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PhD Candidate in Economics at George Mason University. Received a Master's in Public Administration from George Washington University. Majored in economics and finance at Washington University in St. Louis. Previously worked as an Options Market Maker/Trader.
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Bubbles and Busts
  • Why I'm Still Not Buying Big Bank Stocks 0 comments
    Jul 13, 2012 3:41 PM | about stocks: JPM

    Recently Mike Sax, who has an interesting blog titled Diary of a Republic Hater, offered this claim:

    No one I speak to thinks the banks are a good bet even at bargain basement levels. Not Nanute, not dwb at Money Illusion, now WOJ who writes Bubbles and Busts has added his name to the list.

    My position on the large US banks has remained skeptical for quite some time. Although reported earnings have been strong over the past couple years, a decent percentage of those earnings stemmed from debt-value adjustments (NYSE:DVA) and the release of loan loss reserves. Add to those uncertainties the continuing halt of market-to-market accounting, unknown off-balance sheet positions and on-going legal liabilities due to frauds stemming for mortgages to LIBOR. Further,JPM is now openly discussing traders' marking positions to hide losses, which is almost certainly far more pervasive than the disclosure suggests. The lack of transparency at these financial institutions simply presents more risk than I'm willing to take.

    For some investors the earnings potential of the major banks may be significant enough to overlook the lack of transparency. As I pointed out to Mike in the comments:

    Check out this post from the Brooklyn Investor ( Low interest rates could be terrible for bank earnings.

    That post shows the disastrous effects of low interest rates on the earnings potential for Japanese banks. Apparently the Bank of International Settlements (NASDAQ:BIS) also fears a similar occurrence in the US. Timothy Taylor drew my attention to a BIS paper on Dangers of Continually Expansionary Monetary Policy. The section, noted by Taylor, most pertinent to this discussion is:

    "Implications of effective balance sheet repair as a precondition for sustained growth"
    "Ultimately, there is even the risk that prolonged monetary easing delays balance sheet repair and the return to a self-sustaining recovery through a number of channels. First, prolonged unusually accommodative monetary conditions mask underlying balance sheet problems and reduce incentives to address them head-on. ... [L]arge-scale asset purchases and unconditional liquidity support together with very low interest rates can undermine the perceived need to deal with banks' impaired assets. ... And low interest rates reduce the opportunity cost of carrying non-performing loans and may lead banks to overestimate repayment capacity. All this could perpetuate weak balance sheets and lead to a misallocation of credit. ...
    "Second, monetary easing may over time undermine banks' profitability. ... Low returns on fixed income assets also create difficulties for life insurance companies and pension funds. Serious negative profit margin problems associated with the low interest rate environment contributed to a number of life insurance company failures in Japan in the late 1990s and early 2000s. ...
    "Third, low short- and long-term interest rates may create risks of renewed excessive risk-taking. ... However, low interest rates can over time foster the build-up of financial vulnerabilities by triggering a search for yield in unwelcome segments. There is ample empirical evidence that this channel played an important role in the run-up to the financial crisis. Recent large trading losses by some financial institutions may indicate pockets of excessive risk-taking and require scrutiny.
    "Fourth, aggressive and protracted monetary accommodation may distort financial markets. Low interest rates and central bank balance sheet policy measures have changed the dynamics of overnight money markets, which may complicate the exit from monetary accommodation ..."

    The combination of all these risks is simply too large for me to consider investing in the big banks, even at current low levels. Obviously my position on the banks could be too risk averse and the stocks may prove big winners. In my opinion, there are many other sectors and companies with equally compelling valuations, better prospects and less uncertainty. Ultimately the decision is up to you of luck!

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

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