• Major US banks turned in mixed performances for 4Q 09; accuracy of estimates were made more difficult by the TARP repayments by several banks
• Positive outperformance of bank profits overshadowed by concerns of an Obama-led clampdown on the sector
• The “Financial Crisis Responsibility Fee” has already met strong opposition from banking sector
• Sample calculations suggest a double digit percentage hit to annual net income for the largest financial institutions
• Further measures to reform the financial sector include clamping down on proprietary trading, as well as preventing further consolidation in the sector
• Stricter regulation to hurt banks, but likely to be milder-than-expected

Financial stocks were recently under pressure as investors digested a slew of earnings reports from the US banking sector. Unlike previous quarters where profits exceeded forecasts by huge margins, earnings were more mixed for 4Q 09. Citigroup, Bank of America and Morgan Stanley reported lower-than-expected earnings, while Wells Fargo, Goldman Sachs and JP Morgan surprised on the upside. Forecasts for 4Q 09 were made more difficult by the repayment of TARP (Troubled Asset Relief Programme) money by several banks, a one-off charge to the quarter’s earnings.

Bank earnings surprise somewhat, but overshadowed by Obama’s financial reform plans

Several banks suggested that loan losses would peak this year, bringing an end to escalating provisions which have been eroding profits since 2007. Also, huge outperformance of market expectations was seen in the case of Goldman Sachs, which reported 4Q 09 earnings per share of US$8.20, shattering the consensus forecast of US$5.20. Wells Fargo managed to eke out a small profit for the quarter, against expectations of a loss while JP Morgan’s US$3.3 billion quarterly profit was significantly higher than the expected US$2.46 billion.

Despite the positive surprises, the Obama administration’s recent move to reform the financial sector has left investors in a sea of uncertainty. On 14 January 2010, President Barack Obama announced plans for the implementation of a “Financial Crisis Responsibility Fee”, which would be paid by the largest banks with assets larger than US$50 billion. According to the President’s statement, the intention is to use this tax to recover the anticipated cost of the TARP programme, currently estimated at US$117 billion.

Impact of bank levy on net income

The proposed levy involves a 15 basis point (0.15%) fee assessed against the financial institution’s covered liabilities (assets minus Tier 1 capital minus FDIC assessed deposits). Key executives in some of the largest US banks have already expressed their displeasure, indicating that the tax does not take into account the early repayment of TARP money by several institutions, and that TARP beneficiaries like smaller banks and the automobile financing units of General Motors and Chrysler are not subjected to the tax. Also, legendary investor Warren Buffett sarcastically suggested that members of Congress should be slapped with a special tax for their mishandling of mortgage lenders Fannie Mae and Freddie Mac.
 
While most of the large financial institutions impacted by this new “responsibility fee” are unlikely to have any trouble paying it, the tax would negatively impact net income for at least the next ten years (officials have indicated a minimum tax period of ten years). Using Bloomberg data, we calculated the potential annual tax based on the guidelines issued so far for the eight largest financial institutions in the US (by assets, see Table 1). If the Obama administration gets its way, net income of the largest US financial institutions could see a double digit percentage impact. 2009 net profit for Citigroup, Morgan Stanley and Bank of America are probably not reflective of actual earnings power and the impact of the tax may be a smaller percentage of normalised net income.

“Financial Reform” Bombshell

In addition to the proposed tax, the Obama administration has also dropped a “financial reform” bombshell on the banking sector. In his remarks on 21 January 2010, President Obama laid out a proposal which will see a clampdown on proprietary trading by commercial banks. In the exact wording in Obama’s statement, “Banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers”. Also, limits will be placed on bank size to prevent the creation of “too big to fail” institutions.

Proprietary trading clampdown

The announcement was met with much disappointment by investors, as US financial stocks (as represented by the S&P 500 Financials Index) fell 3% in the trading session. This was not surprising as proprietary trading has already become embedded within the banking sector’s operations and in certain institutions, is a key driver for profitability.

The key to Obama’s announcement lies in the administration’s definition of “proprietary trading”. Many financial institutions use their proprietary trading desk to offset risk in other parts of the bank’s operations, and it would be very difficult to draw the line between “risk management” and “trading for profit”. A complete clampdown on trading activity would be akin to a move back to the Glass-Steagall Act, which required the separation of commercial banking operations and investment banking operations. On the other hand, if banks themselves are given the leeway to distinguish between the two, they could very well carry on operations as usual under the guise of hedging risk.

Limits on size

In addition to the existing 10% market share limit on US bank deposits, Obama has suggested expanding the existing regulation to cover non-deposit liabilities to ensure that banks do not grow too large, making them “too big to fail”. The details on this aspect of regulatory change are sketchier, making it impossible to assess the potential impact on the various financial institutions at this juncture.

Regulatory changes to hurt banks, but to be milder-than-expected

There has been much prior discussion on regulatory scrutiny, but until the Obama’s latest announcements, there was nothing concrete. Recent measures threaten the profitability of the US banking sector, and there may be curbs on growth and expansion. However, we believe that the impact of these increased regulatory measures will be milder-than-expected for a few reasons.

First, the measures described so far are rather sketchy and there will be extreme difficulty in implementation. As described earlier, a clampdown on proprietary bank trading may be taking away the risk management arm of modernised commercial banking operations, leaving the institutions exposed to even greater risk. It will be incredibly difficult to regulate operations which are already integrated in the bank’s operation process, and we expect this regulatory change to face substantial opposition when it goes to Congress.

Secondly, even if a milder form of the regulation is passed, banks will be allowed sufficient time to unwind their trading positions which regulators deem to fall under the category of “hedge funds” or “private equity funds”, perhaps over a period of many years. A quick demand to “deleverage” would have potential to cause a repeat of 2008, where financial markets would be sent into a tailspin yet again. This could allow financial institutions time to spin off trading operations, as if the Glass-Steagall Act was in force, and concentrate on commercial banking operations.

Thirdly, even the bank tax suggested last week has already met with strong opposition from most industry experts, and the reception to the latest set of announcements will be less-than-lukewarm. Though a highly debatable point, financial institutions represent some of the largest employers in the US and their corporate well-being has given Congress much to ponder over. There is still much potential for modification of the Obama administration’s financial reform plans, and a watered-down version (the recent healthcare reform bill comes to mind) could be the likely result.

What does this mean for investors in financial stocks?

We do not deny that increasing regulation presents strong headwinds for financial institutions and their earnings. Also, we accept that there must be certain changes made to ensure that excessive risk-taking by banks in the future does not occur to precipitate another financial crisis. However, we believe that current ideas for reform are rather sketchy still, and a rush to push out these new regulations without considering the feasibility of implementation will render them less useful. We expect some form of regulatory rulings to be passed, but will result in less harm to the financial sector than is currently being perceived by the market.

At this juncture, we think that the bank tax is a key consideration in terms of a direct impact to corporate earnings, while rules on consolidation may ultimately require a few of the largest US financial institutions to divest non-core portions of their banking operations in select states. We also remain sceptical that the “proprietary trading” clampdown can be passed in its current form.

As of 21 January 2010, the global financial sector (as represented by the MSCI World Finance index) trades at a PB ratio of just 0.93X, while the S&P 500 Financials index trades at a PB ratio of 1.1X. Earnings for the largest US financial companies may be impacted by the bank tax, but as of 21 January, the consensus expects earnings of US financial companies to jump 111.8% in 2010, and 48.1% more in 2011.

The sector continues to trade at undemanding valuations on a price-to-book basis, while the anticipated recovery in earnings means that US financials are currently valued at just 10.2X 2011 earnings. Despite the recent headwinds faced by the financial sector, we maintain that the sector remains an attractive investment proposition with substantial potential upside.

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