Reports of Profits While Banks Fail

This week Citigroup (C) shocked Wall Street by announcing that the company would be profitable in the current quarter. At the same time, the Obama Administration indicated that it would be unlikely to nationalize American banks, preferring to provide low cost funding to encourage the private sector to buy distressed assets from the banks. The two developments sparked a vigorous rally in financial stocks, which had been drifting downward for weeks, caught in what appeared to be an unending death spiral. But have the good times really returned?

On the surface at least, there are some promising points. Based on current income, and an upward trending yield curve (that will allow banks to borrow at nearly no cost from the Fed and lend to borrowers at a good profit) the banks should generate strong cash flow. But that is hardly the full story.

Write-downs in the value of toxic assets already held on banks' balance sheets will continue to explode like ticking time bombs. These debts may be too large to be overcome by a positive cash flow fueled by cheap access to short-term funding. If banks were simultaneously forced to write down assets, they could be rendered insolvent from a capital balance sheet point of view. This is the underlying problem that America and the much of the world face with their banks: banks can be trading with positive cash flow but from a technically insolvent capital position – which is illegal.

Some argue that toxic assets make up only a very small part of the total assets of the banking system. That may be so, but the real issue is the enormous size of the toxic assets in relation to both the capital of the banks and the funding ability of the government.

According to the Bank of International Settlements, the world's total of derivatives investments, including the poorly understood credit default swap (CDS) market reached some $700 trillion at its height, or more than 20 times the world's total annual production! The American portion was about $419 trillion, or some 40 times America's annual production.

The essential problem is that these inherently risky securities were used as collateral for loans. The fall in their value resulted in massive deleveraging. Of course, not all derivatives are yet flawed, or toxic. So, it can be assumed that, in the absence of a total financial collapse, only a limited number will default.

However, if a conservative assumption were made that only some two percent of derivatives fail, it would still amount to some $14 trillion. The American share would be about $8 trillion, or almost one year of GDP once that figure declines to a sustainable level. The estimated total capitalization of all U.S. banks is some $1.6 trillion. But, this amounts to only 20 percent of the potential American liability.

So far, American citizens have been forced to provide financial institutions with nearly $2 trillion in additional bailouts. This brings the total of current U.S. banking capital to some $3.6 trillion, still less than half of the potential problem, leaving a massive $4.4 trillion shortfall. In light of this, even noted bearish economist Nouriel Roubini's estimate of a $3.6 trillion shortfall appears to be too optimistic.

Of course, not all American banks are in trouble. There are a number of local and regional banks whose managements did not participate in gambling away America's financial future. Nevertheless, investors should ask themselves some hard questions. What if the government is forced to face the fact that the U.S. banking system, as a whole, is already fundamentally insolvent? What if the Administration is therefore forced, despite its expressed disinclination, to nationalize the problem banks?

Most importantly, while the good banks are being separated from the bad in the FDIC's ‘coral', will all American banks be forced to close? Worse still, after the forthcoming G-20 meetings, will all international banks be closed on a temporary basis, on a long bank holiday, as happened in the Great Crash? If so, what would happen to consumer confidence and the price of gold?

Citigroup says that it is profitable. At the same time, most banks are in dire straits. Until Citigroup is able to put its capital where its mouth is, investors in U.S. financials should remain cautious.

Comments

[Chezfrederick]

Gloomy, but plausible...let's hope you are wrong. Orderly unwinding is the approach used successfully in the past... let's hope clear heads prevail to institute such an approach, limiting losses and impact.

2009 Mar 12 06:45 AM

[Dr. Roberts]

John Browne, another gloom and doomer. How big are your short positions in the financials John? Read this and then look at a transcript of Warren Buffet's interview with CNBC, a man that not only knows a thing or two about the banking business but puts his own money where his mouth is. Who ya gonna believe?

2009 Mar 12 10:19 AM

[Rocknbob]

Thank you Mr. Browne for a very analytical post. Plausible numbers...albeit gloomy ones...I say invest in SKF and SRS for good entry and exit points...

2009 Mar 12 11:26 AM

[Dr. Roberts]

Gee thanks monday1929 for believing that with a few words I have the power to not only influence, but to control asset prices around the globe. I'm quite flattered really although wanting to deny me my Constitutional right of free expression seems a bit draconian and off the wall. Your psycho-babble however reminds me of the old saying...you gets what you pay for. Tell ya what, if you can think of a method whereby we put our money on the line as far as who is more correct, whose position is closer to reality, you got a bet. You can name the stakes.

2009 Mar 12 12:53 PM

[Jason Rines (iThinkBig)]

At barebones minimum, it is the $60 T x 2% = $1.4 T in fees that will be paid by taxpayers at settlements. Banks don't want to sell at some floor set by government of say .50 cents on the dollar and there lobbying investment of the past is unfortunately paying huge dividends :( Chris Dodd needs to be impeached at this point. Monday1929, you get zero respect for not acting as a gentleman. Dr. Brown, I hope you visit theburningplatform.com and facilitate discussions. I own this site and am giving every Patriot such as Jim Quinn there own website to rapidly scale education to the masses in this country.

2009 Mar 19 03:41 PM