Source: Daniel Case
Last week we heard optimistic noises coming from some of the top executives in the world of mortgage finance at the Americatalyst 2017 event. Falling interest rates have managed to get new applications for mortgage refinancing even with purchase loans for the first time in months, this as the 30-year mortgage has fallen back to pre-election levels. We're still calling for the 10-year Treasury to go to 2% yield or lower.
The good news for Q3 ’17 earnings is that production volumes and spreads are improving for many lenders after a dreadful start of the year. Bad news is that falling yields on the 10-year Treasury implies a significant mark-down for mortgage servicing rights (MSRs). The movement of benchmark interest rates, coupled with significantly lower lending volumes and surging prices for collateral, could make Q3 ’17 a very interesting – and treacherous – earnings period for financials with exposure to MSRs and other aspects of residential housing finance.
Away from the blissful consideration of the housing sector, tongues were set wagging late last week when Liz Hoffman at The Wall Street Journal reported that Goldman Sachs (NYSE:GS) commodities head Greg Agran will leave the firm. “Mr. Agran’s departure follows the worst slump in Goldman’s commodities unit since the firm went public in 1999. Bad bets on the prices of natural gas and oil contributed to a second quarter in which the unit barely made money,” The Wall Street Journal reported.
The GS “Fixed Income, Currency and Commodities Client Execution” (FICC) arm has seen performance fall by double digits sequentially and year-over-year, causing investors to ask whether Wall Street’s preeminent trading shop has lost its edge. With investment banking and asset management essentially flat last quarter, GS’s net income dropped sequentially. Only a strong performance in equities prevented GS from seeing the Institutional Client Services income line break below $3 billion last quarter.
Even though our contacts in the world of credit have been reporting better-than-expected results in the world of energy production, many Wall Street firms have been playing the long-side of energy (and bond yields), and with disastrous results. GS under Agran’s direction in particular was reportedly stung by taking principal exposures related to the Marcellus shale market in OH and PA. This fact is significant for several reasons.
As we discussed last week with Paul Murphy, CEO of energy lending specialist Cadence Bancorp (NASDAQ:CADE), prices for natural gas are unlikely to see great upward volatility any time soon. Oil prices too remain under considerable downward pressure as domestic producers continue to develop new ways to cut production costs. “The Permian is still red hot with people paying high prices for acreage,” Murphy reports. “The Permian works at $49 per barrel all day every day.”
While most commercial banks can make money primarily by lending, GS is forced to earn its profits by being smarter than other market execution platforms and thereby attracting institutional client trading volumes. Many buy side investors give their business to GS because they believe – rightly or not – that the boys of Broad Street have an edge when it comes to market intelligence.
But the past few quarters of underperformance by FICC and the particular misstep with respect to the Marcellus trade suggest that GS may be losing its premier cachet when it comes to market acumen and related mindshare among institutional customers. Indeed, since the start of 2017, GS has significantly under-performed its peers and the S&P 500.
With a price-to-book ratio over 1 and a beta of 1.4, GS is still quite fully valued – especially when you consider that the Street has negative revenue growth rates for the bank for the rest of the year. But magically the Street has GS showing a 4% positive revenue growth rate for 2018 and a 20% positive earnings growth rate to boot. Wall Street, after all, is about selling hope.
Looking at the big picture for all US banks, commodities trading for customers has not be a strong contributor to total earnings since the implementation of the Volcker Rule in 2012. First comes investment banking fees, followed by credit products which contributed significantly to Q2 ’17 results. Income from commodities and other exposures has significantly trailed other components of non-interest income for all US banks. Notice how the big negative swings in credit contributed to losses in the 2008 and 2012 periods.
For universal banks such as GS, a lot of trading and other types of capital markets activity is conducted outside of the bank in the broker-dealer and is not captured by the FDIC data. For GS, total non-interest income of $14.9 billion at Q2 ‘17 is about 3x the bank’s $5.9 billion in net interest income, the reverse of the distribution seen in most large banks in Peer Group 1. Or to put it another way, the net interest income of most US banks averages 2x the non-interest income.
With non-interest income at GS equal to 3.37% of total assets vs 1.3% for most large banks, the dependence of GS on transactional income is pretty much total. In many respects, GS is a hedge fund with FDIC insurance and access to the Fed's discount window. But not being able to overtly trade its own account represents a huge disadvantage compared with its larger peers.
There are an awful lot of former GS bankers running around Washington, but the fact that Chief Executive Lloyd Blankfein and his colleagues actually allowed a bet on rising gas prices anywhere makes us wonder. Just about anybody and everybody The IRA speaks to regarding energy prices thinks that natural gas is a dead trade for years to come. The fact that GS chose to bet on whether a privately funded pipeline would be completed on a date certain illustrates the risks that universal banks must take to earn their keep.
More, as Liz Hoffman reported in the Journal in August, the ill-fated Goldman trade with Marcellus apparently was to ride the price up as the transportation related discount for production from that region ended, but that sure looks like a principal trade to us. Why is GS even making wagers on Marcellus shale for its own account given the Volcker Rule? Good question. You can be pretty sure that nobody in the bank regulatory community will deign to ask that question so long as former Goldman President Gary Cohn remains employed at the White House.
But then again, just about every major Wall Street bank has its own list of exceptions to the Volcker Rule. Look at the earlier chart and note the way that income from credit positions has languished until last quarter. Isn’t that remarkable? Could it be that the largest Wall Street banks are already starting to cheat with respect to Volcker Rule compliance by trading credit exposures for their own account on the assumption that this part of Dodd-Frank will eventually be repealed?
The banking industry has made repeal of the Volcker Rule its number one priority in Washington, perhaps explaining the large number of GS alumni operating inside the Beltway since the election of Donald Trump. But to us, the real question with GS and the Volcker Rule is whether the smallest of the major universal banks can survive long-term without being able to aggressively trade its own account.
With larger players such as JPMorgan (NYSE:JPM), Bank of America (NYSE:BAC) and Wells Fargo (NYSE:WFC) able to use their balance sheets to win business, GS is the low man on the proverbial totem pole of big banks. Will the firm that survived the Great Crash of 1929, the Mexican peso crisis and the financial collapse of 2008 be the next name to follow in the unfortunate footsteps of Lehman Brothers and Bear, Stearns & Co?
This Hedgeye Guest Contributor piece was written by Christopher Whalen, author of the new book Ford Men and chairman of Whalen Global Advisors. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington. This piece does not necessarily reflect the opinion of Hedgeye.