Bearish on bank stocks

I think it should be abundantly clear that I am bearish on financials given my sell equities call two weeks ago.  After all, it was the banking sector which I was most bullish on in April – August. They are also the stocks that have run up the most as well.  But now is the time to sell.  Why?  The conditions which created the bull run are effectively over.  Here was the notice that put me over into the bearish camp. It came last week:

US banks will have to pay $45bn in up-front fees to the Federal Deposit Insurance Corporation under a plan presented on Tuesday to shore up the FDIC’s depleted deposit insurance fund. The agency warned it will run out of liquid funds early next year due to bank failures, and said the estimated cost of expected failures from 2009 to 2013 had increased to about $100bn from an earlier estimate of $70bn. Most failures are expected this year and next.

Paying $45 billion in capital is an enormous impediment to increases in capital for the financial sector and the worst-case scenario for credit growth. This is very bearish for bank stocks and the broader economy as well.

I see it as a tad ironic that the agency tasked with seizing insolvent banks has run out of money and must tap the very pool of institutions for accelerated payments.

The FDIC chose this option for political purposes as their options were limited.

1. Borrow from the banks. Their was a leak by the New York Times last week that the FDIC was considering borrowing from the very companies it regulated in order to recoup lost funds. I criticized this proposal harshly because it could only lead to regulatory capture at the FDIC – the least captured of America’s regulators. The general public reaction was wildly negative to the leaked information. This is a crazy but legal idea that Sheila Bair was forced to defend – but reject as not ‘serious in the same breath (see my comments here).
2. Borrow from the Treasury. The Obama Administration was able to get Congress to authorize the FDIC a $500 billion line of credit back in May. This seemed like a great fallback then.  But, with the Federal deficit spiraling out of control and people yelling about government intervention in the healthcare debate, no one in Washington wants to be seen tapping what could be construed as taxpayer money. Bair said “I think there’s some recognition that . . . everyone’s got bail-out fatigue and should be extricating themselves from government support, not getting in deeper.”
3. Tax the banks in a special assessment. I say ‘tax’ because the special assessment idea which was being considered was bad for optics.  Banks are not lending because they ostensibly have a weak capital position. So, you want to go in and weaken that base further by ‘taxing’ them?  OK, now we know who to blame when the double dip recession happens.
4. Get the banks to pre-pay. This is the option chosen. Let’s be honest, there is zero difference between this option and the third option above except this is couched as money the banks will have to pay anyway. Not a very good option, really.  But, are there other choices?

Now, if you are running a bank and still expecting a decent number of writedowns in commercial property, residential mortgages, and credit cards, you are not too thrilled to have to pre-pay your FDIC insurance premiums. Then you hear Dick Fisher of the Dallas Fed and Don Kohn the Fed Vice Chairman jawboning in a hawkish way like they are going to raise rates. Not that you believe them, but still.  If Sheila Bair comes around asking for a pound of flesh, you are already feeling a bit beaten down.  I guarantee you this is not going to be good for lending.

But of course, there’s always the government spin:

John Dugan, an FDIC board member and the comptroller of the currency, said he supported the “thoughtful” proposal.

The only downside, he said, was that the cash provided to the FDIC would not then be used by the banking industry to provide loans. “This may not be likely to have a material effect on credit availability . . . but I think this is an important question,” he said.

OK. Keep telling yourself this won’t affect lending. But, owners of bank shares have to look at the situation a bit more dispassionately.   Back in April, I said:

Despite obvious problems with the bailout packages provided by the U.S. government and a huge amount of writedowns still coming due, I now fully anticipate that 2009 will surprise to the upside in financial services… I see financial services companies shedding troubled assets, not marking other assets to market and having an enormous margin spread due to ridiculously low interest rates. To me, this is a huge buy signal.

And the rally has been MUCH more than I expected.

Amongst larger banks, Bank of America (BAC) is at $16 and change from $2.53, up over 600%. JPMorgan Chase (JPM) is up almost 400% from March lows. Wells Fargo (WFC) is up over 300% from the lows. Even Citi is up over 400% –and I thought they were dead money.

Amongst large regionals, you have Fifth Third (FITB) up over 900% from a near bankruptcy valuation. Zions (ZION) is up nearly 300%. SunTrust is up more than 300% too. 

I think you get the point. There has been the mother of all rallies for bank stocks. But, this is going to change.  The low-hanging fruit (government bailouts, subsidized borrowing, low interest rates, huge spread margins, bonus payments for lending) has been picked. 

Prepare for tough headwinds:

1. A flattening yield curve
2. FDIC pre-payments
3. A withdrawal of subsidized borrowing
4. Larger commercial mortgage losses

I expect the momentum born of upside earnings surprises to turn to the dread of earnings warnings.

Update 2009 10 05: Goldman is singing a different tune and has upgraded the big banks in the sector today.  I agree that the TBTF institutions will outperform, but can or will they rise further from here? Credit Suisse is cutting earnings estimates. Stay tuned.

More update: Chris Whalen is apoplectic that Goldman is upgrading the too-big-to-fail banks and has given his own downbeat assessment, a view I shared on Credit Writedowns just yesterday. See his comments and video here.