To Kevin Conn, who has been analyzing bank stocks for 15 years, the investment climate for Wall Street’s biggest firms has entered the realm of science fiction.
“It’s like that Ray Bradbury short story where it rains for months in a row,” said Conn, who works for Massachusetts Financial Services Co., referring to “The Long Rain,” published in 1950. “It’s one of these terrifically depressing short stories where the weather just never changes.”
For banks such as Citigroup Inc., Goldman Sachs Group Inc. and Deutsche Bank AG, the downpour shows few signs of stopping. Almost four years after the financial crisis, their stocks are trading below liquidation values as investors like Boston-based MFS, which manages $285 billion, forecast no rebound in revenue or profitability soon. Last month’s shareholder rejection of executive pay at Citigroup is the most public symptom of the frustration with large lenders and their managements.
“For whatever you’ve seen publicly that’s happened in the last six months on pay, multiply that times 10 and that’s what’s actually going on in private” between investors and bank executives, said Benjamin Hesse, who manages five financial- stock funds and leads a team of 15 analysts at Boston-based Fidelity Investments. “Breakups are likely, but I’m not sure they happen in the next six to 12 months.”
Goldman Sachs Chief Executive Officer Lloyd C. Blankfein, who runs the fifth-largest U.S. bank by assets, and JPMorgan Chase & Co. CEO Jamie Dimon, who heads the biggest, have sought to reassure investors that investment-banking and trading revenue will bounce back. Even though markets rose in the first quarter, Blankfein said his firm’s 12.2 percent return on equity, a measure of how well a company reinvests shareholder capital, was weaker than what Goldman Sachs expects to earn when the business cycle improves.
“I tend to be a little more optimistic than what I’m hearing from other people,” Blankfein, 57, told Bloomberg Television’s Erik Schatzker on April 25. “One of the big risks that people have to contemplate is that things go right.”
Dimon, 56, expressed a similar view at a Feb. 28 presentation about revenue at his investment bank.
“Is the downturn you saw in the fourth quarter cyclical or secular?” Dimon said. “ We’re telling you it is cyclical. I’m not hedging that. It is cyclical.”
Spokesmen for JPMorgan and Goldman Sachs, both based in New York, declined to comment.
Wall Street analysts are signaling agreement: 85 percent of those who cover JPMorgan have buy ratings on its shares, according to data compiled by Bloomberg. Of those who follow Citigroup, the third-largest lender, 69 percent say buy.
‘World Has Changed’
The depressed stock prices of the biggest banks indicate that investors aren’t convinced. Instead of anticipating a revival of trading and investment-banking profits, shareholders are waiting for the firms to reduce headcount and pay across the board, even for CEOs. They see the banking boom before the 2008 financial crisis as unlikely to return amid stricter regulation and efforts to reduce sovereign debt.
“The world has changed now,” Fidelity’s Hesse said.
Analysts including Charles Peabody at Portales Partners LLC and Meredith Whitney at Meredith Whitney Advisory Group LLC anticipate a deterioration this year after revenue from fixed- income trading and mortgage lending improved in the first quarter compared with the previous three months.
“By the end of this year, we are going to have another round of headcount reductions because the revenue I just do not see as sustainable,” Peabody said in an April 19 “Bloomberg Surveillance” radio interview with Tom Keene and Ken Prewitt. “We are going to see a severe economic slowdown in the second half of this year, and maybe a recession in 2013.”
Tangible Book Value
The pessimism runs counter to the 26 percent gain in the 24-company KBW Bank Index in the first quarter. Even after a 43 percent jump in its stock this year, Bank of America Corp.’s closing share price yesterday of $7.96 was less than two-thirds of the Charlotte, North Carolina-based lender’s $12.87 in tangible book value per share at the end of March. Tangible book value is a bank’s estimate of how much money would remain if all its assets were liquidated and liabilities paid off. Morgan Stanley is trading at about 60 percent of liquidation value.
Of the five largest Wall Street banks in the U.S., only JPMorgan is trading above its tangible book value per share, Bloomberg data show. Before the 2008 financial crisis, the stocks occasionally exceeded three times tangible book.
One reason: Investors don’t trust the numbers.
“How do you determine book?” said Matthew McCormick, who helps oversee $6.2 billion at Cincinnati-based Bahl & Gaynor Inc. and doesn’t hold stocks of big Wall Street banks. “That’s the $64,000 question, because the true liabilities can’t be ascertained. You have to make more macro calls. There’s still a lot of risk.”
Investors also are waiting to hear from Moody’s Investors Service, which said in February that it’s reviewing the creditworthiness of 17 banks and securities firms with global capital-market operations. The firm said it may cut ratings on Morgan Stanley, Credit Suisse Group AG and UBS AG by as many as three levels. Downgrades would force the banks to post more collateral on derivatives trades and pay more to borrow.
U.S.-focused lenders such as San Francisco-based Wells Fargo & Co. and U.S. Bancorp have higher valuations than the financial conglomerates that own global investment banks. Wells Fargo, the fourth-largest U.S. lender, is trading at 1.75 times its tangible book value, while Minneapolis-based U.S. Bancorp’s stock price is almost three times its liquidation value.
Buffett on Banks
Berkshire Hathaway Inc., led by billionaire Warren Buffett, is the biggest shareholder in Wells Fargo and also owns stakes in U.S. Bancorp and Buffalo, New York-based M&T Bank Corp. Berkshire holds warrants in Goldman Sachs and preferred stock and warrants in Bank of America, and Buffett has said he owns JPMorgan stock in his personal account.
“The American banking system is in fine shape,” Buffett said at a May 5 meeting of Berkshire investors in Omaha, Nebraska. “I would put European banks and American banks in two very different categories.”
The U.S. lenders with the highest valuations are those without global investment-banking and trading businesses, because they have the least counterparty risk to European companies and governments, said Hesse of Fidelity, whose firm manages $1.6 trillion.
‘A Lot Worse’
Conn, who started covering bank stocks at Sanford C. Bernstein & Co. in 1997 and joined MFS in 2001, said he has become more negative on the big banks amid signs that low interest rates and Europe’s sovereign-debt crisis, which are weighing on profits and share prices, aren’t going away.
“It’s actually a lot worse than I would have guessed three or four years ago,” he said. “The persistence and the duration of these problems feel like there aren’t short-term fixes.”
Conn and Hesse declined to comment on specific stocks or their funds’ investments, citing company policies.
New capital requirements and regulation are making bank stocks more like utilities, with “lower and more stable” returns, Conn said. Still, most pay dividends below the 3 percent yield that income-oriented investors demand, he said.
Investors can no longer analyze banks using a traditional one- or two-year horizon and instead are making short-term trading bets or taking views of five years or more, said Hesse, the primary analyst at Fidelity responsible for large U.S. lenders such as Bank of America, JPMorgan and Morgan Stanley and global investment banks including Deutsche Bank, based in Frankfurt, and Credit Suisse and UBS, both in Zurich.
The future of the euro may be determined in the next six months -- an outcome that could lead Wall Street bank stocks either to drop 50 percent or rise 25 percent, Hesse said. After that, he said, he expects investors to focus on the potential impact of U.S. government fiscal policy on the country’s growth and borrowing costs.
“If you model out a euro breakup for these things, U.S. banks all lose 20 percent of tangible book” value, Hesse said. In the U.S., “the austerity we could potentially attempt makes Spain look like nothing.”
At the same time, banks are grappling with a reduction in return on equity because regulators have demanded they hold more capital, Hesse said. Excluding provisions, revenue fell last year at each of the six biggest U.S. banks except for Morgan Stanley. Bank of America, Citigroup, Morgan Stanley and Goldman Sachs had returns on equity below 10 percent.
With so many factors outside their control eroding profitability, banks have to try to boost returns using the only tools they have, Hesse said.
“They’re getting rid of investment bankers, they’re getting rid of traders, they’re getting rid of higher-priced guys and moving juniors into covering their biggest accounts,” Hesse said. “You’re seeing a big repricing of financial- services talent at the big banks.”
Shareholders such as Hesse are part of the reason. He said he spoke last year to the top 300 people at one of the world’s 10 biggest investment banks and presented statistics on how much the industry paid employees over the past decade compared with how much it generated in profit before taxes and provisions.
“The statistics were not attractive,” Hesse said. “Employees took home multiples of what investors did.”
Bank of America plans to eliminate more than 300 jobs from its investment-banking and trading units, a person briefed on the matter said this month. That’s in addition to a companywide cost-saving program initiated last year to cut 30,000 positions.
“You’re going to see a drastically reduced workforce, you just have to,” Whitney of Meredith Whitney Advisory said in a May 3 “Bloomberg Surveillance” interview. “Eighty percent of revenues on Wall Street over the last 10 years came from Europe and the U.S. That’s a staggering number considering that the U.S. and Europe are in contracting mode.”
Investors also are pushing back on executive pay. In Europe, Barclays Plc and UBS faced mounting opposition to their compensation plans this year. At London-based Barclays, 27 percent of shareholders opposed the $19.5 million pay award to CEO Robert Diamond, up from 10 percent a year earlier. UBS, Switzerland’s biggest bank, won approval from 60 percent of shareholders on its 2011 compensation report in a consultative vote, down from 64 percent the prior year.
Citigroup’s board said in a statement it would “carefully consider” the shareholder vote, which isn’t binding.
Hesse said most of the stocks he follows are trading below tangible book value per share because investors aren’t sure reducing expenses is the solution.
“What the market’s telling you is either they won’t be able to achieve the cost cuts, or if they are able to achieve the cost cuts they’ll do it at the expense of revenue,” Hesse said. “Or the macro uncertainty is just too big.”
Investors, who already traded financial stocks at a discount to the Standard & Poor’s 500 Index because of the difficulty analyzing their balance sheets, have become even more distrustful since the 2008 crisis, MFS’s Conn said.
“Historically, investors have been wary of the balance sheets,” he said. “But now ‘they’re just un-investable at any cost’ is this overarching theme. It will just take a lot of time before people start to trust again -- trust the managements and trust the numbers.”
Bankers can only hope Conn is as wrong about his forecast as Bradbury was about Venus, where “The Long Rain” was set. In 1962, a dozen years after the story was published, the Mariner 2 spacecraft determined that the planet’s surface temperature was at least 800 degrees Fahrenheit -- too hot for rain.
© Copyright 2013 Bloomberg News. All rights reserved.