What Is The Real Condition Of Banking, In The United States And The World?

by: John M. Mason

Summary

Bank stocks have tanked this year, coming off of optimistic executive statements and fair earnings reports.

Barclays PLC reports that more than 40% of the banks it follows are trading below tangible book value.

What really is the condition of the banking system? Does the investment community know something that others don't?

Two articles concerning the state of the banking industry caught my eye today. The first appeared in the Wall Street Journal, titled "Investors Shun Bank Stocks." The second was the front page on the New York Times, titled "Worth Trillions, Bad Loans Haunt Global Economy." This article spends most of its time discussing China and Europe, but also includes the United States, Brazil, and others for good measure.

The basic question is "why are investors seemingly shunning bank stocks?" One of my basic principles is "trust markets," but then investigate them as thoroughly as you need to in order to feel confident that they are not misleading you.

So, what are the markets telling us right now? According to the first article, "more than 40 percent of the banks tracked by Barclays PLC (NYSE:BCS) are trading below their tangible book value, or what each company's assets would fetch were they to be liquidated, analysts said." This has happened only three times in the last three decades.

Furthermore, bank stocks are off since the beginning of the year, which is surprising, the WSJ article contends because of the good feelings about financials in the fourth quarter of 2015. And, "despite a series of pronouncements from bank executives expressing confidence in the health of Wall Street and the broader economy, investors on Tuesday extended a prolonged rout in financial shares."

To me, the fact that so many banks are trading below their tangible book value says more about how investors are viewing existing bank assets than they do about the future business prospects of the banks. The immediate issue on a lot of people's minds these days is the quality of loans to the energy industry. Some banks have already begun to ramp up their loan loss reserves in order to prepare for a coming shakeout in this area due to the slump in oil prices and the heavy debt loads of many companies in the industry.

A second factor of concern is that the Federal Reserve throughout the whole period of financial crisis and the subsequent recovery has focused on providing liquidity to the banking system with the idea that if the banks have sufficient liquidity, that they will be able to keep their doors open for as long as possible so as to be able to work out their bad loans or allow the FDIC and other bank regulators to either close banks quietly or oversee mergers and acquisitions to take place without market disruptions.

With sufficient liquidity, the pressure was never that great to write down assets because the banks' doors were open and the economy was recovering. I have been arguing for most of the past five years or so that there are two things to watch for coming out of this scenario. First was the decline in the number of banks still remaining in the banking system.

Over the past seven years, more than 200 banks per year have left the banking system. Most of them have been less than $100 million in asset size, but there have also been a large number of losses in the $100 million to $1.0 billion asset size. It is expected that this decline will continue over the next five years or so.

There are other factors impacting the banks, like the changes in information technology, competition from non-banks, and scale issues, but there still is the question of the value of bank assets in the banks that are leaving the system and how much the regulators are doing to smooth this decline in the number of banks.

The second thing to watch is the performance of commercial real estate loans. This was a problem in the financial crisis, but, since most of these loans were one payment loans due when the loan matured, the loans were not delinquent going into the period of economic recovery, were protected because of the liquidity available to the banks themselves, and as the economic recovery expanded, the loans were renewed, most with additional funds provided to help contractors complete the project, and extended time wise.

According to the Federal Reserve statistics, the H.8 release, most of the commercial real estate loans in the banking system exist outside the largest 25 domestically chartered banks in the country. And, since the recovery began, this has been the fastest growing class of loans in the banking system.

I believe that this is still a very weak area of the US economy. The economy is not that strong and does not seem to get any stronger in 2016. Furthermore, I am not convinced that the projects are progressing that well throughout the nation, developing very strongly only randomly in the nation. I see lots of "for rent" signs, and there is also an indication in some areas that some of the building is slowing due to overbuilding.

But, this is just in the United States. In the past week or so, we have read about all the problems the European Union is experiencing in terms of banking issues and bad loans. Especially prominent in the news this week has been Italy, but Portugal, Spain, and Greece all are having their bank loan problems.

Then, as the New York Times article gets into, there are the rising bad loan problems in China. And this doesn't include the bad loans in Brazil, Argentina, and especially in Venezuela. One could argue that worldwide there is a real debt problem, and the question becomes when will that debt problem come due. Certainly, if we are toward the end of the long-term debt cycle, as I wrote about yesterday, the answer to any further asset quality questions will not be to issue more debt.

So the problem may be that we have "kicked the can down the road" on the question of bank asset quality, not only in the US, but also in a lot of the world. If this is the case, the only real way to deal with the issue is balance sheet restructuring...or writing assets down to more appropriate values. Italy seems to be on the verge of having to swallow this distasteful pill. But it doesn't seem that liquidity and an economic recovery are going to "buy us out."

Maybe the bank investors are right, as cited above. Maybe banks are trading below tangible book value for a reason.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.