Why are financials selling off with bank earnings season starting next week? Large-cap banks such as JPMorgan led the markets higher earlier in the year, but have since underperformed the markets. What gives?

First and foremost, when the markets are looking for a reason to sell, large-cap financials usually catch more than their share of attention. Remember, Wall Street only ever cares about the top 10 names in financials by market cap.

When the thundering herd sells, banks usually get a disproportionate share of the short volume. The sector accounts for about 15% of the S&P 500. When a broad selloff is under way, look for financials to participate and then some, in terms of both cash and highly liquid derivatives.

Second, financials are still overvalued. When JPM peaked at just shy of $120 per share on Feb. 26 of this year, the market leader was trading just shy of 2x book value. The stock is still up 15% over the past six months, vs. single digits for the S&P 500. JPM has single-digit equity returns and no real growth in terms of revenue. Hit the bid.

Third and most important is the question of net interest margins and financial repression. In the inaugural edition of The IRA Bank Book, we discuss why the banking industry is facing a squeeze on margins thanks to the Federal Reserve’s Federal Open Market Committee (FOMC). Few analysts on the Street know or care about this looming threat to bank profits.

At present, the U.S. banking industry is earning about $130 billion per quarter in net interest income from loans and investments, but is paying depositors and bond holders a mere $20 billion per quarter for funding. This skew in favor of bank equity holders has been extreme since 2008, but the issue of financial repression goes back to the 1990s. Ponder the chart below, showing the banking industry’s plummeting ratio of net interest income to total interest expense over the past few decades:

In Q4 2007, when U.S. banks grossed $180 billion from loans and other earning assets, they paid depositors and bond investors almost $100 billion. In 2015, the total cost of funds for the U.S. banking industry was just $11 billion per quarter, but the industry booked $110 billion in net interest income. Get the joke? Bank depositors and bond holders should be earning not $20 billion per quarter but more like $40-50 billion.

Today, yields on deposits and fixed-income securities are rising faster than the yields on bank loans. Just as the FOMC suppressed the cost of credit for banks after 2008, now the financial engineering of former Fed chair Janet Yellen has created an interest-rate trap for banks a la the 1980s.

For those of you who missed that party, in the 1980s funding costs for S&Ls rose faster than asset earnings, gutting the capital of the entire housing finance sector. The unfortunate demise of the S&Ls also created the opportunity for banks to get into mortgage lending a decade later, with similarly disastrous results.

We look for the cost of bank funding to rise faster than the yield on earning assets over the next two years — a situation that’s likely to put an effective cap on bank earnings and public market valuations. The kicker in the analysis is that credit costs are also likely to rise faster than either revenue or pre-tax earnings, adding extra headwind to financials as 2018 unfolds.

Christopher Whalen is chairman of Whalen Global Advisors, a provider of investment banking and consulting services to institutional investors and corporate clients worldwide. This article was initially published in Whalen’s online publication, The Institutional Risk Analyst. It is reprinted here with Whalen’s permission.

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