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Issue 20 • April 15, 2009 Is This a ‘False Spring’ for the Financial Sector?
The news helped extend the market rally that began after stocks most recently bottomed on March 9 at 12-year lows. Since then, the S&P 500 Index has jumped 27% higher over the past five straight weeks.2 Does this mean the worst is over for the financials and is the bottom in? Not by a long shot. Getting past first-quarter earnings reporting season is only the first hurdle in what promises to be a long and grueling marathon toward financial sector recovery. Another hurdle for banks is looming as government-administered “stress test” results are due by the end of this month — just a few weeks away. Coming Soon: ‘Stress Test’ Report CardsOver the past eight weeks, 200 federal examiners have been crunching the numbers on 19 of the nation’s largest banks and the “report cards” are due soon. Examiners have been stress testing the banks under a range of economic assumptions to determine their financial health.3 Of course details of the tests aren’t available, and the final results may not be either. In fact, the Treasury Department has cautioned banks against discussing anything about the tests with investors, perhaps due to fears of triggering a run on “failing” banks. So much for transparency, even after taxpayers have pumped nearly $200 billion into 511 banks already ... we may still not get to see the report cards we’ve paid big bucks for.4 The stress tests, so we are told — combined with the government’s Public-Private Investment Plan (PPIP) — are supposed to help restore confidence in the battered financial sector while removing “toxic” assets (the Treasury Department’s politically correct term is: “legacy” assets) from bank’s balance sheets ... perhaps in time, but not so fast! Here’s why you need a strong dose of skepticism: First, the whole process of government “stress tests” for banks appears more and more like a side-show — a sham to confuse the public while the Treasury force-feeds its bailout plan on the sector. A recent New York Times article that sources un-named “officials involved in the examinations,” reports that “all 19 banks undergoing the exams will pass them.”5 Could the reason for the expected “passing grade” have anything to do with the less than realistic economic assumptions used in these stress tests? Two economic scenarios are being used in the bank stress tests:
GDP just plunged at a -6.3% annual rate in the fourth quarter of 2008 and we’re almost certain to see another steep contraction of -5% in the first quarter.7 Housing prices have already declined almost -30% from the peak and could easily slide much more, based on several estimates.8 And the true unemployment rate is already at a record high of 15.6%, once you add the underemployed and those who have simply given up trying to find work.9 Second, on April 2, accounting rule-makers at FASB (Financial Accounting Standards Board) voted to change mark-to-market accounting rules for banks and other firms, allowing them to “use ‘significant’ judgment in gauging prices of some investments on their books, including mortgage-backed securities.”10 Accounting Shell-Game Could Torpedo PPIPIt is absurdly convenient that the rule change took place just days after the first-quarter reporting period ended on March 31 ... and it applies retroactively to banks’ results for the entire quarter.
But the accounting shell-game could also spell trouble for the Treasury’s PPIP program to buy toxic assets. The problem: banks already value these assets at what appear to be ridiculously high prices. Now they have a perfect excuse to maintain these phony valuations. The Treasury and Federal Reserve seem to think that the toxic assets rotting on bank balance sheets are worth upwards of 80 cents on the dollar, at least in “normal” markets.12 But the majority of potentially toxic loans sitting on bank balance sheets have ONLY been marked down to 90 to 95 cents on the dollar, on average, so far.13 That’s a far cry from the 80 cent value suggested by the Treasury’s purchase plan. But consider this, based on actual market prices; the real economic value of many toxic assets may be just 30 cents on the dollar today!14 Let’s recap this ridiculous plan: the banks say this junk is still worth 90-95 cents ... the Treasury would like private investors (with funding mostly provided by U.S. taxpayers) to ante up and buy the debt for 80 cents ... but their true value could be more like 30 cents! It’s no wonder the Treasury Department is having trouble rounding up folks to invest in the PPIP scheme. In fact officials just extended the deadline for interested investors to apply for the program because “the plan isn’t getting the kind of traction hoped for”15... what a fiasco! In reality, if the banks sold these toxic assets for anything close to their true market value, it would result in more huge write-offs ... destroying more bank capital (including taxpayer-funded capital) and further depressing their stock prices. But, even with more taxpayer funding, private investors may not be willing to pay ridiculously high prices for this junk either. Sounds like a standoff to me. Meanwhile, the economy continues to worsen and banks are exposed to even more losses from accelerating defaults on prime mortgage loans, commercial real estate loans, auto loans, credit card debt ... you name it. So bank balance sheets are likely to get even worse, not better, the longer this drags on. How Much Worse Can it Get for the Financial Sector?The truth is that total loan losses may exceed the worst levels we’ve experienced, even during the Great Depression, by as much as 60% in a high-stress scenario. This could mean that the government may ultimately be forced to take over large banks to prevent total collapse.16 So far, banks and insurers have only confessed to about $1.3 trillion in toxic asset losses, but as the economic slump grinds on, banks face even more losses. In January, the International Monetary Fund (IMF) forecast that total losses could reach $2.2 trillion — or about twice what’s been reported so far ... but the IMF may soon update this forecast to a much steeper expected loss of $4.4 trillion ... more than three-times the hit taken by banks so far!17 The biggest banks are in the worst position to absorb such a hit right now and Washington knows it.
A key measure of financial health for banks is the ratio of tangible equity capital-to-total assets (the higher the better). The top 20 financial institutions have a razor-thin capital cushion of only 3.3%, on average (see table). In other words, a bank would only need to suffer another 3 to 4% write-off from toxic assets to wipe out ALL of the banks’ tangible capital ... making it technically insolvent!18 Many of the biggest banks that have suffered the largest stock price declines are in even worse shape. Citigroup, for example, would have its capital wiped-out with another asset write-off of just 1.5% ... for Bank of America; a 2.6% write-off would do it!19 The bottom line is that many big banks and other financial firms are already technically insolvent NOW, surviving only thanks to taxpayer-funded government life support. The latest proposals to prop up the financial sector by the Treasury and Fed seem like complicated half measures that may do nothing but buy a bit more time for Citigroup and the rest … at taxpayers’ expense, of course. The credit crisis wreaking havoc in the financial sector is far from over and full recovery may not be realized for many years to come ... regardless of the rosy first-quarter results we are seeing due to this well timed mark-to-market rule change. Good investing, P.S. Unfortunately, we see more tough times ahead for banks, and many other firms, as the economic slump continues. The bear market is not over yet ... but you can find out how to help protect your wealth and potentially profit as markets decline further with our Weiss Bear Market Strategy. 1 Bloomberg: “U.S. Stocks Gains, Capping Biggest Jump Since 1933 as Banks Rise”, 4/10/09 Disclaimers: 1. Weiss Advice is a publication of Weiss Capital Management, an SEC Registered Investment Adviser. Weiss Research is a separate, but affiliated publishing company. Both entities are owned by Weiss Group, LLC. 2. "Weiss Advice" is published for general information and educational purposes only and should not be construed as a specific recommendation to buy or sell any security. Specific recommendations can only be given to advisory clients of Weiss Capital Management, with the benefit of knowing their financial condition and suitability. Receipt of this publication should not be construed as a solicitation to do business outside the jurisdiction for which the Firm is approved. Currently, Weiss Capital Management offers investment advisory services to individuals maintaining legal residency within the United States. For details, please contact the Firm. View Weiss Capital Management's Privacy Policy. To make sure you don't miss our urgent updates, add Weiss Advice to your address book. Just follow these simple steps. |
Wells Fargo helped “circle the wagons” last week, announcing unexpectedly strong first-quarter financial results. The S&P 500 Banks Index surged 25% higher on Thursday alone as a result.
Economic Scenario #1: A single baseline scenario not much worse than current conditions.
In fact, the rule changes alone “may reduce banks’ write downs and boost their first-quarter net income by 20 percent or more” according to estimates.
