After TARP: Part 1

Includes: BAC, C, WFC
by: optionMONSTER

By David Russell

Citigroup (NYSE:C) and Wells Fargo (NYSE:WFC) repaid $45 billion of government funds under the Troubled Asset Relief Program last week, freeing their management teams to increase executive compensation without government interference. As a result, the general perception has been that these banks and others that received TARP money at the height of the financial crisis are now free of taxpayer support.

But these institutions are still enjoying extensive benefits at the public's expense--albeit with much less publicity. In this first installment of a two-part special report, we will explore three unspoken subsidies the banks still receive, and will probably continue to enjoy, long into the future.

Subsidy No. 1: Cheap Money

Banks can now repay government funds because they're getting virtually free money from the Federal Reserve's low-interest rate policies. Case in point: Bank of America (NYSE:BAC), the country's biggest lender.

BAC Chart

Between Dec. 31, 2008, and Sept. 30, 2009, BAC's deposit base grew 10% to $975 billion, but its interest expenses on those deposits plunged by 56% to $1.7 billion. The cost of its short-term borrowings, which consist of commercial paper and notes tied to the Libor index, fell 62% to $1.2 billion over the same period.

However, despite higher long-term borrowing costs, BAC's overall interest expense fell 33% between the fourth quarter of 2008 and the third quarter.

Of course, the company earned less money as many of its loans adjusted lower because they're tied to short-term interest rates. But its overall interest income fell barely half as much--by 17%--during the same period.

BAC also bulked up on "cash and cash equivalents," quadrupling them to $152 billion, and shrank its loan portfolio by about 1.8%.

In other words, the company took much less risk yet still earned almost the same amount of money from its core banking business because of cheap money afforded by the Fed's lending policies. The low rates also helped revive the broader capital markets, which allowed BAC to add $5.9 billion of income from investment-banking and trading activities over the same period.

Instead of receiving the public's money in the form of government support, banks now simply pay much less interest on the public's deposits. This will reduce Americans' taxable incomes on savings and make them more likely to put capital into investments like gold or foreign equities, which reduces investment at home. The Fed's plan to keep rates low for an "extended period" suggests that we may face an extended period of capital flight similar to Japan in the wake of its financial crisis.

Subsidy No. 2: Agency Bonds

Banks traditionally held Treasuries as their "cash and cash equivalent" assets. But over the last 20 years, the financial sector has come to rely almost entirely upon Fannie Mae (FNM) and Freddie Mac (FRE) securities as their "cash."

Bond Yield Chart

The nice thing for the banks is that these "agency" bonds yield more than ordinary Treasury securities. For instance, on Dec. 16, Fannie Mae sold $1 billion of five-year notes at a yield of 2.526%. That same day, the five-year Treasuries yielded 2.35%. While 18 basis points might not sound like much, it's massive in fixed income--especially for "risk free" assets and when you're paying almost nothing on deposits.

FNM and FRE are now largely insolvent wards of the state. Their balance sheets are so choked with bad mortgages that the Treasury Department quietly issued a decision on Christmas Eve giving them unlimited access to public funds. (This also came just days after the White House allowed their chief executives to collect $6 million of annual pay in cash--unlike widely criticized Goldman Sachs (NYSE:GS), where top executives will receive their bonuses in company stock.)

So the banks increasingly rely on the yield-rich government-sponsored enterprises, and those same GSEs are wholly dependent on the Treasury. Letting banks invest so heavily in taxpayer-supported bonds that pay higher yields amounts to another hidden subsidy.

Subsidy No. 3: 'Regulatory Forbearance'

In many ways, this is just a fancy way of saying "not enforcing the rules." It's made possible under a policy that, in its own right, has a long history: For example, many of the same banks that received TARP funds were deliberately allowed to mask big losses in the 1980s after their loans to Latin American countries went bust.

Today, banks are doing the same thing by underreporting losses and delinquencies. This means that, even if banks aren't collecting, they can keep counting interest they're owed as if they are getting paid. This allows them to delay the write-down process, and casts doubts on their financial statements.

Financial-institution guru Chris Whalens of Institutional Risk Analytics recently described the practice on Yahoo Finance's Tech Ticker: "Loans can sometimes go for 180 days in terms of non-payment before the bank admits that the loan is bad. So they'll keep accruing interest as though you're still paying the mortgage. But you're not. So on a cash-flow basis, the bank is in much worse shape than they show to investors in their disclosure."

Whalens says this process allows some firms to misrepresent the value of their assets. Some lenders want to write down bad loans while others wish to keep holding them at artificially high valuations.

"The regulators don't make accounting judgments," Whalens said. "It's between the auditor and the management team. It's part of the judgment of the audit profession. This is how they earn their fees."

In other words, banks can legally distort their finances. Government officials and central bankers have helped salve such wounds for decades, allowing the industry to avoid the type of pain that would be inescapable for other sectors that have been forced to evolve and in many cases get stronger.

How Long Can This Continue?

My purpose here is not to moralize. The financials were a terrific investment in the 1990s and the 2000s despite--or perhaps because--the government allowed them to cut corners and essentially misrepresent their financial health.

The key question is how long they can repeat this trick before reality catches up with them. Will investors, accountants, regulators and lawmakers start raising questions that previously went unasked, producing a new round of problems for the banks?

Countering this risk is the increasingly steep yield curve, which could allow banks to make even more money with short-term borrowing and long-term investing.

I am not recommending buying or selling banks. The purpose of this article is simply to present another way of looking at the financials based on history and public information.

Continue to After Tarp, Part 2>>

(Chart data provided by tradeMONSTER and Federal Reserve statistics.)