Bank rally ready to be marked-to-market

By J Saft
April 3, 2009

James Saft Great Debate – James Saft is a Reuters columnist. The opinions expressed are his own –

U.S. bank operating earnings are going to have a hard time outrunning credit losses, making the massive rally in bank shares look ready to be marked-to-market.

A series of positive statements about profitability in the early part of the year from major U.S. banks, notably Bank of America, Citigroup and JP Morgan helped to spring a rally in the beaten down sector, as investors bet that with government assistance they could earn their way out of their troubles.

The KBW bank index has enjoyed a blistering rally, rising 51 percent from its March 8 low, though it is still down almost 40 percent from where it ended 2008.

To be comfortable with that, you have to believe two difficult things; that investors will value the earnings banks are now making as if they were sustainable and that banks won’t be swamped by credit losses and potential forced dilutions of shareholders.

“We are unconvinced that the banks have turned a corner,” FBR Capital Markets analyst Paul Miller wrote in a note to clients. “Investors who believe that the recent financial rally is here to stay expect that most banks will remain profitable.

We expect that profitability at these banks will be driven by favorable fixed-income trading revenues, as well as mortgage banking revenues.”

In some ways, balance sheets aside, it’s a pretty good time to be a bank in America. Competition has thinned out and margins should fatten commensurately.

U.S. bank profits from trading and mortgage banking are both problematic. Trading income, because it varies wildly, is hard to predict and hard to value.

If the past two years has taught us anything, it’s that paper profits can evaporate and risks can be hard to spot.

On the positive side, the fact that banks are now putting less balance sheet to work as market makers means that those banks which still operate can make considerably more on the difference between where they buy and sell securities. But given the huge uncertainty about who will be around in a year’s time, especially given the by its nature unpredictable role of government, its hard to know how much competition there will be or even how much capital banks will be forced to hold against trading activities.


Mortgage banking is also going to be bigger this year. The Mortgage Bankers Association predicts refinancing will total $1.96 trillion and purchase loans increase $821 billion, which could make it the fourth-biggest year on record. This is mostly because the Fed has driven interest rates down in a bid to reflate the economy. That makes it profitable for many Americans to refinance their mortgages and is luring a much smaller number back into the house purchase market despite falling prices.

But again mortgage banking is a notoriously tough business, and though a scarcity of lending capital has driven fees up, the record of banks in the U.S. engaging in it profitably is not good.

Mortgage banking, as distinct from mortgage lending, is the business of originating loans, these days almost exclusively for Fannie Mae or Freddie Mac in exchange for a fee and the right to earn more fees by collecting payments in exchange for servicing the loan for the lender.

But the mortgage servicing right that a bank gets when it makes the loan is usually recognized as income based on the current value of the cash it is expected to generate over time.

That means that banks that originate lots of mortgages show huge gains in income during refinancing booms. It does not mean, however, that they necessary make money out of the deal. Servicing rights can go wrong in many ways.

First, people can stop paying their loans back. The servicer usually has to advance the first few payments if a borrower is late and doesn’t get the money back until the loan is resolved. It’s also a lot more expensive to service bad loans than regular payers, making the economics of the business particularly tough right now.

Banks can also lose out if loans are refinanced sooner than they expect, robbing them of the future fees they were counting on.

And what about credit losses? Unemployment, which drives losses on commercial loans, on mortgages and on consumer loans, will be going up for some considerable time.

For example, the baseline forecasts released by the Organization for Economic Cooperation and Development (OECD) this week were considerably more bearish than even the “more adverse” numbers being used to run the U.S. stress tests now being run on banks.

Blog Calculated Risk does a nice job running the numbers here, but the highlight has to be the third q here, but the highlight has to be the third quarter, where the OECD is predicting an economy shrinking by 1.9 percent, as against a rather miraculous recovery to minus 0.2 percent in the “tough” scenario used by Geithner et al. Similarly, the unemployment rates predicted by the severe stress test are lower than the OECD base case all the way out to the end of 2010.

So then, it won’t be the stress test that undoes many banks, it will be reality.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. —


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Thats a good article. James you must be a realy see it the way i see it too.keep it up.

Posted by Ebenezer | Report as abusive

I still think we need to get away from the masquerade of false confidence on Wall Street … what’s really happening ???

the global economies have reached a foldback point of expansion … negative growth is it’s reality … the growth of industrialization and the capitalist system should have had this holistic internal foldback at mid point … all this manipulation and false promise corruption has led to the edge of collapse.

but nothing is gained without struggle … a lot of positive dynamics and communication skills now than before … we must end the manipulations and use them.

intelligent self interest rather than brute force bullying … holistic business methods do strengthen your own investments if fair play becomes normality … look at the positives of other ideologies including socialist .

if in the next sets of financial quarters if is more dodging issues and power games , all to keep the steroid economies pumping out crap … printing more $$$ … there will be a double recession with 25% unemployment and a collapse of the system.

there’s the challenge … don’t panic !!!! and have faith in the good of humanity rather than Gods and the almighty dollar.

just oil for the machinery :)

Posted by Harry | Report as abusive

It is relatively simple, if I can go ahead and lose the money after which I could then received more money. Does not that sound profitable?

Posted by Dennis Chu | Report as abusive

Good article. Nothing substantial has changed between 3/1 and today except MTM rule change. Can we say sucker rally?

Posted by E Teng | Report as abusive

I wish they would get rid of you. You have no knowledge of what your speaking about and people like you want to keep the markets down for your own gain. I suggest you keep the facts correct because I will be reporting you to the SEC for providing mis information. You should be fired because people are talking about you like you are a crackpot.

Posted by Mike | Report as abusive

Any quick recovery will be short lived. The housing market probably hasn’t hit bottom and mortgages are still the meat and potatoes of securities. After that any improvement in the economy will be undermined again when the G20 moves to a new reserve currency or SDR. This will make borrowing extremely expensive for the federal government and require us to cough up a lot of dough when foreign depositors convert their dollar holdings. Then the dollar will devalue quickly limiting our ability to import what we need. I we are going to print and borrow a lot of money, the bulk of it should go to building a 21st century energy infrastructure. Our energy dependence is a position of weakness. We must act quickly not only for the sake of the planet but for ourselves.

Posted by Anubis | Report as abusive

Mortgages,mortgages, mortgages. The “fixers” can lower the rate all they want. You still need 20% down with a 720 FICO score. Plus closing costs. So on a $200K purchase you’re looking at $40K plus 5K-10K closing costs (you have to escrow one yr of taxes and insurance at closing). You got that kind of money? Didn’t think so. It’s a cluster f just putting together a mortgage deal (7 years at it) and yes refis are easier but say you’re in a declining value zip code and the appraisal comes in lower than expected and you don’t have the 20% in equity u thought u must have, say after 4 years, so the PMI you thought u were finally getting rid of is on again,which makes that 4.50% rate u want really is at 5.50%, a 1/2 less than your existing rate. There are so many obstacles here but what really scares me are the changes in mark-to-market policies. Hold on to your hats folks. You’ll get that 3.0% 30 yr fixed rate but your precious home will be down another 20% in value this time next yr.

Posted by WallaceN | Report as abusive

as someone who has relied on holistic foresight to survive at the financial top end , George Soros words are always credible … we can see it is seriously lacking everywhere else …. proping up zombi banks and corporations going nowhere with high paid CEO’s to suck more life blood from what could be salvaged , this is total madness heading for disaster … Obama’s hands are tied but he needs to find a huge moral impetus the apply the change he preached to gain power .I don’t see it happening yet and the next few financial quarters will hurt … the amount of Ponzi and false manipulations emerging now , maybe financial hit squads are needed to avoid this disaster …. or just shoot the messengers for spoiling everyones dilluded imoral fun .

Posted by Harry | Report as abusive

Reality, yes… lets do a ‘realistic’, if somewhat cynical tour of the process of origination before the crisis: the Borrower pops up at a Broker, full of tales of secure income and overtime and bonuses. It is opportunity city – but… the Broker knows that in spite of this, the application will not fly with the Packager. Besides, he gets paid his commission, regardless of the repayment behaviour of the Borrower. So the Broker ‘helps’ out by oiling the gears, so to speak. After all, the Broker isn’t in this game for love. So we add a zero here, subtract a one there – and send it off to the Packager.

The Packager takes one look at this application, shakes his head… this won’t fly with the Originator. Better ‘package’ this up a bit, make it a more attractive proposition, so we delete this, add that – after all, the Packager isn’t in this game for love… and he gets paid his commission regardless of the repayment behaviour of the Borrower. Sell, sell, sell… right? And off to the Originator.

Now, at the Originator, the Underwriter has to review this application, along with 70 others before knock-off time. ‘Better hurry then. Yes, it all looks ok… I’m sure the Packager, and the Broker and the Borrower wouldn’t embellish on a mortgage application, would they?’

If we do not find a way of changing the process described above, it won’t be long before we see Ninja mortgages again. You remember the term, don’t you? No Income, No Job Application. And there, you wondered how it was possible for these to occur.

Without change, there will be no foundation for trust. Which means that any Securitisation Vehicle that is constructed on such a portfolio, will fail to attract investors (add to that, a small trust issue with the ability of Rating Agencies to rate).

To get the ball rolling again, we need to find a way to eliminate the possiblity of deceit. Maybe we should come up with a solution whereby all the intermediaries are paid their fees over a period of time, based on repayment performance. That’ll remove a number of barbs from the origination process, and we all can live happily ever after.

Posted by Quintin | Report as abusive