BankThis year, S&P 500 financial stocks have fallen by more than 10%. Banks stocks have been hit even harder. What may appear as counter-intuitive is that banks stocks have taken a bigger beating than oil or energy stocks. Deutsche Bank stock has lost more than 30%, Unicredit stock is down 35%, and Credit Suisse is 30% down. Barclays, BNP Paribas, Societe General, and UBS have all lost about 20% of their values. Why?

Common Justifications  

One explanation is linked to the low interest rate environment. Low interest rates in most major economies are cutting into banks’ profit margins. To compound banks’ problems, investors are not expecting a change in the interest rates anytime soon. However, this is hardly a new explanation. Low interest rates have been descriptive for most major economies which is why investors are unlikely to react now to low interest rates.

Another explanation is linked to banks facing tougher regulations, which is why they may be forced to scale back on their investments. However, the current regulatory environment is very similar to the regulatory environment since the post-financial crisis period. Therefore, regulation is unlikely to be a key factor explaining current decline in banks’ stock prices.

Bank Loans to Finance Oil and Gas

There is another compelling explanation. Many banks invested heavily in oil production in North American companies when oil prices were high. Over the last five years, oil and gas companies in the United States and Canada have issued bonds and taken out loans that are together worth more than $1.3 trillion, according to Dealogic. Over the past five years, global banks have earned around $31 billion in fees by financing energy-company stock sales, borrowing and mergers-and-acquisition transactions.

However, the collapse of crude oil, or black gold, prices have turned the tables on banks. Profitable investments are now turning sour. The precipitous and sustained decline in energy prices is resulting in major economic losses for the banks as the oil and gas companies are unable to generate sufficient operating cash flows to meet their obligations.

In 2015 alone, at least 42 North American oil companies have filed for bankruptcy which is bad news for banks that loaned money to these oil companies.

Accounting for Bad Loans

Under GAAP, companies must book an accounting loss in the current period (known as “loan-loss reserves”) if they expect future loan defaults because of a decline in the credit worthiness of the debtor company. The largest banks in the U.S. including Wells Fargo, J.P. Morgan Chase, and Citigroup have been setting up large reserves as it becomes more and more apparent that many outstanding loans are unlikely to get repaid.

Wells Fargo & Co. set aside $1.2 billion in reserves for potential losses tied to oil and gas loans. Recent SEC filings indicate that, although about 2% of its overall loan portfolio is in oil and gas companies, more than 10% of the company’s loan-loss reserves are related to oil and gas. In 2014, the bank was unsure whether it would be able to collect $76 million of the loans extended to oil and gas companies. In 2015, the bank estimates that number to be around $844 million, an increase of more than 10 times.

Similarly, J.P. Morgan Chase disclosed $44 billion of total energy exposure to their loans. Bank of America Corp. said that it had about $22.6 billion in unfunded energy loans. Smaller banks are facing similar predicament.

European banks are not far behind. Banco Santander, eurozone’s largest bank by market value, booked €1.6 billion ($1.76 billion) losses for the fourth quarter of 2015. The losses included a €435 million charge for “goodwill” and “other items.”

The Future

If oil prices remain low for a prolonged period of time, expect more loan defaults in the future by debtor companies from the energy sector. This in turn is going to adversely affect the future performance as banks increase their losses from nonperforming loans or book credit losses.

One expectation is that oil prices and bank stock prices are likely to positive correlated, at least in the short run.

The moral of the story is beware of bank stocks – they are risky bets under the current economic environment.

March 13, 2016; 9.04P

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