Since the bear market began in March 2000, investors have been told that even if the economy suffered, the risks of investing in bank stocks were far lower than they had been during the recession of 1990. New and sophisticated risk management practices had enabled the banks to unload much of their lending risks to other market players, the argument went, while the institutions' ability to generate fees continued apace.
But a risk that the banks cannot expunge is the fear taking hold among investors that the nation's largest financial institutions were central to the financing of the stock market bubble that has burst so spectacularly. That perception is not only punishing bank stocks, which were not long ago seen as a haven for investors, but it is also casting a pall over the entire market, fund managers say. If banks are found to have facilitated corporate misdeeds -- such as hiding losses at Enron, as has been alleged in Congress -- severe damage will be done to already battered investor confidence in the entire financial system.
"The banks have been both the least visible and the most important components of the financing of the new economy over the last 10 years," said Jonathan H. Cohen, portfolio manager at JHC Capital in Greenwich, Connecticut, and former head of Internet research at Merrill Lynch. "Investors know that most Internet and telecom companies were part of a bubble, and that many brokerage houses were involved in the sustaining of the bubble. Now people are getting around to focus on the role of the commercial banks."
PHOTO: NY TIMES
Bank stocks, as measured by the Philadelphia Stock Exchange/KBW Banks index, have lost 10.4 percent in the past two weeks alone. The index consists of 24 major banks and large regional institutions. Leading the way down are Citigroup and JP Morgan Chase, which both fell about 15 percent last week.
Traditionally among the most respected financial institutions, Citigroup and JP Morgan Chase were tarnished last week when their executives came under heavy questioning by Congress on their banks' role in the Enron fiasco. Both banks denied that they facilitated the hiding of debt at Enron, but several days after the testimony, the Securities and Exchange Commission said it would scrutinize the banks' Enron-related activities.Until May, the bank stocks were a port in the stock market's storm, a group to which investors retreated as many other sectors of the market collapsed. Holding up these shares was the belief that the recession's short duration meant not only that big banks would soon find increasing demand from corporate clients but also that heavily indebted consumers would not default on their loans as they might have if the recession were prolonged.
"Until recently, the feeling among investors was that banks have regulators and that will keep them out of trouble," said David A. Hendler, an analyst at CreditSights Inc, a credit research firm in New York. "But no one was thinking that the banks enabled the rest of the world's business problems, and that will eventually get reflected in the operating performance of the financial companies."
As bank stocks outperformed the rest of the market, their weighting in the Standard & Poor's 500-stock index has grown. That means that their recent downturn has hurt investors in the big, popular mutual funds that mirror the performance of the S&P.At the market's peak, for example, technology was the single biggest component of the S&P. But as technology shares plummeted, financial services companies stepped into the top spot.
S&P heavyweights
At the end of June, financial companies accounted for 20 percent of the S&P and weigh heavily on the index. The next largest sector is information technology, with a 14 percent weight in the index.Bank stocks have always been vulnerable in an economic downturn because they end up holding loans that sour with the economy. That will once again be the case if the economy weakens, in spite of claims of advanced risk management techniques. But their role as potential facilitators of improper activities at companies like Enron or WorldCom or even as intermediaries who helped inflate the bubble is an additional worry for investors.Some of the nation's biggest and most trusted banks are in this fix at least partly because of their increased reach in all areas of financial services in recent years. The Financial Modernization Act in 1999, eliminated most of the barriers to certain business set up for banks under Glass-Steagall, the law that came out of the Great Depression. Undoing Glass-Steagall allowed commercial banks to compete with investment banks for the right to sell securities to investors. And the larger banks approached the business aggressively.
There are considerable risks associated with the growth of financial services conglomerates. One is that top management and the board of directors cannot possibly know what lower and middle-level employees are doing inside the bank. "Senior management and the board of directors must have very comprehensive orientation, knowledge and understanding of what's going on and in many instances that is not the case," said Henry Kaufman, the economist and head of Henry Kaufman & Co in New York.And the nation's financial system, he said, is put at risk when these companies become huge conglomerates.
Monopolistic tendencies
"These conglomerates tend to move toward monopolistic practices," Kaufman said. They are saying: "We want to be your banker, which means we want to make you the loan, syndicate the loan, underwrite your bonds and distribute them, we want to do your stock issues, we want to place your commercial paper and we want to manage some of the assets in your pension funds. This not only diminishes competition, but it creates institutions that are too big to fail, because if they would fail then the response is they pose a systemic risk."
Some analysts suspect that in the interests of grabbing more of the lucrative securities underwriting deals that had been the province of the investment banks, commercial banks may have been eager to advise companies on how to get around tax rules and accounting regulations or leverage their balance sheets excessively. While such strategies may have been acceptable even as recently as last year, they are now drawing the attention of Congress and regulators and the ire of investors.
The work that JP Morgan Chase did for Enron was plain-vanilla stuff, according to its executives. "They are a normal financing arrangement," William Harrison Jr., the bank's CEO said. After Enron's failure, normal financing arrangements like these have become questionable.
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