In the six months following their lows in early March, US financial stocks rallied by 135% to early October while the overall stock market rose 51%. In Europe, financial stocks put on 121%, compared with 54% for the overall market, and in the UK they rose 139%, compared with 45% for the market as a whole.
Forward price-earnings ratios in the broad US and European stock markets are now above historical averages, and for financial stocks in particular even above their pre-crisis levels.
Banks aren’t yet saying that the peak of credit woes has passed or is even in sight. Investors, however, don’t seem to care.
Let’s hope they don’t come to regret that.
So, on the morning of October 14, even as Michael Cavanagh, CFO of JPMorgan, began talking analysts through the bank’s surprisingly good third-quarter earnings, the bank’s stock price was already rallying strongly. The headline news was that JPMorgan had beaten analysts’ earnings per share consensus estimates by a wide margin, bringing in profits of $3.6 billion, bolstered by $1.9 billion from investment banking alone, exceeding the $1.5 billion in the strong second quarter of 2009, as well as another $900 million or so from own-account trading in the bank’s investment portfolio.
It’s a result that underscores JPMorgan’s immense strides in recent years to the top of the league tables in most investment banking disciplines. But it will be tough for it, or any other investment bank, to keep this going. Cavanagh suggests that wide bid-offer spreads on customer trading are quickly narrowing.
In the past quarter, as credit spreads continued to narrow from historical wides, JPMorgan’s own portfolio managers saw good opportunities to put on winning trades. But they won’t be bringing in anything like so much profit on a regular basis.
Even the Institute of International Finance, the industry body for large global banks, now says, in its October Capital Markets Monitor, that the markets’ recent rallies raise troubling questions. Has the recovery been too fast, too soon? And how discriminating has it been?
In debt markets, for example, the lowest-quality credits have produced the highest returns in the past six months. The value of triple-C rated corporate debt, for example, has doubled. The carry trade is back, with the weakening US dollar as the funding currency for investing in high-yielding emerging markets. Liquidity – $10 trillion of it in cash, bank deposits and money market funds, according to the IIF – is suddenly looking for yield once more. But during this latest run-up in high-yield credit and in bank stocks, have investors lost sight of the prospects for rising default rates and losses?
Contorted syntax
As investors clamoured to know how sustainable JPMorgan’s succulent investment banking earnings were, those still hoping for soothing words about reserving and loan losses having passed their peak as well, found themselves parsing some fairly contorted syntax. Cavanagh told them: “We continue to see initial signs of stability in the early buckets of consumer loan delinquencies”, but warned that “we are not ready to declare that a sustained trend”.
The next day, on Citi’s earnings call, Vikram Pandit talked up the bank’s 18-month plan to restore its financial strength, boasted of its $100 billion in tangible common equity and its tier 1 ratio of 12.7%. But on the outlook for credit he was more vague, telling analysts: “Our credit costs remain elevated and clearly US consumer credit remains the number one issue affecting our near-term results, but our NCLs [net credit losses] declined for the first time in the cycle.”
Citi’s realized credit losses came in at $8 billion for the third quarter of 2009, down from $8.4 billion for the second quarter, with the first decline in US consumer losses since the third quarter of 2007. The bank slowed its build-up of loan-loss reserves as it continues to reduce its balance sheet. But that may not be good news. “We do remain cautious,” Pandit said, “since the underlying trends remain mixed.”
Citi admits that, because of new remediation efforts to prevent credit card customers going into delinquency, as well as trial modifications of large volumes of mortgage loans in line with the Obama administration’s Home Affordable Modification Programme, it is now virtually impossible for any outsider to derive any sense of forward credit indicators from its published results.
In credit cards, for example, new remediation efforts saw fewer customers fall into arrears of greater than 90 days, a traditional early indicator of future losses. But net credit charge-offs still rose because now, once customers do go past 90 days in arrears, there’s less chance of preventing loss.
On the day after Pandit spoke, Ken Lewis, chief executive of Bank of America Merrill Lynch, tried his best to sound more positive, saying: “We may have peaked in total credit losses this quarter.” Lewis put a heavy emphasis on “may”. He also said that “the pace of deterioration in credit quality slowed”, during the third quarter. But the gloss was taken off this by the fact that Bank of America surprised analysts with a larger than expected loss as net charge-offs increased, especially in credit cards.
“There’s a perception that smaller, regional banks are more at risk now than the large banks,” one analyst tells Euromoney, “because of commercial real estate loan exposures. But that misses certain key worries for the large banks, one of the biggest being that credit card exposures are heavily concentrated among the biggest 10 or 12 banks in the country.”
Back on the much more upbeat JPMorgan call, for fully half an hour analysts dimly sensed the brooding presence of chief executive Jamie Dimon, holding himself in check as the good news gushed forth. Finally, as questioners pressed for clarity on the outlook for credit costs and reserve building, Dimon broke his silence. He saw the need for some straight talk and it wasn’t about the investment banking deal pipeline or bid-ask spreads on customer trading in flow rates products.
“Look, the credit card business is going through a substantial adjustment. We have an early sight of losses for next year and we will lose a lot of money next year. We could lose north of $1 billion in the first quarter and north of $1 billion in the second quarter. And we have to do a better job, starting with underwriting upfront. We’re looking through 2010 and asking our people in the cards business to build good, new, clear products.” Dimon went on to suggest the bank will eventually emerge with a smaller but better credit card business, but that “we won’t see the results of that until 2011 or 2012”.
Key measure
Later Dimon also confirmed that investment banking was unlikely to continue to perform at such an elevated level and pointed analysts to what he saw as the key measure for the bank: its $32 billion of loss reserves. These eventually should come down, perhaps to $15 billion or $10 billion, potentially boosting the bank’s earnings in the process, but only as long as actual charge-offs don’t eat up the rest. And Dimon points not to next year for that, or even the year after, but rather to 2012.
In the meantime, loss reserves could well have to rise further.
For the third quarter of 2009, JPMorgan reported net charge-offs on home equity loans of $1.14 billion: it now forecasts “quarterly losses trending to approximately $1.4 billion over the next several quarters [Euromoney’s italics]”. Prime mortgage charge-offs at JPMorgan were $525 million for the third quarter of 2009. It sees this trending to $600 million over the next several quarters. For sub-prime mortgages it charged off $422 million in the third quarter and expects to be charging off $500 million in the quarters ahead. In credit cards, its net charge-off rate was 9.41% in the third quarter. It sees this rising to 10.5% in the first half of 2010. And thereafter... who knows? Jamie Dimon doesn’t. All depends on the unemployment rate – and the sustainability of economic recovery, now being put at risk by the restricted availability and high price of bank lending.
Dimon seemed to be saying something important, even if it wasn’t what investors had wanted to hear. Was anyone listening?
By the end of the day, Wall Street traders were cheering as the Dow Jones index went back through 10,000 for the first time in a year. Yet what JPMorgan was saying on October 14 was that it could not be sure the worst was behind us. It might well still be in front of us.
The worst is ahead
The IMF came to the same conclusion in its latest Global Financial Stability Report published at the annual meetings in Istanbul last month. The IMF suggests that by the end of the first half of 2009, global bank write-downs had amounted to $1.3 trillion. It expects additional write-downs of another $1.5 trillion still to come. It expects US consumer loan losses to peak towards the end of next year with residential and commercial mortgage market charge-offs also peaking in the second half of 2010. Meanwhile the IMF suggests that euro area banks have been much slower than US lenders to recognize their losses.
If that’s worrying for JPMorgan, which happens to run the world’s largest investment banking franchise and so has profited hugely from the boom in debt and equity capital markets as well as higher customer trading volumes and wider margins, then it’s seriously scary for the rest of the banking industry.
Most other banks don’t have that investment banking earnings power. Rather, they are much more exposed to the more worrying side of JPMorgan’s business: consumer lending. And many smaller banks than JPMorgan also face a second worry in the shape of large commercial real estate loan exposures. Euromoney highlighted this little-mentioned but very large problem in its September issue (“The next leg down”), and it seems that central bankers and analysts have begun paying closer attention to it ever since.
Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, raised a warning voice last month on banks' commercial real estate exposure following a conference it hosted. He reported panellists including investors, developers and bankers as saying that lenders had not yet recognized losses and speaking “derisively of what they termed ‘extend and pretend’ and ‘delay and pray’ measures on the part of both banks and regulators”. With absolute rates so low, it’s easier for banks to extend maturities on certain commercial real estate loans and make out that all is well, even when it clearly isn’t.
It’s eerily reminiscent of the leverage loan bankers who used to assure Euromoney in 2006 and 2007 that default rates would be very low on new loans they were putting on – because there were almost no covenants left for borrowers to breach, and interest and principal payments were all back-ended. That didn't work out so well.
For more on why Euromoney thinks the worst may be yet to come:
Investors may regret rush back into banks
November 2009
Banks have raised private capital in abundance as their stock prices soared over the past six months. Investors may be overlooking how dependent the banks have been on government subsidy. Public support is now being phased out. And looking ahead, bank’s credit losses are more likely to rise than to fall. Peter Lee reports.
“The sector’s fundamentals have been deteriorating all the while the public equity markets have been climbing,” says California-based Institutional Risk Analytics.
