Bank Optimism: Too Much, Too Fast

Signs are emerging that optimism in the financial services sector may be misplaced, or at least, premature.

It’s no secret that banks have been eschewing government aid. But, in the tradition of these giant money machines, they seem to be doing so again at the expense of their long-term security — all for the sake of quarterly earnings results.

Take for example, the approval by the Treasury Department for 10 banks to repay their TARP loans more or less ahead of schedule. Rortybomb points out that the big banks may need as much as $390 billion in the worst case scenario, according to a model using rising unemployment statistics:

I was actually surprised - I assume turning up the numbers a bit would cause everyting to start leaking red ink. Instead it seems that if there is an additional slight downturn in the economy, we know the firms that will have all the problems. They are the ones that are too big to fail. Funny that.

Readers of BNET Finance will be familiar with this conclusion. Tuesday, it was reported there that the congressional panel overseeing TARP repayments gave rising unemployment statistics as the number one reason why banks should be “retested” for capital adequacy requirements. That argument was compounded by the issue that Treasury only tested the banks on a hypothetical two-year scenario.

Most recently, there’s talk of the Private Public Investment Program (PPIP) coming apart at the seams, as banks reject the possibility of marking-down the value of their toxic assets in order to sell them for cents on the dollar. Such a plan, argue banks, would force many of them to declare themselves severely financially hampered in the immediate term, since a price-floor for the securities they hold on their balance sheets would be set by the fire-sale of their assets.

Actually, banks have more or less done exactly the opposite of what the PPIP would ensure. First quarter earnings results showed that banks were not only applying the “fair value” rule of accounting for their toxic assets pretty liberally, but even declaring multi-billion dollar losses as windfall gains.

Part of the potential future problem for banks has, ironically, been their own good fortune lately in the stock market. Reuters’ Felix Salmon puts it pretty succinctly:

The market loved this idea [that assets at banks would finally have a certain value], and started going up rather than down, to the point at which people weren’t scared any more about the amount of toxic assets on banks’ balance sheets. And so it didn’t matter that the adverse scenario in the stress tests is looking positively sunny these days. And it didn’t matter that PPIP disappeared with a whimper, the toxic assets no more priced now than they were six months ago. So long as the stock markets are happy, what’s to worry about?

Now that the stock market is surging, the banks are back to old tricks: generating the best possible quarterly earnings reports in order to play catch-up with expectations.

As the former CEOs of Enron or Worldcom will tell you, operationally that’s a nightmarish game to play, which ultimately only ends in tears. It’s true that banks are seeing signs of an increase in inter-bank lending and business in general, and that confidence has played a big part in getting that going again. It would also be dangerous to abruptly let the air out of consumer and investor optimism.

But confidence and expectations can only provide price support for so long, before the banks will be forced again into having to assume another round of loans. That scenario may put banking in even worse a scenario than the one it found itself in, in the first place.

Comments

[CautiousInvestor]

Things have changed very little from six months ago.

The government has invested around $200 billion in the banking sector and conducted what they call a stress test. Thanks to this and relaxed accounting standards, outside capital has been raised and ten of the nineteen banks subjected to the "grueling" stress test have escaped from the beneath the TARP.

Meanwhile and virtually unreported, one leg of the three pronged Financial Stabilization Plan has died a silent death. The much vaunted PPIP are no longer with us...........but the legacy securities and assets are and can be easily found on bank balance sheets in undisturbed form. The only thing that has changed is their value which has gone down with falling home prices, rising credit card defaults and the imminent collapse of CRE.

So why all the cheer and optimism and why has the XLF doubled in the past three months? Because of green shoots and an understood policy that the government will do whatever it takes to prevent the collapse of a major financial institution; there will no more Lehman Brothers.

The immediate effect of this policy of implicit guarantees is that it will be easier for banks to attract capital, which is exactly what has happened. And with access to capital liquidity risks are reduced giving rise to higher valuations.

Longer-term, and as discussed by John Carney at ClusterStock, this will lead to an over allocation of resources to the financial sector away from safer sectors because of distorted market risk signals. This, then, sets the stage for another crisis as neither the market nor management can send or read risk signals as they are suppressed by implicit guarantees.

2009 Jun 14 03:05 PM