How fear is driving bank share prices

Source: Digital Look

I don’t know what annoys me more: That Barclays Bank shares rose 72% on Monday while I was still finishing off a post suggesting they might be worth a punt, or that I didn’t buy any myself.

Oh ‘greedy’ side of the fear-greed investing equation, how we’ve missed you.

I use the word ‘punt’ deliberately. When shares in a blue chip company go up 72% in a day, even seasoned investors are entitled to wonder whether they are operating in a stock market or a casino.

I’ve previously described how the credit crisis caused Barclays shares to plunge last year – and suggested then that bank shares still looked dangerous. But exactly what caused this month’s crash followed by the huge spike above? And what does it tell us investors about valuing bank shares?

In this post I’ll explain why I think UK bank shares are being driven entirely by fear and greed. US and European financial stocks are behaving similarly, so I hope the post is of interest to my international readers, too.

Bank shares: Boom or bust

Barclays 72% jump upwards in a day has to be put in the context of a fall of 85% over the past 12 months.

Most recently shocking were the falls in all UK bank shares between January 13th to the 23rd. Just as investors started believing the credit crisis was abating, bank stocks plunged again:

What caused the drop in all bank shares?

Various things sparked the decline in bank shares; principally speculation about a new government bail-out package, which investors believed would further dilute their holdings, followed by a dismal profit warning from RBS issued to the markets on 19th January:

Royal Bank of Scotland’s warning of huge losses for 2008 panicked investors across Europe, sending stock markets lower across the region.

Bourses had improved earlier on hopes new rescue packages announced by Britain and Denmark will encourage lending and prevent the recession from worsening.

But UK bank RBS, which may soon be 70%-owned by the government, said it would post a full-year loss of up to £28bn due to massive write-downs and asset losses. Its shares fell an incredible 71% at one stage.

As in last October, falling bank share prices become self-reinforcing because the market understands that governments can’t allow contagion in the financial system, where confidence is everything.

As share prices plummet it becomes more likely that the government will have to step in the shore up the system by fully nationalizing another bank, as it did with Northern Rock, or forcing a merger, as with HBOS last year.

Government support turns to blight

Matters were made worse by the RBS warning coming on the same day as the government’s second financial rescue package was finally unveiled.

The further capital injections that investors feared didn’t materialize. Instead, the key to the new package is a scheme to enable banks to insure their toxic assets, designed to sure up confidence and get banks lending again.

While it was spun as an economic rescue package rather than more first aid for banks, coming on the same day as RBS’s profit warning, investors now feared that the UK government must have known how bad things were getting.

What else did officials know about losses to prompt the new insurance scheme, they wondered?

A theory rumour started circulating that RBS and Lloyds, the two part state-owned banks, would end up being nationalized, with shareholders getting crumbs.

Barclays meanwhile would be forced to raise more capital, the speculation continued, since it couldn’t have escaped the mauling that had destroyed the notoriously aggressive RBS.

The gloom quickly spread to non-state backed UK banks – not just Barclays, but also one of the world’s largest banks, HSBC, as well as Standard Chartered, the emerging market specialist that has largely ducked the sub-prime meltdown. I hold both the latter and had plenty of time to regret it as I watched their prices track their weaker brethren down.

The court stenographer of the credit crisis, Robert Peston of the BBC, was one of many stressing that nationalisation would be the last resort for the Government, but even he didn’t rule it out:

What investors in general appear to have missed in an outbreak of mass-hysteria that nationalisation looms: the prime minister and chancellor have made an unambiguous judgement that the general good would be better served by the semi-autonomy of the banks than by making them instruments of the state.

[…]

The Treasury will be pulling out the stops to make the insurance scheme work. Because if they can’t get it to work, it’s difficult to see how the 100% nationalisation of Royal Bank of Scotland – and even perhaps of Lloyds Banking Group – can be avoided.

Some say that the lifting of the FSA’s ban on shorting on January 16th also hastened the decline in bank share prices. While the timing fits and I’m sure it didn’t help, the evidence from the duration of the ban is that bank shares can fall just fine without shorters putting the boot in.

What caused the subsequent rally in bank shares?

A letter. On Monday 26th January, Barclays’s chairman and chief executive wrote a highly unusual open letter to its shareholders. “Trust us, not the market,” was the message:

The bank said that, even after the writedowns, its tier-one capital buffer would be £17bn more than the regulator’s minimum, allowing it to absorb further losses.

Record revenue in 2008 will more than offset the writedowns on toxic assets, producing pre-tax profit of more than £5.3bn for 2008, the letter said. Barclays also moved the date for its final results forward eight days to 9 February.

“Our capital resources are sufficient to manage Barclays safely and prudently even in these difficult markets,” [chairman] Mr Agius and his chief executive, John Varley, wrote. “We are not seeking subscription for further capital – either from the private sector or from the UK Government.”

This letter, with the promise of more detail to come in February, finally reversed the falls.

Note that Barclays had already given a profit prediction on January 16th, and CEO Varley had given reassuring interviews since then. But the market didn’t believe the bankers; it presumed they were either lying or being complacent about the toxic assets on their balance sheet, especially in the light of the dismal history of rival RBS.

It was by stating the growth in asset writedowns – as opposed to reaffirming the ‘record profits’ already dismissed by investors – that Barclays dispelled the gloomy enchantment that had held the market for two weeks.

By specifically saying its Tier 1 ratio (a measure of balance sheet robustness) was at 6.5% and that it would not seek more government money, Barclays called the market’s bluff.

Never mind that this information was pretty much already in the public domain, and that if Barclays was going to seek government capital it would already have had to tell the markets.

Sentiment turned 180-degrees. Barclays shares boomed, and other bank shares rallied.

Does any of this make any sense?

The volatility in banking shares makes sense if you forget what you were told about markets being efficient discounting machines for a moment. Over the medium term they are, but it seems to me that at a time of crisis like this, they’re more pinning a tail on a donkey.

As I was writing about Barclays at the weekend, a company with a £4 billion market capitalisation generating more that £5 billion a year and boasting well over £30 billion in capital reserves (a worse case estimate I made, which we can now refine to £35 billion or more) is either a bargain, a gambling chip, or a law suit waiting to happen. In barely 48 hours, Barclays shares have nearly doubled, and bank is now worth around £8 billion.

It’s tempting to say the market is crazy, but people always say that when share prices gyrate wildly over a short period. Wouldn’t it be just as accurate to say the market was crazy when Barclays’ share price steadily approached £8 in early 2007?

The market until 2007 put a high premium on the ‘black box’ at the heart of banking that generated consistent high earnings and dividends. Attempts to unravel bank earnings defeated even the best analysts, who chalked it up to financial mastery by highly-paid bankers.

Now, in the wake of the sub-prime meltdown and the ongoing deleveraging that has shown many bankers to be gamblers betting on other gamblers, the market is putting a big discount on the same banking ‘black box’.

Just as we didn’t understand exactly how much the credit bubble was boosting bank earnings, we don’t really understand today exactly how its bursting will reduce them. We know from all the banks that have gone bust or been merged that the answer is in the region of ‘a lot’, but we can’t be more specific.

Will we ever be certain about bank earnings again?

Such crippling uncertainty is why even ardent capitalists are calling for more regulation. Investors want to be able to trust the earnings from bank shares again, and governments want to know where the rot stops so they can draw a line under tax-payer support.

Personally, I believe any attempts to completely regulate away uncertainty are futile. History has shown repeatedly that bubbles, manias and systemic distortion is unavoidable in capitalist systems.

Yes, if I was a politician I’d say we had to put a stop to it – what else can they say? But in reality some new financial product will come along to replace today’s toxic mix of asset-backed securities and sub-prime mortgages, and lead us back to this spot.

What we can do is try to remember bankers aren’t gods but gamblers, and force them by law to prepare for a rainy day, perhaps through some new international central bank funded by a tax on all banks earnings and existing solely to manage financial crisis.

But how you’d stop such a central bank becoming just another agent of moral hazard – by encouraging more reckless activity from bank executives who’d believe they’d ultimately be bailed out by the new central bank – is a question for clever people than me.

Perhaps the solution is to link bankers’ earnings to failure as well as success, so millions granted in the good years can be clawed back in the bad.

Another legal minefield, but given that the agents of this disaster have walked away with millions, for once I wouldn’t mind paying the lawyers.