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Banks, on the Front Line once again?

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bank_1(Sept. 21 - Erwan Mahe) The financial shares that were in the deepest trouble in February have also rebounded the most with the powerful surge in stock markets from their low in March 2009  (+60% in Europe and the US).

Banks whose solvency ratios dipped to dangerously low levels have enjoyed spectacular rallies:  Bank of America  +610%, Citibank +400%, RBS + 475%, Barclays + 640%, Fortress +650%.

While these financial institutions have not returned to their pre-crisis market caps, they have been riding a steep yield curve, while benefiting from seamless support from governments (the Lehman shock more than ever!) and reduced competition, and are now being valued on the basis of marked upsurge in structural profitability.

 

Check out this NY Times article, which traces the evolution of the major banks: How the Giants of Finance Shrank, Then Grew, Under the Financial Crisis.

However, the newsflow in recent days argues for a more discriminatory uptake on the situation of banks, some of which are having a hard time keeping their heads above water, and, in general, on new regulations governing bank profitability.

Lloyds and RBS, for example, would like to reduce its exposure to APS (the government’s Asset Protection Scheme). The shareholder investment plan would prevent the government’s stake in the bank from rising further but it would lead to a substantial dilution of the existing share base in favour of the issuance of new shares for UKFI to remunerate the government for providing this guarantee. This will entail asset disposals, required by Brussels, anyway, given the government support, and new share issues.

But Spanish banks are also in the news. For the time being, they have skirted the worst of the crisis, but many analysts are surprised by their resistance, given the collapse of the real estate sector on the Iberian Peninsula.

BBVA is reportedly ready to sell and lease-back 1,350 branch offices to a Deutsche Bank infrastructure fund. The move would generate a gain of €1.2bn. Santander would raise €5bn, i.e. twice the initial figure, by selling 13.21% of Banco Santander Brazil via an IPO. Bear in mind that the Spanish banks’ loan default rate totalled 4.73% in July, i.e. €87.5bn, or double the figure for the same period last year! With unemployment at 18.5% and a still troubled real estate sector, this ratio could double again.

Moreover, certain banks are hindered from smoothing losses over time due to their practice of making debt to equity swaps with their stressed clients, thereby converting them into shareholders of major real estate developers and building societies or direct owners of land and buildings.

In a country which has as many homes for sale as the United States, despite having one-sixth the population, and where real estate debt to banks totals €470bn, this is looking more and more like a Japanese scenario for our Spanish friends.

On the other hand, Mr Stark might say that, since the country represents a mere 10% of European GDP, there is no risk of deflation or credit crunch on the zone…

As for the United States, the article, New finance rule necessitates pain for banks, explains how the new bank capital requirements to diminish leverage will have an average 25% impact on their profitability.

What is incredible is the totally pro-cyclical aspect of these measures. It would have made much more sense to institute these moves when former Citigroup CEO Chuck Prince carried on like he was the captain of the Titanic, with his statement that “As long as the music is playing,         

The big question now is:

How will banks be able to reconcile the following constraints?

- Lower their leverage, either by increasing their capital or by lowering their exposure.

- Continue to help finance the economy by increasing lending, as regularly demanded by political officials who want to see their aid translate into a real recovery in lending.

-    In Europe, the need to replace part of their hybrid capital by core capital.

-    In the US, the need to contribute to the replenishment of FDIC funds, which will undoubtedly soon draw on its credit line at the US Treasury ($500bn), if the scenario of Institutional Risk Analytics proves to be clairvoyant.

While the FDIC has “only” 400 banks on its short watch list, IRA has given an F, its worst rating, to 2,256 of them. As such, it estimates that the FDIC’s cumulative losses could climb to $400bn to $500bn, while its security cushion has contracted from $60bn to $10bn since last autumn.

Considering the hue and cry raised by the association of US banks when the FDIC imposed a “special” contribution of $5bn, we can only imagine what would happen if the IRA’s estimates of funds that will need to be recovered turn out to be true.

As for Debt Deflation, check out the article in the Telegraph on the situation with our Baltic friends. Swedbank reports that 30% of the mortgages in Estonia are in negative equity, where GDP is set to contract 14.5%, i.e. twice the decline in Iceland!

Lucky that Mr Weber recognised this morning that inflationary risk is unlikely in the near future …

Investment focus:

- We remain favourable to fixed interest rate instruments, now with a bias more favourable to the 5-10 year range than to our 2-year champion.

- On stock markets, we have returned to a negative bias after hitting our Eurostoxx targets in the 2850-2900 range.



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