U.S. Bank CDS Rising, but Still Low

Last week, Rick wrote an entry describing how we’re watching closely for any signs of banking sector stress in Europe as they continue to wrestle with their debt crisis. We are also keeping close tabs on the U.S. financial sector, which is still one of the largest sectors in the S&P 500 Index despite all of the problems of the past few years.

Financials are the worst performing sector in the S&P so far this year, indicating that things still aren’t quite right there. The XLF Financial Sector ETF was off by -3.7% YTD through yesterday, while the S&P was up by 5.2%. And on Wednesday, which was a rough day for the market in general, Financials got hit especially hard as news broke that Goldman Sachs was dealt a subpoena under a new investigation into its mortgage securities business by the New York Attorney General. Investors may be rightfully wondering if the recent action in Financials is portending something ugly for the rest of the market, as it did in 2007.

While Financials’ equity market performance is troubling, the CDS market is telling a different story at the moment. CDS, or Credit Default Swaps, are used by hedge funds and other large investors essentially as a form of insurance. They purchase the contracts to hedge against the risk of default for specific companies. As the cost of CDS increases, it’s usually a negative signal that investors are suddenly clamoring for protection, driving the price higher.

The chart below shows an average of the CDS for 34 U.S. banks.  The line has crept a bit higher recently along with general volatility in the financial markets. But, it’s still lower than where it started the year. Also, since the chart goes back a couple of years it offers some perspective, illustrating that bank CDS is still well below levels reached last year and during the financial crisis of 2008. In short, we aren’t seeing anything alarming at this point in banking CDS.

Banks

We were tossing around a question yesterday regarding the current stock market rally from the July lows, and whether it can continue without the banks participating. The banks in this discussion are the big boys – JP Morgan, Citigroup, Bank of America, Wells Fargo, etc. The S&P 500 is up 15.5% from the July low (before today’s action which was a 4 point loss) while the banks, as measured by KBE (SPDR Bank ETF), were only up 4% from the July low (although down 2.5% today). Additionally, as you will notice in the chart below, the banks are still down over 19% from the April highs. The S&P 500 is the red line, which is approaching the April high after breaking through the June and August highs, and the KBE is the blue line, which has failed to make a new high!

Even so, at this time, the answer to our question is “yes.” The markets can and have rallied without the banks and it seems like they will continue to do so on the back of Federal Reserve stimulus. Consumer Staple stocks and Utility stocks have already surpassed the April high mark with Technology and Industrials hot on their trail. Material stocks are up 26% and Energy stocks are up 21% from the July lows. It is not only a rally but an incredibly strong one for many sectors and industries.

It seems this is just a bank specific issue at the moment as other financial industries like Capital Markets are fairing much better. Today, the cost of insurance for bank stocks is on the rise as indicated by rising Credit Default Swap levels. The fallout from faux-closure and a weak JP Morgan earnings report are causing investors to re-price risk in these stocks. All the while, investors in other stocks could care less.

But I can’t help but feel like it is 2007 all over again. The financials began selling off before any other sector in the market and we all know how that episode ended. Could MBS be the market’s downfall again?

Amhran na bhFiann

Yes, the PIIGS (Portugal, Italy, Ireland, Greece, & Spain) have made headlines once again. With the Greek tragedy continuing, for the hero has still not encountered misfortune, Ireland has thrust itself into the spotlight. Today, the government announced its plans to create a ‘bad bank’ to purchase bad debt from Irish banks and lending institutions. Additionally, they implemented rules that could result in more banks being nationalized. This plan is very similar to plans enacted by the United States in 1989 with the creation of the Resolution Trust Corporation and Sweden in 1992 with S&R. However, this solution has not been utilized in the developed world during the current financial crisis, as governments have chosen to use capital injections to repair the banks instead.

Looking at some of the details, the Irish government will spend 8.5 billion Euros to purchase 1,200 loans valued at 16 billion Euros. The price paid is an astonishing average discount, or price below par value, of 47%. First, the price paid should be a little concerning to U.S. financial sector investors, since many loans here are still marked close to par. Second, and as equally important, it shows how badly the European financial sector has been hit by the financial crisis and housing bubbles. And there is still much work to be done to repair the damage.

John Mauldin recently wrote a piece titled “What Does Greece Mean to You?” In it, he comes to the not so simple conclusion that “…Greece is important? Because so much of their debt is on the books of European banks. Hundreds of billions of dollars worth.” Financial institutions in the developed world are on a precipitous cliff, since a default of similar magnitude would be very bad. Now, the Greek situation has improved recently but we still need the European Central Bank and International Monetary Fund to develop a long term solution. We need to restore confidence in the market, or we will quickly see how many nations follow this tragic path.

Are Financials Getting the Respect They Deserve?

Once upon a time the U.S. financial sector was deemed to be the most liquid and respected in the world. Financial firms in the U.S. were symbols of the strength and innovation of the U.S. capital markets, and companies like Goldman Sachs, J.P. Morgan and Citigroup were great quality names that any money manager could hold as a staple in an equity portfolio. That was before the housing market collapsed and exposed the rot in the banking system that had built on the back on a loose regulatory framework, market complacency, and of course, a good helping of pure greed.

These days, U.S. financial companies are not viewed with much respect; in fact the underlying mood in the wake of the financial crash is one of skepticism regarding anything financial-related. Combine this financial distrust with the possibility of a new and frugal U.S. consumer, and a regulatory and political environment that appears to be reversing from a long-term tailwind into a driving headwind, and it’s not hard to see why investors would question the sustainability of earnings and the appropriate market multiple for the financial sector.

At Pinnacle, we agree that structural headwinds will most likely create a difficult secular environment for financials. However, we also realize that we don’t have the luxury of investing client money over very long secular time frames, so instead our process focuses on investing over cyclical markets cycles. Some positive cyclical fundamentals for financials right now include an ultra steep yield curve that boosts profitability, and mega-consolidation within the industry that has paired payrolls to the bone and left those still standing with less competition. Yes, there are plenty of risks that still remain in the banking sector. Commercial mortgage problems still linger, a new wave of Option ARM re-sets is creating uncertainty regarding capital adequacy, and leadership in Washington appears to be turning up the heat on the regulatory front. These risks have kept us from investing more than just a small allocation to financials.

But despite these concerns, it has also been a risky proposition for managers benchmarked to the S&P 500 Index to be out of the sector entirely. Over the past year the broad financial sector ETF (XLF) has been ranked among the top three sectors (there are 10 in the S&P 500) for the year to date, trailing three months, and one year timeframes. It is the number one ranked sector on a trailing one year and three month basis, and the second leading sector on a year to date basis. I was glancing at these numbers just yesterday. As I looked at the numbers (see chart) and thought about the prevailing skepticism regarding the sector, I was forced to contemplate whether financials are currently getting the respect they deserve?

Accounting Rules in the Spotlight – Again

Earlier this year, a lot of attention was paid to “mark to market” accounting (officially, FASB rule 157). The debate was heated, as critics of the rule blamed it for dramatically worsening the financial crisis, while proponents argued that it improved transparency. The rule was ultimately relaxed in March largely due to pressure from Congress (even though the Financial Accounting Standards Board is supposedly an independent organization). That change helped stem the losses flowing out of the financial sector and helped spark the huge turnaround in financial markets.

Now, a new set of rules from the FASB is ruffling some feathers again. FASB rules 166 & 167 require financial companies to bring many of the assets held in off-balance sheet entities back onto their balance sheets by early next year, which could impede the healing in that sector by requiring additional capital to be raised by those firms.

It remains to be seen exactly what the impact of the rules will be, but the market may already be anticipating a negative outcome. After rocketing off the March low and leading the market higher for several months, financial stocks have recently been underperforming. Whether that’s directly related to the new rules or is just a temporary pause isn’t entirely clear yet. We currently have only a very modest weighting in Financials due to the many ongoing challenges in the sector, and will be paying close attention to how they act as the rules take effect.

Chart: Financial Sector ETF (red line, top panel) vs. S&P 500 ETF (blue line, top panel) with relative strength (green line, lower panel) – Financials have been underperforming since 10/14