5 Reasons Bank Shareholders Will Take a Hit 25 comments
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My hero - Yogi Berra - said it best. "It ain't over 'til it's over."
The market disagrees with him - at least right now. There is a collective sigh of relief that the stress tests will be more cartoon than non-fiction and the banks will not be nationalized, de facto or otherwise. And that is drawing in not only traders but some investors.
I write this today not just because the stress test results are imminent but because long-only money mangers are beginning to recommend the banks - especially those managers who do not read the numbers that go along with bank earnings statements. I appeared on the Fox Business Channel Monday - they have really upped their game, you should check them out - and argued for a few seconds with a nameless but not blameless money manager who kept quoting headline numbers about bank earnings. He seems to have overlooked that Goldman (GS) forgot to report earnings for December, Wells (WFC) and Citi (C) used accounting changes to generate profits that were not real operating earnings, and Bank of America (BAC) made money because of spectacular one-off trading results at Merrill - plus accounting changes. Not a solid foundation for an investor. Reminds me of a great Yogism: "Mr. Berra, do you want your pizza cut into eight or six slices? - Six, I could never eat eight."
We were debating this because stress test results will be released Thursday after the close and while long awaited, the details are either known through selective leaks or are meaningless - at least based on what has been leaked. After the tests were announced, it became clear to the administration that Congress would not be forthcoming with more funds to re-capitalize troubled banks and a decision was made to soft peddle the results - perhaps even modify them by modifying the test parameters - in order to prevent another financial panic. So instead of being near the end of the game - what should the banks do and what are these assets really worth - we are back to the third inning or so.
Do I exaggerate? Hardly. The situation is so muddy but so clear it is best to turn to Warren Buffett's most recent comments to see how people talking up the banks are doing so out of both sides of their mouth. He said the banks do not need a great deal of capital, if any; they can internally generate what they need. He also said the economy was not going to heal itself at as fast a rate as pundits and administration officials are now offering up to the public. Well, Mr. Buffett, you cannot have it both ways - the banks will not be able to re-capitalize themselves without a bottoming in loan defaults -mortgage, credit cards, commercial real estate - and these will not bottom unless the economy turns pretty quickly.
Numbers don't lie - the commercial real estate loan portfolios of major banks, especially Wells Fargo, are overly large compared to their tangible core equity and current and future projected default rates. Not to mention the next mortgage tsunami has begun and will accelerate and continue, with Alt-A and option ARM resets hitting a peak in 2011. As Yogi would say, it could be "deja vu all over again."
So let's say I am right and the banks do need more capital than is revealed by the stress tests -- the IMF puts the number well north of a trillion. If they slow-roll it, and right now they have to with Congress fed up and private investors avoiding them (the Goldman Sachs capital raise being a one-off), they can get it by a) converting preferred to common and b) doing it slowly, using accounting gimmicks and some real earnings to slowly build reserves. That will take years - for some banks easily more than a decade - and they will tighten lending as they do this. If and when they convert preferred shares, the dilution will hit common shareholders and the stock price; as they slow-roll generating capital internally, their stock prices will fall as they demonstrate they have no real earnings power. The bottom line: current shareholders are going to take a hit.
Let's re-cap the logic:
• The stress tests are a fudge at best because a correct conclusion would require far more capital than the banks can raise either from Uncle Sam or the private sector.
• Some banks will convert preferred to common equity - massively diluting existing shareholders - and with that comes a falling stock price.
• Other banks will slow-roll raising capital, suppressing economic activity and perpetuating their misery and that of shareholders as reserves counter profits for many quarters.
• No matter how you slice it, lousy assets need to be replaced with fresh capital and the creation of new capital will require existing shareholders to take a hit.
• The amount of hit they will take will be determined by the amount of capital they need and we do not know that because the stress tests and their earnings statements do not speak to the quality of those assets.
Should any investor put money to work in the third or fourth inning of a game with no real score? Not unless Koufax was on the mound - and he retired a long time ago; Ken Lewis and Vikram Pandit are hardly the guys you want pitching for you right now. Right Yogi? He would know -- eleven World Series rings, more than anyone else in baseball history.
But the stocks are running - should you run with them? I stick to fundamentals, not short term charts and another popular Yogism - "The place got so popular nobody goes there no more."
The bottom line: for traders, the big bank stocks are pure trading vehicles based on expectations of the market's reaction to the stress test results. If you are a longer term long or short side player, please, think twice and read a lot more before going long, and after you get nauseous, you might consider going short the entire segment through an ETF such as the SKF, a double inverse ETF mirroring the Dow Jones Financial Index.
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This article has 25 comments:
You are right about the banks. You may even be right about the market, but only time will tell. I hate mania markets because I find it hard to pull the plug on logic. Many of the big banks actually lost a ton of money last quarter, but reported big profits. Hardly a reason to be buying, but people are.
The one I am very excited about long-term is Long V, Short AXP. V is the debit leader, has no credit risk, and is not cannibalizing its business. AXP is clearly hurting and pulling credit for creditworthy clients. They must have serious cash flow issues.
What will the government gain by doing these things?
Did the government borrowed so much money from China and/or Japan they have so much cash to lend to the banks and other companies such as GM? How will they force those companies to borrow - by doing the stress test?
How can the TARP make more money? By converting them to common shares?
What if the the banks fail and many of them goes bankcrupt or dibilitated by so much borrowings from the government while the economy stays in a funk for several years, then they will have to dismantle many of their operations in order to save cost. That will be very bad for the government who loaned so much money to the banks.
Will the government do something about that to make sure the banks will make money in the future? The government can always create any type of opportunity for any industry through legislation.
I think using that above logic, it will be almost a suicide to bet against the banks.
- Leonardo da Vinci
Thank you Mr. Schulman for sharing your bias free analysis. You won't read stuff like this from your Citi analyst.
Markets are often illogical but even more so now with all the Fed, Treasury and Congressional money sloshing around; $12.8 trillion in stimulus and loan guarantees. How do you calibrate an amount of money that large in an investment strategy?
You have to hold your wealth in something. Energy (the non-renewable kind) and precious metals seem to make the most sense to me in an investment climate clouded with volumes of white noise.
As commercial and residential real estate continues to erode from a shrinking economy the banks will be under more and more pressure. It's not as if the banks are doing well now but had a couple bad quarters.
It's a huge drain on the economy. Now I can see why Japan's economy eroded for years after the great crash.
The market can remain irrational for a long time. But not forever. And when the time comes to pay the piper for this one, it's going to be very ugly.
On May 06 10:26 AM mac123449 wrote:
> About five minutes ago, I was holding my 8-week-old puppy and we
> were looking at the Bank of America chart. The puppy was looking
> intently at the screen as the stock flashed green, then he turned
> his head away and puked all over my keyboard.
> This puppy has more god-given sense than any Wall Street analyst
> ever born.
Simple as that.
Hedge funds have driven this rally, they will end it when they want to make money on the other side.
I have a long term buy list with entry points all set for that day, when the stocks I want, head back to those prices.
BTW: 25 year continuation trend line on the S & P 500 is 750 as of today.
As of today's close the S & P is absurdly overvalued. Every single time for the past 40 years the S & P has reverted to its continuation trend line at some point. As I spoke about in another post, months ago, I feared that this market was going to be driven straight back up to 1000 on the S & P by all the evil forces (hedge funds, FED, Treasury, and all it's partner trading desks) and sadly I appear to be right.
Existing toxic assets, voo doo accounting to cover up the doo doo numbers, credit default swaps, a tsunami of increasing defaults of mortgages / credit cards / auto loans / commercial real estate.......as unemployment increases and approaches 7 million full time and who knows how many part-time?????
Better watch out " THE SKY IS FALLING "
The preferred dividend has to be paid completely before common holders get one cent of dividends. So it really doesn't matter if the preferred is converted to common; the cash flow from holding is going to be nil for years in either case. It's only selling to the next Greater Fool that might be impacted.
But how far can C fall from $3.50? Really.
What is so "evil" about the SPX going back to 1000? My guess is what's so bad is that you missed a VERY tradeable rally.
On May 06 04:58 PM archman82011 wrote:
> It is a traders market.
> Simple as that.
> Hedge funds have driven this rally, they will end it when they want
> to make money on the other side.
> I have a long term buy list with entry points all set for that day,
> when the stocks I want, head back to those prices.
>
> BTW: 25 year continuation trend line on the S & P 500 is 750
> as of today.
>
> As of today's close the S & P is absurdly overvalued. Every single
> time for the past 40 years the S & P has reverted to its continuation
> trend line at some point. As I spoke about in another post, months
> ago, I feared that this market was going to be driven straight back
> up to 1000 on the S & P by all the evil forces (hedge funds,
> FED, Treasury, and all it's partner trading desks) and sadly I appear
> to be right.
It's NOT "YING". It's YIN.
On May 06 03:13 PM Ying & Yang wrote:
> Bankrupting For Profit-JPM-87.4T in Derivatives-G/S 30.2T-B of A
> 38T-C-31.9Trillion
> Feb.6, 2009 the Kazakhstan Tenge went poof and was devalued by 18%
> in a single day.
> “But last week Morgan Stanley and another bank suddenly demanded
> repayment.BTA was unable to comply, and thus tipped into partial
> default.
>
> Morgan Stanley also asked ISDA to start formal proceedings to settle
> credit default swaps contracts written on BTA.”
> CREDIT DEFAULT SWAPS
> A credit default swap (seekingalpha.com/symbo...) is a credit
> derivative contract between two counterparties. The buyer makes periodic
> payments to the seller, and in return receives a payoff if an underlying
> financial instrument defaults.
> Wall Street banks derivative outstanding as 31 December 2008- JP
> Morgan$87.4T-Goldman Sachs-$30.2T-BofA-38.C 31-$ Trillion.
> The Financial Times reports, “As a result speculation is rife that
> Morgan might have deliberately provoked the default of BTA to profit
> on its CDS, since a default makes the US bank a net winner, not a
> loser as logic might suggest.
> In theory, lenders should have an interest in avoiding default. At
> worst, it creates the risk of needless value destruction as creditors
> tip companies into default.”
> Politically privileged banks with worse than worthless toxic assets
> sell them for cash at an inflated fair value lying price to a self-funded
> Special Investment Vehicle (seekingalpha.com/symbo...
>
> For the sake of argument and simplicity assume that Bank G loans
> Company M $1M in either a leveraged buyout or some other type of
> deal that was common over the past few years when credit flowed freely.Then
> Bank G purchases a CDS on Company M’s loan for $30,000 from Bank
> B and the CDS is reinsured by Insurance Company A.
>
> Company M deteriorates because its free cash flow and a little more
> all goes to service debt and Bank G sells 90% of its loan to Bank
> J. Because credit risk has increased Company M’s bond now trades
> in the market for $25,000 and Bank J purchases a CDS from Bank L
> for the current market price of $60,000 and reinsured by Insurance
> Company A.Banks B and L go bankrupt, the trader at Bank L who sold
> Bank J the CDS now either goes to work at Bank J or receives consulting
> fees and the privileged creditors of Banks B and L, such as subsidiaries
> of Bank J and G, receive government bailout payments through Insurance
> Company A.
> Company B, while still able to service its debt, does violate some
> provision of its debt covenant.
> Second, they fund a SIV with $25,000 of cash which borrows another
> $825,000 from the Bank’s government puppets.
> Third, the SIV pays Banks G and J $850,000 of cash for the Company
> M loan which, while trading for $25,000 in the market is being carried
> on their balance sheet for $600,000 and consequently results in a
> $250,000 gain on the income statement for the quarter after having
> written down a couple quarters ago.
> Fourth, Banks G and J receive $2M in bailout funds for the failed
> CDS contracts.
> Fifth, Company M is completely evaporated and thousands of workers
> lose their jobs.
>
> Total profit for Banks G and J:2.85M-$1M-$30k-60k=$... pay for a
> days work
> FINANCIAL WMDs AND FINANCIAL TERRORISTS
>
> The GLD ETF Auth.,Parties-Bear Stearns-Lehman Brothers-Citigroup-Mer...
> Lynch-Goldman Sachs-J.P. Morgan-Morgan Stanley-will use the language
> in the prospectus to do ?
> Derivatives, infest balance sheets of almost every publicly traded
> corp.
> Many local, state and national governments.
> POTENTIAL REMEDIES
> When confronted with financial terrorists society has often had to
> take powerful measures.
> when John Law co-opted the French economyFrench Revolution was sparked.
>
>
> In the United States of America Section 19 Act of 1792 provided,
> “That if any of the coins shall be debased or made worse through
> the default or with the connivance of any of the officers every such
> officersaid offences, shall be deemed guilty of felony, and shall
> suffer "Death.”
Great article. Commercial loans are the next shoe to drop on the banks and they better not go back to Congress and beg for funds.
As a practitioner, I do find hard to beileve that government run tests are going to shed any further light on the risk position of the book of any financial institutions.
at this point it goes beyond the concept of whether size matters or not. both in terms of scale efficiencies and of too big too fail.
recent experience seems to suggest that we all kind of fooled ourselves by thinking that we had it all under control.
Tomaso Spingardi