Bank Balance Sheets: Healed or Ledger Hocus Pocus?

| About: SPDR S&P (KBE)

The resiliency of the markets has many investors, both retail and
institutional, playing catch up and opportunistically stepping in to buy any
weakness, making all corrections thus far shallow in depth. There are many
reasons for optimism as there are a number of reasons for the wise to show
caution. Which is natural when exiting a recession.

The Bear case: We've rallied significantly off the March lows, top line revenue growth is hard to come by, the continued excess liquidity being forced into the market, and the lack of a cohesive exit strategy all are valid arguments for a pause.

The other side of the coin: that global stimuli is gaining traction both
domestically and internationally, we're witnessing a stabilization in the
housing industry, the strong evidence of progress made in credit and
lending, the rate of job losses has ebbed, inflation is under arrest, and it
appears the recession has ended and a resumption to growth for the US
economy should be reflected in the current quarter. I remain cautiously
optimistic, but respectful of the fragile recovery we are currently

I have one nagging concern that refuses to go away and keeps me from being a blind raging bull. That concern remains the bank balance sheets, and how we "healed" them so quickly and effectively. One of the many cures we treated this patient with was merely an accounting gimmick. An amendment to the so called "Mark to Market" account rule, FASB 157. But, it turned out to be a miracle cure. (As you all know, I was very vocal and a proponent of repeal during the financial meltdown). I don't want to be a hypocrite now that the hurricane has moved out to sea, but many of those same assets still reside on bank balance sheets. Many of those same assets are still tied to Real Estate, both commercial and residential that continues to lose value.

The program designed to remove those "legacy" (toxic has such a bad ring to it) assets, PPIP has stalled, for now. This poses the following dilemma for the PPIP. If banks no longer need to mark down the valuations of those assets and can continue to hold them at fictitious valuations why would they sell them at a severe discount to carrying values? How can banks do that? Simply by moving these assets from one column, being "Held For Trading" to the other side of the ledger, "Held For Investment". Now under the new accounting rules, you no longer need to mark them at say .60/100, since you plan on holding these securities until they mature, you carry them at $1.00. That would be similar to you or I with our 5 year old autos, since we don't wish to sell them today, can continue to count them as assets at the original purchase price and not the blue book.

As you can see, it looks great on paper until we need to sell or trade in our car for a new one. Now, banks, due to the steepness of the yield curve are generating huge cash flows. They have also raised fees and are using those enormous cash flows to aggressively build loan loss reserves. Are they over-reserved? Perhaps and there is mounting evidence this is correct. I come down on this side of the equation.

However, just this last week we heard from State Street (NYSE:STT) they may have potentially under-reserved against future losses. There are many smaller regional banks that are still battling a deteriorating loan portfolio and delinquencies that don't have the massive deposit base to bail them out. We most likely will need to recycle those early TARP repayments back to these smaller neighborhood banks that require assistance. Plans are being worked on to do just that. We'll need the following: more time, more TARP money, stabilization in housing and jobs to help heal these smaller non-systemically critical financial institutions. We've certainly bought ourselves the time by printing up the money.

Now I'm on Bernanke's statement, which is most critical.

Yours, still a bull, just not a blind one.