Bank Stress Tests Don’t End the PainA. Gary Shilling
The Federal Reserve has released the results of stress tests of 19 big U.S. banks that assessed how their Tier 1 common capital ratios would fare by the end of 2013 with a 13 percent unemployment rate, a 50 percent decline in stock prices and house prices off 21 percent.
Only one institution, Ally Financial Inc., would fail to meet the 5 percent minimum capital requirement. Yet Citigroup Inc., MetLife Inc. and SunTrust Banks Inc. were so close to the threshold that the Fed won’t allow them to raise dividends or buy back stock.
Relieved investors pushed up bank stocks, mainly because the Fed didn’t require any of the tested companies to immediately raise capital. But they will need to do so to meet new standards set by the Fed and the Basel Committee on Banking Supervision that will soon take effect. Bank of America Corp.’s ratio, for instance, will jump to 9.5 percent, from 6 percent, implying an almost 60 percent reduction in its leverage. This is one of many reasons I believe that many U.S. and foreign bank stocks, now selling below book value, aren’t cheap.
The business climate for major banks around the world has changed remarkably in just four years. Decades ago, they set off on a huge leveraging spree. Then, starting in 2007, many institutions holding bad private and sovereign assets had to be bailed out by central banks and governments to prevent a collapse of the global financial system.
As a result, banks globally have been forced to exit off-balance-sheet vehicles, derivatives origination and ownership, and proprietary trading as they deleverage and shed noncore businesses. They’ve also been hit with much higher capital requirements, further eroding the scope for leverage. And they’re being busted back to spread lending with smaller returns, a far cry from the hugely leveraged, high-flying growth stock outfits that big bank chief executives thought they were piloting.
They’re now a contrite bunch. Only Lloyd Blankfein of Goldman Sachs Group Inc., James Dimon at JPMorgan Chase & Co. and Brady Dougan of Credit Suisse Group AG have survived the housecleaning of major bank CEOs.
Even with help from the release of reserves for bad loans, U.S. banks’ return on equity was 6.8 percent in the fourth quarter, compared with 15 percent in the pre-crisis salad days. Return on assets, which skips leverage, is 0.76 percent, down from 1.4 percent.
Banks will also be faced with low returns on their basic business as slow economic growth, falling house prices, small returns on stocks, low interest rates and a flat yield curve persist in the remaining five to seven years of global deleveraging that I foresee. Consumer loans will be repaid on balance, and record nonfinancial corporate liquidity and slow economic growth will continue to curb borrowing and mergers-and-acquisitions activity. Then there are the huge counterparty risks on derivatives and potential large further write downs of troubled assets.
Even after the recent settlements with the government over bad mortgages and improper foreclosures, major U.S. banks will continue to deleverage. With many companies’ shares selling for less than book value, CEOs don’t want to dilute shareholders by raising equity capital and are dumping assets to meet higher capital ratios. And book values are problematic. Tangible common-equity ratios -- capital without all the questionable stuff -- for major U.S. banks are in the 6 percent to 7 percent range. But total capital ratios, which include goodwill and other questionable items, run 8 percent to 10 percent, even after non-equity capital is adjusted for risk.
Citigroup has cleared out more than half the $662 billion in troubled assets it dumped into its so-called bad bank in early 2009. That includes a 49 percent share of Smith Barney, which Citigroup is selling to the 51 percent partner, Morgan Stanley.
Bank of America is unloading noncore assets, especially from its huge troubled real-estate portfolio, which is dominated by its Countrywide Financial unit. Morgan Stanley exited the subprime mortgage business last fall when it sold for $59 million a unit it had purchased for $706 million in 2006.
Even Goldman Sachs hasn’t been spared from deleveraging; it has closed a hedge fund, sold a profitable investment in Industrial & Commercial Bank of China Ltd. and cut jobs. Its return on equity last year was 3.7 percent -- compared with its earlier norm of 30 percent -- as revenue dropped 26 percent from 2010 and 36 percent from 2009.
The situation outside the U.S. is no different. To satisfy local regulators who want to avoid another 2008-style bailout, UBS AG is making its investment bank a separate unit that will be incorporated outside Switzerland. Late last year, Credit Suisse Group AG, a major player in gathering and securitizing mortgages before the collapse, announced the closing of its U.S. commercial mortgage-backed securities origination business along with layoffs.
In France, the country’s third-largest bank, Credit Agricole SA, announced plans to shore up its capital by exiting investment banking in 21 of the 53 countries in which it operates, and cutting 2,350 of its 160,000 jobs. The other two big French banks, Societe Generale SA and BNP Paribas SA, have said they will discontinue some businesses and cut lending.
Germany’s Deutsche Bank AG says it may dump its asset-management businesses in the U.S. and elsewhere, citing regulatory changes and associated costs. Commerzbank AG, hoping to avoid another government bailout after its 18 billion euros ($24 billion) rescue in 2009, is negotiating to transfer its troubled assets to a government-owned “bad bank,” where they will be written down and worked off.
Big banks in Italy, Spain and Eastern Europe are also deleveraging furiously to recover from ambitious acquisitions that turned out disastrously. The Japanese investment bank Nomura Holdings Inc. -- which reached for global status in late 2008 when it acquired the European and Asian businesses of Lehman Brothers Holdings Inc. and hired 1,000 people -- is engaged in major cost-cutting after its stock price dropped by two-thirds in the last three-and-a-half years.
For U.S. banks, equity capital -- the difference between assets and liabilities -- has risen 22 percent, or $259 billion, from September 2008 to February 2012, according to the Federal Deposit Insurance Corp., and cash holdings have almost quadrupled to $1.7 billion. In part, this is because of the Fed pumping money into the system through quantitative easing and other means. Nevertheless, bank regulators in the U.S. and abroad are determined to limit the size of banks and force financial institutions to increase their capital cushions to ensure that they won’t become too big to fail and require government bailouts. Regulators decided, in effect, not to force banks to become “too small to matter.”
Banks, of course, object that more capital holdings will limit their lending capacity. In addition, European institutions want to extend their capital buffers beyond cash deposited in central banks and highly rated government bonds to include assets such as gold, blue-chip stocks and mortgage-backed securities. And they’ve gotten very creative in meeting the 115 billion euros increase in capital they were ordered to carry out by the European Banking Authority by June.
At the same time that European banks are raising capital by hook or by crook, they need to roll over about 775 billion euros in debt this year, even as European governments are rolling over about 900 billion euros. Troubled euro-area countries such as Italy, Portugal and Spain have few buyers for their debt, except their national banks, which have no option, and then use the bonds as collateral for loans from the European Banking Authority.
But who will buy European bank debt? U.S. money-market funds aren’t interested in the risks, and their loans to foreign banks have fallen 40 percent since last June. In January, those loans accounted for 33 percent of money-market fund assets, compared with 55 percent in 2009.
No Visible Solution
The union of German-dominated northern Europe and the Club Med south under the euro currency has created financial woes and problems for banks that have no visible solution. And institutions in weak euro-area countries will probably remain semi-governmental conduits for financing budget deficits, with the attendant risk of default.
So despite their recent rallies, I remain decidedly unenthusiastic about major bank stocks. They’re now selling about one times book value, far below the three times level of the late 1990s and even the two times in the mid-2000s, but that doesn’t necessarily make them cheap.
Do current prices reflect the continuing deleveraging of banks, persistent slow loan growth, further write-offs of bad real estate and other assets, compressed interest-rate margins, increased capital requirements and increasingly stringent regulation? I’m not convinced they do.
(A. Gary Shilling is a Bloomberg View columnist and president of A. Gary Shilling & Co. He is the author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own.)
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