Do Not Trust the Big Banks

Amid the clamor over health care and all those green shoots the fate of the big banks has faded from the public glare. This has led to a complacency in the analytical and media: the general feeling seems to be that the banking crisis has abated and that we can ‘check it off’ our list of things to worry about.

Not so fast.

Do not trust the big banks.

“… we can predict anti-social behavior. Proof: bumper pay checks even amongst banks still on taxpayer life support, and increased intensity of lobbying against reform. The big banks are back to their old tricks”.

Their balance sheets are still rickety. More to the point: no one really knows what they’re worth.

Let me recap:

• The administration has adopted a passive approach towards big banks: the hope is that, given time, they can earn enough profit that capital ratios will gradually move back towards sensible levels and that the banks can repay TARP money.
• Such an improvement will encourage private investors to buy whatever stock the banks decide to sell, and so capital will be restored even more quickly.
• As proof of this approach: the banks reported generally good earnings in the first quarter; most have managed to raise extra private capital; and many are now repaying TARP money.
• Couple this with the whole stress test process that supposedly gave an objective kick of the banking tires, with a publicly reported set of results and a standard set for capital and earnings soundness, and we are entitled to believe things are progressing nicely.

Except that:

• Much of the first quarter profit was specious: accounting wheezes and trickery helped boost ‘earnings’ at most of the big banks, so those results are not indicative of sustainable profitability.
• Similarly some of the capital that has been raised has simply been through conversion of preferred stock into plain equity. To the extent this is the case the banks actually have no new capital, all they have done is to allocate existing capital to a bucket that looks more solid.
• There are fewer banks. Let’s not forget the crazy days back last year when big banks like Bear Stearns and Lehman folded. The market is much more concentrated. The oligopoly is stronger. So spreads are wider. This is a positive for bank earnings, but it makes controlling the survivors even harder: if they were ‘too-big-to-fail’ before, they are certainly too big after.
• That means we can predict anti-social behavior. Proof: bumper pay checks even amongst banks still on taxpayer life support, and increased intensity of lobbying against reform. The big banks are back to their old tricks.
• While both Goldman Sachs and Morgan Stanley have ostensibly changed their ways and become Bank Holding Companies – and therefore regulated a such – their actual mode of operation is unchanged.
• If anything the incentive to take extraordinary risks has been increased. The administration’s unwillingness to liquidate a large bank has emphasized the extent to which the big banks are beyond control. They now know for certain that they will not be allowed to fail, yet there is no limit on their activities. All the risk lies with the taxpayer and all the gains lies with the management and shareholders. This means there is another bubble in our future [emerging market debt looks as if it might be it].
• And if this is not enough to scare you: those stress tests were a joke. The oncoming wave of commercial real estate and credit card losses will disrupt any earnings growth the big banks have. Much of the commercial real estate mess will occur out in 2011 – beyond the horizon for the stress tests. Plus the worst case scenario within the tests is beginning to look tame: unemployment seems headed higher than imagined.
• Finally, those toxic assets are still lurking on the balance sheets of most big banks. They appear less toxic only because accounting rules have been relaxed which produces an aura of improvement without altering the underlying economic reality.

So while its fun to be diverted from the annoying hubris of Wall Street and all the puffed up egos that still inhabit its trading floors, we should be acutely aware that not much has changed. It is still quite possible that credit conditions could worsen again. While each day that appears to be less the case there are serious potential sources of difficulty ahead. The aforementioned commercial real estate mess for one.

Most of the big banks are now so large that they mirror the broader economic conditions. Their core earnings ebb and flow with the economy. In that regard they are fairly benign, except that the most likely economic scenario is one of very poor growth over a period of years. In that case the big banks are likely struggle to perform well and thus will take a long time to recuperate fully. This lingering and slow recovery will inhibit the flow of credit into the economy, and so our growth prospects will be even further diminished.

The real problems, though, are elsewhere: it is their gambling trading profits that tend to make them lurch around like drunken sailors, so the goal of bank reform should have been to take the bottle away. But it won’t. As long as the taxpayer is dumb enough to pick up the pieces, traders will gamble to their hearts content. One day soon they will assuredly screw up again.

As I said: do not trust the big banks.