Ferdinand the Bull Chelsea Global Advisors By Edward Talisse New York | September 26, 2014 Not all bulls are eager and itching for a fight. Ferdinand the Bull, the delightful lead character from the 1930s children’s book of the same name, stubbornly resisted brawling and battling with the vicious and furious picadors and matadors he faced in the bull ring. Ferdinand, much like your author, preferred to gaze at the blue sky and smell the flowers, rather than tangle in the mud with his adversaries. Refusing to fight, Ferdinand was unceremoniously ejected from the ring. The affable bull retired to his home town farm where he lived out his days in peace and harmony – proving you don’t have to fight to be a bull! The book was banned and burned for its pacifist overtones in fascist Spain and Germany and embraced by Gandhi and surprisingly, Uncle Joe himself, Comrade Stalin! I introduced Ferdinand here to call attention to another reluctant bull- financials and in particular banks. Traditionally, banks have been the market’s leading pugilists, using leverage and taking outsized risks to generate above average returns. That all came to an end back in 2008 when most banks received a one-two knockout blow from Mr. Market and Mr. Regulator. Forced to retreat and sit quietly in their corner, bank management is now hopeful that higher interest rates will improve net interest margins and bring back the heady days of high double-digit returns on equity. Unfortunately, it is just not the case. Here is why. First, a bank’s net interest margin (NIM) is not a function of the level of interest rates, but rather on the shape of the yield curve. In this regard, the yield curve has been flattening and the trend is likely to continue if and when the Fed raises short-term interest rates. A flatter curve hurts bank earnings. So far in 2014, the U.S. 2y-10y yield curve spread has flattened by 65 basis points. Second, net interest margins are a reflection of excess lending capacity in the industry, not low interest rates. Today, the average net interest margin at U.S. banks is 3.10%, not so far from the long- term NIM average of 3.89% (Source: FRED). The Fed Funds rate in late 2005 was 4.25%, yet NIM was just 3.60%. Lending margins are in a long secular downward spiral due to over banking– it has nothing to do with low interest rates. Next, banks cannot leverage their capital to the same extent as they did before 2009. The larger U.S. banks are now faced with the Supplementary Leverage Ratio or SLR. Similar rules exist or will shortly exist in Europe and Asia as well. The SLR forces banks to shrink loan portfolios, at times dramatically, given the same capital base. Lastly, banks are now forced to hold an increasing portion of their assets in high-quality liquid securities to meet new liquidity rules. A high-quality asset is the gentleman’s description of low yielding asset. Maintaining large liquidity portfolios are a severe drag on earnings. The leading ETFs in this sector, the SPDR Financial Select ETF [XLF] and the SPDR S&P Bank ETF [KBE] have both lagged the broader market, the S&P 500 [SPY] by 32% and 43% respectively since the beginning of this now five year old bull market. Financials, once the market’s foremost indicator of the overall health of the economy, have been relegated to the sidelines due to shrinking margins, dilutive capital policies and legal issues. Chart #1 Financial Sector Performance vs.S&P 500 Chart #2 NIM for all U.S. Banks NIM Summary Statistics: Mean 3.89; Standard Error 0.04; Median 3.95; Mode 4.04; Standard Deviation 0.39; Range 1.81; Max 4.91; Min 3.10 (current reading); Count 122 or 30 years of quarterly observations. A quick illustration is in order here: Assume a Bank has $50bn Tier 1 Equity Capital Historical Case: net interest margin 4%, leverage ratio at 3%, net interest income will equal $66.67bn [(50/.03)*.04] Current Best Case: net interest margin 4%, leverage ratio at 6%, net interest income will equal $33.33bn [(50/.06)*.04] Current Base Case: net interest margin 3%, leverage ratio at 6%, net interest income will equal $25.00bn [(50/.06)*.03] The historical case is designed to remind you of the early years of this decade. NIM spreads were high as was leverage. The current best case is the aspirational state a bank can hope for, given the supplemental leverage requirements that the biggest U.S. banks now face. The current base case is the likely case, an unchanged NIM and higher supplementary leverage ratios. Let’s say NIM expands to its long-term average of 3.89% or 4% to be generous after the Federal Reserve normalizes interest rates from today’s all-time low reading of 3.10%. Even in this unlikely event, net interest income will fall over 50% ($66.67 to $33.33) due to more stringent leverage ratios imposed on banks. In the base or likely case, net interest income will fall over 62% given stable NIMs and higher leverage restrictions. The base case can easily turn into the bear case. Consider that banks must not set aside ‘high quality liquid assets,’ essentially earning nothing, to cover at least 30 days of anticipated cash outflows. That means a portion of the bank’s permitted leverage cannot be deployed into higher earning assets like commercial and industrial loans, hence reducing the bank’s earning power. Conclusion The last five years have been very kind to most stock sectors. Many bank stocks have recovered from their 2008-2009 lows and some have even reached new highs [JPM, WFC]. Others continue wallow in utter despair [C, BAC]. Nevertheless, earnings power at all the major banks has been permanently eroded and is unlikely to return. Banks are the new Utilities. Some banks can survive but are unlikely to thrive in this highly regulated environment. Higher interest rates will not spark a return the glory days – nor will cost cutting exercises. The investment implications are clear: financials are likely to continue to underperform the broader market on the upside and should behave as defensive stocks on the downside. Meanwhile, market leadership has moved away from financials to healthcare and technology. Like our good friend Ferdinand, well-heeled bankers can now look forward to their halcyon days idling at peace in the pursuit of pastoral pleasures. There is no need to fight anymore.