Palomino

Independent Analyst Numbers Far Uglier than Official Stress Test Rumors

I agree with your observations and think there is more bad news in the corporate loan books and emerging markets exposures on top of what you list. Not to mention exposures to insurers and autos through credit derivatives. Even after the government capital injections, some of the money center banks and super regionals would be insolvent if they marked their books properly now.

Hence the moves by the IASB and FASB to allow banks not to mark impaired assets through a variety of fudges. In a letter to the current chair of the G-20, Britain's Prime Minister Gordon Brown on April 29, 2009, the Financial Crisis Advisory Group (set up by the IASB and America's FASB) wrote "The FCAG believes that off-balance sheet standards particularly need improvement.....and also in the provisioning area...can increase transparency, preserve financial statement integrity and thus contribute to reducing the financial sector's vulnerability to excesses of the business cycle. As we share a common interest in bolstering the financial system's integrity and stability..." By their own admission, the accounting board's priority is the "system's integrity and stability".

Forcing banks to consolidate large portfolios of impaired assets, write-down and provision for NPAs and impaired assets, would guarantee system collapse. Hence the accounting changes that have enabled the banks to hide the true state of their balance sheets and raise debt and capital in the market from unsuspecting investors. The only reason the government is conducting the stress-tests is because nobody out there other than bank management can actually tell what the banks' true exposures are anymore so they feel the need to pretend to be safeguarding investors' interests. But the stakes are too high to take a cautious approach and so the results can only be intended to reassure (mislead) the market further.

So the banks can't "come clean" because the market would panic and the resulting defaults and lack of liquidity would cause the worst economic collapse in history, which is where we were headed before accounting standards were thrown out of the window.

The first question I have is essentially the same as yours... How will the banks re-build the capital that they have already completely depleted if they marked their books properly? One way is through increased profitability from hugely increased Net Interest Margin (a government capital infusion by the back door). Only banks can borrow from the government at close to 0% and then buy Treasuries at 3+%. Since US Treasuries attract no capital charges, banks can do this ad infinitum, funding the US deficit in the process.

But this Ponzi scheme is backed by the US Government and for now, it isn't in any big institution's interest to announce the Emperor isn't wearing any clothes. Only a buyer's strike by other governments and in particular China, also causing a collapse in the US Dollar, would bring this new house of cards down. And I doubt this will happen anytime soon. China needs the US to export to.

Likely the government will allow smaller banks which do not carry systemic risk to fail, enabling the big banks to pick up balance sheets on the cheap, as well as accessing new and profitable business as the market consolidates.

But ultimately, the bank's ability to re-build capital will be slower than the market imagines, particularly as they will need to write-off NPAs over a long period of time and with profits hampered by new bank regulation likely to limit leverage, impose restrictions on credit card rates and foreclosures.

The markets are now pricing the implicit government guarantee and this has led to the recent rebound in major bank stocks. If the banks are too big to fail, there has to be some option value to buying them in the single digits. Ultimately the question is what is the correct level to reflect likely earnings? I'm sure someone clever will do the maths.