Voodoo Banking Part 4
Time has come to lower expectations.
Editor's Note: This is the final installment in this series. Please click for Part 1, Part 2 and Part 3.
Earning growth in recent years has been driven by a rapid expansion of lending – both traditional and disguised forms such as securitisation and derivatives activity. Bank balance sheets have expanded at rates well above GDP expansion. Lower volumes in the future will mean lower earnings.
Corporate finance and advisory fees are driven by the capacity to finance transactions and also co-investing in risk positions. Lower origination of lending driven deals may reduce this income significantly. Investment banks generated around US$15 billion on fees in 2007 from "financial sponsors" - private equity firms involved in leveraged transactions. Banking fees for leveraged finance deals are expect to be down at least 50% in 2008. Some banks have reported declines in fees of around 90%.
Structured finance has contributed strongly to earnings in recent years. Securitisation volumes have collapsed.
In mid 2008, there were signs that the securitisation markets were showing tentative signs of life. Many "securitisation" transactions re-packaged existing assets into securitised format to allow banks to take advantage of cheap funding from central banks. This used the fact that central banks now allow AAA rated asset backed securities to be used as collateral for direct funding or can be exchanged for government bonds that can be financed by repurchase arrangements.
Trading revenue has been a bright spot. Increased volatility and much wider bid-offer spread have generated increases in both client driven and proprietary trading earnings. Several factors may limit trading income. Derivatives and structured investments, especially complex products, generated significant earnings. Problems in structured finance highlighted concerns about complexity, transparency and valuation. Revenues may diminish as investors and borrowers curtail their use of such instruments preferring simpler products that are less profitable to the bank.
Trading revenues relied heavily on hedge funds and financial sponsors. Hedge fund activity is likely to slow through consolidation and reduced leverage. Derivatives and hedging activity from private equity transactions and structured finance has been significant. Hedging revenues typically contribute 50% or more of bank earnings from a private equity transaction. Reduction in financial sponsor activity will limit revenue from this source.
Banks have increasingly relied on proprietary trading to supplement earnings. This increases risk and depends on the availability of capital. It relies on availability of counterparties and liquidity. Concern about counterparty risk and reduction in market liquidity in some products increases the risk of this activity and reduces its earning potential.
Future earnings will be affected by the availability of risk capital. The banks may not be able to access capital to the extent needed. The demise of the shadow banking system will mean that purchased capital will not be available. Regulators may also increase capital levels for some transactions exacerbating the capital problem.
Risk models in banks are a function of market volatility. The low volatility regime of recent years reduced the amount of capital needed. Increased market volatility will increase the amount of capital needed. This may restrict the level of risk taking and therefore earnings potential.
Rating agencies have downgraded a number of investment banks and many are still on "negative watch" as a result of concerns about asset quality, capital requirements and earnings outlook. Lower credit ratings may limit the ability of banks to trade. Where accepted as counterparty, the banks may have to post increased collateral. There is anecdotal evidence that large hedge funds are now asking banks to post collateral as surety to mitigate credit risk in transactions. Merrill Lynch (MER) estimated that a downgrade of its credit rating by one category (notch) would require it to post an additional US$3.2 billion of collateral on over-the-counter derivative transactions. Similarly, Morgan Stanley (MS) and Lehman Brothers (LEH) estimated that a single level ratings downgrade would require posting an additional U.S. $973 million and U.S. $200 million of additional collateral. Weaker credit ratings will affect the ongoing profitability of affected banks.
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Higher costs will also increase limiting earning recovery. Bank funding costs have increased. Most firms have been forced to issue substantial amounts of term debt to fund assets returning to balance sheet and protect against liquidity risk. To the extent, that these costs cannot be passed through to borrowers, the higher funding costs will affect future funding.
Banks have issued high cost equity to re-capitalise their balance sheets. Hybrid capital issues paying between 7.00% and 11.00 % pa will be drag on future earnings. Highly dilutionary equity issues (often at a discount to a share price that had fallen significantly) will impede earnings per share growth and return on capital.
Banks also face additional short-term costs. Litigation against banks has increased. There may also be prosecutions of banks. The costs of these are unknown. In the longer term, banks face higher regulatory and compliance costs.
As banks begin to adjust their business models (selling assets and reducing staff), significant restructuring costs will affect earnings in the short run. The benefits of the restructuring will yield benefits but they will take time to emerge.
Accounting factors may also affect any earnings recovery. FAS157 allows the entity's own credit risk to be used in establishing the value of its liabilities. Changes in the entity's credit standing are therefore reflected as changes in fair value. This results in gains for credit downgrades and losses for credit upgrades.
As credit spreads increased, U.S. banks have taken substantial profits to earnings from revaluing their own liabilities. European banks have also taken significant gains. If markets stabilise and the credit spreads for banks improves then banks will have to reverse these gains. There may be significant mark-to-market losses especially on new debt issues by banks at high credit spreads since mid-2007.
Normally, a dysfunctional financial sector and weakened individual firms would result in significant consolidation through mergers and acquisitions and asset sales. Consolidation activity usually provides support to values. In this instance, many likely predators are themselves weakened. There is also a shortage of capital to undertake such transactions. Acquisitions, in the present environment, are complicated by uncertainty about assets values and a weakening economy. For example, the JP Morgan (JPM) and Bear Stearns (BSC) transaction was effectively a "distressed" sales at what everybody assumed was "bargain" prices. All this makes the inevitable "consolidation" difficult and reduces the support to bank valuations.
Investors are looking for a rapid recovery in bank earnings. Earnings may recover but the "gilded age" of bank profits may be difficult to recapture.
Glamorous banks reliant on "voodoo banking" may find it difficult to achieve the high performance of the "go-go" years. Banks with sound traditional franchises that have avoided the worst excesses of the last 10-15 years will do well in the changed market environment. Such old fashioned banking may ironically do well in the "new" environment. Interest rates that they charge customers have increased. Bank deposits have become far more attractive than other investments. Stronger banks have also benefited from a "flight to quality."
Will the recovery in bank stocks take the form of "V" or "U"? It may be a "L." With the Northern Rock and Bear Stearns bailouts, central banks and governments have signaled that major banks are "too big to fail." This is a necessary but not sufficient condition for recovery of bank earnings and stock prices. The recovery might take the form of a "L" in calligraphy font, with a small upturn at the far right of the flat bottom.
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