Monday, June 30, 2008
Restoring Trust in Bank Stocks
Financial stocks are down 17% this month, and the simple explanation is that investors have lost their trust in banks and brokerages. Further evidence of investor distrust: Citigroup Inc. and Bank of America Corp. are both trading at nearly 80% of book value, while J.P. Morgan Chase & Co., considered to be the soundest of the big banks, is only trading around book value. Many smaller banks are trading at less than half of book values. How then can banks win back that trust? A lesson from the savings-and-loan crisis is that banks that fail to quickly acknowledge problems and act on them pay a steep price. So far, too many banks have drip-fed losses, and then capital raises, out over a number of quarters. Yet regulators haven't pushed hard enough to force banks to quickly write down the value of their assets. And not enough banks have been willing to sell stock at low prices to bolster their balance sheets. A reluctance to recognize these two realities has led to two proposed fixes being discussed by the banks, potential investors, politicians and, to a lesser extent, regulators. Both could potentially help the situation, but the assistance would come at a cost. And it's not clear that the system won't heal itself without them. First are rules on private-equity investments in banks and second are rules concerning mergers between banks. Banking regulations say that if a private-equity firm buys more than 25% of a bank, the firm itself will be treated just like a fully regulated bank, a level of scrutiny that a Carlyle Group or Blackstone Group would never submit to. Making a smaller investment doesn't help. With a stake between 10% and 25%, the investor would typically have to enter an agreement with the regulator not to control the bank's management. And private-equity guys want control in return for their money. Private-equity firms argue that the rules are archaic and prevent them from riding to the rescue of failing banks. But there's a logic to the rules. They're designed to prevent a firm from using the bank to lend money to its other investments, in effect using the bank like a giant credit card. And since the banking sector relies on a range of government subsidies -- embedded, for example, in deposit insurance -- taxpayers deserve this protection. Also, any rule changes could lead to an unfair playing field, where unregulated private-equity firms compete for acquisitions with regulated banks or public investors. The rules are less restrictive than they first appear. Private-equity firms can set up separate bank-holding companies that can be used to acquire banks. JLL Partners did this in December when it set up a regulated entity that has acquired several Texan banks. Regulators also have to doubt how much money private-equity firms would put into banks. To make investments pay off, they typically use enormous leverage, which no regulator is going to allow in the banking sector. That means banks only become attractive if their valuations fall to rock-bottom levels. Another area that has drawn attention: banks' longstanding complaint that rules make it tough for strong banks to buy weaker banks. Banks typically don't have to put a market price on many of their assets, typically big portions of their loan portfolios, even if the market has tanked. But if one bank buys another, the buyer must mark the seller's assets to the current market price, even if the loans are still current. That would force losses which would hit the levels of capital the regulators require banks to hold. Banks gripe that this makes it tougher for them to do deals. But that misses a big, underlying cause of banks' current problems -- lack of investor trust. By dumping bank stocks, investors are in effect doing what would happen in a bank merger -- marking down the banks' assets, even if the banks themselves are holding the values steady. When a bank trades at half of book value, investors are saying the bank's assets are worth somewhere near half of what the bank says they are. The way to end this problem is by recognizing more, not less, of the losses that investors believe will prove real. Until banks accept that the housing market won't magically return to normal, the gap between share prices and book values may only grow wider. The shortage in bank capital has nothing to do with rules that private-equity investors or banks themselves deem to be unfriendly. It's that banks haven't confessed enough to regain investor trust. That might be painful, but in the end, it will heal the system.