Diary of a Financier

Financials Taking Losses; Hold Off on the Zombie Nation

In Capital Markets on Wed 20 Jul 2011 at 00:06
  • Horrible 2q11 EPS from GS & BAC continue a streak of Financials’ underperformance.
  • Using Japan’s Lost Decade as a baseline, maybe US financials should take their losses now to avoid the economic dead-weight of zombie banks.
  • It is important for banks to define their core businesses as either deposit/loan institutions or proprietary vehicles.
  • I’ve been accumulating Banks’ Preferred stocks (especially those that’re callable soon) in waiting for common stocks to start resurgent comeback.

Goldman Sachs (GS) reported 2q2011 EPS this morning. They announced whopping miss $1.85 v. $2.31 expected by the Street. While the numbers showed year-over-year growth, I’m starting to take an interest in the underperformance of Financials.

Take a look at the trough in a few Financial names’ EPS, starting with GS:

Goldman Sachs (GS)- EPS

Now Bank of America (BAC), who reported its worst loss ever this morning:

Bank of America (BAC)- EPS

I remember a comment I made back in May:

[I]f SPX cares to rally beyond its multiple top, it will have to be under new sector leadership–specifically laggard Financials (XLF).

Financials have still not taken that lead, and SPX has still not surpassed its multiple top. Yet in reviewing the EPS charts above, I’m starting to interpret the persistent underperformance as a good thing for the long-term. Japan’s “Lost Decade” has taught us a lot about how to approach the American mess…

Japan’s Lost Decade truly began around 1989, when Japan’s Finance Ministry sharply raised rates to choke off speculation. Japanese markets crashed (much like America’s in 2000), which was palatable for regulators since the alternative was to let the bubble inflate even more toward a bigger crash in the future. The Japanese economy stagnated through 2000 nevertheless. (The key is to prohibit the bubble’s inflation in the first place. China take note.) In fact, the sputtering even spilled into the 2000s due to the zombie banks, kept alive by government support despite substantial unrealized losses:

Michael Schuman of Time magazine noted that banks kept injecting new funds into unprofitable “zombie firms” to keep them afloat, arguing that they were too big to fail. However, most of these companies were too debt-ridden to do much more than survive on further bailouts, which led to an economist describing Japan as a “loser’s paradise.” Schuman states that Japan’s economy did not begin to recover until this practice had ended.

Eventually, many became unsustainable, and a wave of consolidation took place, resulting in only four national banks in Japan. Critically for the long-term economic situation, it meant many Japanese firms were burdened with massive debts, affecting their ability for capital investment. It also meant credit became very difficult to obtain, due to the beleaguered situation of the banks.

At least Japan’s Lost Decade didn’t feel all that catastrophic, perhaps because Japan’s finance ministry chose to prick the bubble by raising rates:

The impact on everyday life was muted, however. Unemployment ran rather high, but not at crisis levels. This has combined with the traditional Japanese emphasis on frugality and saving to produce a quite limited impact on the average Japanese family, which continues much as it did in the period of the miracle.

The US, in contrast, continued easing monetary policy after its crash in 2000–piling leverage on top of leverage. Further, Americans spent their way to a negative savings rate throughout the 21st century. The American trough in 2009 was therefore quite deep, with economic consequences (persistent unemployment at crisis levels) more dire than Japan’s.

To avert a second decade of economic stagnation (using Japan’s 2001-present as a baseline), the US must heed the lesson of Japanese zombie banks.  Banks have to take losses, not paper them over with government liquidity.

Bank of America, for example, is a private-sector, modern reincarnation of a “bad bank” a la the Savings & Loan Crisis. BAC swallowed two toxic failures (Countrywide & Merrill Lynch), now it’s choking on their carcasses.  But, at least BAC is taking losses.  The stock is back under $10 because of them, and it’s amazing to see how far down it has sunk in 2011:

BAC v SPY

BAC is an extraordinary case–like I said, they swallowed hand grenades.  Here are some other ailing banks that seem to be taking their medicine, starting with Goldman, who’s starting to feel the impact of Dodd-Frank & the “depository banking” charter it agreed to in 2008:

GS v SPY

Morgan Stanley (MS) suffers from much the same symptoms as Goldman.  Add to that the incompetence on its proprietary (fixed income) trading desks and a general lack of volume in capital markets, then you have a stock that’s rolling steadily downhill:

MS v SPY

Not much to say about Citigroup (C), other than it’s been picked clean by the feds, and it’s now a shadow of its former self:

C v SPY

Of course I have to add a chart of the Financial Sector ETF (XLF), which illustrates the stagnation:

XLF v SPY

This is all a long-term interpretation of the underperformance in Financials–an alternative hypothesis, if you will.  Maybe, just maybe, Wall Street is governing itself with the long-term in mind for once?!  I’m currently reading Sabastian Mallaby’s More Money Than God, an anecdotal history of the Hedge Fund elite.  While I rather enjoy the read, Mr. Mallaby seems to press the message that Hedge Funds are good citizens whereas banks are not: he often concludes chapters with a comparison between a major bank failure (linked to a government bailout) and a garden-variety hedge fund implosion.  His advice is that hedge funds are risk management specialists and banks are not.  The latter, he suggests, should stick to the business of deposits & lending.  They shouldn’t build businesses around proprietary trading, structured products, derivatives, and leverage.  Bank deposits in the front door are better paired with loans out the back door than with leveraged proprietary portfolios.  Banks are not structured correctly for outsized prop trading; they’re not funded appropriately and their back offices/risk management aren’t geared adequately.  The client money (cash/assets) coming in the front door isn’t attuned to such non-core activities that pose significant risks to deposits.  Despite their opacity, Hedge Funds are the ones equipped for that kind of stuff, and their clients knowingly agree to it.  I don’t have the wind to pick apart Mr. Mallaby’s argument tonight, but he does raise a matter of relevance.  Many of the banks have some fringe businesses & assets to settle-up before they can return to normalcy.  Others need to define themselves and perhaps drop the “bank” misnomer.  Unfortunately, some can end up like Citi.  Fortunately, none would end up like Lehman.

Eventually, Financials will make their comeback, and it will be a terrific trade to play.  (John Paulson jumped the gun on this one.)  They have a big gap to close in catching-up to the broad market.  For the past 18 months, I’ve been buying Preferred stocks of banks like BAC on every dip.  Preferreds are mostly consumed by capital structure arbs and retirees looking for income with a growth kicker.  A lot of my Preferreds will be called in the coming years due to Dodd-Frank or simple refinancing opportunities, so they’re trading at a discount.  Retirees are selling these issues now to reallocate into other preferreds/bonds that won’t discontinue their income stream.  I am buying since I’m happy to accumulate 6-8% yield-to-call for a few years.  I’ve even picked up a few issues at discounts to par, which add capital appreciation to the mix.  Eventually, I expect to shift my focus to financials’ common stocks as the Preferreds roll off.  The common stocks are where 2x-3x IRRs will await.

–Romeo

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  1. […] markets ahead of economics. I must echo the recent comments from Market Anthropology and my own Diary entries, which celebrate the underperformance of Financials as a steady “workout” phase. Aided […]

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