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In recent weeks, the financial world has been dazzled by strikingly high earnings reported by our leading investment banks... or at least what we used to call investment banks. The numbers are reminiscent of another era - the one that came to a crashing end last September. Today's euphoria is keyed to the record $3.44 billion second quarter profit announced by that branch office of the Treasury Department also known as Goldman Sachs (GS). Wells Fargo (WFC), JP Morgan Chase (JPM), and State Street (STT) also chipped in with strong numbers.
The seeming health of these institutions, which are often referred to as the "backbone" of the U.S. economy, is currently being cited as strong proof that economic recovery is at hand. This conclusion is based on selective memory and dubious logic.
The more immediate question hinges on whether this rise in bank and corporate earnings can be sustained in the face of increased commercial real estate mortgage defaults, rising unemployment, and increased savings? Would it then be likely that the broad stock market can continue to rally while the financial sector sputters? If not, a serious correction in U.S. equity prices is a foregone conclusion.
In the early years of this century, major money-center banks and shadow banks incurred irrational risks and paid themselves unimaginably large bonuses. They were termed "gambling casinos" and deservedly drew fire when their bets went south. But instead of forcing these irresponsible firms to pay for their bad behavior, the federal government forced the general public to rescue them.
The Treasury and Fed instituted four key measures intended to boost the banks' earnings, which in turn, would boost their share prices, improve their capital ratios and force their share prices upward.
First, Congress was pressured into giving instant approval to the $750,000,000,000 Troubled Asset Relief Program (TARP). This massive sum of public money was designed to buy toxic assets from the banks. However, the government soon realized that buying some toxic assets would create a real price and thereby threaten the inflated value of other toxic assets held by financial institutions worldwide. The initial TARP plan was dropped in favor of injecting billions of dollars into certain banks, leaving the toxic assets on their books. Meanwhile, the true values of these toxic assets were officially camouflaged by the initiation of "exceptional" accounting changes.
The injection of free TARP funds enabled the recipient banks to enter a charred landscape that was, nevertheless, bristling with easy profits. For example, $10 billion of TARP funds enabled Goldman Sachs to make leveraged trades during the bear market rally of the last four months. Though this is the same activity that caused its downfall, Goldman now assumes a government guarantee on its risk-taking. With no limits on their appetite for risk, record profits are theirs for the taking.
Second, some of the shadow banks, such as Goldman Sachs and Morgan Stanley, were allowed to become bank holding companies. This change allowed them access to the Fed Window to borrow at zero percent interest. This greatly increased the profit margins of the banks day-to-day lending operations.
Third, the reduction of Fed rates to below one percent has steepened the yield curve, enabling banks to take six to eight percent plus spreads in lending to boost earnings.
Fourth, for the first time, the Fed is paying interest on bank reserves. This meant that all banks can borrow at zero and lend back to the Fed at an interest rate spread of some three percent, thus boosting earnings further. The downside is that banks are discouraged to lend to risky companies and individuals while they can lend at no risk to the Fed. Therefore, despite political pressure for banks to lend, credit remains tight.
With the great privileges listed above, and with the competitive landscape improved by the disappearance of Lehman Brothers and the absorption of Bear Stearns and Merrill, it is little wonder that the surviving banks earned more. A firm like Goldman Sachs, with its stellar earnings, is now effectively a hedge fund subsidized by taxpayers.
However, toxic assets remain on the books of the banks. In addition, problems in the commercial property and consumer lending field loom menacingly.
The Fed has also acknowledged that, eventually, it will need to sharply increase interest rates to "mop up" all the liquidity it's pouring into the world economy. This action alone, if the Fed ever has the nerve to execute it, could bankrupt every financial firm that survived the initial crisis.
Should earnings falter and banks stumble for a second time in the face of a looming $3.4 trillion commercial mortgage problem, the entire U.S. stock market could follow suit.
That would be the crisis we've been predicting. Better be prepared.
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When did this happened?
The only good thing with the consumer pulling back and saving more is that it makes dollars more precious rather than something to be thrown around with gobs of credit from banks like we did in the past.
> jack
What's it going to be next?
Credit card losses/defaults continue to rise but some lenders are beginning to see stabilization on residential real estate. Look for unemployment to tick up a but more and stay there for a while, ultimately pushing other credit losses higher. Commerical will also get worse but not like the housing bubble.
I think we've pretty much bottomed out - most of the above tend to be lagging.
We do realize it is happening. However, what can be done? Revolt would harm everyone. It is legal theft, a theft that we will have to live with until government changes the legality of banks and the Feds current actions.
"The seeming health of these institutions... is currently being cited as strong proof that economic recovery is at hand."
By whom?
"...whether this rise in bank and corporate earnings can be sustained in the face of increased commercial real estate mortgage defaults, rising unemployment, and increased savings?"
Mortgage defaults hurt bank earnings - check. Rising unemployment hurts bank earnings - okay, in that more economic activity is better for earnings. Increased savings hurts bank earnings - on what planet? Increasing savings means increased deposits at banks - deposits on which they pay less than 1% interest. You noted the spreads in the market currently - increased savings will increase bank profitability.
"If not, a serious correction in U.S. equity prices is a foregone conclusion."
Why is it that only a move down is a "correction"? Why isn't a move up ever referred to as a correction?
"But instead of forcing these irresponsible firms to pay for their bad behavior, the federal government forced the general public to rescue them."
1. You mean like Bear Stearns and Lehman Brothers? Or Merrill Lynch and AIG?
2. Could it be that "forcing these irresponsible firms to pay for their bad behavior," which might have meant the banking system as a while seizing up, would have been far worse for the general public? Is it possible that it was in the general public's interest to keep the banking system working?
"However, the government soon realized that buying some toxic assets would create a real price and thereby threaten the inflated value of other toxic assets held by financial institutions worldwide."
Total mischaracterization. The problem with the original TARP plan was always one of valuation; the government didn't want to overpay, and the banks didn't want to sell at too low a price, in part because of the effect you're talking about to other assets on their balance sheets. Your statement makes it look like this was completely a government decision, that the banks weren't active sellers, pushing for as high a price as possible. It's not like the government had a line of bankers with their bad assets, willing to take whatever price necessary to get them off the books.
"Meanwhile, the true values of these toxic assets were officially camouflaged by the initiation of "exceptional" accounting changes."
"Exceptional" according to what? Why haven't you talked about the change in mark-to-market accounting rules that occurred in 2007, forcing banks to mark more assets to market just as asset values started declining?
"The injection of free TARP funds..."
Free? I guess you're unaware that the banks were paying dividends on these investments? Or that they had to issue warrants to the government? Did you miss it when Goldman bought the warrants back, resulting in an annualized cost or TARP funds to Goldman of 23%? Perhaps your definition of "free" is different from mine.
"... Second, some of the shadow banks, such as Goldman Sachs and Morgan Stanley, were allowed to become bank holding companies. This change allowed them access to the Fed Window to borrow at zero percent interest."
Wrong #1: Both already had access to Fed lending facilities, though on an emergency basis that was likely to end as soon as the Fed was satisfied that the systemic pressures had eased.
Wrong #2: The Fed doesn't lend at zero percent interest - the discount rate is 0.5%.
"Fourth, for the first time, the Fed is paying interest on bank reserves. This meant that all banks can borrow at zero and lend back to the Fed at an interest rate spread of some three percent, thus boosting earnings further."
Complete nonsense. The interest rate the Fed pays on reserves is the same as the target federal funds rate, which is currently between 0% and 0.25%.
"The downside is that banks are discouraged to lend to risky companies and individuals while they can lend at no risk to the Fed. Therefore, despite political pressure for banks to lend, credit remains tight."
Again, nonsense. The Fed began paying interest on reserves AFTER the banks starting hoarding cash to shore up capital. The Fed then entered lending markets (notably commercial paper) that the banks were abandoning. As banks re-enter these markets, the Fed disengages; this has been happening over the last 9 months.
And why would banks lend to more risky borrowers than the Fed? For the same reason they choose any borrower - the increased risk is balanced by higher interest rates. Why would a bank lend to the fed at 0.25% when it can lend to a prime borrower at 3.25%? The nominal interest the Fed is paying is barely a blip in the decision process.
Banks are less willing to lend for three reasons: (1) they are holding enormous reserves to protect against future loan losses; (2) they are more risk-averse than they were previously; and (3) there simply aren't as many worthy borrowers in a recession.
"Goldman Sachs... is now effectively a hedge fund subsidized by taxpayers."
Subsidized how? You do realize that Goldman repaid the TARP money more than a month ago, right?
"The Fed has also acknowledged that, eventually, it will need to sharply increase interest rates to "mop up" all the liquidity its pouring into the world economy."
I don't think the Fed has EVER said that it will need to "sharply" increase interest rates. I think that officials are in agreement that, as the economy improves, it will need to take steps to reduce the money supply. It's hard even to IMAGINE a central banker planning to "sharply" raise interest rates.
"This action alone, if the Fed ever has the nerve to execute it, could bankrupt every financial firm that survived the initial crisis."
How?
"Should earnings falter and banks stumble for a second time in the face of a looming $3.4 trillion commercial mortgage problem..."
Source your data, please.
"...the entire U.S. stock market could follow suit. That would be the crisis we've been predicting. Better be prepared."
And since North Korea might lob a dirty bomb at the Pacific northwest, I guess everybody in Seattle should start living in fear and stockpiling canned goods.
When it's an individual it's grand larceny. When the banks do it, it's called "business". LOL
The reality is that while shady accounting practices and making money from the government gifts are propping up the banks, the banks are single-handedly bankrupting their best customers.
Totally under the radar and it is becoming more and more destructive.
If you review earnings from the past couple weeks, it becomes obvious, the "chosen" winners are making money, the companies that slashed American jobs but still sell Americans necessities (Kraft) are making money, but everything else continues to shrink.
If banking is our "backbone" we better get prepared for a French styled revolution as former business owners and their employees are starved in the dark.
There are multiple other shoes that can bring down this Ponzi scheme that the Treasury, Fed and banking industry has created.
Good luck to us all.
Cynicism and pessimism often exascerbate losses in the downturns and paralyze people from seeing the upside opportunities.
On Jul 30 11:00 AM Vox Rationalis wrote:
> This is article is chock full of strawmen and misinformation, making
> its conclusions fairly weak.
(Clipped)
While I personally believe "mark-to-market" violates the principle of consistency in accounting, especially when there "is no market" (ie, a distrssed market such as last fall/winter), it was nonetheless forced onto banks, seriously hitting their earnings (and IMHO nearly destroying our economy). Then the impact was reduced for financial firms, which is NOW showing up in the form of better earnings.
Beware: FASB is considering what would amount to forcing marl-to-market on everyone. The insurance company I use to work for held bonds to maturity, so absent a default, their "straight-line" amortization of a bond discount or premium might become "mark-to-market" and thus turn into an extremely volatile source of earnings, EVEN for US Treasury bonds. If you doubt UST's are volatile, just look at the charts!
Kinda one-sided. The low interest rates have also pushed down mortgage rates to near all-time lows, which directly advantages the large middle class component of our population and puts two orders of magnitude more cash in their pockets then any tax rebate check ever could. In case you haven't figured it out, its our large middle class that will lead in the spending needed to get us out of this mess.
Sure, it also helps banks like Wells Fargo offset their mortgage losses with near record net interest margin on deposits... for a little while, anyway. That's probably a better solution then the government having to spend another trillion dollars propping up the banks even more then they have already. So I'm not complaining.
Oh, I forgot, the author seems to believe that we should have just let all the banks crash and burn. I'm trying to imagine what effect that would have had on our economy. Entire population abandons banking system, bankers go bust. U.S. enters severe depression that lasts 20 years. No thanks. The mess we have now is nothing compared to the disasters we have managed to avert.
-Matt
What is wrong with the banks helping themselves? Why would the government (people) provide them with financial supports if they don't help themselves recover from their own mistakes? There are other ways of reforming sinners other than the death sentence or amputations. Some banks maybe are zombies in paper but not necessarily dead weights for the economy if they can do their jobs of helping the economy recover. Give them a chance, if they don't function, then cut them off.
The govt must also monitor their activities to prevent abuses such as the 30% credit card charges and even perhaps excessive market expossure of GS, JPM et al that is starting to raise questions among traders and investors and can quickly erode confidence in the stock markets if left unchecked.