Banks have staged a remarkable recovery since last winter, when waves of cluster bombs hit the financial services industry. Since then bank shares, thanks to forced taxpayer largesse, ultracheap funding and the waning recession, have more or less doubled. Niagara-like torrents of new equity are filling bank treasuries and eye-popping signing bonuses have returned.
If it all seems too good to be true, that's because it probably is. Last week, bank shares pulled back. Minor correction? Or the start of a gut-wrenching selloff?
There are plenty of advocates for the first scenario. Any of the older fund managers, guys who have actually lived through a banking crisis or three, believe history is on their side. Bank shares collapsed in 1974 (oil embargo), 1981 (crippling inflation and interest rates), 1991 (real estate collapse) and 1998 (Asian and long-term capital flameouts). Each time, after a relatively short stint in the penalty box, the banks came roaring back and investor fortunes were made.
The true believers say this time will be no different. "Look at the historic share-price graphs," says Georg Thilenius of Dr. Thilenius Management, a Stuttgart fund manager who has been loading up on bank and insurer shares.
"There will be a recovery. It just might take a bit longer this time."
Yes, the post-Lehman bank mauling was the worst ever, but governments will never let another bank or investment firm of Lehman's size go under, the bulls say.
Meanwhile, banks are bailing themselves out by playing the spread between loan rates (5 per cent to 6 per cent) and the cost of funding the loans (1 per cent or so). Do the math. It's called money for nothing.
Then there is the widespread belief that the recession is already yesterday's story. Indeed, you would be hard-pressed to find an economist anywhere who predicts the end is nigh. "The global recovery has almost certainly begun," the top strategists at Barclays declared in their latest hunk of research. On top of all this merry news is the fact that banks are recapitalizing themselves through equity issues. The process will take a bit longer in Europe, where capital ratios are thinner than those in North America. Bankers everywhere fully expect regulators to be patient in their capital cushion demands.
The trouble is, those who support the selloff theory have equally compelling arguments. They say the runup in bank shares has been too quick and appears to be fully discounting an economic recovery.
Exhibit A is bank price-to-earnings ratios - they're back and they're fat. Forward ratios, at least among the European biggies, range from 10 (Deutsche Bank) to 13 (Société Générale). In 2007, a year before the crisis, the ratios were roughly the same. You could argue that the ratios just reflect the overall economic recovery. Or you could say the banks are stupidly overpriced, given the recovery's uncertainty and problems festering like ulcers in the banks' bowels.
Take the sobering data provided by Institutional Risk Analytics, a California bank consulting firm. It ranks banks from A-plus to F. Those in the latter category have the most troubled assets. The F-rated banks had total assets of $4.6-trillion (U.S.) in the year to the end of June. That's greater than the combined total of the banks in A-plus and A categories - the healthiest banks. A collapse of the F-rated banks is not unthinkable and could be catastrophic.
In the United States, the Federal Deposit Insurance Corp. reported that non-current loans - loans 90 days overdue or not accruing interest - were at their highest level in 26 years, at 4.35 per cent. The number of banks with 20 per cent of their loans 90 days overdue is at its highest level since 1991, Bloomberg reported Friday.
Then there is the banks' daunting recapitalization effort. True, great gobs of money are being raised almost every day. But the amounts raised so far - about $135-billion, according to a recent Financial Times report, citing data from analysts Dealogic - are a drop in the bucket compared to the cost of restoring the capital ratios of American and European banks. Not long ago, the International Monetary Fund put that figure at $1.7-trillion.
The IMF has a stricter definition of "capital" than some banks; the Europeans, for example, count their peculiar debt-equity hybrid as a form of regulatory capital. But still, if you were to be generous and cut the IMF's figure by half, the banks still have a long way to go before the recapitalization effort is finished. If the markets turn against them and they cannot build equity easily, they will have little choice but to reduce their asset base.
The bigger question is the direction of the economy. The Big Banks have an incentive to talk up the end of the recession simply because they are banks; any downturn would batter their capital ratios. The bears gained more credibility when the Conference Board reported that its U.S. consumer confidence index for September had tumbled. The figure - 53 - was still firmly in recession territory. As Gluskin Sheff chief economist and strategist David Rosenberg noted, the consumer confidence index averages 102 during an economic expansion. Meanwhile, U.S. unemployment continues to rise.
The bank crisis may not be over. Zombie banks - the undercapitalized banks that can't make loans, that are drain on both the banking system and the greater economy - may return. Investors beware.
Eric Reguly