Green shoots. Signs of life. Sprouts of hope … whatever you want to call it. With the S&P 500 up more than 40% since early March, it suddenly rocks to be a stock investor.
This newfound hope seems especially prevalent in the banking sector. Bank shares have been going gangbusters in recent months, thanks to a few green-shoot catalysts:
- The notion that nationalization is off the table.
- The notion that low interest rates mean profit margins are higher than ever.
- The increasing stabilization of the credit markets.
All three are legitimate points. The idea of all-out nationalization appears dead (at least for now); the Fed has cut interest rates to essentially zero; and credit markets are firming up to "normal" levels. If you're looking, it isn't hard to find reasons for optimism.
But as we know all too well, optimism can get ahead of the truth. That's how we got here in the first place. And while they are encouraging, the last two points might be prime examples of excitement prevailing over reality. Let's dive deeper.
Minding margins
Banks borrow at low interest rates and lend money back out at higher interest rates. The difference between the two yields is called the net interest margin. Borrow low, lend high. That's what drives profits.
And since the Federal Reserve has dropped interest rates to essentially zero, this spread should be wider than ever. The logic here is simple: Banks can borrow money at 0% and lend it back out at 5%, 6%, 10%, whatever. Hence, their margins should be enormous right now.
Unfortunately, the data shows that reality isn't quite this axiomatic. Take a look at net interest margins in the most recent quarter, compared to previous years:
|
Bank |
Most Recent Quarter |
2008 |
2007 |
2006 |
2005 |
|---|---|---|---|---|---|
|
Citigroup (NYSE:C) |
3.3% |
3.1% |
2.4% |
2.6% |
3.1% |
|
Bank of America (NYSE:BAC) |
2.7% |
3.0% |
2.6% |
2.8% |
2.8% |
|
Wells Fargo (NYSE:WFC) |
4.2% |
4.8% |
4.7% |
4.8% |
4.9% |
|
JPMorgan Chase (NYSE:JPM) |
3.3% |
2.9% |
2.4% |
2.2% |
2.2% |
|
US Bancorp (NYSE:USB) |
3.6% |
3.7% |
3.5% |
3.7% |
4.0% |
Source: Capital IQ, a division of Standard & Poor's.
Some big banks are actually facing decreasing margins, while those that have managed increases haven't done so at eye-catching levels.
Why is this happening? A few counteracting forces are at work:
- Banks are holding inordinate amounts of cash to preserve liquidity. So, yes, they can borrow money at next to nothing, but they're not lending all of it back out at attractive rates. They're hoarding a lot of it in assets that yield close to nothing, which compresses margins. "There is nothing more important than liquidity in this dangerous environment" said Goldman Sachs (NYSE:GS) CFO David Viniar in April. Goldman upped its liquidity by nearly 50% in the first quarter.
- The process of de-risking a balance sheet naturally compresses margins. Selling long-term assets (like mortgages) in exchange for short-term assets (like Treasury bills) involves swapping a high-yielding product for a low-yielding one.
So while factors are in place to give banks exceptionally high margins, the counter-effects of eschewing risk and boosting liquidity are drowning them out. This could, of course, shift if banks gain an appetite to lend to riskier borrowers. But for the time being, that isn't the case. To see what I mean, check out the estimated $2.7 trillion in credit card lines being cut from consumers.
Accounting rules that will make your head hurt
Another headwind to consider is the impact that strengthening credit markets will have on banks' bottom line. It sounds completely counterintuitive, but the stronger credit markets become, the bigger losses some banks may face.
Why? A ludicrous accounting rule allowed widening credit default swap (CDS) spreads to be booked as profit, even though this situation represents investors betting that a company is in danger of default. As credit spreads blew out earlier this year amid fears of nationalization, some banks offset losses with accounting gains.
And these weren't trivial gains, either. At Bank of America, widening CDS spreads accounted for 52% of profit last quarter; At Citigroup, they amounted to a staggering 156% of profits.
But now that fears of fallout are dwindling, credit spreads are coming back in. In fact, the Wall Street Journal reports that CDS spreads on Merrill Lynch debt (now part of Bank of America) have narrowed by more than half since the end of March. That means those "profits" that were booked could be reversed into losses. This is exactly what happened to Morgan Stanley (NYSE:MS) last quarter.
Check your enthusiasm at the door
Green shoots? Sure. Reasons to be more optimistic? Probably. But this hardly means banks are out of the woods for good. Consider these counteracting forces before piling back into bank stocks … not to mention the tidal wave of other problems they're facing.
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