FYI | Apr 07 2009
By Greg Peel
From trough to peak, the rally in the US broad market S&P 500 index in recent weeks has measured 24.5%. Impetus from the rally has come from the financial sector, the subset index of which has rallied close to 54%.
Such movements in bank stocks are unprecedented. The financial sector was once the most powerful subset of the S&P 500, representing 20% of capitalisation. But the GFC has seen the stock prices of some of the world’s biggest banks by asset value nearly disappear out the backdoor on solvency issues. Indeed, colourful billionaire investor George Soros this week declared that US banks are “basically insolvent” – a state denied by the banks but long believed by just about everybody else. The US government has been propping up the major banks with capital injections since the fall of Lehman Bros in September last year, deeming them “too big to fail”. One assumes that if the government had not stepped in such banks would have indeed failed, meaning they were technically insolvent.
The GFC has seen America’s biggest bank by assets held – Citigroup – fall from over US$50 to under US$1 in share price. Since that point, in early March, several things have happened.
Firstly, at US$1 an investment in Citigroup shares became almost like a call option. Buy the shares and all you could lose is a dollar. And who knows what might happen to provide upside? Secondly, the US government gave Citi individually another capital shot, taking the public investment in the bank to US$45bn compared to other large institutions with only US$20 invested. This only served to reinforce the “call option” nature of the shares. It was clear the US government would never let Citi go down. Fed chairman Ben Bernanke said as much.
Then came a series of developments, the first of which turned the shares around. Citigroup declared that, ex write-downs, it had actually made a profit in January and February. Other banks soon joined the chorus. The financial sector suddenly took off. Confidence was then fuelled by rumours that the mark-to-market rules would be relaxed (they have been now) and the uptick rule would be reinstated (not yet). Then the government finally announced its long-awaited public-private toxic asset scheme which was first flagged in February. In between, the Fed announced it would begin quantitative easing, and more money was pledged by the government for various credit market rescue packages. In short, everything was thrown at the US banking sector.
If anyone had told you back in 2007 that Citigroup shares could rally from US$50 to US$150 in less than a month you would have thought them mad. But Citi has rallied from US$1 to US$3 in March and that’s an equivalent 200%. A 200% return is clearly a 200% return whichever way you slice and dice it, but share price increments and simple human nature tell you it’s a lot easier to rally 66% from a dollar than it is from fifty dollars. Nevertheless, such an outstanding move is one reason why the bears are shaking their heads at the foolish believers. It’s all just “window dressing”, they say.
And that’s exactly how US bank analyst Mike Mayo describes it.
Mayo has built a reputation for himself on Wall Street as the leading bank bear. As early as 1999, Mayo suggested US banks were becoming too reliant on asset-backed securities and that US house prices were setting themselves up for a fall. Long term clients know Mayo has few words in his vocabulary other than Sell. It is the nature of hero status that if you say Sell and are right, Wall Street will love you. The fact that anyone who says Sell for long enough must eventually be right is apparently inconsequential. Mayo may have hit the nail on the head, but we can only guess at how much money his clients lost between 1999 and 2007.
Mayo has since been head-hunted by Caylon Securities, a subsidiary of Credit Lyonnaise Securities Asia (CSLA) which is currently trying to grow its global analysis footprint. CSLA has also recently snatched Australia’s leading bank analyst – Brian Johnson – from JP Morgan.
Mayo’s move follows another in the high ranks of US bank analysts. So flushed with success was Oppenheimer’s Meredith Whitney in 2008 that she left to form her own consulting service. Unlike Mayo, Whitney was not known as financial sector uber-bear prior to the subprime crisis. But her star ascended rapidly in October 2007 when she shocked Wall Street by declaring Citigroup would need to either sell assets, raise capital, cut its dividend, or some combination of all three in the face of the credit crisis. Then Citi CEO Charlie Prince scoffed at Whitney’s claims, but within a week he was out of a job. Within a few months, Whitney was right.
Given the GFC was rooted in the financial sector all along, the broad stock market was never going to rally alone. It was always going to require a lead from the financial sector before investors felt it was safe to go back in the water – safe from the next shark attack of some new bank blow-up. The turnaround in banking stocks in early March gave the nod. While the financial sector’s capitalisation weighting has now halved to 10% (and become almost meaningless within the Dow Jones Industrial Average), the S&P 500 only needed a baton-twirler to lead the parade out of its oversold and over-gloomy status. All sectors have rallied, including the beaten down materials sector.
So – is it all just smoke and mirrors? Is it just a typical bear market (sucker’s) rally, a short-covering scramble, a false dawn for the finger-crossers? That would depend on whether the rally in bank stocks is realistically justifiable or not. And that’s where the argument really starts to get serious.
Last night Mark Mayo sat down at his new desk, switched on his new computer, and proceeded to initiate coverage of the US banking sector on behalf of his new employer with a big, bold Underperform rating. He individually placed either a Sell or an Underperform on no less than eleven of America’s major listed banks. If this wasn’t enough to cause a stir by itself, Mayo qualified his ratings by suggesting loan losses at US banks will continue to escalate to a point they exceed those of the Great Depression.
[You could split those two ratings up as Sell meaning “get out now” and Underperform meaning “reduce portfolio holdings”.]
The real biggies – Citigroup, Bank of America, JP Morgan and Wells Fargo – all scored Underperforms while the Sells were reserved for some of the smaller majors.
Mayo’s reasoning, outside of the hyperbole, is that the commercial loan tidal wave is yet to hit. If you look at Australia, local investors are well aware that while Aussie banks have been caught in the downdraught of the US sector’s woes, exposure to toxic asset-backed securities, credit default swaps and the like has always been relatively minimal. More pressing for the Aussie banks is the expected rise in loan defaults which has already and will further stem from the global recession. In the meantime, the focus in the US has been all about writing down the value of toxic assets. Bad loans have not yet become the headline. The toxic asset relief program and relaxation of mark-to-market rules will either together or separately now put a brake on write-downs. But the US economy contracted by 6.3% in the fourth quarter. The subsequent jump in bad loans – commercial, consumer, business, real estate – which must occur has only just begun.
Mayo suggests his calculations show US banks are currently valuing their loan books on average at 98c in the dollar. Call that a 2% risk provision, and Mayo suggests that by the end of 2010 bad loans will amount to 3.5% of the book. Under further stress, that number could reach 5.5%. In the Great Depression, the level reached was 3.4%.
Mayo also provided some theatricality to his call, entitling his initiation report “The Seven Deadly Sins of Banking”. Those of you who know your seven sins will recognise the references to the original set. Mayo listed greedy loan growth, a gluttony of real estate, lust for high yields, sloth-like risk management, pride of low capital, envy of exotic fees, and anger of regulators as his particular collection.
I wonder if they’ll get Raquel Welch back to play High Yields in the movie.
Such theatre and hyperbole of view from a stock analyst is not necessarily well received from a Wall Street which prefers its number-crunchers to be dry and dreary, just as number-crunchers should be. Mayo’s comments were thus summarily dismissed be many.
But Mayo continued on to suggest that US government efforts to save and restimulate the banking sector – those which have been a major factor in the rally – are only building up a “catch-22”. (Oh he’s into Heller as well). If the government is too lenient on those banks that have made big mistakes, those banks will keep their toxic assets on their balance sheets. If the stress-testing is too severe on other banks, they may be forced to raise more dilutive capital. All that will result, says, Mayo, is a transition from a financial crisis caused by asset write-downs to a more severe economic crisis caused by bad loans.
Mayo explained his views last night to the influential CNBC network, and the network then rushed in its pin-up girl Meredith Whitney to either support or rebut Mayo’s report.
Whitney’s most recent warning has been that another phase of asset write-downs is yet to come, being in consumer credit which is further down the tree. Hence one could not say Whitney is bullish on the banks. However, Whitney’s retort was to suggest selling banks at this point would be ill advised. While suggesting the sector still had far to go before actually recovering from the credit crisis, Whitney told CNBC:
“I think you’ll see a directional turn. Banks will make a little money – as little as a penny a share – but they won’t lose money”.
Whitney’s argument is that while the fundamentals are still poor for banks, relaxation of the mark-to-market rules and lower mortgage and refinancing rates through government initiatives will help to make bank capital ratios look a little healthier. Whitney is not saying “buy banks now”, she is simply saying don’t go short into the rally. She nevertheless believes US housing prices will yet fall another 30%.
But a warning against shorting banks is about as bullish as Whitney has been since October 2007.
George Soros is another market celebrity who likes to seek the follow-spot. If Mayo is the uber-bear and Whitney a ray of quasi-bullishness, Soros lies somewhere in between. While many economists are tagging the third or fourth quarter of 2009 as the point at which the US economy might begin to recover, Soros disagrees, but he does see eventual recovery some time in 2010. He thinks the recovery will take longer because of the US government’s policies.
Soros believes the public-private toxic asset policy will work but rather than reinvigorating lending it will just suck more funds out of the wider economy that needs them. Selling toxic assets will not recapitalise the banks sufficiently to necessarily encourage them to start lending again. Speaking to Reuters, Soros declared:
“What we have created now is a situation where the banks who will be able to earn their way out of a hole, but by doing that they are going to weigh on the economy. Instead of stimulating the economy, they will draw the lifeblood, so to speak, of profits away from the real economy in order to keep themselves alive. This is the zombie bank situation.”
The “zombie bank” reference is a nod to the expression oft used in retrospect to describe the Japanese banks in the 1990s. Rather than letting large local banks fail as a result of the 1989 stock and property market busts in Japan, the government and other banks instead propped up the system to save face, leading to a decade of “non-performing loans” dominating balance sheets and stifling any recovery in lending.
If you consider that US banks are “too big to fail”, meaning to die, and that government support is simply preventing death while not being sufficient to restore life, then the US banks are now indeed the Undead – the zombies.
But we could now go into the argument which has raged throughout the entire global credit crisis: Do you let the system collapse, causing widespread hardship, in order to wipe the slate clean and start positively afresh, or do you stave off hardship and attempt to encourage a slow but less painful recovery (which really only perpetuates the initial problem)? Do you allow a Great Depression again and get it over and done with, or do you go into a decade of deflation like Japan?
Or will global monetary and fiscal stimulus packages prove the Goldilocks solution?
This is the macro consideration against what is otherwise still micro – the question of whether this current rally can last. From an Australian bank sector point of view, clearly there is no need for a toxic asset auction and no need for government capital injections (beyond the expensive deposit guarantees). The latter may, nevertheless, still depend on just how bad Australia’s bad loan situation becomes over the next twelve months. And Kerry Packer is dead (he saved Westpac in 1992).
Currently, Australian banks stocks are still rising (today is an exception) on renewed exuberance. Stock prices have run clearly ahead of average bank analyst target prices. Broker ratings are now quietly switching from Buy to Hold or Hold to Sell. Despite the well founded belief that Australian banks are in a much better position than their US counterparts, Aussie bank share prices will still live and die by the sword of Wall Street’s lead.
We play on.
