Distorted Markets: Why Banks Are Better Off Than You Think, And Real Estate Isn’t
Banks are probably safer than people believe, and real estate, the sector investors are rushing to, has become riskier
In the U.S., the financial crisis still looms large. The banks are treated with distrust and the markets with anxiety, and few believe the economy will ever return to normal.
After running The Wall Street Journal’s Asia finance and markets coverage for the past 4½ years, it is eye-opening to return home and see how little has changed. The rest of the world has largely moved on, sometimes to new crises. The U.S. financial meltdown matters to the rest of the world only as it waits, and waits, for U.S. interest rates to go higher.
While the markets and policy makers have been paralyzed, the distortions in the financial system have increased. That has made it harder to move beyond the crisis. By trying to finely chart the economy’s course, the Federal Reserve is acting like it did before 2008 when it engineered the Great Moderation, which led to the excesses that caused the financial collapse.
The nasty selloff and strong rebound in markets this year shows how trapped we have become. Bonds and stocks declined far more than the otherwise decent economic fundamentals demanded. But if these markets are going to react the same way at any sign of Fed tightening or economic slowdown, then the otherwise decent economic fundamentals could be undercut.
Something has got to break the stalemate. On the positive side, the economy, corporate profits and inflation could pick up, making it clear the Fed has to act. But given how long the current expansion has lasted, the sad reality is a recession may be the most likely scenario.
The disparity between banks and commercial real estate illustrates the distortions that have paralyzed the U.S. financial system. Everyone hates the banks and everyone loves real estate, yet the two sectors are deeply intertwined. If the economy is strong and credit is flowing, both prosper. If banks are struggling, many real-estate buyers can’t get affordable financing.
More important, the industry that scares everyone is probably safer than people think, and the one they are rushing to has become riskier.
There are good reasons to be distrustful of banks. They lent too much to energy producers, and if Credit Suisse Group AG is representative of the rest of the industry, they still don’t completely understand the risks.
But these are normal concerns for an industry that always grapples with uncertainty. None will critically injure, much less topple, a major bank. Yet by some measures, the banks are trading at crisis-level valuations. At best, investors believe bank shares will stagnate until the economy really picks up, and at worst, they think there will be another crisis.
Neither is true. Banks look a lot like they did before the housing bubble. The industry is cutting costs, trying to ride strong markets and scale back exposure to weak ones and generating lots of cash, which, with the blessing of regulators, they are once again returning to shareholders.
According to analysts at Bank of America Merrill Lynch, big banks increased dividends faster than any other sector, and the total cash yield to shareholders, including buybacks, is at its strongest level since 2003. Both are signs of strength, though investors refuse to believe them.
“Banks are in a lot better shape than they were in 2007; even if we are in a bad recession, banks will hold up a lot better than they did,” said Jill Carey Hall, an equity and quantitative strategist at Merrill.
When banks get as cheap as they are now—with many trading below tangible book value, a measure of what they are worth in a fire sale—they typically perform well relative to the market. With downside limited, the yield is safer than many other cash-generating investments.
Contrast that with commercial real estate—office buildings, shopping malls, apartments and the like—which has suffered none of these problems. Since the market bottomed in 2009, prices have risen more and the rally has lasted longer than the run-up leading to the financial crisis, according to Green Street Advisors LLC, a real-estate research firm. Driven in part by strong fundamentals, prices have doubled from their lows. Capitalization rates, the yield generated by properties, are just above 5% and are now just above triple-B bond yields, which Green Street sees as a good proxy for risk.
“Real estate is not cheap anymore,” said Peter Rothemund, a senior analyst at Green Street. The risks in the sector emerged during the February selloff, when real-estate securities fell in value and deals slowed.
Another worrisome sign is the flood of foreign buyers—not known as the most price sensitive—into the U.S. market. Foreigners bought a net $57 billion of U.S. real estate last year, compared with an average of $3 billion a year for the previous five years, according to Green Street.
Both investors and the Fed are paralyzed with fear that we might return to 2008. Investors won’t touch the banks because one misstep and they will go off the cliff. The Fed is hardly doing anything because raising rates could cause markets (driven up by loose money) to collapse, potentially taking the economy down with them.
In Asia, there is always talk of the future, no matter how bumpy the road there might be. The U.S. is terrified of any bump, and because of that, it is stuck looking backward