Are the Banks Out of the Woods?
August 5, 2009
Alvaro Vargas Llosa
WASHINGTON—Several U.S. banks posted impressive second-quarter earnings. Citigroup’s $4.3 billion, Bank of America’s $3.2 billion, Goldman Sachs’ $3.4 billion and JPMorgan Chase’s $2.7 billion are being touted as signs that the financial institutions have turned around. But a closer look indicates otherwise.
Some banks (Citigroup, Bank of America) have reported positive earnings because they have engaged in one-off sales of some big assets, not because their core business has recovered. Others (JPMorgan Chase, Goldman Sachs) have benefited from the collapse of competitors in the midst of the meltdown, from the fact that many companies are raising money by issuing debt and securities because their core business is kaput, and from the rise in long-term bonds due to the fear of inflation.
There is no evidence yet to conclude that the financial system has overcome its fundamental problems. Naturally, the government’s intervention—through the acquisition of toxic assets, loan and asset guarantees, and injections of capital—has helped the short-term prospects of some of these institutions. But the question is whether they will be able to stand on their own in the future.
The so-called meltdown caused by mortgage-backed securities seems to be over. Numerous banks had assets whose market value collapsed in the expectation that the mortgages to which they were linked would default sooner or later. Accounting regulations, foremost among them the obligation to value those assets according to their current market price as opposed to their maturity price, complicated matters by turning balance sheets into horror stories. Through the transfer of this burden onto taxpayers, the government rescued the banks from the securities trap.
But that is not the end of the story. The system at large has not yet purged the excess of bad loans, which go well beyond residential mortgages and include commercial real estate as well as consumer credits. Since there is no end in sight to the recession, we are nowhere near a restored commercial banking system. As a recent study by McKinsey & Co. titled “What’s Next for U.S. Banks” explains, the reason this aspect of the financial mess has received less attention than the mortgage-backed toxic assets has more to do with accounting than with reality.
Unlike the mortgage-backed securities, most of the bank loans are not accounted for at prices that reflect market value but “hold-to-maturity” value, which means that losses are not counted as losses until the defaults actually happen. When the toxic asset crisis hit, the defaults on other types of credit had not yet taken place and were therefore not negatively reflected in the banks’ books. They are now taking place big time and will continue to do so.
The impact is being felt by many banks, including those that have benefited from the reduction of mortgage-backed securities on their books but still have many other types of credit outstanding. Not to mention banks heavily exposed to consumer loans that are yet to default in this ongoing recession.
Commercial banking took $38 billion in loan-loss provisions in the first quarter of this year (no figures are yet available for the second quarter), a big increase over the previous year, when the economy had already tanked. The implication is that defaults continue to increase.
McKinsey expects total credit losses on U.S.-originated debt from mid-2007 through the end of 2010 to be as high as $3 trillion. Two-thirds of that amount has not yet been realized. U.S. banks are exposed to about half of the expected losses. This means considerable trouble for commercial banks. The big players that looked insolvent a few months ago and that many people think may have weathered the storm thanks to government bailouts—including Citigroup, Bank of America and Wells Fargo—are in that lineup.
It is widely believed that government intervention has kept the financial system afloat. But there are signs that it may have actually postponed the recovery. The aforementioned report indicates that even in the midst of this crisis the banks have irresponsibly increased their expenses rather than cut their costs, as they should have done if they were serious about getting back into shape. And because the Federal Reserve has maintained low interest rates, they have benefited from the rising difference between the interest they pay on money that they owe and the interest they receive from money owed to them. That won’t last forever.
No, the banks are not out of the woods by any means.
Alvaro Vargas Llosa is Senior Fellow of The Center on Global Prosperity at The Independent Institute. He is a native of Peru and received his B.S.C. in international history from the London School of Economics. His weekly column is syndicated worldwide by the Washington Post Writers Group, and his Independent Institute books include Lessons From the Poor: Triumph of the Entrepreneurial Spirit, The Che Guevara Myth and the Future of Liberty, and Liberty for Latin America.
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