Monday, July 28, 2008

Bank Corporates: Obi Wan once thought as you do

OK, so we're more or less through bank earnings. We had some highlights (Wells Fargo) and some low lights (Wachovia, Washington Mutual). Overall, the good news is few banks saw an immediate need for fresh capital. The bad news is that credit losses continue unabated, with few signs of improvement. We also got a scare out of Fannie Mae and Freddie Mac, roiling the bond market and spurning a massive government bailout. Now that the long believed implicit backing has become explicit, the GSE's liquidity position looks strong.

So where do we go from here with credit spreads? While I acknowledge the possibility that we've bottomed in credit, I remain bearish.

First let's look back at the fall then rise of the markets around the time of the Bear Stearns collapse. We'll zero in on financial corporates and junk bonds (using the Lehman Brothers indices for both), as these are the high volatility areas of the bond market these days. For comparison, I've also thrown in financial stocks as measured by the Amex Financials Index (on which the XLF is based). This chart will cover January 1 through May 6.

For the corporate bond components, the graph shows the percentage excess return (or return of the bond less the return on Treasuries, think of it as your return with interest rate risk hedged away). For financial stocks, the total return in percentage is graphed. What we see is that financials hit a low at -20% on March 17 (the day after the Bear/JP Morgan "merger"). At that point, the bonds of financial companies had fallen 6.5% vs. Treasuries, and high yield had fallen 10.3%. Then of course there was the rebound in April and early May, but let's put that aside for a moment.

There are two things to notice here. First stocks, high-yield, and financial corporate bonds have all been highly correlated. Second, performance of bonds tends to be smoother than stocks, even after correcting for scale, because bond performance is all about survival and liquidity, as opposed to stock prices which are about growth.

Now let's look at the period from May 7 through July 24. To make an easy comparison, we'll reset all the returns to zero and go from there.

Here we see that for most of May and June our two corporate bond indices remained right around zero in terms of excess return. At the same time, financial stocks basically moved in a straight line down. Something had to give there, and eventually something did.

From May 7 to June 16, the financial corporate index had underperformed Treasury bonds by a whopping 8bps and high yield had actually outperformed by 127. From then until July 24, financial corporates underperformed Treasuries by 397bps and high-yield by 509bps.

Alright so where does this leave us? Looking in total from May 7 to July 24, financial stocks have fallen 23.6% whereas financial bonds have fallen 4.05% vs. government bonds. That's about a 6-1 ratio. As of March 17, financial stocks had fallen 20% and financial bonds 6.5%, for a 3-1 ratio.

To me that implies that financial bonds remain overvalued vis a vie the equity. Now the counter-argument would be that the June-July stock market sell-off was about equity dilution among banks. If banks sell more equity that actually benefits bondholders, and therefore bonds can remain tight even while the equity falls. I don't buy this argument. What's happened is that bank stocks have fallen to the point that public equity capital is unavailable. Troubled bank CEOs are more likely to roll the dice on recovering than dilute equity holders further. If bank stocks were to keep rallying, then indeed equity capital would come back into the picture, but that proves my point doesn't it? Stocks have to keep rallying to justify bond prices as they are.

Now its possible that stock and bond prices rally, with the former just moving more quickly. But rather than try to call a bottom, I'd rather wait to buy bank bonds when it looks like banks have more easy access to capital and/or it looks like loan losses are nearing a bottom. Right now I see neither.


Michael H said...
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Michael H said...

Could you explain to us mere mortals why banks issue bonds instead of funding loans via deposits?

Also, what kind of recovery has historically been the norm for holders of bank senior bonds if the bank were to go poof?

I can't figure out why there is such a spread in interest rates between deposits, senior notes, and preferreds of large banks.

PNL4LYFE said...

I think financial spreads reflect the fact that many people believe that many/all of the institutions will not be allowed to fail. The Bear bailout is the model that I think many people expect to be repeated if any of the brokers or major money center banks were about to fail.

It could also reflect an expectation of high recovery in the event of a failure. If you picture a bank with 5bn in equity and 95bn in debt, a 5bn loss is enough to wipe out the equity. But even if losses end up being twice that high, you can recover over 90%. I realize that actual bank capital structures are very complicated and that bondholders are subordinated to depositors, but I think the argument probably holds.