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Big bank stock prices, already suffering from an avalanche of difficulties, suffered another setback when news broke last Thursday that Goldman Sachs Group Inc. (NYSE:GS) had received a subpoena from the Manhattan district attorney for records relating to its role in collapse of the mortgage market.
The subpoena served as a reminder that the fallout from the financial crisis that hit its apex in 2008 is far from over.
The banking sector already has had a rough year, as its 6% decline is the worst performance among the 10 industries tracked within the Standard & Poor's 500 Index.
"Financials have become hated in recent months," Alan Villalon, a senior bank analyst at Chicago-based Nuveen Investments, told Reuters.
The Goldman subpoena is part of a probe based on the findings of the Senate Permanent Subcommittee on Investigations, released in April. The panel's report accused the bank of profiting at the expense of clients when it bet against the mortgage market in 2007 by taking large short positions in mortgage-related securities.
"We did not have a massive net short position because our short positions were largely offset by our long positions, and our financial results clearly demonstrate this point," the company said in a statement.
Goldman is considering the public release of documents to help defend itself.
Meanwhile, investors are left to wonder how far the Manhattan investigation will go and whether it will eventually lead to indictments of high-ranking executives at Goldman, or whether other large banks might become a target. The Senate report was also critical of Deutsche Bank AG (NYSE: DB), for instance.
But even if the Manhattan DA office doesn't extend its net, other investigations relating to the mortgage activities of the large banks are already underway.
One major investigation being conducted by all 50 state attorneys general into similar mortgage services abuses seeks a settlement of at least $20 billion.
The Cost of Reform
Ongoing legal issues are only one slice of the financial crisis hangover.
New regulations from the Dodd-Frank financial reform law could severely eat into already-weak bank revenue. Bank of America (NYSE: BAC) estimates that just the part of the law known as the Durbin Amendment ,which restricts debit card processing fees, could cost it $2 billion in revenue.
Other regulations in Dodd-Frank could cost the banking industry a collective $8 billion.
But since many of the regulations have yet to take effect, the big banks can only guess at their full impact, creating a lot of uncertainty within the industry.
"I am surprised that the bank sector continues to underperform as they have been laggards all year," Mark Bronzo, who helps manage $26 billion at Security Global Investors told Bloomberg News. "Concerns over what the new fin regulations will require, and no real loan growth, continue to hold back these names."
After having no choice but to bail out financial institutions back in 2008, the government is seeking ways to avoid a repeat.
The Federal Reserve, for example, is developing a system that will raise capital requirements for banks with more than $50 billion in assets, with the requirements increasing along with the size of the institution.
That won't help banks that have been masking weak revenue by releasing their capital reserves, money set aside to cover bad loans. If the banks are forced to reverse this policy, profits will suffer.
In the first quarter of this year, the release of capital reserves accounted for 40% of the profit of the top 20 banks. It was as high as 54% in the fourth quarter of 2010.
Add to that a faltering economic recovery, and you have a ton of downward pressure on bank stock prices.
"Banks are macro plays on the economy," Jason Ware, a senior analyst with wealth management firm Albion Financial told Reuters. "As the economy starts to hit a softer patch, those types of investments become less attractive."
Stampede to Exits
In yet another bad omen for bank stocks, several major hedge fund managers are now tossing them overboard.
Lee Ainslie's Maverick Capital, Jeff Altman's Owl Creek Asset Management and Stephen Cucchiaro's Windhaven Investment Management sold their entire stake in both Citigroup (NYSE: C) and Bank of America earlier this year.
In fact, members of the Smart Money 30, a group of top stock hedge funds, dumped 29% of their combined bank holdings in the first quarter.
The exit from financials was widespread. David Tepper, manager of the Appaloosa Management fund, shed his stakes in JPMorgan Chase & Co. (NYSE: JPM) and Wells Fargo & Company (NYSE: WFC) in addition to selling some of his holdings in Bank of America and Citigroup.
Some contrarians insist that bank stocks are a good deal, noting that diversified banks trade at about 9.4-times earnings, compared to 12.4 for the S&P 500. The top six banks trade at an average price about 88% of book value, down from 100% a year ago and 225% before the recession.
They also argue that a rise in long-term interest rates will revive bank stock prices, although there's no indication that's going to happen anytime soon.
Given all the issues big banks face at the moment, investors may not be back for a while.
"Overall, bank stocks have come down dramatically and are relatively cheap," Alan Gayle, senior investment strategist with RidgeWorth Investments, told the Wall Street Journal. "But one of the things that most market participants have learned over the past few years is that cheap is not a catalyst. Cheap is just cheap."
News and Related Story Links:
- Money Morning:
Downgrades Crush Goldman Sachs Stock On News of Criminal Investigation
- Money Morning:
What You Don't Know about "Mortgagegate" Could Crush the U.S. Banking System
- Money Morning:
Watch Out, Zombie Banks Still Haven't Been Buried
- The New York Times:
Bank Shares Take a Beating, and It May Not Be Over Yet
- The New York Times:
Goldman Said to Get Subpoena Over Its Role in Crisis