Banking on Soft Ground

A banker once told us that a bank’s only concern is the
solvency of its debtors.

Interest rate risk is not a factor, he told us, because
banks can hedge that risk…so as long as its customers
aren’t going bankrupt, a bank will always be okay.

In normal circumstances, our banker friend may be quite
right. But in decade three of the world’s greatest credit
bubble, banks are no longer banks, we’d argue, they are
houses of financial speculation…or in the industry
parlance, ‘financial services corporations.’

So this morning, we’ll take issue with our grubstaker’s
thesis, and argue that, as we currently stand, modern banks
face a three-pronged attack on their profitability…

We will start with the credit-worthiness of debtors. And to
get the ball rolling, yesterday, we sought out the expert
opinion of an insider, Chris Mayer. Chris used to be a
senior commercial loan officer at a large financial
institution, so he’s familiar with this risk. He
immediately recalled the WorldCom debacle when we asked him
how credit risk might affect bank stocks…

"All kinds of bad things can happen to banks," said he,
"but the credit quality of our customers was our main
concern."

"I remember when WorldCom hit the wall. It had a material
effect on the quarter’s earnings. And not just because we
had WorldCom bonds in our inventory…Suddenly every
company in America was a credit risk. If WorldCom could
blow up, any company could. A witch hunt had started, and
the whole market’s credit-worthiness was brought into
question."

General Motors must be making a few hairs stand on end, we
joked. Earnings are drying up, said the company last week,
and its stock got hammered. So did its bonds. Now there’s
speculation GM’s credit rating may soon be downgraded to
junk status.

Did GM’s business partners rally round to help? Course not.
Yesterday, GE Capital withdrew GM’s $2 billion loan
facility. GM said the timing was a coincidence, but the
market didn’t believe it, and pushed GM’s debt to new
lows…and with them, the returns of nearly every pension
fund and institutional investment portfolio in the country
sank, including positions at Chris Mayer’s old bank, we’d
wager.

"The General Motors profit warning last week seems to have
ignited a feeling that the boom times for the credit
markets are over," says the FT. "Spreads over government
debt finally reached their nadir."

Which brings us swiftly to our second source of
concern…credit spreads.

The last few years have been described as a "golden age"
for mortgage originators. The likes of Citigroup, Wells
Fargo, Countrywide Financial, Chase Manhattan, Washington
Mutual and Bank of America have all been booming.

Investors in publicly traded mortgage REITs like Annaly and
Anworth have been making nearly 20% per year in dividends.

And financial indices like BKX and RKH were making all-time
highs as late as last year.

It was all possible thanks to Alan Greenspan’s manipulation
of the yield curve. He created a large spread between
short- and long-term interest rates, at a time when
absolute yield was hard to come by, and the hot money
rushed in. By borrowing at 1% and lending at 4%, with
leverage of course, fund managers were able to print money.

The FT thinks the speculative money involved in this carry
trade may have doubled – from $200 billion to $400 billion
– in the past few years. But now, with the yield curve
having flattened, it’s much harder for the banks to
generate profit this way and the threat of unwinding carry
trades may soon unnerve investors.

"The danger for the markets is that short rates may reach a
‘tipping point’ at which speculators decide the carry trade
is no longer profitable," explains the FT. "That might lead
to a sudden exit from such positions which could have
substantial effects on asset prices. Just the perception
that the tipping point is near may be enough, since traders
have an incentive to be the first to move."

The final threat to the modern superbank is the most
interesting, and perhaps the least talked about: the hedge
funds…or more accurately, their business.

CSFB estimates that the global banking industry may have
earned up to $25 billion in revenues from hedge funds in
2004. $19 billion of that came from sales and trading, they
calculate, and the rest from prime brokerage services.

"That helps clear up one mystery," says a Bloomberg
article. "We now know why investment banking profits have
been soaring in the past few years, even though mergers and
acquisitions have been flat for most of that time, and
equity markets have been moribund. All those new fees from
hedge funds have been filling their coffers."

"It has become a very incestuous relationship between the
banks and hedge funds," said an analyst to Bloomberg. "They
are selling hedge funds, managing hedge funds, lending to
them, and competing with them through their own trading
desks. In effect, Wall St. has found a way of trading with
itself."

And then Bloomberg concludes: "About 9,000 hedge funds have
been launched. The law of averages suggests some of them
will go bust and lose a lot of money. It is just a matter
of time before one of the main investment banks is caught
up in the mess. When it happens it won’t be pretty."

Might a small sell order on one of the financial indices
make a nice trade?

As Eric Fry likes to say, "Let the reader decide…"

Crisis Point Trader

Did You Notice…?
By Tom Dyson

Larry Kudlow of CNBC has tried to argue that the trade
deficit doesn’t matter. It’s a sign that the U.S. is
growing faster than the rest of the world, he says, and
that it’s our trade partners who need to take up the slack.

We can’t be bothered to argue with Kudlow. One look at the
below chart says it all…

EverBank’s World Currency Accounts

And the Markets…