Bank stress tests to trade or invest?

bank quake

Here we go again. Europe is about to take its latest stab at the quality of assets in its banking system. In the absence of any shocks, savings pools/funds will continue to own shares in this sector… but should they? 

As a trade maybe, but as a long term investment one wonders how the average investor can know what’s going on inside a bank’s balance sheet. The mere need for an external review tells you the subjectivity inherent in any bank’s assessment of their assets. Matt Levine at Bloomberg expressed this point beautifully in the context of Bank Of America’s recent quarterly results. Here’s a snippet which captures the subjectivity we are so wary of…

Is it conceivable that Bank of America’s measurement of its assets could be wrong? Well, as of June 30, Bank of America had $27.7 billionof “assets and liabilities where values are based on valuation techniques that require inputs that are both unobservable and are significant to the overall fair value measurement,” a technical term meaning that Bank of America takes its best guess about how much those assets are worth.4 Again: If that guess was off by one percent, that would more than wipe out (or double) Bank of America’s net income for the quarter.

Or: Bank of America has $891.3 billion of loans on its balance sheet. Some of those loans will go bad. Bank of America currently expects that about 1.69 percent of them, or $15.1 billion worth, will go bad, so it reduces its assets for accounting purposes by $15.1 billion.5 If in fact Bank of America should have increased that number to 1.72 percent, that would wipe out its net income for the quarter.

Yep, that’s a 0.03% change in the estimate of bad loans. As a reminder, the European stress tests are to ensure bank’s ability to survive, they are not in any way an indicator of the returns to a shareholder over time. Now think about that for a moment as you see asset prices and yields hit records around the globe. What if there was a 5% asset accident/valuation miss? Regular WealthiFi readers will also be well aware of the massive technology, competition and regulatory pressures invading the average bank’s operating space. And yet, and yet…… look at how big the weighting of the financials sector is in the S&P 500 today. The chart is courtesy of Bespoke Investment Group:

That’s a huge weighting, the second biggest destination for every dollar of equity savings in the US. You’d think there would be huge visibility and certainty about the future of shareholder returns for financials wouldn’t you? So much visibility that Europe needs to reassure us that their banks have enough capital to survive an asset shock. Read those Bank of America numbers again and think about the difference between survival and actual investment returns. We really don’t know do we? That means we are speculating. That means the sector is a trade, not an investment.

 

Financials

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