MORE BEARISH: Banking
MORE BULLISH: Brokerages
I get it. I really do. In February, the situation for banks looked as dire as the Jedi on Genonosis. Surrounded by hordes of battle droids, the capital markets shut off both for debt and equity, there was no apparant solution. Nationalization seemed like a legitimate option.
Turns out there was a ready-made clone army which was able to rescue the reminants of the Jedi attack force and bring the banking system bank from the brink. Who knew? Certainly not me. I thought the Stress Tests were, at best, a useful regulatory tool. Who knew they would inspire so much confidence? I don't know that Geithner himself can claim he really knew it would work so well.
Anyway, given how far we've come, I get why a Bank of America can rally from $2.5 to $17. Is $17 too high? Maybe, but that's not the point here. The point is, some kind of huge rally in bank stocks fits with how much things have improved.
The "systemically important" banks (i.e. the Stress Test 18 not including GMAC) have now managed to raise about $53 billion in new equity capital through stock sales. Many have increased their capital position further through earnings retention, asset sles, etc. That is all fantasic news, especially since as a tax payer, I'm a shareholder in all of these firms.
But the story doesn't end there. There is almost universal agreement that the situation at large banks is much improved. It isn't just about new capital raised or even access to capital. Its also because large banks have gotten much more aggressive about recognizing and/or provisioning for losses. I picked five of the largest true banks: J.P. Morgan, Citigroup, Bank of America, Wells Fargo, and PNC. Over the last year, loss reserves at these banks have increased by $20 billion, from a total of $20 billion to $40 billion. According to the FDIC, there is currently $193 billion in total loss reserves among all FDIC insured institutions, up from $121 billion one year ago.
Let's do the math. Loss reserves in the overall system was $121 billion one year ago, $20 of which was our five large banks. Loss reserves then increased to $193 billion, $40 of which was the Big Five. So other than those five, loss reserves increased by about 51%, whereas loss reserves increased by 100% at the Big Five.
Do you think that loan losses have increased at the largest bonds at double the rate of all other banks? Think about that while you read on.
Loan loss reserve as a percentage of loans tells a similar story. The Big Five have loan loss reserves equal to 3.9% of total loans. I estimate that all other banks have only 2.3%. In fact, I estimate that while the Big Five account for 13.6% of all loans, they actually account for 21.1% of all loan loss reserves.
Are big bank's loan portfolios really that much worse? Maybe they are somewhat worse, but what seems more likely to me is that big banks are further along in terms of recognizing potential problem loans. And this makes sense. What does a typical regional bank loan portfolio look like? Local loans right? Small businesses, local developers, etc. I was driving through a small town a few weeks ago and pointed to an empty building that looked like it was once a convenience store or small resturant. I said the loan for that building didn't come from J.P. Morgan or Wells Fargo. It came from someone like First Community Bank of Mos Eisley.
All banks like to think they have above average loan portfolios. And why not? I'm sure they all think they have loan officiers with extremely high midi-chlorian counts. Otherwise the bank wouldn't have hired them. I'm also sure when management asks the loan officers about certain loans, they are given an optimistic picture. Afterall, the credit officer has his own ego and reputation. But we know in reality that not all banks can be above average, and even some of the above average banks are going to suffer greater losses than they expected.
One final thought on large banks vs. small banks. The big banks took large losses in securities early in this cycle. Stuff like CMBS, leveraged loans, etc. Most of that stuff needed to be marked to market, and thus the loss on these should already be recognized. In the case of CMBS and other securities, there have been substantial improvements from the worst levels, actually adding to bank profits. Small banks didn't get into as many problems with securities, which is to their credit, but it also means that their losses are yet to come.
On to where I'm more bullish: regional brokerages. Sure I think Goldman Sachs and Morgan Stanley will make their money. In fact, the IPO and bond underwriting business looks much better now than it did six months ago, which will clearly benefit the big boys.
But I also think we're ushering in an era of diminished liquidity, which will benefit regional brokerages disproportionately over large brokers. Back in the good old days of 2006, if I wanted to sell 2 million Pepsi bonds, I'd just call 3 or 4 dealers and collect competitive bids. Dealers were happy to committ their capital. Today not so much. Today if you want best execution on a bond you need to work a little harder, actually find an end account that wants to buy the bond.
In a world where capital commitment was the name of the game, Goldman Sachs had a severe advantage over someone like Stephens. The former had all the capital in the world. The later had to watch their pennies. So what did Stephens' salemen do? They spent their time developing relationships with end accounts. When a bond came for the bid, the Goldman salesman just called his desk. The Stephens salesman called his accounts.
Now Goldman is less willing to committ capital. Now the Goldman trader might not be willing to bid at all, or maybe bid something silly cheap. Whereas the Stephens salesforce is doing exactly what they always did, call their accounts. Those firms are better suited to thrive in the new, lower liquidity world, where its less about capital and prop trading and more about relationships and finding sources of liquidity.
Wednesday, August 19, 2009
MORE BEARISH: Banking