Financial stocks have been very busy over past the few months. With U.S. interest rates plunging to near record low yields last week (1.57% on the U.S. 10 Year Treasury), financial stocks have been selling off hard. The theory being that low rates would hinder the bank’s profitability and their all-important net interest margins (basically, the difference between the rate they pay depositors and the rate they lend out for mortgages, commercial loans, etc). Also, oil prices continued to slump, which weighs on bank’s loan portfolios. Financial Inverse ETFs offer one way to reduce exposure to financials in your portfolio.
Inverse Financial ETFs Provided a Hedge
While that is bad news for shareholders of financials, the ProShares Short Financials fund, SEF, provided a nice hedge. The inverse financial ETF increased 24.75% from November 6, 2015 ($16.28) through February 11th ($20.31), just over three months, with other inverse financial ETFs including the double leveraged SKF and triple leveraged FINZ gaining as well. Average daily volume traded in SEF surged eleven-fold from 29,699 to 333,705.
Over that same time period IYF, the ETF that tracks the Dow Jones U.S. Financials Index lost 20.75%. The discrepancy is due to compounding outperformance given the steep nature of the sell-off in financial shares. This is noteworthy because this is the ETF for the Dow Jones U.S. Financials Index Average, which is the benchmark that SEF also tracks, but inversely.
What are the Risks for the Dow Jones U.S. Financials Index?
The Dow Jones U.S. Financials Index is comprised of the major U.S. financial institutions including Berkshire Hathaway, Wells Fargo and JP Morgan. These three banks alone comprise almost 20% of the ETF, so it is highly concentrated. This represents a serious risk to this index. Wells Fargo is extremely exposed to ‘non-investment grade’ loans, which may comprise up to 70% of their book. Subprime auto loans represent a hefty portion. Berkshire Hathaway, despite its legendary track record, is full of highly cyclical companies. Berkshire is really a conglomerate and is in the fund because it owns large stakes in General Reinsurance, US Bank and Wells Fargo.
Weakness in capital markets is also being felt by the big banks. In an investor presentation, JP Morgan relayed that their investment banking revenues fell 25% year over year. The lack of IPOs is certainly not helping matters. Finally, big banks are required to hold so much cash in reserves due to regulations that they are becoming de facto utilities (highly regulated dividend payers with low growth prospects).
Energy Exposure for Big Banks
With West Texas Intermediate crude oil trading around $31 today, it brings to light a serious risk for banks who have lent money to the energy sector (especially the exploration and production space). Just today, JP Morgan is issuing a bit of a mea culpa regarding their true lending exposure to the energy sector, sending its shares down 4% today. The bank revealed it has $25 billion of exposure to investment grade debt of energy companies, of which one-fifth has already been written down. The more troubling is the high yield component of its loan book, which is $19 billion but half is written down half. This is $44 billion in exposure and JP Morgan CEO estimated that if oil stays at $25 for the next 18 months the bank will need to hold reserves of $1.5 billion.
Berkshire Hathaway is actively accumulating more energy investments in addition to its large current holdings, notably Phillips 66. It is pursuing beaten down infrastructure master limited partnerships.1 MLPs are highly leveraged investments that are essentially directional bets on oil prices, despite their reputation as being ‘toll booths’ for oil to run through their pipelines. The company recently purchased over 26 million shares of pipeline operator Kinder Morgan.
Countries with petro-based economies have been harshly affected by the drop in Brent crude oil. Some oil-rich Middle Eastern countries like Saudi Arabia have been hit especially hard and may have to sell off assets to run their country. They are currently contemplating an IPO of part of their precious state-owned oil producer, ARAMCO. The giant sovereign wealth funds of the Middle East’s Gulf Countries (Kuwait, Abu Dhabi and Qatar) have roughly one third of their fund invested in financials. If oil doesn’t return to former levels, they will be financially strained and liquidating investments in their fund will be the obvious next move. Expect selling pressure for financials. But it’s not just Middle East countries, several Nordic countries are oil-based economies. For example, Norway also has about one quarter of its portfolio in financials. A steady selling pressure by these funds could continue to pressure financial stocks for the foreseeable future. Consider hedging with inverse financial ETFs now because these stocks can be very volatile and when financials sell-off, they sell-off fast.