After TARP: Part 2

by: optionMONSTER

<< Go back to Part 1

By David Russell

As the last major banks that received TARP funding paid off their government debts last week, the general public has been left with the impression that the financial industry finally has a clear path toward recovery. But just as we reported yesterday that the banks are still benefiting from hidden subsidies, they continue to face largely unknown risks associated with that support and other factors.

In this final installment of our special report, I will focus on two new types of risk that are emerging in the financial sector and could become major issues in 2010: political exposure and questionable assets.

Unpredictable Political Events

Dick Bove

Given their continued dependence on government support, banks now face the unpredictable risk of political developments. This was confirmed by prominent analysts Dick Bove and Sean Egan, who recently spoke with optionMONSTER.

"There's no question about the fact there is political risk in these stocks at the present time," said Bove, who covers banks at Rochdale Securities. Bove cited example of Dec. 15, when investors dumped regional banks on the concern they'll be forced to raise more capital.

"Politics have been critical over the past 18 months for better or for worse," said Egan, who was named analyst of the year by Fortune for accurately predicting the financial crisis. "It's the politically relevant that have been saved," he added.

Sean EganEgan suggests that investors distinguish between "anointed banks" and "un-anointed banks" and think they're worth considering now as investments. Bove shares his belief that banks are now attractive to long-term investors.

Another potential political risk is the Federal Reserve. On Aug. 25, Bloomberg won a Freedom of Information Act lawsuit forcing the Fed to disclose emergency loans to the banks. The decision was delayed pending an appeal that will begin Jan. 4. There is no way to know what kind of information will leak out of this case, but it's hard to imagine that any of it will be positive for the banks.

A second risk is an attempt in Congress to audit the Fed, which reflects the mounting pressure building on both sides of the political spectrum to rein in the central bank, which could hamper its ability to support the banks.

Like many other things in finance, investors should view this as a trend. It is impossible to know where it's going but, once established, it makes sense to assume it will continue.

Rise of 'Miscellaneous Assets'

Every quarter the Fed publishes a report known as the Flow of Funds that is mainly read by economists rather than investors. It shows a pattern of questionable finances at the banks that I have not seen addressed by a single analyst.

Bank Assets Chart
The first issue is the rise of "miscellaneous assets," which include all the real estate and other questionable items banks have quietly been loading onto their balance sheets.

One troubling thing about this chart is that the blue line shows banks are now more solvent than at any other point since the data began in 1952, which clearly isn't true. It also indicates that excluding nebulous miscellaneous assets, banks have been insolvent for a long time. (The Fed hasn't returned calls seeking an explanation of this item, found in its Flow of Funds report.)

Furthermore, the value of these items remains questionable. Some $1.1 trillion of new miscellaneous assets appeared on bank balance sheets at the height of the financial panic between September 2008 and March 2009.

Rising Assets ChartGiven that they haven't fallen in value, it seems possible they're still being carried at unrealistically high prices. (See this interview with Chris Whalens on Yahoo Finance's Tech Ticker for more on bank accounting.)

The conventional wisdom now is that banks will reach a certain point next year when they stop taking writedowns and begin churning out huge profits--just like in the early 1990s. The problem is that bank balance sheets are much harder to understand than in the past.

Aggravating this issue is the fact that most assets--like houses or mortgage loans--require bank financing to be worth anything at all. This produces a chicken-and-egg effect where banks need the assets to be worth something in order to be solvent and lend, but those same assets can only be worth something if the banks are solvent enough to lend.

(Chart data provided by Federal Reserve statistics)