Banks Get Frothier and Frothier
August 2nd, 2009By David Goldman
Banks are getting frothy, I offered on July 15 before decamping for Italy. I spoke at a conference on ethics and financial markets sponsored by the Instituto Bruno Leoni in Rome, of small interest to this blog’s readers. Since then banks have outperformed the S&P 500, getting even frothier.
As usual, the bank story is asset pricing: as the price of so-called toxic waste recovers, so does the BKX index of bank equity. In fact, the recent improvement in subprime AAA tranches, the big sore spot in bank portfolios, has been remarkably swift.
ABX Index of Subprime Home Equity AAA’s Issued in Late 2007 (Markit)
This 2007-2 vintage is the sloppiest part of the market, and its price is up 40% from the bottom. One of the best ABS traders I know notes in an email to customers, “Limited signs of the anecdotal improvements in the low-end market” are modest, ”though arguably remain better than modelled/feared.” Nonetheless, “it is clearly not collateral performance that has driven prices. The 7-9 credit tranches in ABX are up 2-7 pts in July, or 15-40% in proceeds terms, and loss-adjusted yields in subprime have basically halved (~18% to 9%) in less than two months.” The rally in subprime paper is driven by cheap government financing through the PPIP and TALF programs, Howard concludes, and the absence of new supply. “Throw in the large buy program currently in the market and the technicals continue strongly favor those who hold assets as the sector continues to be supply-constrained.”
In a nutshell, the zombie regime that the administration established for the banking system by grial and error is working precisely as it should. If anything, investors are far too confident. ABX are doing better than the slight improvement in cash flows merits. Another benchmark for the distressed assets market, the AAA-rated portion of the commercial mortgage backed securities market, is doing even better in the face of rising losses.
CMBX AAA Index (Markit)
This is even more remarkable than the surge in subprime ABX prices, because the worst already has hit ABX, but is yet to come with CMBS. According to Deutsche Bank’s CMBS analyst Richard Parkus in a July 21 report to clients, “The speed of deterioration in loan performance is unprecented, even relative to the early 1990s.” He predicts that delinquency rates will reach 8%-12% over term for the 2007 vintage. The total delinquency rate for the universe hit 4.1% in June, 2.2 times higher than in March and 3.5 times higher than in December.
As Peter Howard indicates, cheap leverage and federal sponsorship for securities buying programs have pushed up the prices of the available inventory. The frothiness in bank equity prices is likely to continue as the zombie feeding chain shoves cash flows down the line. But it seems like a good time to take profits given the poor fundamentals. Nothing in the data over the past few weeks has changed my view that this recession will be L-shaped, driven by a bottomless demand for savings from a rapidly-aging US population.
August 4th, 2009 at 9:46 pm
Mr. Goldman,
Speaking of leverage, I had the following rant about the lack of leverage and incentives for real industries that actually need this.
Its still astonishing that people would rather spend a ton of money to hire people to pour cement than utilizing that money to invest in human capital in an important industry like health care. 2 trillion dollars folks. You can buy out all the best doctors and medical professors with 2 trillion dollars. For all the talk about public/private vehicles to invest in financial ‘toxic assets”, there is no talk at all about a public/private investment in medical schools, practices or anything else. Instead of fronting a few hundred billion dollars to private equity so that they can leverage up their financial returns, why not provide the same cheap financing to anyone or any group that aspires to start a medical school or practice? In exchange for this cheap and non-recourse leverage and a fraction of the equity, the potential practitioner or the medical school den can equally leverage up the returns from the expanded scale of operations and would naturally demand less in return for tuition or other expensive to meet the desired returns. Sadly, our current financial genius in the administration and elsewhere are not capable of conjuring up a plan as simple as this.
Hope you don’t mind that I posted this here. Thanks for continuing to share your insights with the readers of this blog.
August 11th, 2009 at 5:19 am
[...] assets August 11th, 2009 By David Goldman TALF and PPIP asset-buying programs, I noted Aug. 2, have pushed up asset banks and made bank equity look frothy. Even the dicier parts of Commercial Mortgage Backed Securities (CMBS) are showing exceptional [...]