Buy US banks - once they’ve fallen another 40%

By Associate Editor David Stevenson Aug 18, 2008

David Stevenson

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Wall Street sign and US flags

Investors around the world have been waiting and praying for months for a clear sign that the money markets are finally starting to defrost –so far, to no avail.

But within the last month, there’s been a big rally in US banking stocks. That’s got investors excited. After all, it was the US banks that kicked off the global carnage last year, when all those subprime mortgage woes began moving out of the internal audit departments and onto the front pages.

So does the bounce mean that we can all breath a bit easier now?

No. Here’s why...
How Merrill Lynch has made life harder for other banks

US financials have rallied sharply in the past month. But trying to get to grips with what’s really been going on in Wall Street’s banks isn’t easy. Sure, some banks are ‘fessing up to their lending sins. Merrill Lynch last month cleared its books of a massive $30bn of dodgy debt, for just $6.7bn - a huge write-down to just 22 cents on the dollar.

But while Merrill’s move may seem a step towards getting over the credit crisis, it is in fact muddying the water for everyone else.

That’s because Merrill has set a new low-ball benchmark that its peers may be very reluctant to follow. Take Citigroup for example. In July, it said it was valuing its CDOs (collateralised debt obligations – packages of assets backed by loans such as mortgages) at about 61 cents on the dollar, clearly a much higher level than the Merrill clearout price.

As Goldman Sachs analyst William Tanona points out, if Citigroup were to write down its own $22.7bn of CDOs to similar levels, it’d need to take a $16.2bn hit.

So it seems fair to suggest that there’s still a good deal of ‘blue sky thinking’ in a lot of bank asset valuations. As Tony Jackson says in the FT, “in spite of improved disclosure by the banks, the picture of their liabilities is still quite fuzzy”. And Deutsche Bank analyst Mike Mayo is putting it politely when he says that Merrill's action “raises ongoing credibility issues for the industry”.

This is far from being the only outstanding problem for banks to deal with. There’s the small matter of ‘mis-sold’ bonds. Merrill, Citigroup and UBS have together repurchased $40bn of auction-rate securities (I won’t go into these securities here, but suffice to say they were meant to be both liquid and risk-free, and turned out to be neither) from disgruntled investors, against a backdrop of lawsuits and fines – another recipe for extra balance sheet damage.

Then of course, there’s the knock-on effect on bank balance sheets of further house price falls. Also, there's business debt. Last week, Moody’s Investors Service said that the global corporate bond default rate could reach 10% if the US sinks into a protracted recession. And there’ll be more credit card defaults as consumers run out of cash and lose their jobs. You get the picture – things look grim.

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Yet, you may say, the stockmarket knows much of this. The S&P 500 Banks index is down 56% over the last 18 months. Between February 2007 and July this year, it saw the steepest tumble since at least 1962, according to Birinyi Associates, as the credit write-downs – globally $500bn and counting - have mounted.

Why US banking shares have not reached bargain territory yet

But all those ‘value’ players who’ve recently been picking up bank shares could well have jumped in much too early. Because for US banks to be able to start a proper recovery, their share prices need to fall quite a long way further first.

You see, right now, the published price-to-book ratio on the S&P 500 Financials index stands about 1.23x, says the latest Bloomberg data. That means that investors are currently paying $1.23 for every $1 worth of net asset value (NAV), the average book value of the businesses in the index. In terms of recent history, that looks cheap, particularly compared with ten years ago when the ratio briefly reached the dizzy heights of almost 3.5x.

But the last decade has been new territory for bank valuations. The average ratio over the last 80 years is more like 1.38x, says James Montier of Societe Generale. And here’s the rub: the 1.23 published average doesn’t include his guess on the latest write-downs. Factoring these in means that the NAV of US financials falls further. It all adds up to the sector really trading on 1.32x, i.e. a premium of over 30% to NAV.

That, says Mr Montier, is much too close for comfort to the long-term average (when an overvalued sector ‘reverts-to-the-mean’, it usually undershoots the long-term average in the process of correcting). Perhaps more to the point, there’s almost certainly a massive dose of further credit crisis damage on the way, which would slash some of those bank NAVs (and thus push up the price-to-book ratio) yet further. So investors should really be looking for a decent “margin of safety” to allow for many more nasties before they start looking at financial stocks.

In fact, Mr Montier reckons US banking shares will only have hit “bargain basement” levels when they are trading at somewhere between 50% and 75% of their published NAV.

In other words, hang on for another 35%-40% slide in US banking stocks. Then you might be reasonably sure that the bad news is built in. At that point, any upswing in those banks’ share prices, might be a sign of the recovery starting for real.

Until then, best to watch, and wait. I suspect it may take some time.

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