Bank bottoms are back

A post from The Big Picture cites a new report from RBC Capital that provides another gloss on what many people have been saying -- we are nowhere near a bottom in bank stocks, and in fact the real economic damage is still yet to come. This stuff keeps coming out with such monotonous regularity that there might even be something to it.

5 Reasons Why Bank Stocks Have Not Bottomed

1) Bank Stock Valuations Are Still Excessive:
• Current stock valuations of the Top 50 banks relative to historical valuations, remain expensive -- even with the recent poor performance.

• The Top 50 banks' forward 12-month P/E ratio stands at 13.2x, which is roughly one standard deviation above the mean (25-year avg of 10.9x).

• During the trough of the last two bank stock bear markets, 1990-91 and 2000-01, P/E ratios for the top 50 banks declined to 5.7x and 10.1x, respectively.

2) Recessionary Forces Will Lead To Bigger Credit Quality Problems:
• In prior recessionary periods, credit problems typically followed as a result of the weakening economy. We believe the U.S. economy is currently facing recessionary pressures that will only worsen extending into 2009.

3) Exposure to Riskiest Loan Areas Remains Extreme:
• Construction, Commercial Real Estate (CRE) and leveraged loans have provided steady growth over the past few years. Commercial loans outstanding for the US banking industry grew 64% from 2004 to 2007 due to demand from the syndicated loan market, in our opinion. As the economy weakens further in 2008, the underlying fundamental strength in commercial real estate and industrial America will soften leading to higher defaults in poorly underwritten CRE and leveraged loans.

4) Loan Loss Reserves Are Too Low:
• Bank management teams will often claim loan loss reserve adequacy only to boost reserves in subsequent quarters. We have adopted the Eyles Test (ET) for loan loss reserve strength. Banks should build and maintain reserves that will ensure survival during the down leg of the credit cycle.

5) Credit Problems Are Not Likely To Peak Until 2009:
• Given our belief that CRE, construction and leveraged loan portfolios have significant room to weaken in 2008, we believe credit problems will not reach their peak until sometime 2009.

Una ganga

I love the idea of bottom-fishing and vulture investing more than anyone, but I continue to wonder whether the market's mini-catharsis following the Bear Sterns debacle isn't a false dawn. Certainly, I'm not alone, as this FT article suggests. Some choice metrics:

Domestic banks – this excludes Standard Chartered and HSBC, which make most of their profits overseas – trade on a prospective price earnings ratio of around 7.6 times earnings, according to estimates from Goldman Sachs.

However, it has been cheaper. In the period before the last recession in the UK, the sector was trading on a forward multiple of 5-6.

In any case, p/e ratios are of limited value when there is no visibility of earnings. And for a number of reasons that is certainly the case at the moment.

Of course, there are other ways to value banks. Many analysts use price to book value or price to tangible book value, which excludes things like goodwill. But even on this measure the sector does not look cheap. Domestic UK banks trade on 1.3 times book value and 1.7 times tangible book value, according to Goldman Sachs.

“This compares to 1.0-1.2 in the early 1990s when goodwill was written off against reserves, so making it more comparable to price to tangible book vale today,” the broker says.

As with p/e ratios, it is worth questioning how useful book value is. After all, Northern Rock was nationalised at a fraction of its year-end book value.

Somehow I keep coming back to the conclusion that the problems in the financial market simply will not go away in the near future. You have a housing meltdown that, by the very nature of that market, will be protracted. You have a financial industry that had reached epic proportions as a percentage of the economy. You have financial globalization built on the back of enormously complex instruments that no one really understood. None of these things make for a swift turnaround. If -- in addition to what looks like the worst economic situation for the financial industry since the great depression -- the stocks have yet to reach valuations consistent with the relatively mild set-back of the early 90's, how can you argue that we have already seen the bottom?

Monkeys and Markets

George Soros published an editorial in the FT today, criticizing the Paulson financial industry regulation "reform" (who are we kidding here, the guy is the former head of Goldman Sachs -- reforms are for the little people) and, more importantly, providing some suggestions of this own.

• Create a CDS exchange with margin requirements to solve the counterparty risk problem that led the Fed to bailout Bear.
• Bailout underwater homes either through an outright purchase of mortgages or through modifying bankruptcy laws to allow judges to dictate workouts with creditors

The first of these ideas sounds extremely smart. I'm more skeptical about the second one, but that's probably because I would still have to pay for it, even though I don't own a house in the US. Maybe it's necessary to have the government rescue home owners. Certainly it is politically inevitable.

The larger point Soros makes -- that regulation and risk models to date have been based on a sort of "market fundamentalism" -- also strikes me as a good one. I'm generally and as a matter of principle in favor of markets, but I also know that they are not always efficient and do not grow on trees. To have markets that serve their purpose (distributed coordination, information transmission, and tending to equilibrium) you have to create them, with sensible rules everyone is forced to play by, designed to produce the outcomes you were looking for. "Everyone" in this case, refers to a bunch of former monkeys, and when designing your sensible market rules, it pays to keep this in mind. Unfortunately, the regulators are themselves former monkeys (either of the two groups whose professional success depends on more bailouts), which may account for the fact that crises like the current one are always taken to mean more regulation, especially for people who didn't cause the problem, rather than simply better regulation.

What is a Bubble?

Brad DeLong has a long post that is another piece in the on-going hand-wringing saga of what, if anything the government should do about declining home prices. Of course, you can't swing a dead cat these days without hitting an econ professor with a blog about his brilliant ideas on how the government can single-handedly bail us all out, magically lifting the economy up by its own bootstraps, so to speak. But the post does end with a very interesting quote from Keynes:

While some part of the investment which was going on in the world at large was doubtless ill judged and unfruitful, there can, I think, be no doubt that the world was enormously enriched by the constructions of the quinquennium from 1925 to 1929; its wealth increased in these five years by as much as in any other ten or twenty years of its history....

Doubtless, as was inevitable in a period of such rapid changes, the rate of growth of some individual commodities [over 1924-1929] could not always be in just the appropriate relation to that of others. But... [a] few more quinquennia of equal activity might, indeed, have brought us near to the economic Eldorado where all our reasonable economic needs would be satisfied.... It seems an extraordinary imbecility that this wonderful outburst of productive energy [over 1924-1929] should be the prelude to impoverishment and depression. Some austere and puritanical souls regard it both as an inevitable and a desirable nemesis on so much overexpansion, as they call it; a nemesis on man's speculative spirit. It would, they feel, be a victory for the mammon of unrighteousness if so much prosperity was not subsequently balanced by universal bankruptcy. We need, they say, what they politely call a 'prolonged liquidation' to put us right. The liquidation, they tell us, is not yet complete. But in time it will be. And when sufficient time has elapsed for the completion of the liquidation, all will be well with us again.

I do not take this view. I find the explanation of [depressions, i.e.] the current business losses, of the reduction in output, and of the unemployment which necessarily ensues on this not in the high level of investment which was proceeding up to the spring of 1929, but in the subsequent cessation of this investment. I see no hope of a recovery except in a revival of the high level of investment. And I do not understand how universal bankruptcy can do any good or bring us nearer to prosperity...

I find this interesting because it makes you question what exactly you mean by "a bubble". These days, we're liable to label just about anything that increases quickly in price (and can potentially decrease just as quickly) a bubble. That strips the word of any meaning though. A better definition would reserve it for a more technical use in situations where the price of something cannot be justified by its fundamental value. We speak of a property or stock bubble when the historical relation between prices and the drivers of those prices (incomes and earnings respectively) breaks down. That's a better use of the word, and maybe even a good way to predict future prices of the asset, but in practice, these types of frothy disjunctions between values and prices are not simply taken as price signals, they acquire moral dimensions. People don't call it a bubble until they feel hoodwinked.

But the other thing I think we have (re)learned about bubbles is that they also have a positive side. It's a bit of a chicken and egg question, but bubbles actually stimulate real investment, which is what Keynes is point out. The internet bubble had a building all kinds of new technology, some of which was dumb, some of which was fradulent, and some of which enables me to write, distribute and monetize (with a little help from Google) this terribly clever blog. Was that such a bad thing? Would I be able to do this without those sky-rocketing tech stocks?

At first glance, this also seems to be the way to condemn the housing bubble. Houses are not productive. They are consumer good. I'm not sure if Americans will ever understand this, though presumably their prices falling another 20% will help. The problem with the price of housing increasing is that it encourages you to build more housing, and having an even bigger McMansion doesn't actually allow you to make an even even bigger one somewhere down the line.

In other words, the housing bubble wasn't an investment bubble, and it's busting doesn't leave us with anything that we didn't have before, and especially not anything useful for future production like railroads or the internet.

But wait. Even though it was pretty indirect, the housing bubble did encourage investment -- IN CHINA. All that excess consumption in the US, all those people using their house as an ATM and racking-up credit card debt was accompanies, step for step, by the expansion of productive capacity in China. The housing bubble was their ticket to modernity. So maybe bubbles aren;t so bad after all.

Credit-Equity Decoupling

This chart is kinda interesting. It is also kinda dumb, because the things it plots -- investment grade credit spreads on the y-axis, and the absolute level of the S&P index on the x-axis -- don't really have much of anything to do with each other. Nevertheless, what it does indicate is that the relationship between equity and credit markets has recently changed dramatically. The grey dots are points generated since the beginning of the subprime conflagration last July. Not only do they occupy a different area, but their trendline has a different slope. The question, naturally, is whether this suggests that credit worries are overblown, or that equity markets are drinking the kool-aid (these are not mutually exclusive). Frankly, I think that when you consider the fact that corporate profit margins are at multi-decade highs, wages at multi-decade lows, home prices are falling more than 10% per year, and we are pretty clearly heading into a recession that if history is any guide will be serious -- if you consider all this, you might consider the S&P at slightly above its historical mean PE somewhat overvalued.

Credit Writedowns

Bloomberg has a chart this morning tallying the credit write downs to date at major investment and commercial banks. The total so far is $232 billion. This is approximately half of the Goldman Sachs estimate of $460 of mortgage related losses, of which they estimate half will effect leverage financial institutions, and contribute directly to the process of deleveraging. This $230 billion that's going to get wiped out represents, according to the same paper, about 1/10th of the total banking system equity, and they estimate that this will create a cumulative US balance sheet contraction of around $2 trillion (after accounting for recapitalizations). This figure is again about a tenth of the assets held by leverage institutions in total. Please note that these estimates are not mark-to-market or anything remotely fictitious. They are based on estimates of how many people will default-- i.e. they are real economic losses.

What are the implications of all this? First, that we're only halfway through the writedowns in the banking sector. Bottom my left foot. Second, that 10% of the money in the US banking system just went up in smoke, and that's probably a conservative estimate.

But, well, in the immortal words of Tricky Dick Cheney, "So?" After all, a 10% reduction in equity hardly puts you on the doorstep of insolvency, so what exactly is the problem? Shouldn't this simply mean that bank stocks are worth 10% less, with a potential knock-on effect as they have to sell off 10% of their assets in order to maintain their leverage ratios? Perhaps the deleveraging effect (where reductions in equity are pro-cyclically accompanied by reductions in leverage ratio) makes this a little worse, but still, Citibank is not going out of business here. The biggest implication of the crisis may simply be that the US goes into a prolonged recession, as a comparison with the effect of past international banking crises suggests.

The Chinaman

Calculated Risk has a post today about all things Chinese. The basic observation is that everything sucks -- the property market is off, the stock market is off, the economy's growth is projected to slow, inflation is already up, and new labor laws can't help but feed its further increase. It's hard to know how severe this will get, and how much it is caused by China's connection to the US versus their own home grown problems, but with the quantity of manufacturing that occurs there and the size of their dollar reserves, having some opinion about China seems increasingly important to developing any coherent macro economic picture.

So what would the immediate impact of a Chinese slowdown be? I can think of a few consequences, the most concrete of these being a drop in industrial commodity unit demand. But before you jump from this thought to the imminent collapse of the commodity bubble, consider the impact of inflation. China may want slightly less tin and copper, but they may be able to pay more for it. With the amount of dollar reserves they have built up, this is hardly a strange hypothesis, although it does mean that the Chinese would have to either accept a higher level of inflation or let the renminbi appreciate.

So what does this mean for the rest of the world? It seems clearly inflationary. And really, why wouldn't you expect this to happen at some point? For almost a decade now the US has been growing the money supply at an unbelievable pace, the latest monthly figure is 36.8%. The just-so-story would go that this monetary growth hasn't been inflationary so far because the US has been exporting it to the rest of the world, which has absorbed it through a combination of a lower dollar and increasing piles of foreign reserves in those countries that have pegged their currency to the dollar. This strategy worked fine as long as these countries were busy investing in their factories and infrastructure, and selling their products back to the US. The circle closes when you realize that the US was only able to buy this stuff on the back of an enormous mountain of household equity extraction facilitated by low interest rates caused by the Chinese being willing to hold so many low yielding treasuries.

Eventually though, the world is a closed system, and if you want people to buy more stuff, you have to give them more money. Since you can't give the American consumer any more money, you're going to have to start giving it to the Chinese -- i.e. wages increases. This might paradoxically mean that you could end up having high inflation in China and other export economies pegged to the dollar, even while you end up with deflation and de-leveraging in the US as the credit bubble unwinds. US import prices would increase, at the same time as the US balance sheet would contract, requiring us to save more.

I think, however, that there may be an alternative and perhaps far scarier scenario. What if an unhappy coincidence between the US credit bubble and political circumstances in export economies created a truly international bubble, call it the China bubble. China's forced march industrialization may be completely unsustainable without the bizarre coincidence of the inflated demand of the US consumer and the Chinese willingness to finance it. This would suggest that we are seeing the end of a period of globalization marked by increasing leverage and irrational exuberance world-wide (though in different forms in different places) similar to what happened on the eve of WWI. The fallout would be a period of de-leveraging and contraction in aggregate demand similar to what happened during the great depression. On this view, people like Brad Sester and Nouriel Roubini seem much more convincing.