Is Bank of America Sick? Maybe

Its stock sure acts like it and here's a little bit of an article on the subject:

http://www.businessinsider.com/bank-of-americas-stock-collapse-2011-8?op=1

Two things disturb me about Bank of America (BAC) at the moment. One is the persistent and massive decline in its stock price. The other is the fact that even on a good day it could not rally.

The good news is that it appears that its potential capital problems probably won't come to a head all at once and it will have time to remedy them.  As bad as the past few weeks have been, this isn't at all like 2008.

Ireland and Financial Contagion

So, I believe it is time to bring out this table again of U.S. banking exposure:

As you can see, our banks have a fair amount of exposure to Ireland, but more worrying is this article from the Daily Telegraph. The exposure that British banks have to Ireland may be sufficient to sink them in their already battered state. What's more is that the current government in the UK is already somewhat hobbled by flagging approval ratings in the face of budget cuts. I am not certain how much stomach there is for potentially another big round of bailouts. International coordination might take some of the sting out of it, but we are looking at another round of substantial bailouts that are quite unpopular. Apparently, the IMF stands ready to save the day. The indications are that Ireland is actually the reluctant party and that the EU and and the IMF have been attempting to push for a bailout for some time.

Fundamentally, a bailout is needed to prevent a severe near term financial crisis in Ireland. While many have tried to point out that Ireland's government is funded through mid-2011, that is only relative to current spending. Ireland has guaranteed basically all deposits at domestic banks, meaning that widespread failures would trigger significant immediate government spending. In short, if the banking crisis gets bad enough, there is a solvency issue.

Frankly, I'm amazed that the Irish banks are still standing after a run amounting to 11% of deposits has already taken place. We'll see if an international backstop stops the bleeding. If you want to speculate on worthless Irish bank stocks, have at Anglo Irish (AIB), but what little is left of the value there is probably at risk even at these levels. At best we are probably talking serious dilution.

What if China's Real Estate Market Does Pop: U.S. Outlook

On the heels of Alex's post on his on-the-street view of the Chinese real estate market, I wanted to provide a good sense of what the actual risks are. As you may have seen earlier, I don't buy into the double-dip recession hypothesis except if there is a large unforeseen shock. Now, as soon as I wrote that, a reader might have gone "AHHHHH!!!! They've said this all before!" Indeed it does sound awfully familiar. Indeed, some friends of mine may know that I thought the 2008 recession, which I admittedly called in 2007, would be shallow and long in the absence of a total freeze in credit markets. In truth, even short of Lehman, it appears that it would have been deep in any case. So, I guess to try to be better prepared it might help to examine what are the potential channels of a relapse.

The first one we might want to examine, because its effects set in the quickest, is on the banking side. I drew up this little table that showed bank risks by country as of Q1 2010. I am quite sure these haven't changed much since then.

In relation to the risks that our banks took in the real estate sector, the risk to China is small potatoes. Even in the event of a total calamity, maybe 30% of that would be written off. Spread among the various banks that lend to China, it's not a particularly big deal. Now, I put in Japan and Korea because it's possible that some of the large financial institutions there have also been providing credit to China. I can't find data on that because: 1. The relevant websites are in their native languages most often and 2. Disclosure in most other countries isn't as good as it is here. It's actually one of the reasons the U.S. has commanded lower risk premiums over the years, recent experiences notwithstanding.

A second channel some might point to is the U.S. Treasury market where China might sell off assets and repatriate money in the event of a major financial crisis. There is actually historical precedence for that where in World War I France and the UK repatriated assets from the U.S. and helped contribute to a rather nasty decline in equity markets here. The fear is that China would cause interest rates to spike prematurely, raising borrowing costs for corporations and governments alike and that the interest rate shock could completely unsettle financial markets. However, this is only really a problem on a short term rather than a long term basis as what can happen is that the Federal Reserve could step in and soak up the sales and slowly work that off over several months in order to keep markets orderly. There is no guarantee that the Fed would do this, but they could do this.

The third major channel is of course through exports. Now, U.S. exports to China are running at about an $80 billion annual rate or so. This is about .7% of GDP. Even a huge hit to these exports of, say, 40%, would not be enough to drive the U.S. into recession, even in our presently weakened state. I have said as much before. However, I did some more thinking on this and of course there are other spill overs. Other trading partners including Brazil and Australia buy decently large amounts of capital equipment including mining machines from the U.S. in order to extract raw materials to sell to China. Add up the $36 billion at an annual rate we sell to Brazil and the $14 billion at an annual rate we sell to Australia along with maybe another $30 billion to other large natural resource extractors and you get, well, around another China's worth of secondary effects. I haven't looked closely enough at the trade data with each of those countries to know how much of what we export is actually economically cyclical, but the odds are that it is quite a bit.

Even with all of this, it would not be a calamity, but it could be enough to grind growth to a complete halt for a time given how modest growth is right now at maybe 2% annualized in the third quarter. Luckily, China seems to be dragging this real estate cycle out long enough that a crisis might not occur until our growth is a little more self-sustaining. As for some other economies, anything Australian-related worries me. They have this potential pitfall as well as their own housing bubble. Brazil would suffer badly if China suddenly stopped importing so much iron ore among other things. The same holds for Peru and Chile and whatever commodity-export countries you might think of.

Now, the Chinese real estate market should give plenty of warning signs before a collapse in both residential and non-residential investment might occur. The first would be stagnation in prices followed by a pullback of some sort. As prices drop, expectations about future returns drop leading to cancellations of building projects and a slow down in new projects. This in turn leads to a drop in the imports of raw materials and machinery. All of that actually takes some time to manifest and you can spot it in advance if you are looking for it.

Prepare for Apocalyptic Home Sales Numbers

As we have been discussing for a while now, home sales are likely to be quite weak following the expiration of the home buyer tax credit. "How weak?" you might ask? Well, let's just say they could be the lowest in any relevant time span. The expectation of economists is probably way off this time as is being discussed over on Calculated Risk.

If these sorts of sales rates are maintained (if that is the proper word to use here) prices will certainly decline again, which has been our expectation here. What that means is that even now might not have been the best time to buy a house as you will not be building up equity. Of course, it depends on the market, but most will be quite weak.

Now, as for whether or not this will push us into another recession, I don't think so. Existing home sales, which are the bulk of home sales, really aren't that economically productive as they don't reflect the production of new goods. New home sales are really about as low as they can go and were probably actually depressed by the credit pushing more people into existing homes. A decline in prices may make banks a little more skittish, though it would be hard to see how they could be more tight-fisted than they are now.

U.S. Banks' Exposure to Risky Countries

I've heard quite a bit of talk about contagion from some of the more toxic countries in the world and I think it is helpful to actually quantify what we are talking about. I made this table based on data from the Federal Reserve on bank exposure by country:

As you can see, most of the high risk countries do not pose particularly mortal threats to the banking system. This is certainly true when you compare them to the size of the commercial and residential real estate portfolios that they had as of Q1 2008. The spill-over countries are a different story, with the UK being the most problematic if there suddenly was a complete collapse of the European financial system. However, that event looks increasingly unlikely. By the way, I included Australia and China due to their large and out of control real estate bubbles.

As such, I don't fear the risk of a sudden financial shock as much as I do the slow grind of deflation. With 10-year treasuries well below 3.0% now, I think the market is indicating the same.

European Bank Stress Tests vs. U.S. Stress Tests Part 2

I think that these stress tests are the equivalent of only testing what happens to a patient's heart when they walk ten feet. Bloomberg has a good article on the subject here: http://www.bloomberg.com/news/2010-07-23/eu-bank-stress-tests-fail-to-reassure-investors-wary-of-capital-criteria.html

In our stress tests, several banks were found to be in need of tens of billions in new capital, which they subsequently raised from markets that were satisfied about the stress tests' rigor. In this case, I rather doubt markets will be satisfied once they have time to digest the results.

Quick Update of Dynamic Asset Allocation Model

The model still suggests an 80% allocation to equities in the current environment. Despite the contraction in the yield curve, the expansion of the earnings yield measure and corporate credit spreads added more than the narrowing in the yield curve took away.

On a fundamental basis, this allocation makes sense for entirely another reason. The dividend yield on the S&P 500, forgetting earnings for a moment, is just shy of 2%, so you are only giving up 1% on 10-year treasuries just there. Among those stocks that are actually paying dividends right now, the average yield is 2.54%. Further, these numbers are depressed by the fact that almost all financial stocks, normally payers of robust dividends, have pulled back over the past two years to pay virtually nothing. Case in point, JP Morgan Chase (JPM) was once a payer of a 4% dividend or better, but in order to preserve capital during the financial crisis it put that down to 0.5%.

With such a narrow differential between bonds and stocks in terms of income generation, it doesn't make long term sense to be heavily in bonds at the moment. From a trading perspective, it varies, but for those without sufficient cash to trade, it makes the most sense to be heavily in equities in the present situation.

Bank of America to Customers: We Don't Ever Want to See You

This is an interesting trend in banking. Bank of America (BAC) is giving you a strong financial incentive never to set foot in one of their branches. Really, that is what they are doing. Even to me, with as short a time as I've been on the earth, this is hard to fathom, but I suspect that over the next five years this will be much more common than not. It's amazing to think that as recently as a decade ago, banks were still trying hard to increase their number of physical branches. That seems a quaint idea now. 

Are Indian Bank Stocks Good Buys Now?

For years, the Indian bank stock, principally HDFC Bank (HDB) and ICICI Bank (IBN) have traded at earnings multiples that would make even an aggressive growth investor flinch. Back in the heady days of 2006 (at least they were heady days for emerging markets), these banks often traded at 30-40x forward earnings. That compares to the general practice of only paying 15x forward earnings or less for most bank stocks. Part of this discount, regardless of growth rate, comes from the fact that banks can in fact be prone to massive calamities. Of course, we wouldn't know anything about that. Speaking of which, I haven't seen my shares of Wachovia recently. Do you know where they might be? (Disclaimer: I never owned Wachovia)

That being said, after a few years of continued earnings growth and stagnant stock prices, it might pay to see where we are here. IBN, on its surface, seems to be the better buy, trading at around 14x next year's earnings and growing earnings at a torrid pace. HDB trades at over 21x next year's earnings with a very similar growth clip, though the market may be indicating that analyst estimates might be in error. Frustratingly, I must confess I know little of the Indian banking system, being much more familiar with Brazil's among the BRIC countries. What I do know is that the central bank is currently tightening which will probably keep these stocks under pressure for some time to come as their net interest margins come under pressure. I would say then that there is little reason to nibble here for now, but in about six months time it may be fruitful to buy one or both of these banks as long term holdings. The lofty estimates for earnings growth should be obtainable so India is a country with relatively low credit utilization.

Of course, there are those that are skeptical of India's long term prospects. I am not among them and I actually favor the long term prospects of India over those of China for the reason that I believe India to have a more fundamentally sound political system. I am sure there is going to be a great difference of opinion on that point.

European Bank Stress Tests vs. U.S. Stress Tests

I must confess some ignorance on the exact nature of the stress tests being conducted in Europe. When we conducted ours, the criteria were laid out in a fairly robust and comprehensive manner. Everyone could see what assumptions were being used and, though many scoffed at the scenarios as being too rosy, it would appear that there was some measure of success.

From what I have read, such as this post from Naked Capitalism, the tests do not include possible losses that the banks would incur from sovereign debt defaults. In other words, say the fictional Bismarck Financial had $50 billion in equity, but $75 billion in holdings of sovereign debt from Greece, Portugal, and Spain, they would be wiped out in a rolling series of debt defaults. However, under the stress tests (as I understand them), these exposures would be excluded. That would have been similar to if in our own stress tests we had excluded the possibility of further house price declines and rising mortgage defaults. As it turned out, the estimates for house price declines in our own stress tests were actually much more pessimistic than what panned out.

This brings me to a point here for those looking at Europe right now. Our own stress tests, despite being widely mocked by the more pessimistic analysts and observers, actually did  a good job of quantifying the unquantifiable. The most dangerous aspect of early 2009 was that no one knew the exposure the banks were facing and financial markets froze under the uncertainty. It was nearly impossible to raise capital to replenish the equity positions of these companies. The stress tests provided a benchmark from which investors could use differing assumptions on whether or not a bank could be saved and decide then whether to supply it with more capital. As it turned out, as I recall anyway, not one of the major banks tested has since failed or had to be swallowed up by another in an emergency basis in the way that National City and Wachovia were in late 2008.

This was all possible because the standards being used were transparent and they were actually fairly sensible. I liken it to if a company forecasts that based on 4% GDP growth they expect to earn $4.50 a share. You can say that's nonsense and you think the economy will only grow 1% so they will earn less, but it's all out in the open and the market can decide, based on good information, what price capital can be raised at. From this perspective, the European stress tests do no seem adequate and I think it would be wrong to apply the relative success of our own experience to Europe.