What Banks Need to Worry About After Market Rout

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The outlook for the rest of the year seems to have changed right under bankers' feet.

Just a few weeks ago the KBW Bank Index was as strong as it had been all year, the Greek debt crisis was receding from the headlines, the U.S. jobs picture had improved and in the eyes of some the Federal Reserve was steaming toward a September interest rate hike. It seemed like some momentum finally might be headed banks' way.

Then came the Chinese currency devaluation, concerns about global growth and a lot of sudden second-guessing about everything.

The KBW index fell 5.4% Monday, worse than the 3.6% decline in the Dow Jones Industrial Average and the nearly 4% decline in the S&P 500.

Analysts attributed much of the fall to a shift in investors' expectations about the timing of an eventual hike in interest rates. Amid the turmoil in global markets, the chances of the Federal Reserve Board taking action next month seemed lower on Monday than it did last week.

"What has changed is the market perception of when that event is going to occur," said Marty Mosby, a banking industry analyst at Vining Sparks.

And the prolonging of tight lending margins is just part of the hit banks could sustain. A sustained shock would complicate bank M&A dealmaking, could crimp wealth management and foreign-exchange fees, and could present other risks.

Threat to 3Q Results

It will be bad news for banks — and for everyone else — if the market shocks of the past few days leave the economy wounded long term. But the turmoil may not be terrible for banks' short-term profits.

Banks do not hold equities as investments, of course, but equities contribute a big portion of their capital-markets trading and brokerage income. Market volatility generally benefits banks and other trading middlemen, which earn fees as their clients shift positions in response to market swings.

"The takeaway, at this point, is that banks that have strong franchises in equity capital markets should see some benefit" from the recent market volatility, said Justin Fuller, a senior director at Fitch Ratings.

Morgan Stanley has the largest share of that business, followed by Goldman Sachs, JPMorgan Chase, Bank of America and Citigroup, he said.

However, while volatility could help in the short term, megabanks are so sprawling and complex that what helps them on one line of the earnings statement could hurt them on another.

Take fixed-income trading. Wild stock-price swings could raise bond prices as investors seek safety, which would help banks' trading desks. On the other hand, if volatility causes Treasury yields to keep falling, it could "grind down net interest margins" still more, said Fuller.

That is just one example of how hard it is to predict the effects of market volatility on banks' profits.

"I don't think anyone will say unequivocally [the market drop] is a negative, because it depends on what side of the trading ledger the banks were on," said Gerard Cassidy, managing director of equity research at RBC Capital Markets. "Capital-markets forecasting is fraught with risks in any environment, and this volatility just compounds it."

It seems safe to say, however, that if the U.S. does not rebound from its market correction, banks' third-quarter wealth-management fees will likely be lower, because they are generally charged as a percentage of assets under management.

And looking beyond equity markets, the underlying causes of the recent market volatility, including the Chinese slowdown and falling commodity prices, should hurt third-quarter earnings for the largest banks.

The sudden devaluation of the yuan will likely harm banks like Citi, JPMorgan, Goldman and B of A that have large foreign-exchange trading desks, said Mayra Rodríguez Valladares, a banking consultant with MRV Associates.

The Chinese government's decision to devaluate the Yuan "was a very unexpected move, so the banks wouldn't have had their hedges in place," she said. "Banks with big forex exposures are going to get hit."

She said the negatives from poor forex and commodity performance are likely to overwhelm any benefit that banks may have hoped to reap from market volatility — which, in any case, regulations like the Volcker Rule have made it tougher to take advantage of.

If turmoil like this had happened before Dodd-Frank and other new regulations, "banks would be bathing in gold because of all the volatility," she said. "But now it's harder to speculate."

The winners from market turmoil are more likely to be less regulated companies, like hedge funds, Valladares said.

Gauging the Fed Factor

The sharp selloff of U.S. bank stocks was the flip side of a trend that played out in equity markets over the last several months. Between May and early August, bank stocks rose by about 5%, while the U.S. stock market as a whole declined slightly.

During that period, the banking industry benefited from the market's perception that higher interest rates would lead to a jump in banks' profits, analysts said.

If an interest rate hike is now off the table, there may be a negative impact on bank earnings of zero to 10%, depending on the institution, said Frederick Cannon, an industry analyst at Keefe, Bruyette & Woods. "Some of the earnings estimates are likely on the high side," he said.

Certain banks that have relatively asset-sensitive balance sheets, and therefore stand to benefit more from an interest rate hike, experienced steeper stock price declines on Monday. For example, shares in Memphis, Tenn.-based First Horizon National Corp. fell 6.3%.

Eric Wasserstrom, an analyst at Guggenheim Securities, expressed the view that investors are paying too much attention to banks' exposure to interest rates. He expects the eventual benefits from a rate hike will be smaller than recent swings in bank share prices might suggest.

"Even though the Fed will eventually hike rates, rates may not be resetting at a substantially higher level," Wasserstrom said.

Don't Forget Oil, Mortgages

Key consumer and commercial lines of business will be watched closely.

Mortgage lenders could benefit if a further drop in rates sparks another wave of refinancing, but some of them many not have properly hedged the value of their mortgage servicing rights.

In addition, the price of a barrel of oil has fallen more than 50% since its one-year peak last summer, which is a negative for banks that focus on the oil sector. San Antonio, Texas-based Cullen/Frost Bankers, which has a large energy business, saw a 5.3% price decline.

M&A Just Got Harder

Volatility in the stock market could slow down bank M&A. Generally, a rising stock market increases the currency buyers have to do deals. Having massive swings can make it harder for banks looking to use their stock to purchase other institutions.

"Whenever you have events like we have had in the market, it causes people to pause and reflect," said Rick Maples, co-head of investment banking at Keefe, Bruyette & Woods. "In the short run, you could see people regroup and figure out whether they think the values are right."

To counter this, banks could look to pay for deals with more cash, rather than stock, but this requires the buyer to have the money available to complete such a transaction, said Michael Iannaccone, president and managing partner of MDI Investments, an investment bank.

Additionally, as the stock market declines, there may also be a perception problem for sellers, Iannaccone said. These institutions may have unrealistic expectations on pricing and this can further hamper dealmaking.

"Everyone's stock comes down, but people's perception of the value of their entity doesn't really move with the market, which causes a problem," he added. "Sellers always want the best of all worlds."

At the same time, many sellers are banks that have illiquid stock and investors are unable to buy more stock if the price goes down and they want to increase their position or sell their existing stake as the market rebounds. If the market goes into a long-term decline, then these shareholders could decide they want out and this could encourage the board to decide to sell, said R. Lee Burrows, chief executive at Banks Street Partners, an investment bank.

"If I get nervous about Bank of America, I just sell the stock or if it looks cheap, I buy more," Burrows said. "But with these illiquid banks, you don't have many options. You are kind of stuck."

Some deals that have already been announced could be renegotiated if stock prices continue to decline over a prolonged period, experts said. Typically deals involving stock include a floor and a ceiling on the stock price so both the buyer and the seller are protected if there are large fluctuations in the market.

However, these safeguards are usually calculated over an extended period of time, say 10 days, so they may not be triggered, Iannaccone said. Also, there is usually a clause that compares the bank's stock to a certain index so if the entire market is down then renegotiations will not be triggered, Maples said.

Moreover, some deals are still likely to be completed since many banks are deciding to sell because of the ongoing costs of regulation.

"In today's environment, transactions are being driven by the costs associated with operating a bank and in the future because of all of the regulation," Iannaccone said. "Most of these deals will find a new negotiation point because of that."

On a Positive Note

Despite the unease, there is one bright spot for the banking industry. Companies that have gotten approval from their regulators to buy back shares from investors may now be able to take advantage of the depressed prices to purchase more of their stock.

"If there's a silver lining, that's it," said Scott Siefers, an analyst at Sandler O'Neill.

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