Wednesday, October 14, 2009

Banking: To Trade or Lend, That Is The Question

By Static Chaos
also on zero hedge, istockanalyst, daily marketsA year after the government applied many extraordinary measures to resuscitate the banking industry, the bleeding has slowed, but it hasn't stopped. Meanwhile, bank stocks have rallied off their winter lows, driven primarily by nonbanking businesses such as fixed-income trading and investment banking.

The major bank stocks all posted massive gains in the third quarter, led by a 57% jump at Citi (C), and 30%-plus rises at BofA (BCA), Goldman Sachs and JPMorgan Chase. With the start of earnings season, many analysts still expect Goldman Sachs (GS) and JPMorgan Chase (JPM) likely to more than double last year's bottom line.

There are several factors behind the big banks seemingly impressive performance:

  1. Responding to pressure applied by Capitol Hill, the Financial Accounting Standards Board (FASB) voted earlier this year unanimously for new guidance on mark-to-market (M2M) rules, allowing banks and their auditors to use "significant judgment" when valuing the illiquid assets such as mortgage securities.

    Some estimated the new M2M guidance could boost bank operating profits by 20%. This is part of the reason banks have been reporting blowout profits in the last two quarters. That means many banks probably haven't put enough money in reserves to cushion losses, and if they took real valuation on their loan books they would be insolvent.
  2. The big banks have been sheltered over the past year by lavish government assistance, ranging from Treasury loans to expanded deposit insurance including federally backed loan guarantees.
  3. The sector was also boosted by indications that the long-awaited troubled asset purchases of TARP will finally begin.
  4. Of course, some positive economic data and optimistic macro forecasts and banking sector upgrades by no other than Bank of America and Goldman Sachs, also have helped.
Now, one would wonder if banks are doing so well, why are credit markets still tight? Believe it or not, banks have discovered that lending to businesses and consumers does not give them comparable returns juxtaposed with juicing up stocks and commodities. For example, according to an article by

"At the end of June, the four major banks owned commodity inventories valued at $8.1 billion — with JP Morgan Chase ($3.5 billion) and Morgan Stanley ($3.3 billion) reporting the largest holdings and Goldman Sachs a much smaller stock $0.7 billion).” (see chart)
"there is a regulatory “physical loophole” that “gives advantage to anyone who can move real assets around.”
With the handouts and special provisions from the government, together with the massive liquidity injected by the Federal Reserve, how can banks not turn a huge profit? And there’s little wonder why everything from stocks, bonds to commodities all have gone up at the same time defying any kind of logical, correlation patterns. As some of the “special programs” are due to start falling. The Federal Deposit Insurance Corp.'s loan guarantee program, for instance, is due to expire Oct. 31, the first wake-up call finally came on this Tuesday. Prominent banking analyst Meredith Whitney Advisors in a note to clients stated that bank stocks are now “at least fairly valued”, cut their rating on Goldman Sachs (GS) to "neutral" from "buy", and removed its price target of $186 share. In July, Goldman reported quarterly earnings surged 33% on blowout trading results, beating forecasts. You may recall Ms. Whitney gained notoriety during the financial crisis for bearish calls on the stocks of large banks. According to the Wallstreet Journal, she spoke favorably of Goldman shares as recently as last month. So, her downgrade on Goldman not only bucked the market’s recent optimism, but also sparked investor concerns and speculations, since just last week, Deutsche Bank rated Goldman shares a "buy," the day after Calyon Securities raised Goldman`s price target to $230 from $194. Also, interestingly enough, last week Citigroup was forced by the Pay Czar to shed their Phibro commodities unit in a fire sale to Occidental Petroleum (OXY) for $250m due to the $100m contractual bonus Phibro had to pay star trader Andrew Hal. Some estimated the sale price is actually below Phibro's net asset value. This is just another indication of how badly managed so many of the nation's banks and financial companies are. The IMF Global Financial Stability Report estimates that the ultimate losses in the financial system in 2007-10 to be $3,400 billion. Within banks, the Fund estimates that losses will total $2,800 billion, of which only $1,300 billion has been recognized; whereas “US domiciled banks have recognized about 60% of anticipated write-downs.” So far, 416 banks were put on the FDIC`s troubled list, but many more should and will be added. The level 3 assets, i.e., those assets banks have a hard time valuing, because there's no real market for them, at just the top five banks, are around $510 billion. A new wave of losses from commercial real estate loans could also get more banks into trouble. Already two big commercial lenders, CIT Group and Capmark Financial Group are both dangerously close to bankruptcy, according to media reports. The six biggest U.S. banks will reveal in coming weeks how they did in the third quarter. Banks no doubt will report another round of stellar earnings further propping up the stocks. A series of bailouts during the financial crisis has left the U.S. government with considerable stakes in the banking sector. It seems the banks are set up, either intentionally or unintentionally by the government, to unload their hidden toxic assets at inflated prices. That would mean in the end, everyone wins, except taxpayers. Final Thoughts The Fed & Treasury through various measures has enabled the banks to made huge profits the last two quarters through a favorable yield curve, transferring toxic assets to government balance sheets, and relaxed mark to market accounting treatment of carried assets. The banks have effectively juiced up equities the last two quarters to return 15% plus per quarter on equities alone, if banks invested strictly in financials, financials are up over 144% since the March lows. These are great returns, but they are short-term profits. They are called banks for a reason, and not trading firms. There first line of business should be lending money, not trading equities and commodities. As lending money is what is needed for long-term profit for the banks, a steady stream of recurring inflows that affect revenue generation for the next seven to ten years for the banks. What we have here is a short term liquidity driven rally in equities that stops recurring revenue for trading units at banks once equities are fairly valued. Then what are they supposed to do for profits? And guess what, because the banks didn’t lend money and CREATE JOBS when they should have by lending money to small businesses and supporting construction projects on a large scale, more of their customers are going to default on their credit cards, car loans, and home mortgages. This will eventually come back to roost on the banks balance sheets, as they will lose their trading profit stream, and have to take more write downs on their existing portfolio of loans. This becomes even more self-fulfilling for banks, as consumers get hit worse, with a jobless recovery; they consume even less, and remember consuming accounts for two-thirds of the US economy. So guess what happens when consumers stop consuming? You guessed it, Commercial Real-Estate crashes under the weight of an overleveraged and underemployed consumer, creating major additional write downs for the banks and their loan loss reserves.
# a minute of perfection was worth the effort #

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