Karl Denninger: Bank Analysts in Denial, Risk Still Towering for Financials
Analysts are predicting a 57% increase in earnings for the six largest US banks (source: Bloomberg). Give us your thoughts on that figure – is it realistic?
“I want to know where the analysts are buying their crack. They said this last year too, and you saw how it turned out. The interesting thing about that forecast is that when you dig into a little bit and start putting some numbers down on paper you'll find that Bank of America is allegedly 25% of the earnings increase that is expected in the S&P 500. I'm not quite sure exactly what makes anyone believe that that is going to happen.
The problem with forecasting earnings for banks at this point in time is that banks make money from doing two things: advising people on various deals, M&A and things like this; and the second is lending money to people. That becomes very hard to do at a profit when you live in a world of financial repression, which we're in right now. We have zero interest rate policies so there's very little loan demand [and low margin].
What everyone has to understand about zero interest rate policy and about interest rate changes is that when you lower interest rates, the banks get a huge capital gain on any trading assets they hold that are dead instruments because as rates go down the value of existing debt goes up because it pays a coupon. So the replacement coupons are at a lower rate of interest; this is why price and interest rates move inversely in the bond market. The problem is that's a one-time gain. In addition to that, you are taking risk because once rates go to zero, they can't go any lower than that. At some point they will go up and you will have capital losses.”
How do you juxtapose expectations of a rally in the US economy in 2012 with the fact that we are in a zero interest rate environment, as well as the fact that financials are typically key participants in sustained market rallies?
The biggest problem I have right now is the divergence of information. [For example]we get this employment report from ADP; the gains in the employment report were essentially all in services. Then we get the ISM report, which covers the same amount of time, and the ISM report says that employment is contracting. Wait a minute – somebody is wrong! I have two pieces of information that tell me opposite things.
As a trader, how much of the positive sentiment do you think is coming from the calendar change and the fact that charts are shaping up nicely in terms of technicals?
“It works right up until the point that somebody has a big earnings miss. You [can] take a look at what has happened with those companies that have been out early or pre-announced that they had a problem: about a year ago, I was pounding the table about the PPI numbers and saying that we had a 9 month to two year window where this was going to work through the system, that margin compression inevitably had to come out of this.
Now you have also a cyclical profit cycle top which has probably occurred within the third quarter, so you're coming into that along with the cost push pressures from the cost side of the equation. I think you have the potential for some really nasty earnings misses in the first and second quarter of this year.”
Are there any specific companies that you see as potential setups for earnings misses?
“I think technology is potentially a very serious problem. I don't like anything in the consumer staples area because they are very heavy commodities users and that is where this cost-push inflation showed up. We have had a couple of announcements already that have been substantial misses and the stocks have gotten hammered.
If you're looking at the possibility of a second-half recovery in the economy I think you're misplaced as well. A lot of people are looking for a big acceleration in GDP in to quarter three and quarter four – I think you're going to see the exact opposite because Europe has solved absolutely nothing and I don't see how we can get through 2012 without at least one significant dislocation in the European side of things. Unfortunately, the [European] financial system is terribly interconnected with ours.”
Is there a price at which you would be a buyer of financials?
”Not today. The reason is I can't look at a balance sheet and tell you what the actual exposure is. Opacity--until that goes away, you are making a bet on a "trust me" basis in the financial sector. If you believed that in 2008, you lost half your money or more. I can't go for that again.
I want to look at companies that have been beaten up but have a franchise that is not going away. There still are firms out there that have a real product or service that needs to be produced.
What I look at is rotation. Where does stress show up first? It shows up in the credit markets. If you find firms that have more leverage on their books, and they start to roll over and fail in price--they start to break some technical levels and the charts look terrible--that's a good indication that it's time to get out of the pool.”
Give us the bottom line on bank stocks.
”[The risk-reward ratio] is terrible, but you can't make an argument for shorting Bank of America at $6. You short something at $6 and something goes wrong with that, and you're dead. The problem is that we don't know what the truth is.
It's entirely possible that JP Morgan, for example, represents some decent value, but I can't tell you because I can't actually analyze their portfolio and what their potential exposures are.”
Why is it taking regulators so long to actually address some of this opacity, for example, in the case of the tri-party repo system?
”I'd like to know how the Federal Reserve can, with a straight face, talk about the tri-party repo system at all when the Valukas report that was written on the Lehman bankruptcy disclosed that Lehman Brothers went to Citibank to do a tri-party repo some time before they blew up--not a day or two, but more like a month in advance of them detonating--and Citibank rejected the collateral and said, "What else you got?" And the answer was, "Nothing."
On that day, the traders that were involved in that--and, I assume, everyone in risk management up and down the line--knew that the company was functionally bankrupt. Now, since this was a tri-party deal, that means that the New York Fed had to know, too, because the deal got rejected.
So, how is it that we then, a month later, supposedly get blindsided? Ben Bernanke is running around Capitol Hill saying, "Well, we just don't have any tools to deal with this. This came out of the middle of nowhere. We didn't know this was going to happen." I don't buy it.
The primary problem with all of these instruments that are not exchange-traded is that transparency is bad, because it tends to drive down spreads, and therefore, everyone makes less money.
I think the real problem is that we don't have anyone in Congress--we need a commission to look into the failures that happened in the 2007-2008 timeframe and hold the entities accountable that were in a regulatory role.
Citibank did not have an obligation to stand up and blow the whistle and say, "By the way, this counterparty that wanted to trade with us is bankrupt." The Federal Reserve, as a primary regulator, is an entirely different kettle of fish.
Where was the OCC? Where was the SEC? Where were these supposed regulatory agencies that were supposed to be watching over this? I've got some problems with this, because all of this agencies either should have had knowledge of it, or they did have knowledge of it and didn't act on it.”
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