From 1982 until the first half of 2007, global bank stocks led the secular long-term bull market in company profits. As long-term interest rates plunged from over 21% in 1981 to a low of just 3.5% in 2004, earnings at the majority of banks were literally stupendous, including huge dividend increases and massive shareholder buybacks.
But that party is over. And, in all probability, bank stocks will remain poor investments over the next five years and beyond, as a host of formidable challenges confronts a badly bruised financial services industry. These include new government regulation, the loss of traditional investment banking deal flow and far less lucrative leveraged loan portfolios, all conspiring to make financial services stocks a dull investment proposition.
The Easy Money is History
Most banks have been operating as casinos until last July, when subprime first imploded credit markets.
The collateral damage inflicted by the subprime crisis will revolutionize the way banks do business going forward. In all likelihood, some of the most profitable revenue streams on Wall Street will disappear, mostly those tied to CDOs, or collateralized debt obligations, and other illiquid and hard-to-price synthetic securities. Worse, government regulators are bound to reshape the way investment banks mark these illiquid securities and, in some cases, will even forbid trading in the more exotic and leveraged securities that risk trashing the financial system.
In a nutshell, the investment banking business model is about to change; for shareholders, this implies far less profits as traditional sources of revenues are streamlined or liquidated altogether in 2008 and beyond.
The Fed, Bear Stearns and Systemic Failure
In order to avert a probable run on U.S. and many international prime brokers in March, the Federal Reserve orchestrated a $39 billion dollar bailout of Bear Stearns. This event marked what many pundits called the “end of the subprime crisis” as the Bernanke Fed unofficially guaranteed the solvency of all major U.S. financial institutions.
The implications of this watershed event are enormous. The Bear Stearns saga shows with brutal clarity that modern financial markets are even more tightly interwoven than before – leaving regulated institutions increasingly exposed to each other’s risks. The next U.S. administration will spearhead a global effort to legislate and superimpose a watchdog on the financial services industry as the threat of systemic collapse is addressed through policy initiatives. More rules or restrictions will not be bullish for bank and investing banking revenues.
The bottom line for the banks and their shareholders is not inspiring.
Greater financial market regulation, especially as it pertains to credit risk, will reduce long-term earnings for the majority of investment banks worldwide. Though Wall Street has an uncanny ability to create new models to maximize profits, government regulation and a new set of restrictions will likely dilute the potential of innovative financial product development. Increasingly, the government will scrutinize dealers and market makers to isolate where systemic risks threaten the global financial system -- destructively prohibitive to Wall Street.
Buffett Correctly Predicts Shareholder Dilution
In an interview with the National Post in Toronto, Canada, earlier this year, Warren Buffett of Berkshire Hathaway urged his audience to avoid most bank stocks in the future. Buffett stated that although some banks might be fair long-term investments, other sectors of the market offer far superior returns.
Buffett correctly predicted a wave of rights offerings or dilutive equity offerings as banks issue a rash of new shares to the public to finance bulging losses. Five months after his speech in Toronto, Buffett was right on the money; many U.S. and European banks have announced new rights offerings this year to shore up depleted capital ratios.
For the record, Buffett does own stakes in U.S. Bancorp (NYSE-USB) and Well Fargo (NYSE-WFC). The former is probably the cleanest of all U.S. large-cap banks with no subprime exposure.
To-date, over $200 billion dollars of losses has been amassed by global banks, with Switzerland’s Union Bank of Switzerland (NYSE-UBS) responsible for almost 20% of that total. The International Monetary Fund, or IMF, has pegged total losses tied to subprime and other credit losses to peak at roughly $1 trillion dollars, suggesting banks still have a stash of cash to writedown over the next several years.
Dead Cat Bounce or Market Bottom?
From their lows in mid-March following the near demise of Bear Stearns, U.S. bank stocks have gained 14% as investor’s bargain hunt amid the credit wreckage.
To be sure, some banks are probably worthy investments at these levels, assuming writedowns have peaked and their respective dividends will not be reduced or cut entirely. But, for most of the financial sector, more pain lies ahead as other segments of the credit markets and real estate come undone.
The United States is likely to suffer a prolonged economic slump as subprime and other facets of credit continue to unwind, constricting bank lending and reducing the economy’s ability to recover quickly like it did in the 2001 recession. Also, the next administration will spearhead a global effort to regulate financial services -- especially segments of investment banking that threaten the viability of the financial system. That will not be bullish for earnings.
Some banks probably belong in a diversified global portfolio. These should include institutions with no subprime loans, minimal securitization revenues tied to real estate and capital Tier 1 Ratios at or above international standards. And yes, make sure the bank pays a dividend, too!
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