Bank Bond Run Can't Last
May 29, 2009
By: Tom D.D. Graff, Managing Director

Green shoots may be springing up, but one really has to question how well financial bonds have been performing. In April and May, corporate bonds of all stripes have been performing well, but the performance of financials has been especially striking.

Source, Merrill Lynch-Bank of America

You are reading that right. Over the last two months, supposedly investment-grade subordinate financial bonds have returns almost 18% on average. Various sub notes from Capital One, Fifth Third, PNC, Lincoln National, Sun Trust and Regions Financial all have produced 50% or greater returns in May.

To be sure, these issues are still trading at large discounts to par value. Most of the issues mentioned above went from prices of $30-40 to $60 vs. $100 par value in the last month. But that is besides the point. The fundamental picture surrounding banks remains very shaky. Investors in these firms are counting almost entirely on government support.

Consider the FDIC’s Quarterly Banking Profile released on Wednesday. Mainstream media coverage has focused on the obvious: number of problem banks rise to 305, loan loss reserves up 64%, while the FDIC’s insurance fund is down 25%. In reality though, this is all old news, not of much use to investors.

Look a little deeper, and there is more disturbing news. The FDIC reports insured banks have $7.7 trillion in loans and leases, broken down as such:

We can take this data and overlay the loss estimates the Fed used in its Supervisory Capital Assessment Program (a.k.a. the Stress Test).

The Fed was careful to emphasize that “these estimates are not forecasts of expected losses.” Regardless, it does provide a mainstream view of potential losses on loans.

Multiply these loan loss estimates and the assets as published by the FDIC. It paints an ugly picture.

In the above chart, the blue bars represent the range of “Baseline” loss estimates, and the red bars reflect the range of “Adverse” estimates. Based on Fed estimates, banks in aggregate will lose between $345 billion and $809 billion. The green bar on the right represents the aggregate amount of losses for which banks have already accounted: $171 billion in loss reserves and $150 billion in charge-offs.

Even under the low-end of the baseline scenario, banks in general are under reserves for potential losses. Now consider that these aggregate numbers actually represent a combination of some banks with more benign loan portfolios, better geographics and/or better loan types, and other banks with worse geographics and weaker loan types. So the banks that are weak look much worse than the aggregate.

Admittedly, odds are good that the Treasury will back-stop any systemically important bank, but what form future bailouts take is unknown. Look no further than the treatment of Chrysler’s debt holders. Normal rules of bankruptcy won’t apply if tax payer dollars are involved.

Plus one has to question the definition of “systemically important.” KeyCorp has $98 billion in assets. Fifth Third has $119 billion. In its last quarterly filing before its failure, Washington Mutual had $310 billion in assets. WaMu subordinate bond holders were wiped out. Why are investors so sure that the same fate wouldn't befall Key or Fifth Third?

Bear in mind that subordinate bonds have an un-even risk/reward profile. In the event of bankruptcy, sub-note holders will likely get wiped out. But even if a bank’s credit improves, the return on a sub-note is limited. With many of the weaker bank sub notes trading at $60-$70 vs. $100 par, the upside is no more than 50%. The downside is -100%. I’d argue that if a Fifth Third or KeyCorp or Regions survive into the next several years, there is much more upside in the common stock, but with the same downside: 100%.

Yesterday, news came that the government was backing away from the Legacy Loans Program portion of the PPIP. This is bad news on top of bad news. Not only are banks not going to enjoy any capital relief on their bad loans, but its signaling that banks can’t sell their assets at market clearing prices and remain solvent.

The bottom line is that many banks are insolvent now, and would have no access to capital markets without government interference. While the Treasury’s programs are probably the right move for the economy overall, it does not guarantee bank securities will produce profits. Especially subordinate bond holders who face such a large downside.

Disclosure: No position in any bank mentioned.