The Macro Strategist

David P. Goldman

+1 917 915 2985

dgoldman@macrostrategy.com

Where's the Risk in American Banks?

Tuesday, November 01, 2011
SUMMARY
Shortly before the close today, Bank of America was down 3.66% while Socit
Gnrale was down more than 16%. The market is right to distinguish between
American financials whose balance sheets have shed risk since 2008, and European
financials, who are saddled with the brunt of the European sovereign crisis. We
remain short European financials and again recommend cautiously adding exposure
to American financials.
Since 2008, American banks shed subprime and bought governments; European
banks also bought governments, but they turned out to be subprime. Don't touch
any part of the European bank capital structure (except to short it).
We continue to believe that the political class of Greece as well as Italy is incapable
of the measures that would be required to sanitize state finances, including the sale
of crown-jewel assets to foreign investors.
European financial deterioration will have far less impact on American equities than
the market appears to believe.
Exhibit 1: Overnight and Continuing Repos, US Primary Dealers

Financing of
securities at
American brokerdealers remains a
third below the
2008 peak

Source: New York Federal Reserve

The Macro Strategist

Where's the Risk?

We haven't changed our view since September 5, when we wrote (in "Hopeless But
Not Serious"):
Italian backtracking on promised fiscal discipline and the sixth-in-a-row state
election loss for Germany's ruling party triggered another round of pessimism
about the likelihood of a solution to the southern European economic mess.
The pessimism is justified: the most probable outcome is that Italy's $1.4
trillion sovereign debt will take a 40% or 50% haircut, the Italians and Greeks
will leave the Euro, and French banks (among others) will require
recapitalization.
That said, is the market reacting appropriately? Today's response (a ding for American
banks and a blow-up of European bank equity prices) is about correct. Morgan Stanley
was down by 11% at today's worst, a nonsensical overreaction (but still down a silly
7.5% close to the close). But there is a lot of catching up to be done: European banks
are still trading higher than some US banks vs. pre-2008 levels.

US banks own
Treasuries, not
structured
securities

The bad news is always the good news: the reason that American banks can't make
any money is that they can't find risk to put on their books. The highly profitable
business of financing hedge funds through the repo marketone source of contagion
concern during the Lehman Crisishas fallen by a third since 2008, as Exhibit 1 on
page 1 shows. We observe in Exhibit 2 that risky securities at US banks have shrunk
by a fifth since the crisis. That is not surprising, given the collapse of structured
product issuance. The securities that offered banks a phony Aaa/AAA rating and a 25
basis point spread above LIBOR have become legacy assets tucked into the back book,
and their principal continues to run off rapidly.
Exhibit 2: Non-Treasury Securities at US Banks

Source: CBOE, Macrostrategy calculations

2 Where's the Risk in American Banks?

The Macro Strategist

MF Global seems to have spooked the market, after Jon Corzine's European
government bond trade contributed to the demise of the broker-dealer. But the fact is
that risk is diminishing among broker-dealers.
The amount of leverage on broker-dealer books, meanwhile, continues to shrink. We
observe in Exhibit 3 overleaf that shareholders' equity as a percentage of total balance
sheet has improved substantially since 2008.
Exhibit 3: Ownership Equity/Assets, Securities Industry

Equity has
returned to 5% of
assets in the
broker-dealer
industry from only
3% in 2007

Source: SIFMA

What does not make sense is that European banks still are trading at higher levels
than the most beaten-up American franchises, namely Citi and Bank of America.
EXHIBIT 4: SELECTED US AND EUROPEAN BANKS, JANUARY 2, 2006 = 100

What's wrong
with this picture?

3 Where's the Risk in American Banks?

The Macro Strategist

The comparison is even more relevant to preferred stocks. There is now a nearly 4point (or 20%) price difference between the preferred stocks of Bank of America and
Deutsche Bank, respectively.
EXHIBIT 5: BAC 6% PREFERRED (IKR VS. DEUTSCHE BANK 6.375% PREFERRED (DUA)

Source: NYSE

There's an enormous difference between the problems of American banks stemming

from the subprime catastrophe and exposure to shaky commercial real estate, and the
sovereign debt problems of European banks. In the wake of the 2008 crisis, American
banks loaded on Treasury debt after 2008, buying nearly half a trillion dollars of US
government instruments.
EXHIBIT 6: TREASURY SECURITIES AT US BANKS

Source: Federal Reserve

4 Where's the Risk in American Banks?

The Macro Strategist

European banks loaded up on higher-yielding European government debt. The risky

part of American banks' portfolios blew up in 2008. It has since been cauterized, and
overall balance sheet risk is diminishing. The risk on European banks' books was
supposed to diminish as well, but it was the supposedly safe portion of European bank
balance sheets that exploded.

Zombies are hard

to kill

There's no reason to expect American banks to make much money during the next
year. Non-performing loans will be somewhat worse than the banks forecast, if the
price of structured home equity and commercial real estate securities is any guide (see
"Portfolio Implications of the Recovery in Business Investment"). The flat yield curve
leaves little room for the banks to make money in that market. The recovery in
commercial and industrial lending is proceeding slowly and will have little impact on
earnings in the short-term. They are, in fact, zombies, but that is not a bad thing.
Zombies are not dead, and they are hard to kill.
EXHIBIT 7: WHY SHOULD CITI TRADE IN LOCKSTEP WITH (AND LOWER THAN)
UNICREDITO? DAILY DATA SINCE JAN. 1, 2006

Source: Federal Reserve

Short European financials, long American would have paid well today, and I doubt the
trade is close to finished.

5 Where's the Risk in American Banks?