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Bank Shares Fall On Profit Warnings and Rate Fears David Enrich, Dow Jones Newswires 6-14 Three big regional banks - Commerce Bancorp Inc. (CBH), Fifth Third Bancorp Inc. (FITB) and National City Corp. (NCC) - warned in mid-quarter updates that they're still struggling to cope with steadily rising rates. By boosting the banks' borrowing costs, the current rate environment makes it harder for them to profit by lending money. Meanwhile, new government data Wednesday pointed to an increased risk of inflation, signaling that the Federal Reserve is likely to keep hiking rates. Investors and analysts interpreted the three profit warnings as a sign of weakness throughout the bank sector. "You're probably going to see more margin pressure than people had anticipated for the quarter," said Bob Maneri of Victory Capital Management. He said investors appear to be rotating out of bank stocks, just as they exited brokerage stocks last month. Even as the broad stock market rallied Wednesday, reversing some of its recent losses, investors punished bank stocks. The Philadelphia Stock Exchange's bank index fell about 2%, before rebounding slightly late in the afternoon. Commerce suffered more than most. In a regulatory filing, the New Jersey, bank cautioned that its net interest margin - the rate at which it earns money by borrowing low and lending high - will shrink in the second quarter to 3.35% to 3.4%. That's down from 3.53% in Q1, when Commerce managed to stabilize its margin after repeated narrowings. A year ago, Commerce's margin was more than 4%. The filing prompted several analysts to rein in their profit projections for Commerce, a longtime Wall Street darling. Commerce's shares recently traded for $35 each, down 5.6%. In their own mid-quarter updates filed with regulators, Fifth Third, Cincinnati, and National City, Cleveland, each issued similar warnings about margins remaining under pressure. The reports weren't a major surprise. Both banks have been grappling, at times unsuccessfully, with a challenging rate climate for more than a year. Still, investors dumped the stocks Wednesday. Fifth Third's shares recently were off 3.8% at $36.70, while National City was down 3% to $35.72. The warnings are the latest sign that even after 18 months of balance-sheet restructurings and other steps aimed at softening the blow from rising rates, many banks remain vulnerable. And new consumer price index data released Wednesday indicated that inflation is lurking and that the Fed's rate-raising campaign probably isn't over. "It's going to be harder for banks to make money," said Mark Fitzgibbon, a Sandler O'Neill & Partners L.P. bank analyst. "I think people are sort of stepping back somewhat from financials... As we get closer to the end of the quarter, you'll see more pre-announcements or outright misses." The banks that issued second-quarter warnings weren't the only ones whose shares tanked. Other regional banks, including AmSouth Bancorp (ASO), PNC Financial Services Group Inc. (PNC) and KeyCorp (KEY), saw their stocks tumble about 2%. Even more diversified national banks saw their shares decline Wednesday. Bank of America, Citigroup, JPMorgan Chase, Wachovia and Wells Fargo all fell more than 1%. "The concern is the inflation (and) the Fed is probably going to have to raise rates more than we had expected," said Peter Kovalski, a bank-watcher and portfolio manager at Alpine Mutual Funds. "People are skittish. How much more is the Fed going to do?" Investment banks are placing bigger bets than ever and beating the odds Business Week 6-12 One recent spring day, a dozen or so of Lehman Brothers top executives filed into a conference room to run through risks, relive past financial crises, and worry about new ones. They analyzed how much money the firm might lose if the markets were buffeted like they were after the terrorist attacks of 2001. They pored over complicated risk models showing how tens of thousands of trading positions and financial contracts with clients would fare in the event of an Avian flu epidemic. They tested all conceivable scenarios that might put Lehman in harm's way. "We are in the business of risk management 24/7, 365 days a year," says Chief Administrative Officer David Goldfarb. Wall Street has always been about taking risk. But never has risk been such an obsession for the nation's biggest investment banks. Never have they had to reconcile so many bets made on so many fronts. The conditions have been ripe. Historically low interest rates and relatively calm markets in the last few years have allowed a new type of firm to flourish, one that acts primarily as a trader and only secondarily as a traditional investment bank, underwriting securities and advising on mergers. Goldman Sachs' CEO Henry Paulson has led the charge. Major Wall Street firms have watched with envy as Goldman has repeatedly racked up record earnings on the strength of its trading business. The biggest stunner came in March when Goldman announced that in three months it had tossed off $2.6 billion in profits -- nearly half as much as it earned in all of 2005 -- on $10 billion in revenues. Not coincidentally, Goldman also put a record amount of the firm's capital at risk of evaporating on any given trading day. Its so-called value at risk jumped to $92 million, up 135% from $39 million in 2001. "[Goldman is] a horse of a different color now," says Samuel Hayes, professor of investment banking at Harvard Business School. Goldman shows no sign of easing up. Nor do its followers. This trading boom, fueled by cheap money, is fundamentally different from the ones of the past. When traders last ruled Wall Street, during the mid-'90s, few banks put much of their own balance sheets at risk; most acted mainly as brokers, arranging trades between clients. Now, virtually all banks are making huge bets with their own assets on many more fronts, and using vast sums of borrowed money to jack up the risk even more. They're shouldering risks for their clients to an unprecedented degree. They're dabbling in remote markets from Brasilia to Jakarta, and in arcane products like credit-default swaps and catastrophe bonds. Led by Goldman, many investment banks now do more trading than all but the biggest hedge funds, those investment pools that almost brought down the financial system in 1998 when one of them, Long-Term Capital Management, blew up. What's more, banks are jumping into the realm of private equity, spending billions to buy struggling businesses as far afield as China that they hope to turn around and sell at a profit. With $25 billion of capital under management, Goldman's private equity arm itself is one of the largest buyout firms in the world, according to Thomson Venture Economics. The moves are not unrelated to trading. In both cases, banks are flocking to exotic and inaccessible markets where there aren't many others to fight for profit. Counterintuitively, they're seeking out the investments that would be the hardest to get rid of in the event of a disaster. They're betting that handsome returns when times are good will make up for losses when things turn ugly. Larger Leverage = Smaller Safety Cushion So far, the rewards are justifying the risks: Big investment banks are booking record profits, and their stocks have zoomed, up 64% since 2001. But once-calm global markets are getting rocky as interest rates rise, choking off the easy money. Fears of more rate hikes to come have triggered sell-offs in stocks, bonds, and currencies around the world since early May. That's raising the stakes for arguably the biggest game of risk ever to play out on Wall Street. If banks succeed, they'll rack up even bigger earnings. But if they borrow too much money for their trades or take on more risk than they can manage, the wreckage could be considerable. "A world where huge amounts of leverage have been brought into the system is a dangerous world," Berkshire Hathaway's CEO Warren Buffett observed. And "as interest rates rise . . . people will stretch even further and take greater risks," warns John Gutfreund, the former CEO of Salomon Bros. Andy M. Brooks, head of equity trading at investment manager T. Rowe Price Group, puts it more bluntly: "If people step out too much, they're going to get whacked." Just as investment banks are taking more risks, so are millions of individuals. They've bid up prices and accepted thinner safety cushions in the past few years on commodities, international stocks, and shares of the riskiest U.S. companies. Penny-stock trading has soared, up 640% from three years ago. And home buyers have leveraged up, buying more expensive houses with more complex mortgages. Says James Grant, editor of Grant's Interest Rate Observer and a financial market historian: "The world is stretching for return." The last time investors stretched so far, during the dot-com boom of the late '90s, the results were disastrous. But the biggest danger may be on Wall Street. As the banks trade in ever-more-obscure products with ever-more-opaque clients such as hedge funds, observers worry that they might not be able to settle their trades in the event of a market shock, intensifying the damage. Or scandals might get them first. Suspicions are rising that bank traders are acting on nonpublic information gleaned from their clients. So-called front-running is nothing new to Wall Street watchers, but with so many different kinds of financial products being traded today, and so many parties involved, the temptations are unprecedented. The SEC has "very active examinations and investigations under way," says Lori Richards, an agency director. Banks insist they're safer than ever. They've hired many of the greatest mathematical minds in the world to create impossibly complex risk models. They deal in so many markets that the chances of all of them going haywire simultaneously appear minuscule. And traders have been feathering banks' nests for five years. They've produced record earnings and boosted asset bases to unheard of sizes, making even bigger bets possible. Although the scale of trading activity has soared, risk now accounts for about the same percentage of brokers' total equity as it did in the 1990s, notes Tom Foley, financial-services credit analyst at Standard & Poor's. Investors have been cheering banks on to raise their risk profiles even more. Even though the recent corretion in the emerging markets has knocked Goldman's stock price down 9% since May 9, wiping out $6.8 billion in market value, analysts from UBS, Merrill Lynch, and Punk Ziegel have either upgraded or reiterated their support for the stock. They expect that any rise in volatility will create even more trading opportunities. The question is, how far will Goldman and the others go? From the looks of it, pretty far. All of them are ramping up teams of so-called proprietary traders who play with the banks' own money. Merrill Lynch is expanding a "strategic risk" team for a wide variety of equity securities. More than 100 UBS traders have migrated to a hedge fund the bank has seeded and is marketing to outside investors. The appetite for proprietary traders is growing "exponentially," says Richard Stein of executive recruiting firm Korn Ferry International. Banks are paying up, offering some traders $10 million to $20 million a year, he says. Banks are building out their infrastructures, too. UBS already boasts the largest trading floor in the world in Stamford, Conn., where more than 1,000 traders inhabit a 103,000-square-foot space that was last updated in 2002. It is no longer big enough. "We're expanding," says Mark Bridges, a senior executive. The Swiss bank is so eager to keep its employees focused on the task at hand that it has sprinkled six concession stands that sell Starbucks coffee around the trading floor. Across the street, the Royal Bank of Scotland expects to start construction of a 95,000-sq.-ft. space this summer. Citigroup, meanwhile, is focusing on squeezing more bodies onto its three main trading floors. Right now there are twice as many technologists crunching analytics and market data as there are traders on the floors. By 2008, the ratio could be 1 to 1. They're needed: Transactions have become so complex that some traders have eight computer screens at their desk. Wall Street's exuberance is palpable as the pain of big blowups of the past recedes from memory. John Meriwether, the former head of Long-Term Capital Management, is now considered a hero to some. On June 28 the industry newsletter Alternative Investment News will give Meriwether a lifetime achievement award for pioneering alternative investment strategies. (Meriwether now runs a fund called JWM Partners) JP Morgan Reports "Value at Risk" How the markets will respond to a major crisis is uncertain. That's because banks are dealing more with unpredictable clients like hedge funds and in less familiar financial products like derivatives of derivatives. They also use any number of risk models whose predictions vary wildly depending on the assumptions. For example, JPMorgan Chase estimates in its annual report that in 2005 its trading portfolios were at risk of losing $88 million on any given day, a pittance compared with its annual profit of $8.5 billion. The figure it cited is called value at risk, or VAR, which describes the total losses across all positions, from pork bellies to Iraqi bonds, that could be sustained in any single day under normal trading conditions. On average, major investment banks report VAR of $56 million. But such backward-looking estimates don't capture the extent of the banks' risks. JP Morgan's annual report tells investors that losses could have soared to as much as $1.4 billion over, say, a four-week period last year if an abnormal event had occurred. That figure was based on a "stress test" it performed on its books, another kind of risk-modeling technique. The good news? At least banks are reporting their VAR numbers; they didn't before the late 1990s. The bad news is that JPMorgan is one of only a few banks to divulge results of a stress test or any other measure of unusual risk. Investors, guided mostly by VAR amounts, have no idea what might happen in an abnormal event. "Banks are treating exceptions [to the norm] as adjunct risk," says Nassim Taleb, a professor at the University of Massachusetts Amherst and former proprietary trader at UBS and Credit Suisse First Boston who has written extensively about the limits of VAR. "But when you ride a plane, you don't worry about your coffee being cold. What you worry about is the risk that your plane will crash." Wall Street chiefs are aware of risk models' limitations. During an investor conference last November, Goldman's Paulson was asked to talk about his readiness for a big blow to the financial system. Paulson issued a litany of warnings. The main risk measure Goldman discloses, VAR, "always assumes that the future is going to be like the past," he said. And even though the bank regularly uses many different models to test its resiliency to various disaster scenarios, no one can correctly predict where the next disaster will come from. "The one thing we do know," Paulson explained, "is [that] if and when there is another shock, things you hope wouldn't correlate [or trade in tandem] are going to correlate." Seemingly unrelated assets like, say, silver and options on Japanese commercial mortgages could all go into free fall. Yet, even if the financial markets don't crash, banks' aggressive moves into trading threaten to scare off clients who wonder where they will rank if a panic triggers a sell-off. Will the bank perform its fiduciary responsibility to its client and execute its trades, or will it cover its own hide? June Ratings Changes On 6-16 Brean Murray Initiated coverage of WFC at Strong Buy, Brean Murray Initiated coverage of WB at Strong Buy, and Brean Murray Initiated coverage of BAC at Strong Buy. Exodus of Takeover Speculators Sinks Citizens Shares Dan Seymour, AP 6-26 Shares of Citizens Banking Corp. have lost almost 12 percent since the company said it is buying Republic Bancorp as the deal chased away investors who thought Citizens would be selling itself instead of buying another bank. Citizens said early Tuesday it is buying Republic in a mostly stock transaction valued at $1.05 billion. Citizens shares, which fell 8.8 percent Tuesday to a new 52-week low, dropped an additional 81 cents, or 3.3 percent, to $23.85 in afternoon trading on the Nasdaq Wednesday, their lowest value since early 2003. Boenning & Scattergood analyst Wilson L. Smith said investors had baked a takeover premium into Citizens stock, wrongly thinking the company was looking to sell itself. "A number of people have said that apparently there was some takeover premium in the stock," Smith said. "Management were not sellers; if you thought they were, you were wrong." Baird analyst Young B. Im lowered his price target on Citizens shares to $28 from $30 to erase the potential for a sale to a bigger bank. Im said the deal's value is reasonable, but news of an expansion amid a challenging economic environment for banks will add "near-term noise" for the shares. The 85-percent-stock, 15-percent-cash deal values Republic at about $13.86 per share, which represents a 31 percent premium to the company's closing price Monday. Stocks of targeted companies usually trade lower than an offered price leading up to the closing of a sale. How much lower depends on the market's expectations for the likelihood the deal will close and the potential for the asset offered in the purchase -- in this case, Citizens stock -- to depreciate before the deal closes. As Citizens stock falls, the deal becomes less valuable for Republic. Im said if Republic shares reach $13 investors should sell the stock rather than wait for the Citizens deal to close. Whether Citizens is overpaying for Republic is a matter of perspective. Boenning's Smith said the premium over Republic's stock price is 5 or 6 percentage points higher than typical takeover premiums for similarly sized banks. But Citizens is paying a price in line with comparable takeovers in terms of book value, and is getting an inexpensive price relative to similar deals in terms of earnings multiples, Smith said. Investors may also be worried that by buying Republic, which operates mostly in Michigan, Citizens is expanding into a weakening economy, Smith said. The local economy is suffering from an ailing car industry and a slowdown in housing. But Smith said the merger makes "all the sense in the world" because banks facing a slow economy need to save money through scale. City National Reduces Growth Estimates AP, 6-22 City National Corp. reduced its full-year 2006 guidance citing lower-than-anticipated deposit growth. City National said it now expects 2006 earnings per share growth of 1 percent to 4 percent over 2005 levels, down from previous guidance of growth between 8% and 10%. The new estimate implies 2006 earnings of $4.65 to $4.78 per share, versus the $4.60 per share earned in 2005. The Beverly Hills, Calif.-based company attributed the reduced guidance to lower-than-anticipated deposit growth and higher funding costs. "So far in the second quarter, the addition of mutual fund and brokerage assets has substantially exceeded the decline of low-cost deposit balances," the company said in a filing with the SEC. Merrill Lynch analyst Heather Wolf downgraded the company to "Neutral" from "Buy," shaved her 2006 estimate to $4.75 from $5, and lowered her 2007 forecast to $5 from $5.35. "The deposit environment is so uncertain that management wants to keep its balance sheet liquidity available in case it needs additional sources of funding," Wolf said in a client note. Wolf noted the deposit issue is likely industrywide, as City National has not historically had problems in this area. Also on 6-22, Merrill Lynch cut UnionBanCal [UB] to sell from neutral, saying it expects earnings forecasts to be lowered in the coming quarters. The broker told clients it is concerned about the San Francisco-based bank's margin after management recently indicated that the hedge book will become more dilutive to earnings per share in the next quarters. Ryan Beck analyst Jacqueline Reeves lowered her rating on City National to "Market Perform" from "Outperform" and cut her 2006 estimate to $4.65 from $4.95. "The company's revised outlook and our lower estimates indicate that the stock appears appropriately valued in relation to the industry benchmark," Reeves said. Reeves also lowered her price target to $73 from $78. Wall Street analysts have pegged the company to earn $4.94 per share in 2006, and $5.47 in 2007, according to Thomson Financial. June Ratings Changes On 6-16 Brean Murray Initiated coverage of FULT at Accumulate. On 6-12 KeyBanc Capital Mkts / McDonald Upgraded ONB from Hold to Buy. On 6-20 Ferris Baker Watts Upgraded SUSQ from Neutral to Buy. On 6-23 Merrill Lynch on cut CMA to "sell" from "neutral" and said it expects downward revisions in the company's estimates over the next several quarters. The brokerage said, based on announcements from the bank's peers, it expects the company's margin to be under more pressure than investors expect. It also expects credit to put pressure on Comerica's earnings from the second half of 2006. On 6-29 Keefe Bruyette Upgraded CBCF from Market Perform to Outperform. May Ratings Changes On 5-26 Prudential Downgraded SNV from Overweight to Neutral. On 5-25 Lehman Cut Associated Banc-Corp To Equal Weight. On 5-18 Ryan, Beck & Co Downgraded FMER from Market Perform to Underperform. Home Page Factoids Previous Update |