Jordan Wealth Management Group - ScotiaMcLeod Truro

May 13, 2009. The KBW Bank Index has rallied nearly 150% since the March 6^th low with some stocks in the index more than tripling in value. U.S. banks were discounting a worst case scenario at the beginning of March, most notably the risk or fear of partial or full nationalization. Further, the U.S. government’s decision to undertake an extensive review of major financial institutions to determine capital adequacy, only added to confusion and concern. With both events now in the rearview mirror and the sector up sharply, where to from here?

To begin with, the stress tests were designed to ensure major U.S. financial institutions have sufficient capital to weather the rest of the recession. Under an adverse scenario the government estimated losses could approach nearly U$600 billion. To satisfy capital requirements, they’ve directed 10 of the 19 financial institutions under review to raise an additional U$74.6 billion through the sale of new equity, conversion of preferred shares to common equity, or the sale of assets. Additional capital requirements are not overly onerous and the process was vigorous enough to satisfy most analysts and reassure investors.

The stress test results provided additional relief to a market that believes it has seen the worst of the financial crisis and recession. To be sure, economic data suggests a bottoming process is in place, and corporate spreads are gapping in. It is highly unlikely we will see another failure of a major U.S. financial institution. Investors and analysts alike are now shifting their focus from tangible common equity and solvency ratios to recovery and normalized earnings levels. First quarter bank earnings surprised to the upside and there is talk of banks repaying TARP funds as some banks appear over capitalized. Some analysts note that pre-provision earnings for many banks are strong and earnings could soar when the economy recovers. While valuations are looking stretched on the basis of price to earnings, on book value they look cheap by historical standards.

However, it may not be all smooth sailing from here. While the banking sector is on the road to recovery, U.S. banks are still on life support. Take away all of the special lending facilities and TARP funds and the industry is likely to run into trouble again. Government intervention will come at a cost (greater regulatory oversight) and higher mandated capital requirements and deleveraging will reduce earnings power. There is a lot of talk about "normalized earnings", but what are normalized earnings when the industry is undergoing such broad structural changes. The asset securitization business model that worked so well for the industry before the credit crisis began is still broken. Stronger than expected first quarter earnings were a head fake, as they were driven by a number of one-time items and far too dependant on trading revenue. Core retail and commercial banking operations were characterized as weak by many analysts and economists. While the industry is consolidating, many analysts believe there is still excess lending capacity that will place pressure on interest margins. Also, banks are unlikely to be active lenders anytime soon as the stress test exercise forces them to scale back on lending activities. A sustained recovery in the banking sector is highly dependant on the broader economy. Record amounts of stimulus and inventory re-stocking should lead to a sharp rebound in U.S. GDP sometime in the second half of the year. However, housing prices are still falling and consumer credit is contracting for the first time in over 15 years. The shadow banking system (hedge funds, structured investment vehicles, conduits, pension funds, and investment banks) were an integral part of the credit creation process and the downsizing of the hedge fund industry, SIVs and conduits could impede economic recovery. They all played an important role in the asset securitization business model that was so prevalent amongst the "big" banks. In recent testimony, Fed Chairman Ben Bernanke said the recovery could be long and painful with high unemployment and little pricing power for companies. Business investment and commercial real estate remain mired in recession.

With signs the economy may be bottoming and the threat of nationalization fading, bank stocks needed to be re-priced. However, shorter term the pendulum may be swinging too far the other way. Bank stocks are now due for a pause as investors need to re-evaluate fundamentals. A correction in the banking sector will likely be both a function of price and time. In the earliest stages of recovery, the weakest players lead the rally before quality begins to outperform. Consolidation should provide the time for analysts and investors to differentiate between the two.