Financial stocks - Trouble is not over yet!

After a couple of weeks where every one was more focused on the VIX and the VSTOXX than any thing else, it is interesting to sit back and try predict where the markets are going to move for the rest of the year. We can be sure about a few things - the European debt crisis is far from over, property (and hence stock) price correction in China still has quite some way to go and the banking sector in US and Europe hasn't seen the last of regulatory changes! Considering the above, any long-term directional strategies are prone to extreme volatility...it's much safer to sit on cash and watch from the sidelines! But, if you have the appetite and energy to track and play index funds, there is more money to be made than any other time - provided one doesn't get greedy enough to try and catch the rock bottom or time the peaks!

If there is one sector to avoid jumping in to invest at this point, it is financials. A combination of factors would make good returns on equity extremely difficult to achieve in this sector. A simplistic way to look at how ROE can be impacted for this sector is the way Dupont model looks at it:
Return on Equity = Net Income/Equity = Net Income/Sales * Sales/Assets * Assets/Equity

Factor 1 - Corporate and investment banks would be forced to move out of more and more of their propreitary trading functions out of the banking entity if not stop some forms of propreitary trading altogether. The recent news on Goldman stopping prop trading on CLOs should come as no surprise. Though the regulation to carve out swap desks from FDIC-covered entities would probably not see the light of the day (and would be a shame if implemented!), there is still the looming possibility of regulatory restrictions forcing banks to curtail some of their most lucrative revenue streams. If not regulatory changes, the very fact that the more complex, and hence in most cases more profitable, instruments would face higher capital charges would force banks to be much more selective in the new product area than they ever have been. Winning banks would however find a way to manage capital risk and liquidity risk well while still forging ahead with products that provide greater-than-normal returns. That's why GS and JPM are still good bets in the medium term despite any negative publicity and legal risk that stares in their face!

Factor 2 - Key drivers for this factor goes hand in hand with some of the drivers from factor 1. The ability to increase sales on assets is severely constrained if banks are forced to depend more on revenue streams from traditional net interest and fee income streams. Trading shops get an unfair advantage in this area - though covering settlement risk and liquidity risk are more important than ever, banks with strong trading desks would continue to exploit volatility to generate maximum spread revenue from trading across different asset classses, while locking up poportionately lower capital than traditional banking functions. Though the last couple of quarters saw low volatility and hence lower spread income than the same period in 2009, the spike in volatility (which i bet is going to sustain itself for some time) would boost trading revenues again for the best trading desks in the industry. Traditional financial entities focused on retail and commercial lending, asset management or for that matter trust and custody, would on the other hand face severe challenges to increase sales on assets. Asset managers would especially see more and more end customers preferring less-lucrative passive strategies instead of higher-spread active strategies. Again, GS, JPM and maybe even MS has an advantage.

Factor 3 - This is an area where every one from the best to the worst in the industry would be hard hit. There simply is no more appetite for abnormal leverage - Tier 1 capital as a proportion of total capital would need to increase significantly from current levels. This combined with the fact that Tier 1 would be defined much more striclty - no hybrid instruments, netting of minority interest components etc for example - would force several banks to raise more capital. The recent directive from the Swiss government to UBS and CS for curtailing risk taking and increasing capital (www.bloomberg.com/apps/news?pid=20601110&sid=aCGxFLs8FV64) is a sign of things to come in this area. There are some analysts who have predicted that US and European banks would have to raise over USD 250 bn in additional capital over the next 12-18 months to meet more stringent rules on risk weighting assets and Tier 1 capital as a proportion of total capital.

A combination of these factors would make it extremely difficult for most, if not all banks, to maintain and increase ROE at or above the pre-crisis 15%+ levels. This, combined with lower options for fueling top line growth, would mean that there is not much room for share prices to go up! I would still bet on GS in specific since it is going to be new product ingenuity and smart strategies that are going to be even more important for driving shareholder value in the immediate future.

But, if governments and regulators go ballistic and blame banks for all the ills in the world (the Greek PM blaming US and European banks for 'misleading them' for example!!), God help even Goldman! It is difficult to find any logic in any kind of mob-mentality driven regulatory action though - blaming Goldman or Citi or JPM for making some propreitary profits on shorting MBS while some clients lost money on it is like blaming your stock broker for increase in value of his personal portfolio while you suffered losses on yours!! It's you who got to take care of your own money! Just to make it clear, i am not talking about asset managers here, but the traditional sell-side part of the industry.

Having said that, GS at 140 or even C at sub-4 is still defintely worth putting your money in!