Tuesday, July 21, 2009 0 comments ++[ CLICK TO COMMENT ]++

How good are the American bank earnings?

In a opinion piece for MarketWatch, David Weidner wonders about the reliability of bank earnings in America. This is a story that the bank bears, and maybe even the broad stock market bears, were making over the last week. I wasn't going to write about it but then realized that this might turn into an "unexpected" event which could impact the markets.

With the large commercial banks, David Weidner says:

Commercial banking is essentially about one thing, net interest margin. A bank makes its profit, or net interest margin, by simply lending money at a higher rate than it has to pay to get the money. The environment for net interest margin has rarely been better. Banks only have to pay depositors interest of around 1%. Even better, they can borrow money from the Federal Reserve at a rate between 0% and 0.25%. The banks are lending it at rates of at least 5% all the way up to 30%.

The problem is that borrowers aren't paying back their loans. Bank of America Corp. said its nonperforming commercial loans, or loans nearing permanent loss, increased 23% in the last three months and nearly three-fold over the last year. Net charge offs topped $8 billion during the period.

This isn't just a Bank of America problem; it's a problem for all the banks in America. Citigroup Inc. took the same $8 billion hit for charge offs. Commercial loans are failing at the fastest rate in 20 years. See full story.

To this decline, the chief executives of the nation's biggest banks say the good news is that conditions aren't getting as bad at the same rate they were earlier in the year, which is kind of like saying the patient with four to six weeks to live may maximize his potential.

On top of all this, it is questionable whether consumers and businesses will borrow anywhere near the amounts they have in the past. For NIM (net interest margin) to be profitable, someone must be doing the borrowing. So, not only are commercial banks taking losses from defaults, but their earnings will also weaken.

Regarding investment banks, Weidner has this to say:

Goldman Sachs Group Inc. reported a $3.44 billion profit for the quarter, mostly on the trading that made up 73% of the investment bank's revenue. This is the sweetest spot in the market right now. After last year's financial crisis, few banks are willing to make trading bets because, well, bets can turn out badly.

As a result, the spread between bids and asks, and credit spreads is wider. That gives traders more margin, and Goldman, which put more value at risk during the quarter than at any time in its history, was uniquely poised to capture trading gains.

No other bank, not even J.P. Morgan Chase & Co., was willing to make those kinds of bets -- or, if they did, they missed the market and didn't have Goldman's results.

Either way, save for the trading monopoly at Goldman, investment banking was a pretty flat-to-lower-result business for the institutions with significant operations.

Global mergers and acquisitions volume fell 38% from a year ago. Initial public offerings totaled only $12.7 billion globally for the entire first half of the year and debt issuance fell 14.6% in the second quarter compared with the same quarter a year ago, according to Dealogic.

And yet even though every category was down, big banks reported surprising profits from investment banking during the quarter. Why? Both government-aided secondary offerings and government-backed bond issues spurred huge fees.

As pointed out above, a lot of the investment banking profits, except those of Goldman Sachs, seem to have come from government-influenced operations. It is likely that the situation won't repeat to the same degree in the future.

Why does any of this matter? Who cares, assuming you are not a bank shareholder or a bondholder, if the big banks are making money? Well, it's kind of important. I have come around to the view that many of the banks are insolvent. If earnings can't make up the losses, the banks have no chance. Even companies like Wells Fargo, which is a big holding of Berkshire Hathaway, would face problems if earnings continuously decline, while losses keep increasing.

Given the rally in bank shares, not to mention the general optimism regarding the economy, everyone has forgotten about how bad these banks were. But problems are still lurking in the bankground. Moody's, which moves slowly and rarely says something without any serious concern, recently suggested that banks are not setting aside enough reserves to handle potential losses. A lot depends on what happens to the economy.


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