Posted by: Ben Levisohn on April 6, 2009
The banking sector has been banging its head against its recent highs and those with a bearish disposition need to look no further than Mike Mayo’s latest report, “The Seven Deadly Sins of Banking,” for a confirmation of their negative views. Mayo weighs in with his first report since leaving Deutsche Bank for CLSA (allegedly because he was too bearish) and he doesn’t disappoint – or pull his punches. His report documents how we got into this mess. But more importantly, since the market is a forward looking beast, Mayo and his team explain why banking – and bank stocks – won’t be returning to their lofty heights any time soon. The reasons include:
Bad loans: At the height of the credit boom, banks gorged themselves on loans to risky borrowers. And those loans are only now starting to go bad. Sure, we may be halfway through the mortgage cycle, but loan losses in consumer credit, commercial real estate and industrial loans are only now gaining steam. Mayo expects losses to swell to 3.5%, 10 basis points above the Great Depression peak, from its current rate of 2%. It’s not quite an apples-to-apples comparison, however. Today’s banks have huge amounts of home equity, credit card and construction loans, loans that either didn’t exits in 1929 or were comparatively small. The bottom line however remains the same.
Smaller, less profitable institutions: Financial industry revenue rose only 5% during the 2000s, down from an industry average of 8% during the 1990s. But you wouldn’t know it from looking at the earnings. Banks goosed their profits by boosting leverage and making high risk loans, but without the fig leaf of leverage and risk profits should stay down, even after the overhang of bad loans and securities have been dealt with. Higher insurance fees, perhaps as high as 3%, won’t help matters.
Government action: In the short term, government action could dictate the direction of bank stocks. Stress tests will be completed in late-April and the public-private investment plan could be up and running in May. And the threat to replace management or even nationalize the banks still looms. Government action is unpredictable and “a key reason for [Mayo’s] negative bias on the group.”
Sound reasonable to me. Any bulls care to pick his argument apart?