Happy Columbus Day!
Last week financials continued their relentless march toward the sky as investors chased the happy prospect of higher interest rates from the Federal Open Market Committee and maybe even tax cuts from Congress. In a world with too much debt and regulation, and too little economic growth as a result, driving financials (and all other asset classes) up to valuations not seen since the roaring 2000s is a fool’s errand, especially when you notice that credit spreads remain largely unaffected by the threat of “tightening” by the US central bank.
As we noted last week, credit spreads are so constricted and lending volumes so weak that it is becoming increasingly difficult for larger banks and other intermediaries to earn a profit on old fashioned lending. Yet the members of the FOMC continue to think of current policy as a form of “stimulus.” The sad fact is that most Fed governors and staff economists don’t really know how to think about banks or the credit markets. Like their collaborators in the financial media, Fed officials largely think of benchmarks like Fed funds or the discount window, but it is credit spreads that really matter, both to bank earnings and economic growth.
In fact, benchmarks like Fed Funds have very little impact on the credit markets compared with other factors. The folks at Fed Dashboard, for example, note: “The Federal Open Market Committee (FOMC) expects their interest rate decisions to change the economy because they expect the Effective Federal Funds (EFF) rate implemented at a trading desk at the New York Federal Reserve Bank to consistently cascade across credit classes from Treasury Bills to business and consumer borrowing.” But they warn that the Fed Funds rate “has not been consistently cascading through credit rates for decades, reducing the benefit to borrowers.”
Of course, folks at the Fed do not seem to have much time for thinking about banking matters much less the functioning of the credit markets. One senior DC counsel told a group last week that Fed Chair Janet Yellen is “not terribly interested in bank supervision” and instead is focused on how monetary policy affects “working households.” The same observer says that the Board of Governors is likely “to be forced to do something about the Wells Fargo & Co (NYSE:WFC) board.”
But apart from the intricacies of monetary policy, there is hope on the horizon for financials as President Trump changes the composition of the Federal Reserve Board and the leadership of other federal regulatory agencies. The Fed Board will remain at just four governors next month with the departure of Stanley Fisher and last week’s Senate confirmation of Randall Quarles as vice chair for bank supervision.
Regardless of whether the Trump Administration makes any additional appointments to the Fed or other agencies, over the next year and more we look for a roll-back of regulations put in place since 2008. This is a primary reason why we believe that Chair Yellen is ultimately headed back to the private sector. Even before Quarles was approved, banking agencies were exercising their rather considerable discretion in a number of areas such as capital charges on commercial real estate and the Volcker Rule.
The massive regulatory friction accumulated in the banking system and also in consumer facing nonbanks over the past eight years is being reduced. “The trend is clearly going the other way,” a veteran bank lobbyist opined last week. “Statutory provisions can largely be eviscerated by agency interpretation.”
Indeed, despite the fact that the Trump Administration has not appointed many agency heads with responsibility for financial services, the fact is that the Treasury under Secretary Steven Mnuchin is driving the bus on reform and is making a lot of regulatory changes that are already in process. Deregulation is a far more important factor for financials than the illusory prospect of higher interest rates. Overall, the trend in terms of reduced regulatory burden on both banks and nonbanks is clearly positive and may contribute positively to earnings and economic growth next year.
As we discussed last week, loan yields for the largest US banks are not that strong and volumes are modest, so with Q3 ’17 earnings we don’t look for many positive surprises on the asset side from the large banks as a group. Several names including Goldman Sachs (NYSE:GS) have warned on sales and trading revenues. We expect to see some weakness on the mortgage banking line due to weak volumes, frothy collateral pricing and small down marks on mortgage servicing rights (MSRs). The rebound of yields on the 10-year Treasury in September, however, may be helpful in this regard.
While Chair Yellen may be able to justify rate increases to at least two of the other members of the FOMC, the continuance of QE in Europe and Japan promises to maintain downward pressure on market rates and credit spreads. There is simply not enough demand for credit from the real economy to satiate the need for assets from the financial sector. The world of large banks, institutional investors and insurers, for example, is basically Jurassic Park, where large carnivores compete for limited food in a shrinking marketplace.
For example, sales of all types of asset securitizations by US banks are down 10% year-over year, an illustration of the drought of duration that exists in global markets and has been ongoing for years. Sales of securitizations (which is 90% residential mortgages) was once a multi-billion dollar per year proposition for US banks in terms of revenue, but now is just pennies. Table 1 below shows assets securitized and sold for all US banks through Q2 2017.
Source: FDIC
A big part of the reason for the decline in asset securitization volumes since 2008 is the Dodd-Frank law, but also is due to regulation and the resulting migration of US banks away from residential mortgage lending and also a decline in volumes. As in the case of Europe, public debt issuance in the US since 2008 has seen a big increase, mostly via borrowing by the US Treasury. Debt issuance by corporations, which have tended to borrow to fund stock repurchase programs, has also surged. But neither of these factors is actually bullish for economic growth or bank earnings.
Zero rates and QE a la Yellen, Draghi and Abe is not about growth so much as it is about subsidizing debtors, especially governments and other public obligors who are beyond the point of recovery in terms of ability to repay debt. This financialization of the US economy is perhaps the single biggest driver behind the bull market in US equities and bonds, but has done little for income or employment growth. Chart 1 below show total US debt issuance in most asset classes.
Source: SIFMA
The regulatory pendulum in the US is clearly swinging towards ease and that is good for inflated expenses in most banks and consumer facing non-bank financials. Overall, though, the prospect is for bank earnings and revenue growth to stay “lower for longer,” even as the actions of global central banks drive up prices in many asset classes. Until global central banks end asset purchases and allow credit spreads to revert to something closer to the norm, it is going to be very hard for banks to generate any real earnings growth -- particularly if the Fed’s obsessive increases in short-term benchmark rates result in a flat Treasury yield curve.
An end to QE also implies a significant increase in credit losses for US banks, an eventuality that will not be a problem given robust reserve and capital levels. But the wild card for global financials is whether the suppression of credit spreads by the Fed and other central banks has caused the formation of another hidden hot spot of risk that is currently hidden from investor scrutiny. And for our money, that hot spot of risk may well be in Europe, where many banks are lingering on the edge of insolvency and politicians are absolutely frozen in place.
In that bad idea called the European Union, the tragicomedy known as banking lurches from one absurdity to the next as the community struggles with trillions of euros in bad debts. Last week, the European Central Bank (ECB) “launched a fresh push,” reports the Financial Times, to get European banks to take reserves on bad loans. The only problem is that the new regulation applies only to loans that go bad after the start of 2018, leaving a decade of accumulated bad debts untouched.
Under current international accounting rules, EU banks can essentially ignore (and accrue interest) on bad loans. This makes published financials for EU banks completely useless for investors and credit rating agencies. More, just as “quantitative easing” in the US has not particularly helped either the resolution of bad loans or new lending, in the EU the opportunity created by ECB chief Mario Draghi’s efforts has been largely wasted. More public sector debt has been incurred and the banks – which admit to some €850 billion (6%) in non-performing loans – are essentially insolvent as a group.
The FT’s Lex column notes with considerable understatement that EU banks “may be treading water” and that, when off-balance sheet exposures and derivatives are considered, EU banks are running at about 25:1 or more leverage. This compares favorably to large US banks such as GS, JPMorganChase (NYSE:JPM) and Citigroup (NYSE:C), but is far higher than all US banks as a group.
It is some measure of the extremis in which Europe’s banks now operate that the former Italian premier, Matteo Renzi, almost immediately attacked Draghi’s actions as possibly causing a decline in lending to small and medium size enterprises in Italy if implemented.
“Some European officials in the banking sector ignore that their duty is to AVOID credit crises, not CREATE them,” he Tweeted on Thursday, borrowing from the communication style of President Donald Trump. Later Renzi added: “If these rules pass, credit to small businesses will be impossible. We are making the same mistakes as 2013.”
In Europe the “mistake” leading up to 2013 was when the ECB forced the tiny nation of Cyprus into a forced banking liquidation. Lacking a mechanism like the FDIC in the US to resolve insolvent banks, the Europeans instead destroyed the Cypriot banks and pushed all of Europe to the verge of a financial collapse. Since then, the EU and its members states have subsidized failing banks, most notably in Italy. And the ECB under Draghi has doubled down on QE and negative interest rates to keep the prospect of further financial contagion at bay.
So as earnings season begins in earnest in the US this week, there are two big risks facing investors who hold exposure to US financials. First, there is still little in the way of revenue growth to support rising valuations. Remember, don’t fight the Fed (and ECB and Bank of Japan).
Some of the better performers like Bank of the Ozarks (NASDAQ:OZRK) are up double digits this year, confirming our earlier warning about short positions in this national C&I lender. Even GS has managed to show some upside of late even though it may have some of the more disappointing results for this quarter. But at 1.9x book, OZRK and many other names are fully valued using any sort of Warren Buffett measure of future cash returns.
Second, the continued incapacity of EU leaders to deal with the festering problems inside Europe’s banks creates a very dangerous situation for investors. The media and their enablers in the Sell Side chorus have been touting the prospects of Europe for many months, but the reality is very different indeed.
Europe is drowning in debt and there are a number of large EU banks that are demonstrably insolvent. The use of derivatives and off-balance sheet financing to “double down” and save some of the bigger zombie banks is bound to end in tears. And such machinations increase the chances for a “surprise” event, which as we all know is the precursor to systemic contagion.
With low levels of visible volatility in evidence, we can only note some very big contrarian options trades in the VIX of late that remind us of 1992 when George Soros broke the pound sterling. Have a great week.
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This Tuesday The Institutional Risk Analyst’s Chris Whalen will appear at American Enterprise Institute in Washington, D.C., to talk about “How has a decade of extreme monetary policy changed the banking system.” With Q3 earnings looming next week, a discussion of the Fed’s structural distortion of banks and banking seems most appropriate. Click here to see our presentation.