Now to a less happy topic, namely the US banks, especially the so-called 'TBTF' banks. As long time readers are probably aware, we have always held that people will tend to underestimate the 'stickiness' of the down cycle in real estate.
However, there are a number of historical examples of which the most pertinent is probably Japan's experience since the early 1990's that show that burst mortgage credit and real estate bubbles are quite prone to lead to a persistent secular contraction, especially if the government continually intervenes in the market to prevent it from reaching clearing levels. As it has turned out, the US administration and the Federal Reserve have in concert repeated precisely what Japan's government did when faced with a collapsing housing bubble. Not 'precisely' in the sense that the interventions are similar in all details, but in terms of the scope and intent it certainly appears that the US have cloned Japan's failed policies. It is quite amusing to think back to how US pundits, politicians and regulators kept admonishing Japan throughout the 1990's over such policies. Today the world's new Zombie Bank center is no longer Tokyo, but New York.
Readers may also recall that we have often talked about what we term the 'moving target problem'. The banks may have been diligent in raising new capital and may have taken the odd write-off here or there, but in the meantime the value of their collateral keeps declining. The moment they try to expedite foreclosures it can be expected that their write-offs will increase sharply, as collateral values lurch even lower and losses currently held in accounting limbo abeyance are recognized (currently it takes nearly 600 days for a foreclosure to be processed. Due to fresh uncertainties faced by lenders over the question of legal title to properties that are the collateral to loans that have been securitized, foreclosure activities have been slowed down even further). Note here that US commercial banks still hold some $2.9 trillion in mortgage related assets.
As we have noted before, there are furthermore doubts as to the true extent to which US banks are exposed to the troubles in the euro area. The banks themselves say their exposure is negligible, but the data published by the BIS say otherwise. According to the BIS, US banks hold some $520 billion in derivatives exposure related to Europe. Naturally these are gross exposures, but one must always keep in mind that 'netted' exposure ultimately depends on the solvency of counterparties. As was seen in the AIG case, derivatives hedges are worth nothing if the counterparty to them blows up. If not for the involuntary conscription of tax payers courtesy of the Fed, Goldman Sachs (NYSE:GS) and many others would have recorded billions in losses, far exceeding their 'netted' value at risk.
We suspect that US banks are among the biggest writers of CDS on euro-land sovereigns and that they are therefore exposed to far higher risk than they admit to. After all, there is a non-negligible chance that the euro area will indeed 'blow up', which could conceivably result in cascading cross-defaults of fractionally reserved banks across the continent.
Lastly, the stated book value of many US banks is highly dubious. One example is Bank of America (NYSE:BAC), which sports $70.8 billion in 'goodwill' on its balance sheet, a sum that comfortably exceeds its depressed market capitalization. This goodwill is left over from the string of ill-advised acquisitions BAC's former CEO Ken Lewis engaged in, ranging from Countrywide (today the biggest albatross around the bank's neck) to Merrill Lynch. Both of these firms would likely have gone bankrupt if not for Mr. Lewis' generous takeovers. For instance, he paid $50 billion for Merrill Lynch. Had he waited another two or three months he could have gotten it for $1, and even then he would probably have overpaid.
Shares of Bank of America plunge to a new bear market low on Wednesday – click for higher resolution.
Considering the chart above, stock market participants evidently believe that BAC is in a lot of trouble.
The growing doubts the markets have over the future of US banks are also once again finding expression in the credit default swaps market.
5 year CDS on BAC jump to a new high on Wednesday. Note that this is a new all time high, exceeding the worst levels of the 2008/9 crisis – click for higher resolution.
5 year CDS on BAC, long term. Here it can be seen that the market currently thinks that the bank is potentially in greater danger of insolvency than it was at the height of the 2008/9 crisis. To put it in 1984 big brother language, this is doubleplus-ungood – click for higher resolution.
Other US banks and brokers are seen as slightly less vulnerable than BAC at present, but not by much.
Shares of Citigroup (NYSE:C) nosedive as well. We are fatally reminded of how Japanese bank shares acted after the bursting of Japan's real estate bubble. All recoveries proved fleeting and stock prices were cut down brutally from every recovery high they managed to make – click for higher resolution.
5 year CDS on Citigroup are still below their highs of early October, but this isn't looking very good either – click for higher resolution.
Morgan Stanley (NYSE:MS) has been forced to deny over and over again that it sports potentially fatal levels of exposure to Europe, but once again we suspect that this is only the case if one ignores the growing counterparty risk that is given by the interconnectedness of the global financial system. Neither the stock market nor the credit markets seem to have been convinced by the denials.
Morgan Stanley's stock resumes its merry collapse with verve – click for higher resolution.
5 year CDS on Morgan Stanley are back above the 500 basis point level, but at 525 basis points still below the high of 582 reached earlier this year. Still, this is the worst looking CDS spread of a major US financial firm in absolute terms – click for higher resolution.
One of the reasons why we have decided to comment on US banks is because there are many analysts – inter alia the quite prominent bank analyst Dick Bove – who keep saying that everything is just hunky-dory with US banks and recommend that investors buy their stocks. So far this recommendation has been an utter disaster, so we want to provide an antidote. You don't have to take our word for it – here are a few recent headlines:
If you google 'Bove' and 'banks' you will find page after page of similar headlines. It is of course always possible that the CDS market and stock market have it totally wrong and only Dick Bove is right. The fact remains however that the message from the markets plainly contradicts all this loud singing from the 'everything is fine' hymn sheet. The markets are telling us that there are problems that may not be immediately obvious from listening to corporate presentations and looking at the opaque balance sheets of the banks. The markets are saying that the present dangers to the banks are on a par, or even higher, than the dangers they faced in the 'GFC'.
We happen to think that one of the reasons why the markets are so wary at this time is that it is no longer held to be absolutely certain that the 'TBTF' banks will be bailed out again. There are now significant political headwinds that suggest otherwise. It is quite conceivable to us that the Republican-led Congress would deny the treasury the funds to effect another bailout.
This leaves only the Fed. We would submit that one major reason why we lately keep hearing that the Fed is about to embark on 'QE3' and begin another large scale monetization program of mortgage-backed securities is precisely the sorry state the financial system finds itself in at present and the additional dangers it faces due to the euro area debt crisis.
The Philly Bank Index, weekly. Closing in on fresh three-year lows – click for higher resolution.