Rising Banking Problems!

Charts created using Omega TradeStation 2000i.  Chart data supplied by Dial Data

This morning I woke up to the following headline: Before the Bell: Stocks set to plunge on Fed, Portugal worries (Globe and Mail, July 10, 2014). While many would no doubt centre on statements from the June FOMC meeting one of more important aspects of the story may well be that Banco Espirito Santo of Portugal was covering up a potential $1.8 billion hole in its accounts through accounting chicanery. Banco Espirito apparently missed a debt payment.

Banco Espirito Santo may be a small bank when put beside the global behemoths but oddly it is sometimes these small banks are the source or start point of a global banking crisis. The Dow Jones Industrials (DJI) fell roughly 1% in early trading. The other concern of the markets was statements from the FOMC that “market participants were not factoring in sufficient uncertainty about the path of the economy and monetary policy”.

A number of market pundits have pointed out the desire of investors to chase yield. With interest rates continuing to drag along multi-year lows numerous investors are instead chasing yield in dividend paying stocks and other stocks that provide either dividends, tax preferred dividends or just high yield usually through the purchase of high yield (junk) bonds. Many believe that investors are not factoring in the risk of holding these types of instruments. If there was one thing that was a real shock during the 2008 financial crash is waking up and discovering that all the dividend paying stocks including bank preferreds were down 50% as well. When the banking crisis gets underway, it would appear that everything is “tossed” out.

If another financial crash were to occur it most likely will come from another banking crisis. Financial history is replete with banking crises. With the stock markets trading at multi year highs complacency sets in and everyone forgets that the issues that caused the financial crisis of 2008 were never addressed. Banks, especially the global banking behemoths, are very powerful both financially and politically and attempts to bring them under tighter regulation has been consistently brushed aside.

In the US Glass Seagall, the act that separated securities operations from commercial banking was repealed in 1999 under the Clinton administration. Since then the banking behemoths have grown substantially and former large securities firms (Goldman Sachs, Morgan Stanley etc.) have turned themselves into bank holding companies in order to be eligible for FDIC insurance in the event of a collapse. Both of these banking and securities trading giants were amongst those receiving bailout money as a result of the 2008 financial crisis. Yet it was the banking industry that was behind the 2008 financial collapse as a result of a massive buildup in derivatives trading and loans in the mortgage industry known as sub-prime.

The large banking behemoths of both the EU and the US were at the “heart” of LIBOR rigging, currency rigging and energy price rigging. As well, the large banks that set the daily gold “fix” have been under investigation for gold price rigging. One bank, Deutsch Bank of Germany dropped out of the gold “fix” process and also dropped out of gold trading.

Banks have been under fire for all sorts of misdeeds. Huge fines have been levied. The most recent is the $9 billion fine being levied by US regulators against BNP Paribas, France’s largest bank, for evading US sanctions against Cuba, Iran and the Sudan. BNP pleaded guilty to criminal charges of conspiracy and falsifying records. It is not the largest fine but the fine exceeded BNP’s profits in 2013. The risk to BNP of not paying the fine was that they would be barred from operating in the US. There has been talk that BNP in order to get around things might start more trade in currencies other than US$ so that settlements do not have to go through New York. The vast majority of global trade continues to be in US$ and settlement is through New York.

Other banks have also paid huge fines: JP Morgan Chase $13 billion for chicanery related to mortgage backed securities (MBS); Bank of America $11.8 billion for chicanery related to mortgage foreclosures; Bank of America again $11.6 billion for mortgage repurchases plus another $9.3 billion related to more chicanery related to MBS. The list is lengthy and it is not just the US banking regulators that have fined banks; fines have also been levied by EU banking regulators. Invariably the fines are leveled against the world’s largest banks from the EU and the US. They dominate global banking.

An interesting factoid is that JP Morgan Chase (JPM-NYSE), the US’s largest bank, has assets estimated at $2.5 trillion (2013). At that level, JPM is larger than all but six of the world’s economies.

Even Canada’s banks have come under fire. Canada is believed to have the world’s strongest banking system with the Canadian banks well capitalized and well regulated. Still Canada’s banks are not immune to a global banking crisis. During the 2008 financial crisis Canada’s banks were the recipients of funds from the Government of Canada. Canada, like the EU, the US and Japan will in future no longer bail out banks with taxpayers money. The word going forward is bail-ins that instead of taxpayers funds at risk in the event of a banking crisis it is depositor’s funds. Moody’s Investors Services, a large rating agency, has revised its outlook on the Canadian banking system to negative given the reluctance of the government to bail out banks in the event of a banking crisis.

None of this is to suggest that a global banking crisis is about to get underway. But given that there has also been warnings that bank debt exposure to potential bad debt is growing is largely being ignored. Potential problems exist once again in mortgages (sub-prime again plus others) as well a trillion dollar in student loans in the US much of which might be uncollectable. The top four banking behemoths in the US (JP Morgan Chase, Bank of America, Citigroup, and Wells Fargo) collectively have $7.4 trillion in assets and constitute some 55% of the entire US banking industry. Three of these banks also the have the highest credit exposure to risk based capital from derivatives. Goldman Sachs has the largest exposure to risk based capital but JP Morgan Chase, Bank of America and Citigroup are a part of the group with large exposure in derivatives. These banking behemoths are truly in the category of “too big to fail”. Yet during the 2008 financial crisis two of them, Bank of America and Citigroup came close to failing.

The chart shown at the beginning is the PHLX KBW Banking Index. The four largest banks noted above constitute only 39% of the KBW Index, less than their actual dominance in the US market. The KBW Index is currently trading below its recent highs seen in March 2014. A failure to make new highs could be viewed negatively. Not only is the KBW Index possibly failing below its recent highs, the index is sharply below its all-time highs seen in February 2007 prior to the 2008 financial crisis. Yet the S&P 500 has soared to new all-time (nominal) highs since its low in 2009. This is a divergence of significant importance that should be noted by all.

Will Banco Espirito Santo be the trigger to a global banking crisis? The fear is contagion. A failure by something small in terms of the global banking industry could turn into a banking nightmare. Yet many are dismissive of Banco Espirito’s possible impact. And then there is the risk of a sovereign default. Argentina could once again default. Apparently, an issue of Greek bonds was put on hold because of the banking crisis in Portugal. History is replete with banking crisis and failures that triggered not only recessions but also depressions. Yet investors are busy chasing yield that often has its own hidden risks and could be related to the banking industry. A favourite expression is “this time is different”. The only thing different is the circumstances that could spark a global banking crisis. Investors should be wary.

Copyright 2014 All rights reserved David Chapman

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