Saturday, July 16, 2011


Observations from Bill Gross:

* Lawmakers "don't get" the ramifications of the debt debate (and the $60 billion net present value liability burden).

* QE3 will likely take the form of strong language.

* The debt ceiling will be raised.

* Look for Medicare age eligibility rising from 65 to 67 (but not for a couple of years, and the market won't be fooled by it).

* The Fed stays at 25 basis points for several years. (In this "inflationary moment," the long end of the curve is vulnerable.)

* Europe lacks political leadership to cure the sovereign debt crisis.

* And he still likes PG.

My first read on the European stress test is relatively positive.

The core CPI (+0.3%) was hotter than expected (at the highest level since October 2008), and I suspect this will continue -- as will the screwflation of the middle class.

Owners' equivalent rent (which makes up 40% of the core rate) is rising, owing to the acceleration in rental prices.

With the propensity to rent overcoming the propensity to buy (after a 34% drop in home prices), the core rate of inflation will be rising in the months ahead.

"I hate banks. They do nothing positive for anybody except take care of themselves. They're first in with their fees and first out when there's trouble."

-- Earl Warren

The problem for investors in bank stocks, in my opinion, is far more deeply rooted than the near-term profit picture (at JPM or any other bank for that matter). The problem is structural:

1. Poor bank managements who have exposed the industry to restrictive regulation and scorn: After the lending and investing policies and travesty of the last cycle, no one in their right mind can have any confidence in the ability of bank managements to manage over nearly any time frame. The industry is a piƱata, scorned by investors and politicians who want retribution and revenge by mandating control over compensation and in the very manner that the banks do business.

2. Changing business model: Because of issue No. 1 above (i.e., the failure of laissez faire regulation and other factors), the entire banking industry is undergoing a forced change in its business model. Not only do we not know but the managements don't know what the exact business configuration will be. The change, however, will not likely be for the better. I can say with confidence that the banking industry earnings power has been markedly reduced, reflecting the changing business model and the dilutive impact of equity raises.

3. Worsening business mix: The banking industry's high return on equity businesses (e.g., prop trading and derivatives) are being reduced in size or jettisoned completely by government fiat. Banks are now left with servicing the consumer, the residential/nonresidential real estate buyer (and seller), small businesses and large corporations. The consumer is in rough shape, however, and although the office sector is fine, the residential real estate market is inactive and double-dipping in price (as the industry is burdened with an extraordinarily high level of unsold shadow inventory). Also, small businesses are pressured by rising costs (and bankers are slow to lend in this sector), and large corporations are so liquid that they don't need the banks to nearly the degree they have in the past.

4. Benefits of improving credit quality fading: Bank earnings have been buoyed by improving credit quality and a steep yield curve over the last two years, but credit quality improvement is fairly advanced -- and comparisons will grow more difficult -- while the yield curve can't be expected to be as steep forever. These two positive factors seem to have shortening half-lives ahead of them.

5. Low interest rates a problem: Quantitative easing and a zero-interest-rate policy is a big negative for banks, as the industry has an imbalance of interest-sensitive earning assets over interest-sensitive liabilities. Low interest rates further delay the return to normalized profits and trump the benefit of a steeply sloped yield curve as a negative.

6. Loan demand remains weak, and legacy losses linger: In particular, the mortgage putback problems (economic and legal) will continue to weigh on the industry's profits. (JPM had a more-than-$1-billion legal charge in the quarter just released.)

7. High cost structure: The banking industry is burdened by a high-fixed-cost branch structure that is antiquated, inefficient and, in the fullness of time, exposed to technological change and competition from lower-cost entrants in the delivery of most consumer banking functions.