Glimmers of light at the end of the tunnelThe combination of improving macro data and a credible stress test suggests that this will be the final round of capital raises for big banks. The key will be that the stress test is credible and sufficient detail is made public at the individual bank level. Up until now the market has faced a dual uncertainty of no foreseeable bottom in the economy and little credibility in balance sheets of the major banks. If the stress test follows the numbers that have leaked in the press, we think the test has sufficient credibility to represent the true mark-to-market investors have lacked up until now. Not enough is public yet, but the leaks provide a credible base case. Consider:
Leveraged loss risk wanes: In 2008, securities losses were at the core of capital destruction. We are now in a “classic” NPA cycle where pre-provision earnings may offset loan losses.
Macro improvement: Better macro data reduces tail risk of a second round of leveraged losses. That said, any economic recovery will likely be weak, leading to a sustained period of high losses and low bank earnings.
Capital raises could cause indigestion: We expect about $130bn of capital needs this year. While banks have stopped destroying capital, they still face the core issue that they are over-levered. The Fed faces a double edged sword. The stress test needs to force a credible amount of capital in order to be cathartic but it may be tough for the market to absorb the supply. Potential capital raises concern us as the last two bank stock rallies ended following $30-50bn of deals. That said the performance of recent deals is encouraging.
Valuation – tangible book vs. pre-provision: We expect valuations to remain tangible book based until recaps are complete. Here, banks do not look cheap vs. prior crises. The risk is investors view the stress test capital raises as the final round and focus on pre-provision earnings.
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