President Obama’s recent announcement of plans to restrict the trading activities of banks has sent their stock prices spiraling down. The banking sector, which is the spinal cord of our economy, has experienced extreme volatility in the recent past due to government intervention and changes in our economic climate. Investors threw in the towel on banks in 2008 during the financial crisis when their stock value evaporated into the thin air. In 2009, we witnessed the failing of 140 banks nationwide. However, just in the last few months, stocks of banks like Wells Fargo, JP Morgan, and Bank of America were bought like hot cakes as stock prices multiplied at a rate that surprised even the most bullish investors. Bank of America, for example, went from $2.53 a share in March to $19.10 about six month later!!!
However, the bullish trend is unsustainable and we could see a reversal in 2010. The fundamentals, dynamics, and structure of banks have changed dramatically after the financial crisis. They are living on life support, will continue to lose their growth potential, and are no longer profitable investments.
Banks today are like an indicted criminal whose fate lies in the government’s hands. They have been found guilty of taking excessive risks and causing the near collapse of our country’s (or even the world’s) economy. In the government’s eyes, they are as good as dead. What keeps them alive are TARP money, stimulus programs, easy monetary policies from the Federal Reserve, and our government’s effort to make them appear healthier than they really are with accommodative accounting standards that mask certain losses. But it is important that the Obama administration keeps this healthy banking system façade as he has used an exorbitant amount of taxpayers’ money to fund his rescue effort, and claiming victory is clearly a political necessity. Now, he also has to walk a very fine line on this subject matter as a rosy picture of the bank will also anger the American taxpayers who are suffering at a time of a 24-year high unemployment rate of 10%, weak economy, and swelling budget deficits. The recent loss of a Senate seat by the Democratic Party in Massachusetts has obviously caused Obama to rethink his political position, and the announcement of his plan to stem proprietary trading and hedge-fund investments at banks right after this politically significant event depicts the administration’s position to cap bank profits.
We are in an environment where there are three stakeholders – the American taxpayers, the government, and the banks – and at most two winners can arise out of the current economy. Since the ball is in the government’s hands and Obama needs taxpayers more than he does banks, the answer to the Wall Street or Washington question cannot be anymore obvious. Thus, the recent plan to rein in the banks is but the first of many moves to be expected from the government that will solidify the winner-loser environment that the American voters demand. After all, the entire stimulus plan was intended to stabilize the financial system and not help banks with their profits. Leaving banks empty handed to keep the financial system stable can definitely be considered an accomplishment for the Obama Administration.
At a time when governments globally are tearing free markets apart and banks take center stage, the rules of the game have definitely changed and investors cannot value banks the way they did in the past. The high PE ratios reflected in bank stocks today, that are easily in excess of 20, show that many investors are still overly optimistic with the banking sector and fail to value them based on their fundamentals that have materially changed. Banks today are not the same as they were before. Tight government regulations and a depressed economic environment will prevent them from achieving high profitability. Even if profits were comparable to the good times, the excessive dilution of stock holder equity that we have seen since the financial crisis began should signal to investors that they probably would not be getting much of it. Shareholders must also not rule out further capital raising activities that the government will impose on the banks in this still fragile economy.
Besides facing a substantially depressed return potential, banks are also high risk investments. Banks have always made money by lending to others at a higher rate than it can borrow at and hope that the margin that it earns will be much larger than the default rate. Default rates are high during a recessionary economy and lending is probably the worst business to be in at this time. The unstable housing market, high unemployment rate, and depressed economic environment will increase the default rates for the loans that banks make to borrowers like home buyers, consumers, and businesses. A potential time bomb for banks would be the huge “shadow inventory” of foreclosed homes that they are holding off the market. Releasing them into the market can cause a material drop in home prices which in turn will further increase banks’ default rate. Banks know how fragile their balance sheets are, and that’s why despite pressure from the government, many still refuse to lend.
After a sharp run up in bank stock prices in 2009, they could experience a material reversal in 2010. The factors that have contributed to banks’ bottom line in the last few quarters were derived from our fiscal stimulus and easy monetary policies. The Obama Administration and the Federal Reserve have bent over their backs to stimulate our economy and the short-term results that we have witnessed through various economic data and company reports have driven up investors’ optimism. However, keep in mind that these are temporary stimulus measures and that they cannot persist indefinitely. After all, our federal deficit is already at $1.42 trillion and the Fed’s balance sheet is at $2.24 trillion – both of which are at a record high! As a matter of fact, signs of fading stimulus and less easy monetary policies are already surfacing. Thus, the very reasons for the recent run up in bank stock prices will also be the ones who will punish them going forward.
In brief, if you step back to look at the banking sector objectively, you will realize that its prospect is depressing. Profitability growth potential is extremely limited at best and risk looms high in its operating environment. Any stock valuation model – as long as you use one – should give you a modest value for stocks in this industry. Of course, there is always possibility for an upside. For instance, banks can do extraordinarily well if we are back into a bull market, housing prices resume their high growth rates, unemployment rate decreases to 3%, and the government allow excessive risk taking activities for the banks again. But the likelihood of the above is not to be bet on.
Disclosure: no position