It’s Time to Bail on Bank Stocks

Money Morning Article of the Week

by Martin Hutchinson, Global Investing Strategist, Money Morning

There was a time when bank stocks actually looked like good investments. And many, having racked up big gains over the past two years, proved to be just that.

But sadly, U.S. banks no longer offer the value and profit-making potential they did immediately following the financial collapse. In fact, they’re actually heading for what could be a catastrophic decline.  Let me explain. On February 18, 2009, I wrote a piece that said bank stocks should not be written off.

I observed at the time that the best U.S. banks had huge business strengths that were not fully undermined by the financial crisis. So I advised investors buy shares of the best among them.

As it turns out, that recommendation may have been too timid.

That is, most bank stocks – including some of the weakest and least investment-worthy – have surged since my article’s publication.

Even following a lukewarm second quarter and last week’s market meltdown, the top six banks – Citigroup Inc. (NYSE: C), Bank of America Corp. (NYSE: BAC), JPMorgan Chase & Co. (NYSE: JPM), Wells Fargo & Co. (WFC), Goldman Sachs Group Inc. (NYSE: GS), and Morgan Stanley (NYSE: MS) – are in a relatively impressive position.

Take a look for yourself:

• Goldman Sachs stock is up about 22%.
• Bank of America is up 30%.
• JPMorgan is up about 49%.
• And Wells Fargo is up 55%.

Only Citigroup, down about 13%, and Morgan Stanley, down 20%, have seen their stock plunge.

But in light of this remarkable run up, and the disastrous pitfalls that lie ahead, now is the time to bail on bank stocks.

Margins are narrowing, government regulation is increasing, and the outlook for big deals is drying up.

In other words: The risks related to bank stocks are as present as they ever were – just the profitability is missing.

A New Investment Game

Truth be told, traditional bank lending is no longer as profitable as it once was. The lengthy recession has dampened opportunities, and corporations are building large cash reserves, reducing their need for bank financing.

Still, the bigger problem is that there’s too much incentive right now for banks to borrow short-term at near-zero interest rates, and then invest in Treasuries.

Of course, now even that strategy is being squeezed by the continuing decline of Treasury bond rates. In the wake of Standard & Poor’s U.S. credit rating downgrade, the yield on the 10-year Treasury note fell as low as 2.03% from a high this year of 3.77%.

Monetary policy remains bank-friendly – and the Fed has indicated it will stay that way until at least 2013 – but that window won’t stay open forever. Rates eventually will have to rise to fend off inflation.

More importantly, trading profits have shown signs of turning into losses. The revelation a few weeks ago that Goldman Sachs – with more market and inside knowledge than any institution in the universe – took a loss on proprietary trading in 2006 – 2010 is a poor reflection on Goldman’s bankers, as well as the potential for this business.

The bank-government relationship also has shown signs of souring.

Political Risks

Banks hired an army of lobbyists to comb regulations out of the Dodd-Frank Financial Reform Act and court the favor of politicians. But a lengthy recession and bleak employment figures have awakened people to the lack of small business lending by banks. Lending to small businesses is still down 25% from 2008 levels.

Another political risk is that the worldwide push for higher capital ratios shows no signs of diminishing. In an ideal world, that push would be extended to government debt, which at the moment is unfairly subsidized by having a zero capital allocation, as if it were actually risk-free. But that’s not the world we live in, and higher capital ratios inevitably mean lower profitability.

More dangerous, the new bipartisan commission charged with finding solutions to the nation’s debt crisis have one obvious tax increase to propose: a limitation in mortgage tax relief, a subsidy which benefits the rich and wasteful at the expense of the poor and thrifty who pay off their mortgages and pay taxes at lower marginal rates.

Should this happen, the housing market would go into another tailspin, at least at the top end (where the tax relief is more significant – with interest rates as low as they currently are, a $200,000 mortgage does not carry enough interest to benefit much).

Sticking with the housing market, the scandals over mortgage repossessions has slowed their pace to a trickle. In one sense that’s a relief to the banks, which have no means of selling the millions of houses they would otherwise be coming to own. But at the same time, the housing market will not recover until the overhang of dead mortgages has been worked down.

That’s another threat to bank profitability.

You might think that bankers will be the ones who suffer the most if profits continue to thin, but you’d be wrong.

The reality is that the ratio of staff costs to profits is notably higher in the less profitable institutions, which believe they have to “keep up with the market.” So when profits are lower overall, staff remuneration ratios increase.

Thus shareholders will suffer more than bankers from the new period of austerity. They will bear any losses, and quite possibly more than 100% of the inevitable declines in profits.

In the “too-big-to-fail” era banks may get bailed out, but shareholders don’t.

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