Banking on an Economic Slowdown

The carnage in Internet-stock land continued today, with both the established names–eBay, Amazon, Yahoo, and AOL–taking serious hits and the relative newcomers being pummeled. Of course, there was also carnage in the market as a whole. No one seems to want to buy tech stocks–the Nasdaq summer swoon is back in full effect–and financial stocks have been taking it on the chin for a while now.

There’s more to say about what’s happening to the Internet sector, and about the incoherence of those people who are now arguing that investors have woken up to the fact that these companies “don’t have profits.” (Any thesis that assumes that investors have been collectively deluded needs to be regarded with serious skepticism.) But here I want to talk instead about what happened to bank stocks yesterday.

Over the past few weeks, as interest rates have risen sharply, bank stocks have tumbled in some cases as much as 15 percent to 20 percent. The governing assumption here is that as the cost of a bank’s borrowing rises (because interest rates are higher), its outstanding loans presumably become less profitable. That’s an assumption that’s not exactly accurate about most big U.S. banks–the Citigroups, Chases, and BankAmericas of the world–since their portfolios are so diversified and they have their hands in so many different businesses that analogies to local savings and loans aren’t really useful. Still, all things being equal, higher interest rates are bad for banks.

Now, interest rates have risen because of the bond market’s concerns that continued strong growth in the economy could spark inflation. Oddly, though, yesterday bank stocks were punished for the opposite reason. Analyst Michael Mayo of Credit Suisse First Boston issued a very unusual “sell” rating on four banks–including Citigroup and Chase–citing both concerns about the Y2K problem and worries about slowing growth in the months ahead.

Mayo is the author of an interesting report on the actual cost to banks of employee stock options and generally does an excellent job of thinking about businesses in economic terms rather than simply accounting terms. In this case, though, his logic seems curious at best. Unless we assume that worries over Y2K are going to provoke people to pull their money out of banks entirely or to stop borrowing money, then are there any safer banks in the world than the ones he downgraded? If anything, concern about possible Y2K problems in smaller countries seems likely to send borrowers and depositors toward large U.S. banks.

Similarly, Mayo’s concerns about a slowing economy seem misplaced on two fronts. In the first place, any real slowdown would presumably also send interest rates down, which would be a positive for banks. More important, though, there is almost no evidence of an economic slowdown in the offing. Consumer demand and capital investment remain high. Corporate borrowing shows no signs of declining, and while there has been some concern about the quality of some bank loans, those seem to be relatively unimportant in the broader scale of things.

Without overstating the case, it seems clear that Mayo’s downgrade did hurt the financial sector yesterday. But before exaggerating or decrying the influence of analysts like Mayo, it’s important to remember that in the long run they have essentially no meaningful effect on the market (except insofar as they disclose information that was previously unknown). And in the long run, given the combination of the globalization of financial markets and the increasing competitive advantages offered by scale, it seems next to impossible to believe that the global U.S. banks will not be dominant players for decades to come. (Which is why, I guess, I own shares in Citigroup.) This has suddenly become a very skittish stock market, and there’s no guarantee that that will change any time soon. But then that’s precisely why being a short-term trader is a recipe for failure.