Bank shares have been something of a one-way bullish bet for quite some time. But several developments suggest the sector, especially small and mid-size lenders, could come under significant pressure in the months ahead.
For one thing, authorities have in recent days stepped up their warnings about looming problems in commercial real estate (CRE), which will almost certainly hurt the industry. Elizabeth Warren, chairperson of the TARP Congressional Oversight Panel, noted in a CNBC interview that there were nearly 3,000 banks that have "'dangerous concentrations in commercial real estate lending.'" As a result, she said, "the economy will face a 'very serious problem' that will have to be resolved over the next three years."
In another CNBC interview (recapped by Business Insider), Federal Deposit Insurance Corporation Chairperson Sheila Bair said "bank failures will be higher this year than last." She added that regional banks have "significant exposure" to CRE, "which will be the key driver of bank failings this year," and that "small banks are having to reserve against loan [losses], which is hurting their ability to lend."
Double Dipsand Higher Rates
It's not just commercial real estate that poses a threat to the sector. The hoped-for recovery in the residential real estate market is also sputtering out. A recent report from real estate information provider Zillow.com, detailed by Bloomberg, revealed that 12 U.S. cities, including Boulder, Colorado, and Providence, Rhode Island, are showing extended declines in housing values, reversing signs of a sustained recovery last year. According to Zillow, the number of markets in a "double dip" in January was more than twice the five reported in December.
But real estate-related woes aren't the only risk, especially to those institutions that haven't been deemed "too big to fail." According to The Wall Street Journal's Source blog, "the U.S. banking industry is poised for another round of capital-raising, this time by mid-sized and smaller banks." However, as Fred Price, managing principal and co-founder of Sandler O'Neill & Partners, an investment bank focused on financial services puts it, for "the roughly one third of all banks whose health is only middling, and the third that is in poor shape, the capital markets are not likely to be receptive."
Another concern for the sector is the prospect of higher rates. With the Treasury Department looking to raise trillions of dollars to finance bailouts, stimulus programs, and the federal deficit, and the Federal Reserve seeking to "normalize" monetary policy and scale back purchases of mortgage-backed and other securities, supply-and-demand pressures are likely to push bond yields higher. Investor uncertainty about future inflation and worries about risks in sovereign bond markets on the heels of problems in Greece and elsewhere will only make matters worse.
As the accompanying graph shows, rising bond yields have historically been associated with lagging sector performance. One reason why many lenders tend to do poorly in such an environment is because they have traditionally made money by "borrowing short and lending long." Simply put, that means their funding costs tend to rise faster than the income they receive on mortgages and other loans. Many also have large bond portfolios that generally lose value in a rising interest rate environment.
Finally, it's worth pointing out that bank shares have been star performers since the year began, with the S&P Banks Index up by 18%, or more than three times as much as the S&P 500 Index. More impressive still, the bank sector has jumped by 172% since the lows of last March, or twice as much as the market. With a number of sentiment and technical indicators flashing caution signals, and with the quarter quickly coming to an end, that could be the trigger for a bout of profit-taking -- or worse -- especially in those shares that have performed best.
In sum, while the rally in the shares has been a boon for banking-sector investors over the past year or so, it seems that the time is right to take some chips off the table.