No more level playing field as the cost of bank funding goes up
Well-capitalized banks with ample liquidity, diversified funding and conservative risk management will fare better during the coming downturn than the former champions that took on excessive leverage and risk in the bull market. Banks with businesses in emerging markets should benefit from more resilient earnings.
WHEN WILL THE bad news end for banks? It would take a brave investor to reply with conviction any time soon. Many investors are still in a state of shock at the speed with which banks have revealed losses on highly rated securities and assumed assets and liabilities that were once invisible in off-balance-sheet vehicles. If complex credit assets of the banks’ own devising and recently rated AAA can be marked down so savagely and so quickly, what else might be?
It seems that the CEOs of banks with trillion-dollar balance sheets are not always aware of what is on them and have no clear idea how these problems will work out. Five weeks into his job as CEO of Citigroup, and in the midst of a review of which parts of the conglomerate to keep and which to jettison, Vikram Pandit had to outline three areas that simply can’t wait for that review and demanded urgent action in January: "our balance sheet, risk management and expenses". The first two are fundamental for any bank and the third is scarcely less important. Pandit added: "These are obviously complicated times in the market."
Just owning bank stocks requires a leap of faith right now. Who would be bold enough to buy more?
Any hope that the new year might mark the beginnings of a recovery from banks’ sub-prime woes seemed to be dashed during the raft of bank earnings announcements in mid-January. Citigroup is, unfortunately for the rest of the industry, its leader and its results were chilling. It wasn’t so much the sheer size of the loss on distressed CDOs of ABS and other toxic sub-prime securities. Although the $18 billion write-down is mind-numbingly large, it is just the latest instalment in a now sickeningly familiar story, with the only new twist being rising doubts about the worth of hedges taken out with bond insurers.
Just as troubling was the smaller $4 billion of costs to cover souring credit card, auto loan and other consumer credit.
Banks might soon be past the worst of the losses on illiquid and untradeable securities they themselves created. Now a second wave of credit problems is gathering as banks’ customers find it harder to refinance and repay loans. According to Pandit: "The environment continues to be uncertain and the results will definitely be influenced by the economy." After the virtual or vehicular credit crisis, does a more traditional, real-world one now inevitably follow?
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"These are obviously complicated times in the market. The environment continues to be uncertain and the results will definitely be influenced by the economy"
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Whether it does or not depends on the length and depth of a US economic slowdown and the degree to which this spreads through the rest of the world. There are about three times as many views on this as there are highly qualified macroeconomists studying it. Gloom is the new consensus, for all the proven track record of the US authorities in speedily cutting rates, as they did when global equity markets teetered on the brink in late January, debasing the currency and abandoning fiscal discipline to stave off the worst.
Bankers themselves, their chief executives, their boards, their customers and investors in their debt and equity want to believe the worst will soon be past. But it was pitiful to listen to bank chief executives trying to rush through their apologies for huge losses and write-downs in 2007 while stressing that, those unfortunate details aside, everything else in their business showed the rudest health. John Mack set the tone for this before Christmas, telling investors: "This loss [it was $7.8 billion on sub-prime mortgages alone] shouldn’t overshadow the fact the rest of the firm delivered really outstanding results." He left it to his CFO, Colm Kelleher, to spell out the implication to anyone not listening closely that the rest of the firm’s employees would have to be paid handsomely because of the "need to retain talent".
It’s no wonder that investors have lost faith in the leaders of the financial services sector.
In January, other CEOs unveiled their own routines for breezing past the piffling details of multi-billion dollar losses, while hurrying on to recount in excruciating detail the hefty rise in commission income from investors adjusting their portfolios amid the market turmoil.
Of course, investors in bank securities have good reason to look for glimmers of good news and to seek to anticipate the recovery of balance sheet stability and earnings growth. In 1991, with Citi’s share price at an all-time low of less than $10, regulators camped out in the boardroom and special teams working through piles of bad real estate and leveraged buyout loans – even as the Fed cut rates amid a recession – the group raised new capital from a little-known Middle Eastern investor, Prince Alwaleed bin Talal. The mere fact of raising this new capital seemed to put a floor under Citibank’s problems. Recovery took hold and the stock price never looked back, rising to $180 by the late 1990s.
With Citi returning to the Saudi prince for new equity at the start of 2008, with sovereign wealth funds recapitalizing troubled US banks, and with the Federal Reserve cutting rates and the Treasury keen to boost the economy, might a similar recovery and rise in financial stocks be upon us, even before the worst of the credit crisis is yet past?
Regaining trust
After all, there are some good signs. Most notably, the alarming rise in 2007 of swap spreads, the price above the risk-free rate that banks charge each other for funds, has reversed. It rose in the first place not because of a shortage of cash – the financial system was full of cash, participants were hoarding the stuff – but because banks could not calculate their own problem exposures or those of other banks and so refused to lend to one another. The narrowing swap spread suggests banks are regaining trust in each other, a prerequisite for and possible harbinger of a recovery for banks.