The only thing worse than losing money in the investing game is thinking about profitable opportunities you missed out on. (Yes, investing is pretty much a recipe for misery. Seriously, go invest in a tracker instead).
Anyone brave enough to buy certain UK bank shares a few weeks ago would by now have made a small fortune.
Barclays shares, for example, have more than tripled since early March.
It’s been a similar story in the U.S. as in the U.K., as the graph shown above from The Economist indicates. US banks as a group are up over 50% in the month.
Indeed, the U.S. banks are largely behind the global rally.
News of record profits at the giant Wells Fargo bank a week ago fueled the latest leg up of the banking stocks recovery. Goldman Sachs followed up on April 13th, reporting expectation busting profits of $1.8 billion, and JP Morgan kept the party moving with better than expected results on the 16th. And today Citigroup posted profits for the first time since 2007.
But what do these results really tell us about bank earnings, and about the sustainability of the recent rally?
Arguably they only remind us how unusual the recent period has been, rather than ushering in a return to regular record profits from the banks.
Fear abated, bank investors salivated
Read the links above for details of how each bank made its money, but to summarize I see three factors at play.
1. Unusual trading opportunities due to broken markets
Goldman Sachs made a tidy profit trading things like fixed interest with crazy spreads, and other kinds of illiquid opportunities caused by the retreat of many rivals and the general headless chicken-ery of recent months.
Here’s The Economist‘s view on the unlikelihood of this profit surge holding:
Goldman, like others, benefited from one-off boosts, such as the surge in corporate-bond issuance as seized-up markets began moving again in January, and from managing each other’s government-backed debt issues. They are also enjoying freakishly high bid-ask spreads and margins in “flow” businesses, such as fixed income, currencies and commodities (FICC). These have widened by up to 300% thanks to spiking volatility and the retreat of several big rivals, according to a study by Morgan Stanley and Oliver Wyman, a consultancy. Fully 70% of Goldman’s first-quarter revenue came from FICC.
These spreads are sure to come down as new actors enter the fray and old ones return, albeit gingerly.
I’m no expert, but it seems to me that a full recovery in the financial system is predicated on this sort of dislocation getting fixed.
These extreme opportunities will eventually evaporate: good news for the balance sheet, but bad news for those fixed income profits.
2. Write downs weren’t as bad as before
Noting Citigroup also made a killing with fixed interest, Bloomberg added:
The company took $5.62 billion of writedowns on subprime- mortgage-related securities and other investments in its trading division, reflecting a further erosion in their market value. That compared with $14.1 billion of writedowns in the first quarter of 2008, for a positive $8.47 billion revenue swing.
In other words, the recent past was so horrible that the current horribleness looks quite good.
That’s a positive sign in some ways, but less bad write-downs is not the same as asset prices rising. Many believe there will be further write downs to come as the recession kicks in and corporate defaults rise.
There are also quirky factors at play, like Goldman making a $2.5 billion unrealized profit on the falling value of its own debt. This situation would go into reverse in a recovering market.
Goldman even got to shift around its accounting dates when it converted to a bank holding company. Suffice to say this didn’t hurt its figures!
3. Benefits to being one of the last banks standing
This is one very real story behind the growth at Wells Fargo, and potentially for banks like Lloyds here in the UK.
At some point, the huge market share of the remaining banks will be a major factor in their valuation.
Wells Fargo, for instance, received $190 billion in mortgage applications for the quarter, up 64% from the previous quarter. It has a full pipeline of applications for its second quarter, too.
With interest rates very low, retail bank margins have recovered. With less competitors and even the possibility of regulation preventing banks from writing unprofitable deals, the chances of these margins staying fat for a while is high.
This winner-takes-all factor is the most durable element of the recent profits.
What next for the bank shares?
I wrote a couple of months ago how fear was driving bank share prices, using Barclays as an illustration:
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 […] the market is putting a big discount on the same banking ‘black box’.
What has happened in the past month is that the discount being put on the black box has narrowed, as investors began to believe the remaining banks won’t be nationalized, and that one day people may even started to buy cars and TVs again.
What’s more, like Libor – the interest rate banks charge when lending money to each other overnight – has continued to improve.
Here a virtuous circle has began to kick in. Libor fell at first on reduced Central Bank interest rates and latterly on quantitative easing. But now that banks are starting to report profits, Libor is falling further for the simple reason that banks are starting to trust each other again, and so are more confident they’ll actually get their cash back in the morning.
These little doses of good news have been enough to reduce the fear, and I’d argue it’s this reduced fear that has enabled banks to rally so far, so fast, rather than the rather unusual profits
Fear is still driving bank prices, but it’s the reduction in fear that is now in the driving seat.
I don’t have any idea how long this period will last. But I think it is quite possible that the next quarter of earnings will fail to benefit as much from the uplifts we saw this time.
That might not matter if the general economic mood is improving, and if equities, corporate bonds and more exotic securities continue to rally. Even if banks’ operational profits fall back a bit, at least their balance sheets would strengthen.
But even in that case, I suspect we’d be looking for a reason to maintain current valuations, rather than sustaining another huge charge upwards from here, at least until the summer is over. Markets tend to pause for breath.
Just a hunch mind. Remember, I’m the bloke who bought HSBC and didn’t buy Barclays, so take my views with a pinch of salt!
