Why your Bank Won't Survive the Coming Depression

Okay, okay, I realize the title is a little gloomy (Joe, glass half empty), but you're reading this right? So it worked? Anyway, I'm not really that negative (Joe glass half full), okay maybe I am a little bit, so read on and we'll find out together what's going to happen to your bank in the next 3-5 years.

Rewind back to the first week of March '09 - all US stock indexes were at 15 year lows, negativity was ever-present in the markets, and investors worldwide were fearing a government takeover of troubled financial institutions including Citigroup and Bank of America. During this doom and gloom era, in which the only safe investment seemed to be ibuprofen/aspirin producing drug companies (Joe Migraine), embattled Citigroup CEO Vikram Pandit shocked the world by declaring that Citi was going to have its best quarter in over two years! (Joe get out of here!) Well, he was almost right, Citi still reported a loss, but it was a good start. Since that week, Citi (C), and Wells Fargo (WFC) stock prices are both up over 400%, and Bank of America (BAC) has shot up over 600%! So is it too late to join the party? Maybe so, and here are a few reasons why.

1. New stock issue

Outstanding common stock shares don't help a company raise cash, they're simply traded on stock exchanges. So if a company needs to raise funds, one method is to issue new stock. Since March, the government has emptied the treasury on Citi and seized 34% ownership in the company in the form of new common stock; Bank of America has issued about 14% new common stock, and Wells Fargo has increased its shares by about 8%. Since a company's value is determined by the number of outstanding shares multiplied by the share price, these new stock issues should theoretically dilute the share price, not boost it. In this case, investors have shrugged off the new issues and the stock prices have shot up rapidly. While these new stock issues haven't negatively impacted the stock prices yet, if conditions further deteriorate, investors will most likely figure the new issue into the stock price and it could get very ugly. (Joe, hope no kids are watching, and if they are, hope their mommas are nearby to cover their eyes)

2. Mark to Market accounting changes

Before the financial crises erupted, banks loaded up on trendy Mortgage Backed Securities and Collateralized Debt Securities (bundled home loans and equity loans). As home prices appreciated, the values of these bundled securities increased rapidly and made the banks' books look incredible. However, as home prices dropped off the cliff the value of these bundled assets crashed as well, causing balance sheet heartache for the banks. (Joe tums extra strength). No problem, however, easy solution. Just hire a bunch of expensive DC lobbyists to wine and dine the FASB (Federal Accounting Standards Board) into changing the rules. Instead of marking the assets to market value, the rules were changed to allow banks to mark the assets to book value, or the value at which the banks purchased the assets. How was this fair? Good question. Banks are valuing these assets at their purchase price instead of the current market price, which is very misleading. The result? Nobody really knows the value of these mystery assets on the books of banks. (Joe, driving a brand-new sleek black Lincoln Towncar limousine with dark tinted windows) Had the accounting rules not changed from market value to book, there's a good chance all the banks that reported earnings during quarters one and two would have reported heavy losses. What's worse, the FASB is currently considering reversing these accounting changes to allow for more transparency. (Joe El Camino clunker - she ain't pretty, but at least you can see what's in the back).

3. Foreclosures are still increasing

Oops, this problem was supposed to be solved with the stimulus bill. Guess what? RealtyTrac announced two weeks ago that "home foreclosure activity in the first half of the year continued its upward trajectory". There's also a growing concern within the financial industry about commercial and industrial foreclosures, which up to this point have been minimal. These loan default/foreclosures are expected to peak sometime in 2011. Scott Sprinzen, a credit analyst for Standard and Poor said "During the next few quarters we will see a sharp acceleration of weakening on the commercial side". Add these conditions to continued job losses and the picture gets even uglier (Joe, now glass neither half empty nor half full, but the glass has been shattered and water is spilling down his shirt). Okay, enough of the negativity and pessimism.

Is it really that bad? Is there any hope? Sure, there is always hope. Both the unemployment rate and the housing price plunge seem to have either moderated or come close to reaching bottom. These two statistics will be very important to watch over the next several months, as the economy is trying to stabilize and markets are searching for sustained hope. JoAnn, who was inexcusably left out of the last post, has returned and has given Joe a plastic cup from which to drink so he no longer has to clean glass up off the floor and change his shirts. Hopefully his bank exposure in the future won't cause him to change his shorts also.