US Banking Results Commentary II

Confidence on banking sector was already reflected in the 30% stock rally in the run up to the Q1 earnings season. The authorities say all of the 14 largest banks have earned a ‘passing’ grade in their just-completed ‘stress-test’. But just six months ago, the authorities swore that without a massive injection of taxpayer funds, those same banks would suffer a fatal meltdown.

Was the bad-debt disease magically cured? Did the economy miraculously turn around? Strike up the band, let the good times roll, banks are making money again (or not losing quite as much)?

A look below the surface reveals some caveats to this positive picture. Banks are benefiting from close to zero borrowing costs and fewer competitors with a massive transfer of wealth from savers to borrowers given a dozen different government bailouts and subsidy programs for the financial system. The recent mark-to-market accounting changes by FASB helps to inflate the value of many assets, hence in my view, this accounting trick helps to minimize reported losses and maximize reported earnings. It is no surprise if someone told me that banks are not properly making provision for massive future loan losses. Not long ago, Fed Chairman Bernanke declared that the total losses from the debt crisis would not exceed $100bn and also at the same time, the IMF estimated the losses would be $1 trillion with only a small percentage written-off. Now, the IMF’s latest estimate: $4 trillion in losses, with only one-third of those written-off so far.

Many of these banks were the main recipients of AIG bailout funds in previous months e.g. Goldman Sachs ($12.9bn), Merrill Lynch ($6.8bn), Bank of America ($5.2bn), Citigroup ($2.3bn), and Wachovia ($1.5bn), according to New York Times data. These firms, however, dismiss this factor as immaterial for 1Q earnings.

On the real economy side, credit growth has continued to slow down at a fast pace in the US as well as in Europe. Moody’s predicts the charge-off rate index will peak at about 10.5% in the first half of 2010, assuming a coincident unemployment rate peak at 10% respectively.