Danger Signals

Bank Bond Spreads Endanger S&P 500 Index’s Advance (Update2)
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By Michael Tsang
March 23 (Bloomberg) -- This month’s record
rally in U.S. financial companies is in jeopardy, according to the bond market, where concern about bank failures is growing.
While the Standard & Poor’s 500
Financials Index of banks, brokerages and insurers surged as much as 54 percent from a 17- year low on March 6, bonds of the companies yield 8.55 percentage points more than Treasuries, about the widest in 13 years, according to Merrill Lynch & Co. indexes. The gap between yields of financial institutions’ bonds and Treasuries widened even as their stocks jumped.
divergence between the performance of banks’ stocks and bonds shows the struggle facing investors trying to determine if the S&P 500’s 14 percent gain in the past two weeks means the worst is over for equities following the steepest plunge since 1937. Financial companies led the past month’s gains.
“Equities are trading as a barometer of
speculative appetite,” said Kevin Caron, the Florham Park, New Jersey-based market strategist at the private client group of Stifel Nicolaus & Co., which oversees about $50 billion. “The bond market is focusing more on the balance sheet and the bogeyman lives in the balance sheet.”
American International Group Inc., the insurer receiving $173 billion of government funds, more than tripled in New York Stock Exchange composite trading since March 6. Its 5.85 percent notes due in 2018 yield more than 19 percentage points over government debt, according to Trace, the bond-price reporting service of the Financial Industry Regulatory Authority.
Geithner’s Plan
Caron says the
S&P 500 will retreat within three months and may fall as much as 35 percent to 500. The forecast is based on his prediction S&P 500 companies will earn $50 a share this year while valuations drop to 10 times profit. His firm recommends clients with a medium appetite for risk invest 25 percent in equities and the rest in cash, Treasuries and investment-grade corporate bonds.
The S&P 500 climbed 3.7 percent as of 11:25 a.m. in New York amid speculation Treasury Secretary Timothy Geithner’s plan to rid banks of toxic assets will help revive economic growth. The program is aimed at financing as much as $1 trillion in purchases of illiquid real-estate assets, using $75 billion to $100 billion of the Treasury’s remaining bank-rescue funds, according to a statement today.
Bear Stearns, Lehman
Financial stocks led the market’s plunge from a record in October 2007 as New York-based Bear Stearns Cos. collapsed a year ago, Lehman Brothers Holdings Inc. went bankrupt in September and the government set aside $218 billion to prop up AIG and Citigroup, according to data compiled by Bloomberg. U.S. financial companies recorded almost $850 billion in losses and writedowns since the start of 2007, Bloomberg data show.
Citigroup Inc., Bank of America Corp. and JPMorgan Chase & Co. triggered the steepest rally in the S&P 500 financial index since at least 1989 when they said they were profitable in January and February. Then, the Federal Reserve pledged on March 18 to buy more than $1 trillion of Treasury notes and bonds backed by home loans to keep interest rates from rising. Financial stocks rose 54 percent in the eight days to March 18.
The combination persuaded some investors the worst of the recession is over after the economy contracted 6.2 percent last quarter.
‘Sniff Out’
“The market to some degree is beginning to sniff out the bottom of the economic and the earnings
degradation,” said Stephen Wood, senior portfolio strategist at Russell Investments in New York, which oversees $150 billion. “We’re getting a silhouette at the very least of how bad things are, and what’s being done. It’s as bad as expected, but not as bad as feared.”
The 10 best-performing
financial stocks in the S&P 500 have climbed more than 64 percent since March 6. The surge helped the index rebound from the worst start in its 81-year history, lifting it from a 12-year low of 676.53. The 17 percent jump in the seven-day period ended March 18 was the best since 1939, data compiled by Bloomberg show.
Last week, the index rose
1.6 percent to 768.54, trimming its 2009 drop to 15 percent from as much as 25 percent.
Bonds tell a different story. The difference between the average yield on 1,159 bonds of financial companies in the Merrill Lynch U.S. Financial Corporates Index and Treasuries ended last week at 8.55 percentage points, compared with 8.52 points on March 6. The index includes debt from two-thirds of
financial firms in the S&P 500. The gap reached a record 8.81 points on March 11.
AIG Bonds
Shares of
AIG, deemed a “systemically significant failing institution” by the Treasury Department after its financial products unit backed $298 billion of assets through derivative contracts, gained 260 percent since March 6, ending last week at $1.26. That’s the steepest rise among 81 financial stocks in the S&P 500.
Its 5.05 percent senior unsecured notes due in 2015, which were sold less than three years ago, now trade at 42.5 cents on the dollar, according to Trace.
The difference between the payout on
Citigroup’s 6.95 percent bonds due in 2018 and Treasuries widened 1.37 percentage points since March 9 to 10.04 points last week. Shares of Citigroup, once the world’s biggest bank by market value, have more than doubled after slumping below $1.
Wells Fargo, Bank of America
Wells Fargo & Co.’s 5.75 percent bonds due in 2017 widened to 5.05 percentage points from 4.61 points in the past two weeks, while shares of the San Francisco-based bank climbed 62 percent. The yield on Charlotte, North Carolina-based Bank of America’s 6.875 percent bonds due in 2018 widened to 11.08 percentage points more than comparable maturity Treasuries. The stock gained 97 percent during the period.
Citigroup, Wells Fargo and Bank of America may each record losses of between $56 billion and $67 billion in the next two years, a March 6 report by David Hendler, New York-based analyst at debt research firm CreditSights Inc., said. The losses could each exceed $100 billion in a “severe case,” he said.
The financial industry’s
writedowns on $6.84 trillion of bank loans may almost double to 3.56 percent, exceeding peak levels during the Great Depression, according to estimates in a March 10 report by Michael Mayo, a New York-based analyst at Deutsche Bank AG.
Even with the stock rally,
AIG and Citigroup are still down more than 90 percent during the 17-month bear market.
‘Still in Trouble’
Investors “are in a pretty big state of what I’ll call denial, just hoping this stock-market rally will help them make back all their losses,” said
Diane Garnick, a New York-based investment strategist at Invesco Ltd., which oversees $357 billion. “Financials are still in trouble. There’s a really good chance that bankruptcy is not out of the question.”
The Federal Deposit Insurance Corp. seized banks in Kansas, Colorado and Georgia last week, pushing this year’s tally of failed U.S. lenders to 20. FDIC-insured banks lost $32.1 billion from October through December, the first quarterly loss since 1990. The deposit insurance fund that reimburses customers of closed banks tumbled 45 percent to $18.9 billion in the quarter, reflecting the closing of 25 lenders last year.
Russell Investments’ Wood says increased confidence in President
Barack Obama’s plans to revive the economy is luring investors to equities after the S&P 500 lost more than half its value.
Taxpayer Money
The government has pumped more than $335 billion in taxpayer money into banks to boost lending, while the Fed said last week it will buy $300 billion in Treasuries, double its purchases of agency debt to $200 billion and acquire an additional $750 billion in mortgage-backed securities on top of an already-announced $500 billion program. The central bank said it will consider expanding a program to relieve companies of troubled loans to include “other financial assets.”
Fed Chairman
Ben S. Bernanke played down the possibility the U.S. economy will slide into a depression in an interview with CBS’s “60 Minutes” on March 15. He predicted the recession will probably end this year and the economy will expand in 2010.
Profit at S&P 500
companies will surge 93 percent in the last three months of 2009, halting the longest streak of quarterly earnings declines since at least 1947, according to analysts’ forecasts compiled by Bloomberg. The U.S. economy may rebound in the fourth quarter, expanding at a 1.6 percent annual rate after contracting by the most in 26 years at the end of 2008, a separate survey of economists shows.
Bank Earnings
Sustaining the rebound may depend on
bank earnings that analysts have overestimated for at least six straight quarters, data compiled by Bloomberg show. In December, Wall Street forecast earnings at financial firms would rise 32 percent this quarter and 56 percent next quarter. Now, analysts estimate profits will drop 33 percent and 34 percent, respectively.
Citigroup, Bank of America and JPMorgan profits from January and February probably don’t include writedowns on bad assets and provisions for loan losses, said Meredith Whitney, founder of New York-based Meredith Whitney Advisory Group LLC.
Bank of America Chief Executive Officer
Kenneth Lewis said on March 12 the lender made money in January and February, joining Citigroup’s Vikram Pandit and JPMorgan Chase CEO Jamie Dimon in indicating the biggest U.S. banks are recovering.
Bank of America spokesman Scott Silvestri declined to elaborate on how the bank’s profit was calculated or whether it included provisions for writedowns and credit losses. Citigroup’s estimate was based on generally accepted accounting principles for net income, spokesman Stephen Cohen said.
‘Solidly Profitable’
JPMorgan spokesman
Joseph Evangelisti referred to the bank’s Feb. 23 conference call on which Dimon said the lender was “solidly profitable quarter-to-date” and its outlook for the quarter was “in line with analysts’ expectations.”
Last year, provisions for loan losses and asset writedowns cost the three lenders a combined $125 billion, more than three times their net income in 2007, data compiled by Bloomberg show.
unemployment and declining home values threaten to forestall a rebound as consumers reduce spending and more homeowners fall behind on mortgages.
jobless rate may increase to 9.3 percent by the end of the year, economists’ estimates compiled by Bloomberg show. The last time more Americans were out of work was in 1983. People collecting U.S. jobless benefits ballooned to a record 5.47 million in the week ended March 7, indicating fired employees aren’t finding new work as companies cut costs.
U.S. home prices, which have fallen 27 percent since the peak in 2006, will tumble at least 20 percent more before hitting bottom, according to
Robert Stevenson, a New York-based analyst at Fox-Pitt Kelton Cochran Caronia Waller. More than one in 10 home loans in the U.S. are in foreclosure or at least one month past due, the highest ever recorded, the Mortgage Bankers Association said on March 5.
“People are sounding the all-clear on this,” said
Peter Sorrentino, who helps manage $15.5 billion at Huntington Asset Advisors in Cincinnati. “But there are still some skeletons left in the closet.”
To contact the reporter on this story:
Michael Tsang in New York at mtsang1@bloomberg.net

Commentary: This rally has dead cat bounce written all over it. Structural problems remain in the economy and in financials in particular. It would be enlightening to see audited financial statements from the banks who triggered the rally by "internal memos". The differential between treasuries and corporate bonds is telling us the true story that long term interest rates will eventually rise. We will examine some strategies to protect our wealth in a future post.