How many billions of dollars do you have to make to impress investors?
The big U.S. banks must be asking this question, after posting big (and frequently estimate-busting) profits in the first quarter of 2012. According to Standard & Poor's, the S&P 500 financials sector is on track to post year-over-year earnings growth of 14 per cent – the second-best sectoral growth on the index, and, more to the point, far better than the 1-per-cent year-over-year decline that analysts had anticipated when the quarter ended five weeks ago.
Financials are showing the highest rate of better-than-expected earnings of any sector in the index, led by Bank of America, whose $3.7-billion (U.S.) quarterly profit (excluding one-time items) beat analysts' consensus estimate by more than 150 per cent. As a group, S&P 500 financials are looking at more than $42-billion in profits for the quarter, according to Thomson Reuters.
A fat lot of good that's done for the stocks. The S&P 500 financials sector is down 4 per cent since earnings season began. Bank of America? It dropped nearly 10 per cent in the two weeks following its earnings release.
The profits are delivering everything investors could have asked. So what's the problem?
The clues might lie with a different group of investors – those in the bond market.
There, the earnings reports have kicked off not jubilation or even cautious optimism, but a new wave of nervousness. The major U.S. banks' aren't making enough progress reducing their biggest risk exposures – and bondholders are losing patience.
In a report issued last week, corporate credit analysts at Standard & Poor's said the yield spreads on the corporate bonds of some of the biggest U.S. banks – namely Bank of America, Citigroup Inc. and Goldman Sachs Group Inc. – have substantially widened over S&P's benchmark for corporate debt in the same credit-rating class (A-minus) over the past few weeks. They're yielding roughly 100 basis points – one full percentage point – above the A-minus benchmark, about double the gap before earnings season began. Credit default swap spreads – which indicate the cost of buying insurance against a default of the bonds – have also turned significantly upward.
"There is evidence that investors may be re-pricing risk," S&P said.
This re-pricing comes after financial-sector bonds had enjoyed a four-month vacation from their problems. After euro-zone fears spiked last November, investors turned to U.S. corporate debt in general, attracted by their combination of strong yields and relative safety, and the financial sector came along for the ride. But after hearing from the banks in their quarterly reports and conference calls, investors have re-awakened to the fact that not all U.S. corporates are the same – and that some of the big banks still carry a lot of risk.
At the top of the list are Bank of America, Citigroup and Goldman Sachs – all of which carry a negative credit outlook from S&P, with "1-in-3" odds that the rating agency will downgrade their debt within the next two years. Bond markets had been largely overlooking this during the happy few months over the winter, but they're noticing again now.
For Bank of America, the big risk is an enormous overhang of bad mortgages and a mountain of litigation relating to its mortgage business. For Citigroup, it's the $200-billion in unwanted (and in many cases deeply unattractive) assets that the company would love to divest, but could be stuck with for much longer than markets had hoped. For Goldman, it's a massive exposure to European sovereigns and banks.
Equity investors may be bothered by an even more fundamental worry: The banks aren't growing along with their profits. A lot of the profit gains have come from accounting adjustments, especially declines in loan-loss provisions; the sector's revenues are essentially flat from last year.
These, of course, have been the nagging doubts that have bothered investors throughout the market during the three-year-old market recovery: Elevated risks and a lack of real growth. The difference now is that for many other sectors, those worries are fading. For U.S. financials, there's still a long way to go.