As panic over the health of European banks exploded in recent weeks, investors began to wonder about the well-being of their counterparts in the U.S. On Tuesday, August 23, those fears coalesced around the largest U.S. lender, Bank of America Corp. credit default swaps to insure against default of the company’s debt soared 47, to 427. BofA shares dropped to $6.01 that same day, down from a 52-week high of $15.31. They had recovered to $6.99 as of August 24, and the entire U.S. banking sector appeared poised for a huge rally on the morning of August 25, when BofA shares were up 21 percent on news that Warren Buffett would invest $5 billion in the lender, praising it as a “strong, well-led company.”
What has driven the wild volatility? Bank of America, which bought Merrill Lynch & Co. and mortgage lender Countrywide Financial Corp. during the financial crisis, has massive exposure to the still-struggling housing market. Investors are also concerned about its about its exposure, both direct and through derivatives, to European sovereign debt. Those fears have been compounded by troubling economic reports, which raised the question: How would U.S. banks in general, and BofA in particular, hold up if the U.S. slowdown continues to accelerate? “The recent downturn in the banking sector? I suspect it amounts to nothing more than a credible bet that these banks are not in any condition to withstand the next recession,” Barry Ritholz, CEO of quantitative research firm Fusion IQ, wrote on Wednesday, August 24, on his blog, The Big Picture. “A rise in unemployment and another next leg down in Housing could very well be fatal.”
Not everyone agrees. “I am impressed with the profit-generating abilities of this franchise and that they are acting aggressively to put their challenges behind them,” Buffett said in a statement. His investment company, Berkshire Hathaway , bought warrants that allow it to purchase 700 million shares of BofA, or about 7 percent of the company, for $7.14 each. The bank said in a statement that it would not have to issue new shares as a result of the transaction.
The pressure on U.S. banking stocks, and the broader market, has eased over the past few days amid somewhat more encouraging economic data and hopes that the Federal Reserve will take steps to calm markets and boost the economy. On Tuesday the spread between bank credit and five-year Treasury bills was high, with BofA leading the pack at 450 basis points. Morgan Stanley came in second at 365 basis points, followed by Goldman Sachs Group (350), Citigroup (275), JPMorgan Chase & Co. (200) and Wells Fargo & Co. (165), according to AllianceBernstein.
The price of CDS protection on Bank of America plunged to 275 on Thursday morning after news of the Buffett investment.
Going forward, bank valuations will be driven to a great extent by the course of the economy, which as yet is unclear. How vulnerable are U.S. banks, especially if the U.S. economy or the European sovereign debt crisis continues to worsen?
Here are two ways to look at the sector.
Strategist: Ashish Shah, co-head of global credit investment at AllianceBernstein
View on U.S. banks: The sell-off “doesn’t make a ton of sense.”
How legitimate are investor concerns over the safety of U.S. banks?
Spreads on banks in the U.S. are back to summer of 2009 levels. That doesn’t make a ton of sense given the recapitalization and deleveraging that has occurred at U.S. banks. There is broad market concern around contagion from what is going on in the financial markets in Europe and the slowdown in the global economy. While U.S. banks will definitely see asset quality deterioration if the U.S. goes into recession, they will see much less than what they experienced in 2008.
The challenge globally is the European banking sector. The sector is long a significant amount of European sovereign risk — all of which is coming under attack. The basis of this concern is that no European country issues debt in its own currency (unlike the U.S. or U.K.). As a result, they are all subject to liquidity runs. Most European governments carry on-balance-sheet debt that is “that is’? much higher than emerging-markets countries. This leaves them quite vulnerable. This is especially true in the context of a slow growth environment where the debt is difficult to “grow into.” Exacerbating the problem is the European Central Bank tightening liquidity because of their inflation concerns. This tightening has created a liquidity environment that is bad for financial market stability, and that has spilled into the U.S.
How would a recession or continued economic slowdown affect U.S. banks?
It’s important to keep in mind that the severity of the ’08 recession has led most of the weaker borrowers to default. This, combined with three years of materially higher lending standards, will lead to much lower bank losses if we go through another recession.
Many investors are particularly concerned about Bank of America’s prospects of withstanding a recession, especially given its exposure to the housing market in the U.S. Are those fears justified?
We believe that Bank of America’s mortgage liabilities are manageable within their current earnings power and capital.
Strategist: Max Rudolph, actuary, CFA and founder of Rudolph Financial Consulting in Omaha, Nebraska.
View on U.S. banks: “I worry about the unintended consequences of the interaction of all kinds of risks.”
What is driving fears about the safety of U.S. banks?
There are a few drivers. The concerns about sovereign debt in Europe are coming to a head. There continues to be a lack of transparency over which banks have the most exposure to that debt, so investors end up throwing out the baby with the bathwater. Maybe some of the banks have very limited exposure, but you just can’t tell. My gut tells me most U.S. banks have direct or indirect exposure to that debt through CDS or other assets. A bigger risk in the U.S. is whether we go back into recession. If we have even a mild recession, there will be problems for U.S. banks. Again: It’s a transparency issue. We can’t tell which banks have the most exposure. We don’t know which banks have completely marked these assets to market. They have unrealized gains which have not been exposed to the investing public. Every time something bad happens, it comes to investors as a surprise, so investors come to expect more surprises.
And I worry about the unintended consequences of the interaction of all kinds of risks, from overbuilding in China to the exposure of money market funds to sovereign debt, and how those interactions would affect banks.
Do you think that the level of concern regarding Bank of America is justified?
I think so. The market certainly implies that the concerns are serious. Due to its exposure to the housing market, it will be vulnerable even in a mild recession. It is difficult for anyone to say what the extent of those vulnerabilties are. I am an actuary and a private investor, and it is hard for me to get a handle on what a bank’s exposure to risk is. There is no way of knowing, and that is part of the issue. Dodd Frank was supposed to force banks to be much more open about their balance sheets. But because of delays in implementation and the influence of lobbyists on the law itself, that transparency has not yet been achieved. It is too easy for banks to hide losses on the housing side. The assumptions about losses and risk are very sensitive. If they estimate the default rate at 14 percent and it turns out to be 15 percent, that makes a difference.
Do you expect U.S. banks to raise additional capital?
Bank of America may not choose to tap the public markets because the yield that it would have to pay is so high. But I could see other types of financial institutions raising more capital. And I wouldn’t be surprised to see more consolidation in the banking sector either.
There has been some speculation over the past few weeks that Bank of America could be sold. Would that be feasible?
I don’t think even JPMorgan could absorb all of Bank of America. If it was sold, it probably would be broken into pieces.
