Shares of virtually every major U.S. bank are down sharply Wednesday morning, after the People's Bank of China intervened in currency markets for a second day in a row.
- Bank of America (NYSE: BAC) is leading the way with a 3.2% drop
- Citigroup (NYSE: C) is down 3.2%
- JPMorgan Chase (NYSE: JPM) is off by 2.4%
- Wells Fargo (NYSE: WFC) shares are lower by 1.3%
The broader market, measured by the S&P 500, has fallen by 1.2% roughly two hours into today's trading session.
The concerns are threefold insofar as America's biggest banks are concerned. First, as I discussed yesterday, a devalued Yuan plus further deterioration in the Chinese economy could ignite higher default rates among borrowers on the Chinese mainland.
If XYZ Corporation, a fictional Chinese company, borrows $100 million from JPMorgan Chase at an annual interest rate of 7%. Before Tuesday's devaluation, XYZ Corp.'s annual interest expense would cost it 42.8 million Yuan. After Tuesday's devaluation, the cost increases to 43.6 million Yuan.
Although slightly higher borrowing costs probably won't trigger widespread defaults, they could spell trouble for highly leveraged companies that are already operating in or near the red.
It's little surprise, in turn, that shares of American banks are down in rough proportion to their China exposure. In Citigroup's latest 10-Q, it lists total exposure of $21.1 billion. JPMorgan Chase is second at $17.7 billion. And Bank of America and Wells Fargo round out the top four, with aggregate exposures of $12.1 billion and $3.1 billion, respectively.
The second concern is the impact that the Yuan devaluation could have on the Federal Reserve's decision to raise interest rates here in the United States.
Even widely diversified banks like JPMorgan Chase, Bank of America, and Citigroup look to net interest income for a substantial share of their revenue and earnings. But with short-term interest rates still around 0%, all of these banks have seen the income from their loan and securities portfolios contract.
JPMorgan Chase estimates that it will earn $7.5 billion more before taxes if short-term rates normalize around 2.25%. Bank of America says that a 100-basis-point (one percentage point) increase in both short- and long-term rates will boost the bank's annual net interest income by $4.5 billion. And Citigroup projects that a 100-basis-point increase in short- and long-term rates will translate into $1.9 billion in additional net interest income.
Bank investors are thus waiting with bated breath for the Fed to make its long-anticipated move. However, China's decision to devalue the Yuan could delay this. "Any rate increase in this country while the rest of the world is seeking to lower currency values will cause the dollar to move higher," noted Richard Bove of Rafferty Capital Markets' in a note to clients today.
Bove went on to explain that a higher dollar would likely increase the trade deficit, lower multinational corporate profits, push small U.S. manufacturers out of business, and increase unemployment.
Finally, as we saw when Switzerland's central bank devalued its currency earlier this year, the volatility in foreign exchange can wreak havoc on poorly positioned trading portfolios. In that case, for instance, Citigroup purportedly lost upwards of $150 million when the Swiss franc rose relative to the euro.
The takeaway for investors is that unexpected devaluations (and devaluations are, almost by definition, always unexpected) can generally be assumed to spell short-term trouble for global money lenders.