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.

Joe Shareholder meets Football

Football season is back! Fans everywhere are making sure their HDTV’s are in fine working order, cleaning their BBQ grills, and reviewing rosters and schedules, hopeful that their team will win it all this year, or in some cases, win any of their games (Joe-Detriot Lion). In football, a team is assessed a penalty if one of the offensive lineman moves prior to the ball being snapped to the quarterback. The lineman then looks embarrassed, shakes his head like he’s done nothing wrong, and the team moves back five yards. Metaphorically speaking, politicians and banking executives (does anyone really trust either source anyway?) may be guilty of a false start in calling for an end to the recession of 08-09. Sure, the stock market is up roughly 50% since March, and the 200 day moving average of the Dow appears to be on it’s way northward for a change. The housing market appears to have turned the corner, and July’s jobs report came in with fewer unemployment claims than Wall Street expected. (Click here for more on the unemployment report) Attention Joe Shareholder: Break out the champaign and let the partying begin! Ah… wait a second… What I meant to say was ah… see what had happened was…

Enter Joe False-Start
July also saw the largest number of home foreclosures in the history of America, and although values have ticked up slightly in parts of the country, there’s no guarantee that the trend of foreclosures will slow in the near future, as more Americans become unemployed. The up-tick in housing and auto sales is likely a direct result of legislation including the tax credit for first time home buyers and Cash for Clunkers, which can’t and shouldn’t last forever. These programs are great for the beneficiaries, but they worsen the budget deficit and consequently put a strain on the value of the dollar. (Click here for more on the budget deficit) Current and future foreclosures could lead to further devaluation of real estate in November when the tax credit is scheduled to expire, due to more aggregate supply on the market (Joe econ 101). Banks, Credit Unions, and home improvement and home furnishing industries will likely continue to suffer as a result. On Friday August 14th, five more banks were shut down by the FDIC, bringing the total for 2009 to nearly 80 failures. Fannie Mae and Freddie Mac, the secondary mortgage agencies who sell and package mortgage backed-securities will also continue to feel the strain of home foreclosures, as well as those who buy these MBS instruments (Joe’s Wall Street firm).

Joe’s Stimulus Package
Much of the credit for America’s ability to pull out of the great depression in the 30’s is given to government spending… perhaps too much. In the 1930’s, government spending helped the economy recover from the depression as the United States was forced to prepare for World War 2 by plowing money into defense. By contrast, a lot of this current stimulus package goes to bizarre funds like government pet projects and special interest groups. Instead of putting a short term, economic band-aid on the economy under the guise of a "stimulus package", America needs to focus on balancing the budget, stabilizing the dollar, and decreasing the national debt. A government option for health care would be nice, but we cannot afford it right now, especially since funding for the proposal is completely up in the air. This has the potential to send the current budget deficit completely out of control…(Joe hang glide during Hurricane Katrina). Finally, the Fed needs to keep interest rates low (Joe Bernanke) to stimulate lending and encourage business and entrepreneurial investment, and this will help to sustain a long term approach to creating and keeping jobs that really build and stimulate the economy. (Joe teach- a-man-to-fish-instead-of-giving-him-a-fish).

Are we optimistic for the future? Absolutely. Unnecessary pessimism depresses markets (Joe or Johnny Rain Cloud), and is unhealthy for an economy. It will likely be a long and slow recovery, as many economists predict. America has shown resilience that has helped us become the world economic leader for nearly 100 years. There’s not a more suitable country that fosters economic opportunity to create jobs and businesses. We’ve repeatedly shown that when we trust in capitalism, we can pull ourselves up after getting knocked down (Joe Austrailian one-hit wonder band), dust ourselves off, and look forward to a better future. But before you quit your day job to invest in the stock market and drink Coronas at the beach (Joe Commercial guy), pay attention to the warning signs lurking beneath the surface. Let’s give the stock market a five yard false-start penalty, and then let’s trust in capitalism to run its course so that relatively soon we’ll be able to enjoy a nice long economic touchdown drive!