Six Reasons Why Goldman Is Wrong to Call a Banking Recovery in 2011
On Thursday night, I appeared on CNBC's The Kudlow Report to debate whether the banking industry is at the start of a period of recovery. Goldman Sachs (GS) this week stated that thanks to economic growth in 2011, the banking industry will enjoy a recovery. I argued that Goldman was wrong -- for many reasons.
Why did Goldman suggest that banks were on the rise? Its analysts, led by Richard Ramsden, said that stronger economic growth, higher stock prices and low interest rates would cause financial stocks to outperform the broader market in 2011 and 2012, according to Dow Jones Newswires. Ramsden's note said, "With a better macro backdrop, the growth outlook for the sector improves significantly next year." Goldman notes that "financials will deliver market-leading earnings growth" in each of the next two years.
How dare I disagree with Goldman Sachs? Perhaps because banks are suffering from a huge overhang of bad loans, as well as declining revenues with little prospect for growth. Here are six observations to support those conclusions:
Declining revenues. I analyzed the quarterly statements of three big banks and found that each suffered declining revenues in the first nine months of 2010. JPMorgan Chase's (JPM) revenues dropped 1%, Citigroup (C) suffered an 18% decline, and Bank of America's (BAC) revenues lost 7%.
Ongoing huge overhang of bad loans. Big banks are still boosting how much they set aside to cover the cost of that uncollectable debt. Allowances for loan losses grew by 17% to $44 billion at Bank of America, 13% to $35 billion at J.P. Morgan, and 21% to $43.6 billion at Citigroup.
Big piles of illiquid, hard-to-value assets. Huge proportions of bank assets are classified Level 2 or Level 3, meaning they're illiquid and lack a definite value -- the institutions have put book values on them that may or may not reflect reality. For example 94% of BofA's assets -- more than $2.6 trillion worth -- are Level 2 or Level 3 which means that a 9% decline in their value could wipe out BofA's capital base. For Citigroup, the percentages are 86% and 14% respectively while JPMorgan's comparable figures are 88% and 7%.
No reason for banks to take the risk of boosting new loans. Why loan money to real people when you can take advantage of the risk-free trade of borrowing from the Fed at near 0% rates and buying U.S. government securities yielding over 2%?
Corporate loan demand is unlikely to rise. Corporations are hoarding cash -- $1.84 trillion worth at last count -- so there is no need for them to borrow from banks. If they do need to borrow, they can issue bonds at extremely low rates of around 2.5% -- much lower than the rate of a bank loan (the prime rate is 3.5%).
Consumers are in no mood to borrow. In fact, they're paying down debt. Americans are deleveraging because there are 15 million people out of work, the unemployment rate is 9.8%, wages are flat. Therefore banks won't make as much money on excessive consumer credit card borrowing as they did before.
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Given those facts, either Goldman is making its case for bank stocks based on reasons that it's not disclosing, or its rationale is flimsy. In any case, I would avoid bank stocks -- even if they do end up paying dividends. After all, if another negative surprise leaks out, those share prices will tumble fast -- regardless of whether they're paying a dividend.
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