Thursday, February 4, 2016

Are Banks The Next Big Short?

Philip Baker of the Australian Financial Review reports, Deutsche Bank's troubles unmask bigger risks:
At the Deutsche Bank annual meeting in Frankfurt in 2015 a disgruntled investor got up in front of the microphone and asked the board of directors if there was a financial scandal the bank wasn't involved in.

A month earlier, the bank had been fined $US2.5 billion by US and British authorities after a seven-year investigation for its part in rigging benchmark interest rates.

Investors were baying for blood, as tougher regulatory requirements and litigation seemed to be taking their toll on the bank's share price.

At the time, stock in Deutsche Bank was closer to €30, well down from its pre-global financial crisis high of €177, while on Tuesday night shares in the bank fell to a fresh low of €15.54, prompting a new wave of worries.

For a start, Deutsche Bank is trading on a price to book valuation of 0.34 times, which implies the market thinks that almost 70 per cent of its loans are impaired and some nasty news is just around the corner.

The bank posted a €6.8 billion loss in 2015, thanks to a €12 billion write-down linked to litigation charges and restructuring costs, and it set aside more to cover any potential litigation.

At a time when it seems like a cottage industry has sprung up in predicting the next financial crisis, there's talk that although this current period of turbulence might not be the next crisis, it will certainly do until that next crisis does arrive.
Heart of the problem

At the heart of these latest concerns is that investors are losing faith in what central banks can do. But the performance of big global bank stocks like Deutsche Bank has also sparked the selling.

It was August 2014 when Paul Schulte, the chief executive of SGI Research, warned Australian investors that all was not well at Deutsche Bank and he still thinks the bank has several problems to deal with.

First, he said that more than any other global investment bank Deutsche had too many leftover assets from the global financial crisis – more than $US10 billion ($14.1 billion) by his estimates – that are very illiquid and simply too hard to value.

With regard to all the financial scandals mentioned at 2015's annual meeting, he also thinks there are further fines to come, while Deutsche also seems to have a large book of commodity-related derivatives that are under stress from the collapses in most commodity prices.

Schulte says there is still too much leverage at Deutsche and it is in the centre of a sclerotic system of Euro-paralysis, which prevents any dramatic sort of "TARP" program.
'Over-stretched, badly run'

"This has been brewing under everyone's nose, because while people thought that the problem was periphery banks in Ireland or Spain, the actual problem is that Deutsche Bank, and the French banks with lots of toxic debt in commodities, are over-stretched, badly run, have no sense of risk management and are organs of state capitalism," Schulte says.

So far this calendar year shares in Deutsche Bank have fallen 30 per cent but it's not flying solo. Citi is down 22 per cent, Goldman Sachs is down 16 per cent, JP Morgan is down 14 per cent, Morgan Stanley is down 23 per cent, Bank of America Merrill Lynch is down 22 per cent and Credit Suisse 22 per cent.

Shares in UBS are also down 20 per cent in 2016, slipping 7 per cent on Tuesday night after its latest profit numbers implied its strategy of moving away from the volatile investment banking business to focus on steady business of wealth management wasn't working so well.

That compares to a 7 per cent fall in the Dow Jones and S&P 500, a 5 per cent decline in the FTSE 100 and 11 per cent drop in the DAX.

As for the next crisis, it is always hard to predict. But with so much debt around and growth hard to come by, there is a mismatch between rising credit, falling growth, trade and prices, and a financial market that is in the mood to sell everything.
More bad news for Deutsche Bank, Jonathan Stempel of Reuters reports it now faces a U.S. lawsuit over $3.1 billion mortgage loss:
Deutsche Bank AG must face a U.S. lawsuit seeking to hold it liable for causing $3.1 billion of investor losses by failing to properly monitor 10 trusts backed by toxic residential mortgages, a federal judge ruled on Wednesday.

U.S. District Judge Alison Nathan in Manhattan said Belgium's Royal Park Investments SA/NV may pursue claims that the trustee Deutsche Bank National Trust Co ignored "widespread" deficiencies in how the underlying loans were underwritten and serviced, and failed to require that bad loans be repurchased.

Royal Park, which is seeking class-action status on behalf of other investors, said Deutsche Bank breached its fiduciary duties in part out of fear it might lose business or prompt retaliation over the German bank's own problem loans.

"Plaintiff's allegations of high default rates, large economic losses, and widespread investigation into RMBS securitization allow the court to draw the reasonable inference that defendant had actual knowledge" of defective loans, the judge wrote.

Nathan dismissed some secondary claims.

In its June 2014 complaint, Royal Park said its own securities had become "completely worthless." The 10 trusts date from 2006 and 2007.

Deutsche Bank spokeswoman Oksana Poltavets declined to comment. Royal Park's lawyers did not immediately respond to requests for comment.

Bond issuers appoint trustees to ensure that payments are funneled to investors, and handle back-office work after securities are sold.

Many investors have in recent years sued trustees, as well as lenders and underwriters, over losses on badly underwritten mortgages.

The case is Royal Park Investments SA/NV v. Deutsche Bank National Trust Co, U.S. District Court, Southern District of New York, No. 14-04394.
Things are not looking good for the once mighty Deutsche Bank (DB). And I agree with that disgruntled investor who got up in front of the microphone and asked the board of directors if there was a financial scandal the bank wasn't involved in (Deutsche was one of a few banks at the center of the $35 billion ABCP meltdown in Canada in 2007).

But the problems are not only at Deutsche Bank. Laura Noonan, Rochelle Toplensky and Ralph Atkins of the Financial Times report, Credit Suisse results deepen bank gloom:
Credit Suisse shares (CS) tumbled to a 24-year low on Thursday after the Swiss bank revealed its first full-year loss since 2008, providing further evidence of the impact of market volatility and low global growth on financial firms.

Vowing to step up drastic cost cuts, Credit Suisse chief executive Tidjane Thiam warned of a “particularly challenging” time for banks.

“Clearly the environment has deteriorated materially during the fourth quarter of 2015 and it is not clear when some of the current negative trends in financial markets and in the world economy may start to abate,” he said. Credit Suisse shares were down 13 per cent by late afternoon in Europe.

The Credit Suisse warning followed 2015 results from European rivals Deutsche Bank and UBS last week that showed sharp falls in fourth-quarter earnings. UBS finance chief Kirt Gardner described trading conditions as “treacherous”.

Despite an overall small bounce in European financial stocks on Thursday, the sector is the worst performing sector in the Euro Stoxx 600 index during the past month, dropping just under 20 per cent.

Globally, the financial sector is the worst performing in the MSCI World Index. The S&P 500 financials are the worst performing major sector this year, down nearly 12 per cent.

Mr Thiam cited a litany of negatives for banks including uncertainties on Chinese growth, the abrupt drop in oil prices, large mutual fund redemptions of financial assets and the impact of “asynchronous policies” of leading central banks.

This has resulted in lower client activity, reduced issuance of securities by companies and material shifts in the prices of some asset classes.

Banks’ stocks have also been hit by investor worries over the groups’ exposure to the US energy sector following the slump in oil prices and expectations that weak economies will see the US Federal Reserve and other central banks delay interest rate rises longer than investors had been expecting last year.

Low interest rates hurt banks because the gap between what they charge for lending and what they pay for deposits shrinks. The most extreme case is when central bank rates are negative — banks are almost never able to pass the full impact of this on to depositors, but borrowers get lower interest rates, especially those with variable rate loans. This means the bank’s margin falls.


“The common themes globally are lower for longer [interest] rates, risk-off and less growth — and those are all bad for banks,” said Mike Mayo, New York-based analyst with CLSA.

Credit Suisse’s global markets division lost almost SFr3.5bn ($3.5bn) in the fourth quarter as it wrote down the value of distressed debt it held and took a SFr2.66bn hit to goodwill.

Revenues at Credit Suisse’s investment banking arm, which advises clients and arranges deals for them, were 20 per cent lower than a year earlier as income from debt underwriting “fell significantly” in torrid market conditions.

The Swiss bank’s private banking arm suffered net outflows of SFr4.1bn, mirroring the experience of UBS, whose shares plunged 8 per cent on Tuesday after it revealed its key wealth management division had net outflows of SFr3.4bn in the fourth quarter.

Mr Thiam acknowledged that conditions had been “particularly challenging” but suggested the share price fall was overdone: “You can’t be deaf to the markets, but these are very nervous markets,” he told reporters in Zurich.

Speaking to analysts, David Mathers, Credit Suisse’s chief financial officer, shot down suggestions the bank should have gone for a bigger capital increase than the SFr6bn it got from investors at the end of last year.

“Part of the point of the cap raise was to fund restructuring and re-engineering of the group. That’s clearly coming through,” Mr Mathers said. “We have not to lose our nerve,” Mr Thiam added.

The bank also promised to cut costs faster, but this did little to appease analysts.

“A key takeaway from this banks results season is that the market has no appetite for “jam tomorrow” despite some very low valuations,” said Jon Peace, analyst at Nomura.
I'm afraid the new negative normal and ultra low low rates for years spell big trouble for big banks, especially European ones saddled with bad loans. And the risks of contagion are rising.

In fact, Anna-Louise Jackson and Dakin Campbell of Bloomberg report, Bank Bear Market Gets Worse as Goldman, Citi Sell Off Again:
The 2016 financial stock rout worsened Tuesday as the country’s biggest investment banks plunged almost 5 percent amid a gathering storm of economic and financial threats.

Goldman Sachs Group Inc. sank the most since November 2012 to lead the Dow Jones Industrial Average to a 295-point loss, while Citigroup Inc., Bank of America Corp. and Morgan Stanley slid 4.7 percent or more. The KBW Bank Index declined 3.2 percent to extend its bear-market plunge since July to 23 percent.


Tuesday’s losses worsened the second-biggest share decline to start a year in two decades for American financial stocks and followed similar losses in Europe after UBS Group AG earnings at the wealth management and investment-banking businesses slumped in the fourth quarter. Concerns ranging from falling interest rates to China and investor disaffection amid increasingly volatile markets spurred the retreat.

“Concerns about problems in the energy sector and a slowdown in the Chinese economy are leading to fears of a global recession,” Jim Sinegal, an equity analyst at Morningstar Inc., wrote in an e-mail. “As a result, bank stocks are getting hit hard as investors factor in higher credit losses, slower growth, lower capital markets activity, and a continued low-interest rate environment.”

All but eight companies in the 90-member Standard & Poor’s 500 Financials Index slipped as the gauge flirted with a two-year low, while the S&P 500 Capital Markets Index tumbled 4.2 percent to levels last seen in August 2013. All 14 members of the latter group declined. The losses came as the 10-year Treasury yield fell below 1.86 percent for the first time since April, while a pair of Federal Reserve financial stress indexes reached the highest since December 2011.

The gap between the two-year and 10-year Treasury yields shrank to its smallest since January 2008. At the same time, predictions for 10-year yields are being cut as U.S. economic data falls short of expectations, potentially curbing further Fed increases. The year-end weighted average forecast in a Bloomberg survey has fallen to 2.69 percent, from about 3.2 percent six months ago.

“The mere thought that rate hikes won’t happen has caused investors to sell banks,” said Mike Mayo, an analyst at CLSA Ltd. “The regulators spent the last eight years helping to make banks less risky,” he said. “But still, on a day like today, they’re not perceived as less risky.”

Plunging energy prices posed another headwind as market speculation focused on the 19 percent of the Bloomberg High Yield Index made up of energy bonds. Oil capped its biggest two-day drop since March 2009 before government data forecast to show U.S. crude stockpiles expanded, exacerbating a global glut. Futures fell below $30 a barrel in New York after a 5.5 percent slide.

Oil has lost 19 percent this year amid volatility in global markets. Royal Dutch Shell Plc had its debt rating cut to the lowest since Standard & Poor’s began coverage in 1990, while Sanford C. Bernstein & Co. warned investors in Asian producers to prepare for a wave of writedowns.

“The yield curve still isn’t cooperating on both up and down days, and oil having two rough days has put the market back in a nervous mode, which is obviously not good for investment banking,” said Jesse Lubarsky, a financial-stocks trader at Raymond James & Associates Inc. in New York.

Selling in financial stocks has gone well past banks in 2016. Discount brokerages Charles Schwab Corp., E*Trade Financial Corp. and TD Ameritrade Holding Corp. have each lost about a quarter of their value this year. Fund firms Franklin Resources Inc., Waddell & Reed Financial Inc. and Legg Mason Inc. are nursing losses ranging from 12 percent to 28 percent.

Financials were the most-favored group among large-cap managers as of Oct. 31, according to data from Goldman Sachs Group Inc. An exchange-traded fund tracking the stocks attracted the second-highest cash flows in the month leading up to the rate liftoff.

“All of this is coming together to create a capitulation trade,” said Charles Peabody, an analyst at Portales Partners LLC in New York. “The investment community came in overweight bank stocks coming into the year largely on the idea that Fed rate hikes would create a positive earnings catalyst,” Peabody said. “What they’re quickly learning is the Fed’s ability to raise rates is limited.”
I don't know exactly what's going on with big banks across the world but clearly the brutally cold chill of deflation is rattling them. Still, cries of a "global banking crisis" are premature at this stage.

Things appear to have calmed down on Thursday with the Financial Select Sector SPDR ETF (XLF) up marginally (1 per cent) but still negative for the year. Some analysts think commodities are bottoming out but that remains to be seen.

I saw explosive moves in shares of Consol Energy (CNX) and Freeport McMoran (FCX) Thursday morning propelling the S&P Metals and Mining sector (XME) up but I've seen many explosive short covering rallies in this sector peter out after big pops. I need to see sustained follow-through and a rise in bond yields to believe in this rally in energy and commodities.

Problems in Europe's highly levered banks might also explain the big drop in high beta small cap biotech shares (XBI). I'm not sure if there was a carry trade that was unwound but it sure looks that way for all risk assets, not just biotech shares.

Are banks the next big short? I certainly hope not but this is a very challenging environment for all banks and it could get a lot worse before it gets better.

Below, Raoul Pal, Global Macro Investor Publisher, explains his concern over European banks and lists his troubled bank list. If you listen to Pal, you just want to curl up in the fetal position and cry.

For a more uplifting view, Dick Bove, Rafferty Capital, discusses the financial sector as financial stocks slide, stating bank balance sheets are in excellent shape. Great comments but he's talking about U.S. banks and ignores the risk of contagion.


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