Correlation is to financial journalists what patriotism is to scoundrels. Nevertheless, this chart from a Goldman Sachs note published on Wednesday still suggests just how quickly US and European banks have begun to move in lockstep:
Goldman goes on to downgrade Q3 earnings estimates and price targets for the big US banks under its coverage. Thus it joins the Q3 earnings bunfight among the investment banks. Not that it’s the banks’ fault, of course, according to Goldman:
Unlike in 2008, we believe this time it is not about capital, but about a weakening macro picture and a sovereign crisis in which no clear resolution appears in sight, which we think is why every single bank we cover has underperformed the broader markets. One would have thought the market would reward those with strong balance and robust capital positions, but it has not, which signals those are not the key issues this time. While we expect the market to eventually start rewarding banks for fundamental outperformance, correlations are likely to remain high at least until contagion fears in Europe are reduced and we have a better understanding of the macro backdrop in the US.
US banks are sitting ducklings amid the eurozone crisis. Their overall net exposure is hard to assess but Goldman does a nice job of explaining the different estimates in plain English. Moreover, whereas most of the talk about US exposure concerns whether derivatives have been properly accounted for, Goldman correctly notes that the really worrying aspects are the knock-on effects of a continuing crisis on risk assets and inventories:
Since the market turmoil in Europe began, a lot of attention has been paid to how exposed the money center banks are to Europe. While US banks’ aggregate dollars of exposure is sizeable as presented as shown in Exhibit 5, we note two things: (1) the numbers presented are gross in nature and do not account for hedges, collateral, margin, etc., that significantly reduce exposure and (2) for US banks exposure to GIIPS countries in particular, about three fourths of the exposure is not direct foreign claims, it is gross notional derivatives and unfunded commitments that significantly inflate the exposure. While unfunded commitments could turn into riskier funded commitments, lines generally have standard conditions that need to be met before being drawn.
The net exposure at the banks appears very manageable, with exposure ranging from $3.2 bn (gross for WFC) to $16.7bn at BAC. That said, the bigger concerns are indirect impacts including contagion, a sell-off in risk assets (CMBX/ABX down 7%/22% qtd), and risk aversion. We believe capital market revenues will suffer in 3Q11 as banks are forced to take mark-downs on inventory, something we have not seen since 2009.
Here’s a useful table showing Goldman’s exposure estimates:
The rest of the note goes on to discuss the likely impact of lower mortgage rates (good), Operation Twist (bad) and US GDP growth (ugly) on US banks. Goldman predicts industry-wide linked-quarter declines in fixed income trading (40 per cent), investment banking (50 per cent) and total trading revenue (30 per cent). On average, this means:
… we revise our 3Q11 EPS estimates down 8% on the back of much-weaker-than-expected capital markets revenues andadditional pressure on NIM (from the meaningful decline in interest rates). As a partial offset, we adjust for better-than-expected loan growth as well as mortgage banking revenue. That said, our revisions for 3Q11 are more negative for capital market focused banks and more positive for banks with strong mortgage banking operations. We make slight adjustments to our 2012 and 2013 EPS estimates (down 3% each on average) to account for a more prolonged period of economic uncertainty which is likely to weigh on capital markets revenue and loan growth, as well as adjustments for recently announced expense initiatives. Following our most recent estimate changes, we are 5% below consensus for 3Q11 and 2% below consensus for 2012 on average.
In other words, “thanks, Europe”.