In recent weeks, the financial world has been dazzled by strikingly high
earnings reported by our leading investment banks, or at least what we used to
call investment banks. The numbers are reminiscent of another era, the one that
came to a crashing end last September.
The euphoria is keyed to the record US$3.44 billion second-quarter profit
announced by that branch office of the Treasury Department also known as
Goldman Sachs. Wells Fargo, JP Morgan Chase, and State Street also chipped in
with strong numbers.
The seeming health of these institutions, which are often referred to as the
"backbone" of the US economy, is being cited as strong
proof that economic recovery is at hand. This conclusion is based on selective
memory and dubious logic.
The more immediate question hinges on whether this rise in bank and corporate
earnings can be sustained in the face of increased commercial real estate
mortgage defaults, rising unemployment, and increased savings? Would it then be
likely that the broad stock market can continue to rally while the financial
sector sputters? If not, a serious correction in US equity prices is a foregone
In the early years of this century, major money-center banks and shadow banks
incurred irrational risks and paid themselves unimaginably large bonuses. They
were termed "gambling casinos" and deservedly drew fire when their bets went
south. But instead of forcing these irresponsible firms to pay for their bad
behavior, the federal government forced the general public to rescue them.
The Treasury and Federal Reserve instituted four key measures intended to boost
the banks' earnings, which in turn, would boost their share prices, improve
their capital ratios and force their share prices upward.
First, Congress was pressured into giving instant approval to the $750 billion
Troubled Asset Relief Program (TARP). This massive sum of public money was
designed to buy toxic assets from the banks. However, the government soon
realized that buying some toxic assets would create a real price and thereby
threaten the inflated value of other toxic assets held by financial
institutions worldwide. The initial TARP plan was dropped in favor of injecting
billions of dollars into certain banks, leaving the toxic assets on their
books. Meanwhile, the true values of these toxic assets were officially
camouflaged by the initiation of "exceptional" accounting changes.
The injection of free TARP funds enabled the recipient banks to enter a charred
landscape that was, nevertheless, bristling with easy profits. For example, $10
billion of TARP funds enabled Goldman Sachs to make leveraged trades during the
bear market rally of the last four months. Though this is the same activity
that caused its downfall, Goldman now assumes a government guarantee on its
risk-taking. With no limits on their appetite for risk, record profits are
theirs for the taking.
Second, some of the shadow banks, such as Goldman Sachs and Morgan Stanley,
were allowed to become bank holding companies. This change allowed them access
to the Fed Window to borrow at zero percent interest. This greatly increased
the profit margins of the banks day-to-day lending operations.
Third, the reduction of Fed rates to below 1% has steepened the yield curve,
enabling banks to take 6% to 8%-plus spreads in lending to boost earnings.
Fourth, for the first time, the Fed is paying interest on bank reserves. This
means that all banks can borrow at zero and lend back to the Fed at an interest
rate spread of some 3%, thus boosting earnings further. The downside is that
banks are discouraged from lending to risky companies and individuals while
they can lend at no risk to the Fed. Therefore, despite political pressure for
banks to lend, credit remains tight.
With the great privileges listed above, and with the competitive landscape
improved by the disappearance of Lehman Brothers and the absorption of Bear
Stearns and Merrill, it is little wonder that the surviving banks earned more.
A firm like Goldman Sachs, with its stellar earnings, is now effectively a
hedge fund subsidized by taxpayers.
However, toxic assets remain on the books of the banks. In addition, problems
in the commercial property and consumer lending field loom menacingly.
The Fed has also acknowledged that, eventually, it will need to sharply
increase interest rates to "mop up" all the liquidity its pouring into the
world economy. This action alone, if the Fed ever has the nerve to execute it,
could bankrupt every financial firm that survived the initial crisis.
Should earnings falter and banks stumble for a second time in the face of a
looming $3.4 trillion commercial mortgage problem, the entire US stock market
could follow suit.
That would be the crisis we've been predicting. Better be prepared.
John Browne is senior market strategist, Euro Pacific Capital. Euro
Pacific Capital commentary and market news is available at
http://www.europac.net. It has a free on-line investment newsletter.