This note was originally published at 8am on September 27, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
“I am a contrarian in the sense of being willing to take on perceived risk as opposed to actual risk, because the market pays you for taking perceived risk. You may or may not get paid for taking actual risk.”
- Wilbur Ross
Wilbur Ross’s quote above gets to the heart of the question facing markets today. Is the risk in the market actual or only perceived? Well, consider some of the following data points.
Bank of America 5-year credit default swaps traded at 402 bps on Thursday of last week, a new all-time high (then dropped slightly to 382 bps yesterday). Morgan Stanley’s credit default swaps closed Friday at 440 bps. 21 of the 40 largest European banks now have their swaps trading over 300 bps, 13 of which are trading over 400 bps and 10 of which are trading over 700 bps. A default swap at 300 bps implies approximately a 20% probability of default, 400 bps equates to a default probability around 25%, and 700 bps of annual premium works out to around a 40% default probability.
At the end of the second quarter 2011, Bank of America had $74.8 trillion of gross notional derivatives outstanding, second largest among US banks (JPMorgan leads the pack). Of that $74.8 trillion, $4.1 trillion represents OTC credit derivatives. Morgan Stanley has $56.4 trillion in notional derivatives outstanding, $5.7 trillion of which are OTC credit derivatives. Of course, the vast majority of these notional derivatives are offset positions that should be effectively hedged (assuming no single large counterparty defaults).
So what does all this mean? Notional derivatives show the size of a bank's counterparty risk, and cds shows the likelihood a bank will default (according to the market). Together, they give us an idea of the problem we have on our hands. The market is currently saying that BAC – a bank with $76 trillion of gross derivatives exposure – has roughly a 25% chance of default. Today, the majority of the systemic risk to the system is coming out of Europe and is likely to be addressed head-on on Thursday at the German Bundestag vote. The market rallied yesterday amid speculation that the EFSF can lever the 440 billion Euro fund up to 2 trillion Euros. However, the German courts may not allow the facility to use leverage without first getting additional approvals from the Bundestag. Stay tuned.
Looking beyond the systemic risk posed by Europe and large bank counterparty exposure, fundamentally, the problems of the US Financials have been on three fronts thus far this year:
- First, there’s been the ongoing issue of mortgage putbacks and great uncertainty on the part of investors around what the true liabilities are for companies with large mortgage exposures like Bank of America. This explains why tangible book value offers no support to the stock. BAC is currently trading at approximately 50% of tangible book value.
- Second, systemically important financial institutions (SIFIs) were hit this summer with an aggressively punitive capital surcharge under Basel 3 of 2.5%. This is in addition to existing Tier 1 common requirements of 7.0%. The largest US banks (JPM, BAC, C, WFC) will all be hit by this. This is one of the factors calling into question whether Bank of America needs to raise common equity. For reference, BAC has approximately $115 billion in tier 1 common capital under Basel 3 but needs $171 billion to be fully compliant (a shortfall of roughly $56 billion), though, importantly, they are not required to reach this level of capital until January 1, 2019, which is obviously a long time from now.
- Third, falling revenues and deteriorating fundamentals are putting the squeeze on the banks’ ability to navigate through these challenges. The newest problem facing the sector is that of declining margins (revenue) hitting simultaneously with rising credit and operating costs. Take Bank of America as an example. In 2Q, the company reported roughly $2 billion in non-cash pre-tax earnings from releasing credit card loan loss reserves through the income statement. For several quarters now, these non-cash pre-tax earnings have been used to offset cash expenses associated with higher mortgage servicing related costs and mortgage putback expenses. The catch is that those credit card reserve release non-cash earnings are about to come to an end for all six of the largest US card issuers (BAC, JPM, C, COF, DFS & AXP). This will occur at the same time that the Fed’s Operation Twist will really start putting the squeeze on bank net interest margins. Earth to the Fed: flattening the long end when banks have no more room to take down funding costs is not going to help bank margins.
None of these issues are going away – or are they? On Friday there was an interesting story out of Bloomberg talking about the upcoming Basel meeting this week (Tuesday & Wednesday). The Basel Committee on Banking Supervision – the same folks who gave us the 250 bps SIFI surcharge this summer – is now considering the need for changes to those surcharges. Not surprisingly, large lenders in the crosshairs of these new rules feel they’re unfair and would like to see them changed. This is a matter of politics, and we have no real edge on the outcome, but we would point out that a substantial chunk of the 34% downside in the XLF since February 21 of this year can be traced back to SIFI surcharge pronouncements this summer. While it’s hard to precisely deconvolve how much of the selloff is attributable to each of the three factors we itemized earlier, an announcement of capital relief by Basel would trigger a material rally in the Financials. Keep your antennae tuned to this potentially important development.
Finally, on a completely unrelated note, take a look at NYSE margin debt. Margin debt hit its post-2007 peak in April of this year at $320.7 billion. Let’s put things in context. The chart below shows the S&P 500 overlaid against NYSE margin debt going back to 1997. In this chart both the S&P 500 and margin debt have been inflation adjusted (back to 1990 dollar levels), and we’re showing margin debt levels in standard deviations relative to the mean covering the period 1997-2011. While this may sound complicated, the message is really quite simple. There are two important takeaways. First, when margin debt gets to 1.5 standard deviations or greater, as it did this past April, that has historically been a signal of extreme risk in the equity market - the last two times it did this the equity market lost half its value in the ensuing period). We flagged this for the first time back in May of this year.
The second point is that margin debt trends tend to exhibit high degrees of autocorrelation. For those unfamiliar, autocorrelation is simply a statistical term that means that trends tend to continue. In other words, the last few month’s change in margin debt is the best predictor of the change we’ll see in the next few months. This is important because it means that margin debt, which has retraced back to +0.64 standard deviations as of August, still has a long way to go. We would need to see it approach -0.5 to -1.0 standard deviations before the trend reversed. We’ve dropped 230 S&P handles in getting from +1.5 standard deviations to +0.64 standard deviations. Bear in mind there’s plenty of room for short/intermediate term reversals within this broader secular move. That said, this setup represents a material headwind for the market.
Josh Steiner, CFA