It's Not Just Financial Jitters, It's Mistrust

Bankers and those who ostensibly regulate them appear to have miscalculated just how badly they have damaged faith in the financial system.

The more interesting question is what it will take to reestablish trust. Assuming that can be done in this lifetime. JL

Gretchen Morgenson reports in the New York Times:

Our nation’s top financial regulators and its big bank managers must be frustrated by the deep skepticism investors hold toward them and their work. But the financial crisis destroyed much of the trust earned by these institutions over the years. Eight years later, investors seem to be telling them, “You have yet to win it back.”

The bear market in big United States financial stocks has many people wondering: Are we headed for another banking crisis?

The KBW Bank Index, made up of 24 money-center institutions and top regional banks, certainly signals pain for this industry. The index has tumbled 19 percent this year and 26 percent since its peak in July.

Some individual stocks have fared even worse. In recent days, shares of Bank of America, Citigroup and JPMorgan Chase have hit 52-week lows. Bank of America has lost around 29 percent and Citi around 27 percent, year to date, while JPMorgan is down 13 percent.

Clearly, the decline in bank shares reflects turmoil in the commodities markets, the economic downturn in China and renewed banking troubles in Europe. How much these woes will damage big banks’ balance sheets and income statements remains uncertain.

Investors seem to believe steep loan losses lie ahead. This message comes through loud and clear when you compare some banks’ market capitalizations with their book values, or their net worths. When investors anticipate loan losses, they price bank shares below their corresponding book values.

That uncomfortable position is where some of the nation’s largest banks currently stand. For example, Citigroup shares are trading at 61 percent of its tangible book value, a measure of a bank’s equity that excludes items that are difficult to assess, like good will. And Bank of America stock trades at 75 percent of its tangible book value, down from a slight premium late last year. Even the mighty JPMorgan trades at 19 percent above its tangible book; at year’s end, the stock represented a 38 percent premium.

Investors clearly expect loan losses at these institutions to mount. But they have also been rattled by the possibility that the United States might experience negative interest rates like those found in Japan. Such rates would drive down banks’ profit margins, a reversal from the previously accepted view that banks’ margins would increase this year as the Federal Reserve Board raised rates.

 

How Bank Stocks Are Performing

 

This is a relatively new fear. One expert who saw this downturn coming is Charles Peabody of Portales Partners, an independent research shop in New York specializing in the financial services sector. In mid-August, Mr. Peabody warned clients that earnings power had peaked at major American banks; that report followed downgrades of Bank of America and JPMorgan Chase in June and July. Mr. Peabody’s caution came very near the highs in these companies’ shares.

Now, however, Mr. Peabody says the selling in some big banks’ shares has been overdone. While he foresees declining earnings at these institutions this year and next, he said he did not expect the level of loan losses that the stocks are signaling.

For the banks, Mr. Peabody said in an interview, “the losses aren’t going to be such that they can’t absorb them in the norm of their earnings streams.”That means the discounts to book values have grown too large. “I think the U.S. banks will come out of this downturn with their book values actually growing somewhat,” Mr. Peabody said.

So why have bank shares continued to fall? Mr. Peabody contended that excess selling pressure was a result of investors being forced to unwind big bets made in these stocks last year when it was widely believed that interest rates would rise and fuel bank profits.

“You had huge money flows into dedicated bank stock funds — they doubled in size from $1 billion to $2 billion last year,” Mr. Peabody said. “What you’re having now is a mechanical margin call by these funds, creating selling that has nothing to do with the fundamentals.”

Another veteran bank analyst who said he is puzzled by the sharp sell-off in these companies’ shares is Richard X. Bove at Rafferty Capital Markets. In an interview, he acknowledged that there is a fear in the markets that some unknown problem will emerge, shaking the assets of the industry and wiping out the equity that banks have built up in recent years.

“Any number of statistics would validate the fact that banks today don’t have the risks they had either in 1990 or 2008,” Mr. Bove said, recalling two of the worst periods for banks in recent history. “The stocks are selling at such deep discounts to book value that they are telling you the book values are not valid.”

This view, which Mr. Bove does not agree with, reflects investors’ severe mistrust of both the banks and their regulators, he said. After instituting hundreds of new rules to strengthen the banking system and protect against disastrous losses, regulators have still not convinced investors that these institutions are sound.

“Nobody believes that the industry has changed,” Mr. Bove said. “Nobody believes that what the government has done has been effective.”

Bank investors have good reason to be doubters. In the years leading to the financial crisis, regulators repeatedly stated that subprime mortgage losses would not be large enough to harm the overall economy. (Remember all the references to the subprime problem being “contained?”) Then, in the aftermath of the mess, investors learned the hard way about losses at these institutions that far exceeded their reserves.

The current psychology “is you can’t believe anything the government says because the government is not prone to telling the truth,” Mr. Bove said. “And you can’t believe anything the banks say because we know they’ve lied to us repeatedly.”

This view represents a “massive failure of government regulation,” Mr. Bove recently told his clients. Investors don’t believe central bankers are effective and they fret that bank balance sheets are “black boxes.”

After a recent in-depth analysis of balance sheets, Mr. Bove concluded that banks are far safer than investors seem to think.

The only thing that could really wreck banks’ financial positions is “a recession that is as bad as 2008,” Mr. Bove contended. “Forget all the other stuff — consumer loan losses will shake the banks and will cause banks to run into negative earnings.” Mr. Bove is not forecasting such an event.

Our nation’s top financial regulators and its big bank managers must be frustrated by the deep skepticism investors hold toward them and their work. But the financial crisis destroyed much of the trust earned by these institutions over the years. Eight years later, investors seem to be telling them, “You have yet to win it back.”