The past few weeks have seen violent behavior in equity indexes as a slew of negative news and data led to some of the most volatile trading days since the 2008 crash. The problems largely began with the debt debate that took longer than expected, while the solution reached seemed to do little to convince investors of our stability as a nation. It also apparently did little for credit rating agency Standard and Poor’s, as the ratings agency issued the first ever downgrade of U.S. debts in the country’s 235 year history. The downgrade was obviously met with furious opposition, but S&P held strong and went on to downgrade outlooks on both Fannie Mae and Freddie Mac, prompting a major déjà vu experience for investors [see also Three Equity ETFs Crushed By Monday’s Massacre].
With incredible market swings, many analysts and investors are drawing comparisons between our current environment and the problems we encountered during the Great Recession. But it is important to remember that the two have a very different makeup.
Then and Now
The chaos of 2008 saw the brunt of the financial crisis centered around banks and their less-than-cautious practices of giving out loans to just about anyone who could open a line of credit. With little regulation on the everyday activity of these institutions they felt a sort of invincibility as they knew they were “too big to fail” because if the government did not bail them out, the global economy would likely plunge into a catastrophic situation. With this assumption in mind, banks and institutions exhibited severe moral hazard by lending out to those who had a low possibility of successfully repaying the debt, simply to boost their short-term profits. That combined with high leverage led to numerous insolvency crises and would eventually be one of the major contributors to our sinking economy [see also Four Volatile ETFs For Active Traders].
Now, banks cannot make the same mistakes as 2008; regulation demands it. With the Dodd-Frank Act of 2009 in effect and the Basel III Accords set to begin in 2013, banks are now more heavily regulated and will eventually have to hold a higher percentage of Tier 1 Capital (6% compared to the current 4%), ensuring higher buffers against downturns that should help to protect investors in the long run. Already, major banks are behaving very differently, as Q2 of 2011 saw many major institutions report “that they have an unusually high level of capital built up. And asset quality is improving, which is the opposite of what happened in 2008,” according to Frank Barkocy, a director of research at Mendon Capital Advisors.
The boost in bank health has come just in time, as the government is currently trying to slash spending to battle our debt issues, leaving little room to bailout another major institution. But while banks may be behaving quite differently than their suspect ways of 2008, they may still be due for a period of pressure, as our current environment is less than favorable for these major firms.
While low interest rates are typically good for banks, near-zero rates, like what we currently have in place, are a bad sign. Normally, low interest rates means that a bank can borrow from the Fed and not have to pay a high percentage back in interest, allowing them to keep more of their profits. And this process is even more so true with near zero rates, as banks barely have to pay any interest at all. But when rates are this low, it is extremely difficult for banks to make a profit off of consumer and corporate loans, as they too are paying next to nothing in the way of interest. Banks, however, had hopes that rates would eventually rise if the economy picked up; those aspirations were dashed by the Fed and their recent FOMC minutes statement [see also Three Defensive ETFs For The S&P Downgrade].
Fed Chair Ben Bernanke released a crushing statement when he said that he Fed will hold rates at their current levels until mid-2013, suggesting that the Fed seriously doubts our economy will experience strong growth in the near future. Aside from the stock market slide and the low growth prospect, this means that banks will have a tough time raking in profits for the next two years. The hold on low rates combined with the downgrades of Fannie and Freddie, which may suggest that defaults are on the way, may create a perfect storm for these financial giants over the next few years. Though this time around, banks are far more prepared for defaults, it is difficult to prepare for two years of ultra-low rates. In fact, S&P warned that it is concerned that banks’ profitability will be depressed as weak loan growth, low rates, and sovereign debt issues will anchor banks’ profits going forward [see also ETF Insider: Be Wary Of Bargain Shopping].
A slew of major banks have seen their share prices tumble in the past few weeks, as Bank of America lost 20% in a single session. Though BofA’s legal troubles likely contributed to it being the front-running loser of the U.S. financials, JP Morgan, Citigroup, and Wells Fargo have all severely struggled the past few weeks. With banks poised for a rough couple of years, investors will form their own opinions about when to buy or sell their financial-related products. While a number of ETFs will have indirect ties to the health of our financials, there are numerous options to make a play, either short or long, and ETFs offering direct exposure to this sector. Below, we outline three ETFs to watch as the drama with big banks plays out:
Financial Select Sector SPDR (XLF)
One of the most popular ETFs on the market, XLF tracks the U.S. financials sector and trades over 83 million shares daily. The fund’s top holdings feature the who’s-who of big name banks including JP Morgan, Wells Fargo, Citigroup, BofA, Goldman Sachs, and others. The top ten assets account for over 50% of the entire portfolio meaning that these big banks will have a major influence on how this ETF performs in the coming years. The giant cap-based XLF has lost approximately 22% on the year and is still far from recovering its pre-recession highs [see also Three Intriguing Alternatives To Popular ETFs (SPY, XLF, FXI)].
HOLDRS Merrill Lynch Regional Bank (RKH)
The name of this product may be a bit misleading; RKH doesn’t actually invest in regional companies, but instead has heavy allocations to many of the same Wall Street institutions that dominate XLF. This fund features just 17 holdings, with JP Morgan, Wells Fargo, and BofA garnering significant allocations. The top ten holdings of this fund take over over 90% of the assets, allowing investors to focus their investment on just a select few banks as opposed the the wider reach of XLF. Investors should note that this product, while largely giant cap, does feature a significant amount of large and medium cap firms as well. RKH has dropped around 26% so far in 2011.
SPDR KBW Regional Banking ETF (KRE)
KRE tracks an equal-weighted index that seeks to reflect the performance of publicly traded companies that do business as regional banks or thrifts. For the most part, KRE is dominated by small caps with some allocation to medium and micro sized firms. This means that the ETF will offer exposure to a collection of companies that may feature unique risk/return characteristics relative to their large cap counterparts that make up the aforementioned products. Thus far in 2011, this product has lost approximately 24% [see also Beyond XLF: Five Alternatives To The Popular Financial ETF].
Disclosure: Photo 1 courtesy of Robert Scoble. No positions at time of writing.