who own DIS and are still bitter about the go.com acquisition–it also requires the consent of the shareholders and may simply be replacing government stock with someone else’s. As for the rest:
“anyone paying attention knows that most banks (not just tbtf) are going to be taking large writeoffs for the next couple years from loans put on their books before 2008. anyone paying attention knows that the banks have not sufficiently provisioned for these writeoffs but are depending on large pre-provision profits in the next couple of years.”
“so there are other explanations besides ‘not out of danger’ for the lower stock prices.”
Please explain how the last statement follows from the first, since the first explicitly acknowledges that bank balance sheets are currently–let me be nice and not say “a lie”–overinflated.
In fact, you are arguing precisely the same point I made: that the market views even the “best” of the TBTF banks (again, possible exception for JPM) as being no better than they were after Bear collapsed–one more hiccup a la LEH or AIG from disaster. (And how is MetLife doing?)
(Parenthetically, Brad DeLong made a similar point several weeks ago when he set the odds of this being a Second Great Depression [third, if you count 1873 et seq.] at 5%. DeLong was optimistic in that comment, quoting the floor of the odds.)
The refusal of the banks and the Administration to put those losses on the books now is going to drag on the real economy–and any good the banks can do–for the next several years, with the large majority of the costs being paid twice by “Main Street”: people using bank services being subject to higher fees and penalties that make up the “large pre-provisions profits” you speak of, after having already paid with tax dollars and tax breaks that will not net the government a profit, no matter how much the Obama Administration claims it to be so.
(The claim of profit is based on selling off the equity interest and calling that “profit.” But that’s a subject for a later post/argument.)
you’re saying a lot of things, and going to partially respond.
the only thing i have disagreement with is whether the banks are “out of danger.” maybe that is a quibble; i’ll write something and if you want you can respond.
the strategy of the administration (this and the previous one) is to let the banks muddle through. i don’t know whether to call it a lie or not, because i don’t think what counts for insolvency is as straightforward as you do. in any case i don’t want to argue over definitions and opinions: the administration laid out a strategy which involves gradual recognition of losses taken against pre-provision profits and set some expectations for the amount of support it was going to give the banks and the amount of additional equity the banks were going to need to come up with. i don’t think you can say the banks are “in danger” until such time as this strategy has run off the rails. and it has not, so far.
as for whether the banks are healthy banks, well, the answer is no, and the answer is that nobody expected them to be yet. if, say, you took BAC and figured that they would have a profit of $15B-$20B/year pre-tax in normal times (not an unreasonable number) what would you expect the market cap to be? right now the market cap is $130B. it doesn’t look to me like the market is pricing in a big probability of a zero there. if the profit per share number looks low, it’s probably because investors expect there to be more shares by the time the bank makes post-provision profits.
as for whether the bad condition of the banks is causing a drag in the larger economy, the answer is yes. whether the government will profit or not is not a real question from my point of view — the losses (there will be losses) will be far smaller than the loss of tax revenue already seen from the deep recession we are in. were there better ways of dealing with the crisis? probably there were, but we have the laws and government we have.
of course i understand that you have a platform and want to change the laws and government we have.
i read delong’s post and i have been thinking at least 5% all along. if i remember right (i don’t have the post in front of me) delong’s post had to do with being fed up with the fed rather than the banks, but whatever. imho the major risks in the short run are not in the US but in europe. there are a lot of things that could go wrong in the next year.
Ken,
Another factor weighing on stock prices of TBTF banks is just how much government interference (regulation?) will exist with their businesses going forward. Higher capital ratios, the return of Glass-Steagall, talent flight to more lightly regulated entities (e.g., hedge funds, private equity, off-shore competitors), Basel III, leverage caps, are all concerns, as well as depressed ROEs and expectation of a slow recovery in ROEs. On top of that, Goldman, who never really wanted TARP funds and was able to raise capital privately (from Buffet) in September/October 2008, prior to the TARP injection, JP Morgan, and others took TARP funds “out of their patriotic duty” basically so as not to identify Citigroup as insolvent (as if the market didn’t know). And in return for fulfilling their “patriotic duty” they’ve had the pleasure of a year’s plus of being bashed by the Administration that basically asked them to do so, even subsequent to paying back the capital with interest.
Goldman is in a no-win situation regarding their bonuses. They’re already generating close to 20% ROEs this year. If they don’t accrue anything for comp in the 4th quarter, the average per employee will be over $500k and they’ll produce an annual ROE north of 25%, which means they’ll get lambasted for being excessively profitable off the backs of taxpayers. Or they can pay their employees at their historicaly comp ratio and get lambasted for that. I guess they could knowingly trade/lend at a loss to depress profits and transfer wealth to their clientele, but considering their clientele isn’t really “main street” not sure that’s such a good idea either.