Thursday, March 3, 2011

What To Do With Bank Stocks?

The financial sector represents almost 16% of the S&P 500.

Only the technology sector (roughly 19% of the S&P) is a larger weighting. So if you are managing equity portfolios that use the S&P as a benchmark (as I do), you have to try to figure out how you invest in the sector.

It was only a little more than 2 years ago that the banking and brokerage sectors nearly collapsed. Without the aggressive intervention of the Fed and Treasury departments, the economic consequences would have been dire.

Although it is very trendy these days to blame government for everything, the simple truth is that the federal government saved the day. Not only is commerce gradually returning to normal, but the costs to the taxpayers (mostly in the form of TARP) has turned out to be nearly zero.

Who would have thought.

Problem now is that the very same problems that nearly destroyed the system are still very much evident. There still remain thousands, if not millions, of home mortgage loans that are underwater, and the outlook for housing is still very poor, in my opinion. Derivative products tied to mortgage loans also are pervasive in the system.

Then there's the problem of growth. Speaking as someone who works at a bank, we have lots of money to lend, but face a real paucity of credit-worthy borrowers. This is part of the problem the Fed is facing, by the way: the central bank can keep adding money to the system, but it is largely being reinvested in Treasurys, which doesn't do too much to either help the economy (or help bank profits, for that matter).

I ran across a couple of good comments about the banking sector that do a good job of describing where the current situation.

First, from The Economist, which compares the large multinationals to the experience of the Japanese banks in the 1990's:

But it is the second decade of Japan’s banking depression that carries the gloomier message, especially for Western bank shareholders. They should not be deluded by the recent flurry of reasonable results into thinking that their prospects are rosy. When the private sector is deleveraging and interest rates are low, banks normally struggle to make adequate profits. To ensure long-term prosperity, European and American firms will surely have to cut costs and re-engineer products more than they have done so far. It will take a long time.

Then there's the article in Der Spiegel, the German news magazine. The most recent issue features an interview with economist Barry Eichengreen, who describes the situation of the European banks as follows:

Europe's banks are in far greater danger than people realize. Most people now understand that last year's stress tests didn't tell us much. The tests were a token gesture and lacked realistic scenarios. They completely ignored the liquidity risks that banks could face. Regulators will not be allowed to get away with that this time. However, what would put my mind at rest more would be if the responsibility for carrying out the stress tests went to the European Commission. National regulators are too susceptible to pressure from the regulated.

SPIEGEL: How much money do the banks need to crisis-proof their balance sheets?

Eichengreen: As a rough estimate, I'd put the costs for recapitalizing the German and French banks at 3 percent of Franco-German gross domestic product.

SPIEGEL: So about €180 billion.,1518,748239,00.html#ref=nlint

So you can see my problem.