Here’s What Should Really Scare Investors About Bank Stocks by Stephen Gandel @FortuneMagazine 5:32 AM EST E-mail Tweet Facebook Linkedin Share icons Wall Street has fallen out of love with Wall Street. Back in early December, at the Goldman Sachs Financial Services conference, the bank’s lead bank analyst Richard Ramsden asked the assembled crowd what they thought the prospects of bank stocks would be in the coming year. A majority of the assembled crowd answered that they were overweight bank stocks. Ramsden soon after wrote a note saying that the fact that so many people were bullish on bank stocks was a reason to be bullish as well. He probably should have known what would happen next. Since early December, bank stocks have been some of the worst performers in the market. The KBW banking index is down 26% since its high in July last year, putting bank stocks in a bear market. Of the 10 worst performing stocks in the Dow Jones Industrial Average this year, four are financial stocks. American Express, the Dow’s worst performer in 2016, is down 24%. Shares of the once infallible Goldman Sachs gs are down 28%, and now have a price-to-earnings ratio of 12, making it look more like a jester than the king of Wall Street these days. Most bank investors seem spooked about interest rates. The spread between short-term and long-term Treasuries has narrowed, which could hurt lending profits. But that’s not actually the biggest problem facing the big banks. Fred Cannon, head of research at the investment banking boutique Keefe, Bruyette & Woods, points out that these days most big banks generate less than 50% of their revenue from interest income. In addition, mortgage lending, which is tied to long-term Treasury rates, is less important for the big banks than it used to be. What is more important these days is corporate lending. The nation’s six largest banks have just over $707 billion in corporate loans. That’s grown rapidly in the past few years, faster than mortgages or other lending categories. But the value of corporate loans, which trade inversely with yields, has been falling lately. On average, high-yield bonds are trading at 86 cents on the dollar, meaning the market is predicting a 14% loss on the loans. And bonds at some well-known companies, like American Express and retailer Neiman Marcus, have been trading at 30% of their original value. Bonds of companies with high credit scores haven’t suffered much yet, but those companies typically borrow from the bond market. Banks, on the other hand, tend to lend to slightly troubled companies, or smaller firms, which can be riskier. Cannon figures that the average credit quality of a the big banks lending portfolio probably falls halfway between high-yield debt and investment grade. Based on that, the average bank loan has probably fallen about 5% in value. But because of accounting rules, banks don’t actually have to record a drop in the value of their loans immediately. They can wait and hope: if the borrowers end up paying in full, then the banks may never have to take a loss. Based on where bonds are trading today, the market is saying about 5% of those corporate loans will go bust, or roughly $35 billion worth at the six biggest banks. If the economy gets worse, expect higher losses. And keep in mind that these potential losses come at a time when banks have put aside loan loss reserves to cover just 1.4% of their lending portfolio, their lowest in years. What’s more, nearly all of the other businesses that big banks are in—the other 50% of their revenue—are falling as well. Debt issuance is down 30% compared to last year. Stock issuance is down 25%, and the IPO window is basically shut. Announced M&A deals have fallen 20% this year. None of this is likely to send the big banks back to bailoutville, but that’s not the point. The latest headwinds could take a big chunk out of earnings at a time when banks are still building up their capital levels in order to comply with new rules that go into effect in 2019. Too be sure, the problem is worse at the European banks. Deutsche Bank, for instance, will have to earn $24 billion after dividends and buybacks over the next three years if it hopes to meet a 5% leverage ratio. Last year, the bank lost nearly $7 billion and its capital ratios have been headed in the wrong direction for the past few years. And negative interest rates in Europe are making it particularly tough for banks there to make money. Investors are clearly nervous about Europe. Shares of Deutsche Bank db have fallen over 35% this year, lower than where they were trading during the financial crisis. That prompted the German Finance Minister to proclaim that Deutsche has “no problems,” which is kind of like your mother saying you are perfect. But even in the U.S. there could be problems. And investors clearly believe some of the big banks could face much larger losses than they are currently predicting. Shares of Citigroup c , for instance, trade at a price-to-book value of 0.5, meaning investors have serious questions about the value of its assets. Still, that’s much higher that the 0.2 price-to-book ratio the bank sunk to during the financial crisis. The large U.S. banks are required to have a leverage ratio of 6.75% by 2019. Most have that. But a year of losses would set them back just as the deadline is nearing. Investors have long assumed banks won’t have a problem meeting their capital requirements. Now, they are clearly starting to sweat.