Earlier this week, Andrew Atkeson and William E. Simon Jr., a couple professors at UCLA, wrote an Op-ed in the Wall Street Journal entitled “The Rising Fear in Bank Stock Prices” discussing how the banking system is essentially a game of confidence and that more volatile bank stock prices are indicative of falling confidence in the world’s banks.
Given the long history of stock prices, the two professors were able to dig up information dating back to the 1920’s and calculated bank stock volatilities (see graph from WSJ) to make their assessment that volatilities rarely cross 3% unless a serious crisis is near (it’s currently above 3% right now and has been since mid-August). According to another market analyst, price-to-book ratios for banks can hover at an average of between 0.5x in times of crisis (which is the area where some major banks like Bank of America and Citigroup already trade) to 2x or more when things get better. As measured by the 24-bank KBW Bank Index (BKX), bank P/B ratios currently stand just over 0.6x. It was last at 2x in January 2006 and has been on a steady decline downwards since then. It began the year 2011 close to 1.05x. A similar but larger 40-bank SPDR S&P Bank Index ETF (KBE) sports a P/B of 0.75x indicating that it is more of the larger nationwide banks which are seeing the lower valuations compared to the regionals.
The article is a nice read, but perhaps something that watchers of credit default swap prices have already known or at least suspected for a while now. Perhaps a more real-time indicator of actual market funding costs, when a bank’s credit default swap price soars, it makes the bank’s actual ability to fund in wholesale markets that much harder as market participants looking to underwrite, hedge or even simply price and mark-to-market their risk get scared away (or demand more compensation to continue participating) by the declining confidence in the bank’s creditworthiness.
This might be a good time to mention the previous Fitch study on whether rising CDS spreads lead to bankruptcies. In that study, one of their findings was that CDS spreads did not appear to provide a leading signal of default risk for financial institutions. As of 12 months prior to the six credit events in the sector, the average one-year PD [probability of default] was 3.3%. For corporates, the predictiveness of CDS spreads was mixed. On average, spreads implied less than 10% cumulative PD for the 18 entities that incurred a credit event, or that fewer than one in 10 companies were expected to default over the following two-year period. However, at 12 months prior to the credit events, the average one-year CDS-implied PD had risen substantially to roughly 23%.
These findings, however, may be lacking in the entire perspective of the path to default. While rising fear does not equal bankruptcy, just because a company averts bankruptcy does not mean investors can still lose money. Unlike the financial sector, the corporate sector received a much smaller level of support (of all kinds but particularly financial in this case) from the public sector in ensuring their ability to continue on as a going concern. While billions and the recently revealed additional trillions of dollars in federal privileged funds were provided to banks that very likely would have otherwise succumbed to actual default if left on their own to fend for themselves, the larger majority of industrials (and the rest of the non-financial community of corporate debt issuing companies in general) were unavailable to receive the benefit of such important political and financial commitments.
There is no doubt, however, that CDS are prone to false positives and every jump up in swap prices is not necessarily a reason to be concerned. But perhaps users need to get a better grasp of the political effects and decisions that seem to play a much larger part in the ultimate performance of bank shares and swaps before being able to create trading and investing strategies around them.
