Many of the big U.S. banks are much better capitalized than they were in the years just after the crisis, and they are also doing a good job of increasing their customer bases, credit card business, and other banking products. So, why are their stocks still trading at extremely low valuations?
In Citigroup's (NYSE:C) case, shares trade at just 88% of their tangible book value, compared with more than 110% of tangible book as recently as 2011 when the crisis was still fresh in our minds. The same can be said for JPMorgan Chase (NYSE:JPM), with shares valued significantly lower than they were a few years ago.
What's the reason for this?
There is no single reason for the low valuations in the banks.
For starters, the recovery in the banks' fundamentals is still very much alive. Citigroup, for instance, has done an excellent job of winding down its Citi Holdings legacy assets so far, but there is still well over $100 billion in old assets on the balance sheet. Another possible explanation is the uncertainty and government influence lingering as a result of the crisis.
However, one of the big reasons the banks are not pulling in tons of profits is the poor performance of their fixed-income trading divisions, and revenue from bond trading in particular.
For the past several years, the banks with the largest exposure to bond trading have been on the losing side of the price action in bonds. Typically, banks with large fixed-income trading operations hold tens of billions of dollars worth of Treasury bonds.
But, according to recent data from the Federal Reserve Bank of New York, the banks actually had a negative position in Treasuries in March.
Why short Treasuries?
The price of bonds is correlated with the interest it pays out. When market interest rates go down, prices of existing bonds increase so their interest rates increase along with the market. Conversely, when rates rise, bond prices fall, so the interest they pay rises on a percentage basis.
By the banks not holding Treasuries, they were essentially positioning themselves for rising interest rates. It makes sense, since virtually every piece of news related to the Federal Reserve's taper or the rising market has been prediciting rates to climb steadily higher for the foreseeable future.
Unfortunately for the banks, the exact opposite has happened. Rates have fallen across the economy and bond prices have rallied. In fact, the average 30-year mortgage rate (a good indicator of the overall direction of interest rates in the U.S.) has fallen from 4.53% to 4.14% so far in 2014, according to Freddie Mac.
The effect on Citigroup, JPMorgan Chase, and the other banks
How badly the rising bond prices will hurt remains to be seen, but banks are already trying to prepare their shareholders for a big hit.
JPMorgan Chase has already warned it's second-quarter trading revenue is going to about 20% less than it was a year ago. Citigroup has said the decline could end up being even worse, projecting up to a 25% drop in trading revenue.
In addition to the falling bond prices, fee income from bond trading has been much lower. Simply put, less bonds are being traded. Some investors are undoubtedly reluctant to trade with the uncertain direction and volatility of interest rates, and some are just put off by the relatively low interest rates offered.
JPMorgan's fixed income trading revenue for the second quarter last year was $5.37 billion, so a 20% decline would mean more than $1 billion less in trading revenue.
Combined with the $5.06 billion in trading revenues for the first quarter, that would make this the worst half for trading revenues for the bank since the crisis ended and would represent about a 5% drop in total revenue for the company.
In a nutshell, the banks are still doing fine, but no thanks to their trading revenue. In fact, all of the growth in commercial banking, wealth management, and mergers and acquisitions we've seen over the past few years is merely serving to offset the declines in bond revenue.