Investors will find less money in banks# Stock
u*n
1 楼
SYDNEY (MarketWatch) -- When it comes to the rebound in U.S. banking stocks,
investors, bankers and many Wall Street analysts alike seem to have
embraced Oliver Goldsmith's advice: "Ask me no questions, and I'll tell you
no lies."
But the much-heralded improvements in the fortune of banks may be
misleading.
Federal Reserve policies, especially low interest rates and large liquidity
flows (from central banks through quantitative easing ("QE"), have
supported bank earnings to a large degree. Low short-term policy rates act
as a de-facto subsidy to banks.
This benefit can be estimated by assuming that deposits attracting near
zero rates are invested in risk-free government bonds to generate carry
income.
For example, assuming it could earn a net spread between Treasury yields
and deposit rates of 2%, JP Morgan Chase & Co. (JPM) would have earned
around $26 billion on its deposits of $1.3 trillion, roughly equal to its
actual 2013 pre-tax earnings of around $26 billion. In effect, the bank
could have generated the same profit without engaging in any banking
activities, purely by investing its customers' deposits in government bonds.
This net-carry on deposits equates to around 97%, 138% and 60% of Citigroup
Inc. (C) , Bank of America Corp. (BAC) and Wells Fargo & Co.'s (WFC) pre-
tax 2013 earnings, respectively. The analysis highlights how a focus on
earnings changes without regard for true earnings potential can be misguided.
U.S. banks also benefit from $2.4 trillion in excess reserves, resulting
from the central bank's QE programs. At the current rate of 0.25% per year
paid by the Federal Reserve, this equates to an additional $6 billion in
earnings.
In a 2013 study, McKinsey Global Institute found that between 2007 and 2012
, interest rate and QE policies resulted in a net transfer to U.S. financial
companies of $150 billion from households, pension funds, insurers and
foreign investors.
Monetary policy also boosts bank earnings indirectly. Low rates have
stimulated a recovery in the U.S. housing market, boosting income through
higher refinancing volumes. Low rates have helped the values of mortgage-
backed securities and other risky assets recover, also improving bank
earnings. And low rates allow vulnerable borrowers to carry high debt levels
, reducing the number of non-performing loans.
Restricted view
But this enhancement of current financial performance comes with
significant risk.
As banks become instruments of policy, holding greater levels of government
securities, deterioration in sovereign quality or rising interest rates
exposes them to the risk of large losses. A reversion to normal interest-
rate conditions would also reverse other identified positive earnings
effects.
The temporary emollient effect of policy actions also disguises weaknesses
in the traditional banking business.
Lower loan volumes, reflecting widespread deleveraging by corporations and
consumers and reduced economic activity, will limit earnings growth.
Corporations are increasingly choosing to finance directly in capital
markets, further reducing loan volumes and earnings.
After 2007/2008, trading revenues remained robust as volatility and
portfolio adjustments fed volumes and profit opportunities. But as the
broader economy stagnates, trading volumes have declined. Proprietary
trading is now restricted or incurs costly capital charges, reducing its
contribution to earnings. Derivatives revenues will be affected by the wider
use of a central counterparty and a clearing model.
Meanwhile, banks' income from advisory work, mergers and acquisitions, and
new debt- and equity issues, is below pre-financial crisis levels,
reflecting less activity as well as competition from smaller boutique firms
and the internalization of this work within large corporations.
Bad and doubtful debt-provision reversals, which have been significant, are
nonrecurring items. JP Morgan's 2013 credit provisions fell by around $3
billion from 2012 (93%). Citigroup, Bank of America and Wells Fargo also
reduced credit provisions in 2013 by $2.8 billion (25%), US$4.6 billion (56%
) and US$4.9 billion (68%), respectively.
The reductions were justified by the improved economic and credit outlook.
But the risk of loan losses is increasing in a weak economic environment and
rising rates, compounded by restructuring and refinancing of poor-quality
exposures that deferred, but did not eliminate, potential write-downs. The
Office of the Comptroller of the Currency has expressed concern that the
industry is using lower loss-reserves to increase reported earnings.
Banks also face higher wholesale funding costs, particularly in
international markets, reflecting their declining credit ratings. This
affects both margins and competitiveness as cost-effective finance providers.
Another challenge is the potential write-down of goodwill on expensive
acquisitions as well as any unused deferred tax assets (resulting from
losses).
Litigation costs are another major uncertainty. Since 2008, global banks
alone have incurred more than $150 billion in legal costs. JP Morgan, for
example, paid out more than $23 billion in settlements during 2013.
Rating agency S&P estimates that the biggest U.S. banks may have to pay as
much as $104 billion more to resolve mortgage-related legal issues. There
are likely to be additional costs from the various rate manipulation cases.
It is not clear whether banks have made adequate provisions for these
potential payouts.
Banks also face greater compliance and regulatory costs. Higher capital
levels, reduced leverage and a requirement to hold more prime-quality liquid
assets, combined with higher costs of capital, will reduce earnings and
return on equity.
Return on equity has fallen sharply, to high-single-digits or low-double-
digits -- and well-below pre-crisis returns. Financials are unlikely to
return to pre-crisis performance levels.
Complicating the outlook is the growing complexity of bank's reported
earnings.
For instance, JP Morgan's 2013 results including a $1.5 billion add-back
for "Funding Value Adjustment," reflecting the bank's borrowing cost to fund
collateral lodged when hedging an uncollateralized trade with an offsetting
collateralized position. The results also include a $2 billion "loss" from
a so-called Debt Value Adjustment, reflecting an increase in the value of JP
Morgan's own debt as a result of improvements in its funding cost over the
relevant period.
Such opaque and subjective adjustments increasingly make it difficult to
evaluate a bank's actual financial performance.
Over the last few years, investors in banks have chosen to ignore the
source of underlying earnings and the fundamental business outlook. To
paraphrase George Bernard Shaw, financial markets have substituted the "
obsolete fictitious for the contemporary real." It will be interesting to
see how long this dissonance can continue.
More from MarketWatch:
The death of America is greatly exaggerated
America's secret weapon to ensure economic power
In defense of the American Way
America plays 'rope-a-dope' with the world
Wall Street bonuses show CEOs think bull market is over
investors, bankers and many Wall Street analysts alike seem to have
embraced Oliver Goldsmith's advice: "Ask me no questions, and I'll tell you
no lies."
But the much-heralded improvements in the fortune of banks may be
misleading.
Federal Reserve policies, especially low interest rates and large liquidity
flows (from central banks through quantitative easing ("QE"), have
supported bank earnings to a large degree. Low short-term policy rates act
as a de-facto subsidy to banks.
This benefit can be estimated by assuming that deposits attracting near
zero rates are invested in risk-free government bonds to generate carry
income.
For example, assuming it could earn a net spread between Treasury yields
and deposit rates of 2%, JP Morgan Chase & Co. (JPM) would have earned
around $26 billion on its deposits of $1.3 trillion, roughly equal to its
actual 2013 pre-tax earnings of around $26 billion. In effect, the bank
could have generated the same profit without engaging in any banking
activities, purely by investing its customers' deposits in government bonds.
This net-carry on deposits equates to around 97%, 138% and 60% of Citigroup
Inc. (C) , Bank of America Corp. (BAC) and Wells Fargo & Co.'s (WFC) pre-
tax 2013 earnings, respectively. The analysis highlights how a focus on
earnings changes without regard for true earnings potential can be misguided.
U.S. banks also benefit from $2.4 trillion in excess reserves, resulting
from the central bank's QE programs. At the current rate of 0.25% per year
paid by the Federal Reserve, this equates to an additional $6 billion in
earnings.
In a 2013 study, McKinsey Global Institute found that between 2007 and 2012
, interest rate and QE policies resulted in a net transfer to U.S. financial
companies of $150 billion from households, pension funds, insurers and
foreign investors.
Monetary policy also boosts bank earnings indirectly. Low rates have
stimulated a recovery in the U.S. housing market, boosting income through
higher refinancing volumes. Low rates have helped the values of mortgage-
backed securities and other risky assets recover, also improving bank
earnings. And low rates allow vulnerable borrowers to carry high debt levels
, reducing the number of non-performing loans.
Restricted view
But this enhancement of current financial performance comes with
significant risk.
As banks become instruments of policy, holding greater levels of government
securities, deterioration in sovereign quality or rising interest rates
exposes them to the risk of large losses. A reversion to normal interest-
rate conditions would also reverse other identified positive earnings
effects.
The temporary emollient effect of policy actions also disguises weaknesses
in the traditional banking business.
Lower loan volumes, reflecting widespread deleveraging by corporations and
consumers and reduced economic activity, will limit earnings growth.
Corporations are increasingly choosing to finance directly in capital
markets, further reducing loan volumes and earnings.
After 2007/2008, trading revenues remained robust as volatility and
portfolio adjustments fed volumes and profit opportunities. But as the
broader economy stagnates, trading volumes have declined. Proprietary
trading is now restricted or incurs costly capital charges, reducing its
contribution to earnings. Derivatives revenues will be affected by the wider
use of a central counterparty and a clearing model.
Meanwhile, banks' income from advisory work, mergers and acquisitions, and
new debt- and equity issues, is below pre-financial crisis levels,
reflecting less activity as well as competition from smaller boutique firms
and the internalization of this work within large corporations.
Bad and doubtful debt-provision reversals, which have been significant, are
nonrecurring items. JP Morgan's 2013 credit provisions fell by around $3
billion from 2012 (93%). Citigroup, Bank of America and Wells Fargo also
reduced credit provisions in 2013 by $2.8 billion (25%), US$4.6 billion (56%
) and US$4.9 billion (68%), respectively.
The reductions were justified by the improved economic and credit outlook.
But the risk of loan losses is increasing in a weak economic environment and
rising rates, compounded by restructuring and refinancing of poor-quality
exposures that deferred, but did not eliminate, potential write-downs. The
Office of the Comptroller of the Currency has expressed concern that the
industry is using lower loss-reserves to increase reported earnings.
Banks also face higher wholesale funding costs, particularly in
international markets, reflecting their declining credit ratings. This
affects both margins and competitiveness as cost-effective finance providers.
Another challenge is the potential write-down of goodwill on expensive
acquisitions as well as any unused deferred tax assets (resulting from
losses).
Litigation costs are another major uncertainty. Since 2008, global banks
alone have incurred more than $150 billion in legal costs. JP Morgan, for
example, paid out more than $23 billion in settlements during 2013.
Rating agency S&P estimates that the biggest U.S. banks may have to pay as
much as $104 billion more to resolve mortgage-related legal issues. There
are likely to be additional costs from the various rate manipulation cases.
It is not clear whether banks have made adequate provisions for these
potential payouts.
Banks also face greater compliance and regulatory costs. Higher capital
levels, reduced leverage and a requirement to hold more prime-quality liquid
assets, combined with higher costs of capital, will reduce earnings and
return on equity.
Return on equity has fallen sharply, to high-single-digits or low-double-
digits -- and well-below pre-crisis returns. Financials are unlikely to
return to pre-crisis performance levels.
Complicating the outlook is the growing complexity of bank's reported
earnings.
For instance, JP Morgan's 2013 results including a $1.5 billion add-back
for "Funding Value Adjustment," reflecting the bank's borrowing cost to fund
collateral lodged when hedging an uncollateralized trade with an offsetting
collateralized position. The results also include a $2 billion "loss" from
a so-called Debt Value Adjustment, reflecting an increase in the value of JP
Morgan's own debt as a result of improvements in its funding cost over the
relevant period.
Such opaque and subjective adjustments increasingly make it difficult to
evaluate a bank's actual financial performance.
Over the last few years, investors in banks have chosen to ignore the
source of underlying earnings and the fundamental business outlook. To
paraphrase George Bernard Shaw, financial markets have substituted the "
obsolete fictitious for the contemporary real." It will be interesting to
see how long this dissonance can continue.
More from MarketWatch:
The death of America is greatly exaggerated
America's secret weapon to ensure economic power
In defense of the American Way
America plays 'rope-a-dope' with the world
Wall Street bonuses show CEOs think bull market is over