This past Monday, April 6, two heavyweight bank analysts made extensive, and negative, comments on the sector. Steve Forbes interviewed Meredith Whitney for his magazine’s online feature, Intelligent Investing. Also Mike Mayo hosted a conference call (sorry, no transcript link) from his new perch at Hongkong based broker CLSA along with CLSA economist Eric Fishwick and veteran independent accounting analyst Robert Willens. Willens stepped out of his restrained accountant’s demeanor to term the new mark to market accounting rules “awful,” and an “unmitigated disaster.” We’re glad to have Willens’s company in the opinion we expressed in our “April Fools” editorial last week.
We understand that bank stocks have continued to move higher since last Monday when the analysts spoke. The Bank Stock Index (BKX) soared 5.66 on Thursday to close the holiday shortened week at 33.81 based on Wells Fargo’s (WFC) preannouncing better than expected Q1 earnings. Our take: based on their track records, Mayo and Whitney are worth listening to, but as any trader knows, you can be right on the fundamentals and look very bad short term. Furthermore, value investor Whitney Tilson thinks that WFC made the number by charging off less than it should have, and will have to increase reserves to cover higher charge-offs in the future. He notes that Wells charged off only $3.3 billion in 2009Q1, while in 2008Q4, WFC and Wachovia, which then reported separately, charged off $6.1 billion combined in Q4. In addition, economic conditions got worse in the first quarter, which would lead one to expect greater loan losses than in last year’s fourth quarter. We agree with Tilson and, as noted in past columns, we think the banks and the Treasury are doing what they can to push bank stocks up artificially. But the tape is the tape.
Having said all that, Mayo thought on Monday that the banks should sell stock to raise capital, given that their share prices had already moved up dramatically from the March bottom. He thinks bank stock investors (presumably as opposed to traders) should demand a substantial margin of safety because of the weak economy and asset quality concerns. In his view bank shares got down to “reasonable” percentages of tangible book at the March lows, and he thought that the shares were too rich on Monday at about 80% of tangible book. In any event he initiated coverage of eleven banks at “underperform” on arrival at CLSA while Whitney said she is “staying away from bank stocks still.” Going forward Mayo states that banks will no longer be able to post high teens returns on equity because they will need to reduce leverage and because revenue streams from securitization are not coming back anytime soon, but given a proper margin of safety he insists that the sector remains “investable.”
Mayo is also wary of “partnering with the government” as a shareholder because TARP and PPIP do not preclude some move that might dilute or even wipe out shareholders down the road, if these programs fail to clean up the banks’ balance sheets. He also thinks current programs are a risky approach for President Obama, who in his view would do better if he cleans house now. If Obama waits longer, Mayo says, the bank crisis Obama inherited, could become his problem. We agree and remember that the first President Bush cleaned house effectively on the S&L crisis by tackling the problem early in his term.
Both analysts say the economy’s weakness will continue to hurt the banks. Whitney says that banks value their loan books based on assumptions that underestimate this recession’s severity, and as the banks catch up with reality they will increase reserves and charge-offs accordingly. The major banks call for unemployment rates of 7.5-8% and house price declines of 31%, peak to trough. As many readers know, the most recent non farm payrolls report (NFP) put unemployment at 8.5%. Similarly, the Case- Shiller index of house prices has already dropped 30% for the top ten Metropolitan Statistical Areas (MSAs). Whitney says futures markets are forecasting a 37% drop from peak to trough. Therefore, although many banks are posting reasonable pretax earnings before loan loss provisions, Whitney doubts that banks can earn enough to maintain adequate capital; the loan losses will overwhelm them in her opinion. She expects the major banks to sell their crown jewels eventually to raise funds. She also thinks that as banks cut risk by reducing consumers’ credit card lines, that could feed back into additional economic weakness. That problem is just getting started in her view.
We can see that one, and we note that prudent consumers who might not ordinarily carry large credit card balances, might use a credit card to tide themselves over during bad times. On the other hand, we are not going back to an economy where consumers spend beyond their means. Ultimately job creation, and not increased use of credit, will be needed if the economy is to recover.
Whitney notes that loan losses are largely a function of “distance from the borrower” and that smaller community banks who know their customers will have a better future eventually. In this scenario sales of assets from the majors will eventually give community the scale they need to compete. Right now, though, the top five banks account for a majority of total US deposits and hold dominant shares in business lines like credit cards. Her thinking makes sense to us, but we note that lots of smaller banks that never got caught with exotic investments like CDOs, could get hurt by loans to real estate developers.
Fishwick’s picture of economic conditions get Mayo to the same place. Fishwick notes that in most recessions unemployment rises about 2.5% from peak to trough and we are already past that. Mayo’s base case predicts loan losses of 3.5% of total loans and his worst case predicts 5.5%, which would exceed loan losses during the Great Depression. He also noted that many banks are effectively valuing loans at about 98c cents on the dollar, and therefore, like Whitney, expects increased loan loss provisions in the future.
Willens explained the new mark to market accounting rules. They provide tests to determine if an asset trades in an inactive market. If a security passes these tests, the reporting entity (that is, the bank filing its annual report) will presume that transactions in an inactive market, reflect distressed sales rather than accurate values. Therefore instead of using market prices to value tradable securities, the bank will use the income approach. That is, the bank will estimate future cash flows of principal and interest they expect the security to yield over its lifetime and then determine the present value of these cash flows. He notes that under this approach, banks can move securities from Levels One and Two (where market prices are used) into Level Three (mark-to-model or mark-to-whatever-management-wants) once they are shown to trade in “inactive” markets under the new rules. During the Q&A one participant observed that he had recently seen very large transaction volumes in asset backed securities (that is, bonds backed by assets such as credit card receivables and auto loans), and wondered how the banks would be able to justify moving such assets to Level Three.
If banks move many assets to Level Three, that will make bank balance sheets less transparent, and Mayo believes that bank stocks will trade at a discount for that reason. Not exactly what the American Bankers Association had in mind when they lobbied for this rule change. Nonetheless, Mayo implied that banks expended alot of energy over this rule, since only about 15% of most banks’ assets are tradable, and only tradable assets are normally considered eligible for mark to market accounting. Most banks value loans at 100c on the dollar until and unless they are found to be impaired, at which time banks take provisons for loan losses. Loans make up the bulk of banks’ assets. Of course that is different for investment banks, and for banks’ off balance sheet entities such as structured investment vehicles (SIVs), which usually own securities.
Finally, we think Whitney made a fascinating point regarding the financial crises of last summer. There were, she says, runs on the bank at Indymac, NatCity, Wachovia, and some others. At that time FDIC insurance covered depositors up to only $100,000 per account. Therefore corporations with large uninsured deposits, used for purposes such as cutting payroll checks, fled en masse once they felt they had reason to fear they’d lose their money. The government intervened to find buyers for these banks. Because these banks got merged out, the public never saw financial reports that would have told us just how severe the outflow of funds got during the third quarter of 2008. Yet another why Treasury and the Fed had to “do something” at that point; we just wish they had done something other than TARP after rescuing these failed institutions.