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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Finally, someone who sees through the emotion-driven hype. Well done.

Posted by Terri | Report as abusive

Another good article with a strong dose of reality. The GDP figures used by the Obama administration are at best ‘opitimistic’ and in reality probably ‘knowingly unrealistic’.

We are now in the phase of trying to convince everyone that all will be okay. This will be done by creating ‘fantasy’ profits as described, saying that we are coming out of ‘recession’ and just generally trying to convince us with selective good news stories. It will all fall apart and reality will eventually reign, probably from 2010 onwards.

Posted by D Rumsfeld | Report as abusive

Then banking is system is our master and we are its slave. Some investors feel that the government will not let it go too quick and some sympathizer engining the market. Specially,African brothers are very emotional about the economy,right now. Let the market relax and it come by its own pace.

Posted by Shahin | Report as abusive

Excellent article as usual. The immediate announcements almost together (the banks) that we are now profitable was very suspicious. My amazement is the banks are considering buying the toxic assets? That is mind blowing. Simply a magical accounting column that shifts what is already on their feeble balance sheets to a nebulous value with a non-recourse guarantee from tax cheat tiny Tim.
The corruption never ceases.

Posted by cf | Report as abusive

I think the banks as well as the markets are getting ahead of themselves. The news today that unemployment numbers are a lagging indicator of the economy is nonsense. If consumers were 70% of GDP in the past then more unemployed less spending right? People have to get back to work to be able to make our GDP rise and to create employment. I do not notice anybody else picking up the slack.

Posted by John Mead | Report as abusive

Banks are a house of cards sitting on top of AIG.
AIG is a house of cards whose financial products group committed the biggest fraud in the history of the world.
Soros estimates thare were $42-47 TRILLION in bogus worthless finacial derivatives flaoting around. WHAT BANK RECOVERY???

Posted by zzwhale | Report as abusive

Yes, true. I am still wondering about credit-card debt. There don’t seem to be a lot of disturbances in that sector. Is this because people are still charging up their cards to pay their bills and haven’t hit their limit yet?

Posted by Robynne | Report as abusive

When your are a major US bank, is almost impossible to be rational, un-delusional.

For almost 2 decades, the banks were the instrument of an economic revolution by design. The industrial sector was downsized because it no longer has a future – so goes the assumption. Who has the future? The financial sector of course. This ideology was adopted by America and UK elites, who proceeded to implement it whether the population wants it or not. This has resulted in an almost irreversible transformation of economic, industrial, governmental and social fabric of these two countries.

Now it has been shown that the products engineered by the financial sectors are vapors. They have no intrinsic value, no net wealth. They were created easily by manipulations of numbers; now destroyed by just as easily. I can appreciate why the banks, the core of this grand fallacy, are still stuck in disbelief. Desperately trying to reshuffle the numbers to reconstitute the vapors into solids. They should consult a second year college student majoring in physics – you cannot violate the fundamental laws of physics he/she would tell you.

Posted by The Real Deal | Report as abusive

Critical thought to investors is as popular today as Galileo was to the Catholic Church in the 17th century.

Once would think that after observing the greatest leveraging cycle in world history and now living through its deleveraging, investors would have gained something remotely resembling the ability to apply critical thought to their investment decisions. Alas, no. The lemming mentality is alive and well as evidenced in the action of the markets major averages.

Could it be due to the deteriating mental state of the middle class (or former middle class) investor. These investors are watching the value of their homes drop below their outstanding loan amount (1/3 of mortgages in the US), the status or their former coworkers and how it impacts their job security as unemployment ranks rate of growth continually increases (highest since 1983), no job prospects for those unemployed, incompetency of the elected officials as they pour money into the top of the banks and financial institutions ie:wealthy class, loss of their homes (this has never changed since man decided to transform himself into a politician), substituting their payroll checks with credit card charges, credit scores deteriating as they are being told they just need to refinance their home and finding their credit scores or loss of income or loan valuation locks them out of the refinancing process. So it’s ‘all or nothing’ into the stockmarket.

Yes…let me read the analysts reports and believe that they possess even a remote degree of due diligence, integrity or competency. Congress changes the mark to market rules and now bank earnings are legitimate.

I think I am going to change the value of my home…lets see…I’ll take the outstanding balance on my mortgage, double it and make that the value of my home. It may not be reality but it sure makes me feel better and isn’t that 75% of the issue, the tender American psychi?

Investors are still acting like children who can delude themselves into a false reality which makes them feel good…this leads to market tops, not bottoms.

Posted by Craig | Report as abusive

I am on the phone with small business owners every day looking for alternative financing. So many credit markets are almost completely dry in the traditional banking sector. I admire all the small businesses owners working so hard to support themselves and their families.

CDFIs (community development financial institutions) can often fill the financing gap. For example, ACCION USA, a national non-profit CDFI, has more flexible lending guidelines. CDFIs are an important resource to communities and small business owners.

Posted by Julie Soforenko | Report as abusive

If the banks are going to buy up toxic securities of questionable value, it means the fix is in and the government is going to cover losses. My kind of gambling.

Posted by Kevin Kakareka | Report as abusive

The rally is as a result of accountants finally addressing the marked-to-mark rules. While MTM makes sense in commodities and currencies, it does NOT make sense for asset backed securities (i.e mortgages). To revalue an asset that is not being sold in a secondary market (the Fannies, Freddies,etc.), but rather are still functioning (roof over one’s head) and producing cash flow is absurd. This rule and the BIS I/II capital requirements should be rethought or removed completely- time to start again.

In the meantime, homeowners who bought in the past 5 years (myself included) need to get used to the thought that they are stuck in their existing house until principle is paid down to market levels. The days of trading houses every 5 years are over. If you need to be mobile, rent. Its no more complicated than that.

Posted by Matt T | Report as abusive

Last month so called rally in the stocks especially the bank sector is highly questionable. Based on figures of banks like BA, C making profits, in the early part of this year is a joke. These banks that is reporting profits are banks that is heavily own by the US gov. It’s definitely a propaganda that the government is trying to throw out on us, trying to create fallacy that the recession is coming to an end. I personally feel the only true indication of recover is employment rate index.

Posted by Yo | Report as abusive

Investment dinosaurs like to dig into the Rothchild’s playbook for strategies. Snapping up shares during times of panic worked well in the past. It might still work today. But most people did not sell their shares due to panic. They needed cash to maintain a certain standard of living. We haven’t recovered from the bubble. We are still in a fugue of the same composition, like a rockbass on a fishing line trying to shake loose its captor. But not only that, this perpetual duality we seem to face as a species will hit a brick wall shortly. Because the environment is in rapid decline. People who cannot have children, either due to economics or infertility, cannot look forward to a future.

Posted by Don | Report as abusive

Toxicity is the degree to which a substance (such as nuclear wast, alcohol, drugs, derivatives etc.) is able to damage an exposed organism; in this case consumers of financial products. However, that high street Banks themselves have now become active producers of toxic waste beggers belief, as does the notion that having caused the crisis in the first place such waste is now on special offer to bankers carrying Geiger counters and wearing 12 inch leaded gloves! Of course if enough ecstasy has been consumed prior to purchase then even the most unattractive proposition can become quite desirable, certainly given the right backing from the Fed. I had once considered banking a science rather than an art form, although as I read the many excellent comments provided here I realise that over the past 18 months it has rapidly evolved to the lofty heights of moral philosophy. It is therefore better to study existentialism as an entry point into a career into financial management than the rather outmoded MBA approach whose teaching frankly no longer cut the mustard!

Posted by Peter J. Middlebrook | Report as abusive

The big banks with the toxic assets will not fail. The Government guaranteed that. The government will borrow, tax, print and steal (PPIP) as much as it takes.

Posted by Mike Belcher | Report as abusive

Everything will be okay when they quadruple my credit card limits for this year.
When the hyper-inflation hits, holding title to real assets, even if acquired with debt, will trump savings and income.
Screw you again, and again, and again – suckers and slaves.

Posted by Prince Ponzi | Report as abusive

I started blogging when a fellow director ex head of quantitative analysis and risk for a merchant bank, warned that money would be in short supply for a while because there would be a credit squeeze – 2006. He chose that moment to exit the bank and cash in his shares. I looked into it, as we were looking at a partnership with a now failed and now government bank. They were insolvent. I was alarmed and rolled back plans to launch a business involving banks.
In early 2007 I started to pay more attention and even began blogging to the industry, as I watched the onset of the freeze and the eventual collapse. It wasn’t hard to see it coming and whatever warning I could give was too late. I had already been told that Fanny was going to be cactus by October.

Back to the banker – I had to tell him not to get back into the market in January and now what really has me concerned is that he is now quickly working towards self sufficiency, growing his own vegetables, and making his own (very good) wine (and enough for plenty of others). The writing was on the wall some time ago and it’ll take a lot of effort and some serious changes to get us out of this one.

The financial system was effectively a taxation system diverting money forom government and creating more out of thin air giving the illusion that we all had more, governments included.
That system really has to change, doesn’t it?

The other important change must be in the way corporations and industry can hijack/buy governments. Perhaps it isn’t in our best interests to let any corporation get larger than the average government.
It certainly doesn’t look wise to let any financial institution get big enough to be critical to the system.

All this is just academic because the individual is the only one who is going to get us out of this. Creativity and innovation and efficiencies inspire optimism, not government announcements.
I am sobered by the thought that it would be fairly easy to eliminate many many jobs through efficiencies, but I think we’d best be a little selective until the new world order settles in.

The mathematician in me says we can’t continue to progress technologically and always create more jobs, the cost on the environment is too great and the temptation to remove labour to reduce costs is too great, however we need people to have ‘jobs’ to earn money to stimulate economies. It does not compute.

It’s pretty obvious that were going to have a form of socio-captitalism whether we want to call it that or not, so lets just go for it, it is the 21st century, probably about time for it. Let’s use this opportunity to choose a better path, rather than try and get back to the wayward one.
I suppose what I’m trying to say is let’s just get over it and get on with it.
I’m doing my bit.

Posted by Dean Procter | Report as abusive

Good comments.

How about some thought and specific ideas to reformulate our economic futures. If we can state what the problems are, I would think the next step is for the people to come up with real proactive solutions. If enough people blog and email the ideas will work their way into the media, and maybe even into the administration.

My ideas:
1). Housing and Banks.

a).Change refinance requirements so that appraisal is not required if the loan was originated with FNMA or FRE. If the loan is there now, they have a lower risk of default if the interest rate is reduced. Locking out the people who’s values have dropped substantially limits the value of the current program.

b). Allow any one who wished (investors and speculators and owner occupied)to purchase a home with a stated income loan, if they are willing to put 25% down in cash and have a credit score of 750 or better. This is similar to the risk ratios of the Geitner plan for undervalued assets in the banks, and would allow real people to participate in housing as an investment again. Stated income loand, which was originally designed for one loan per person, for small business owners who have complicated and varied incomes, worked quite well for many years until multiple loans were given and crazy no down terms were created. Stated income does not have to mean buying above your ability to pay. People who put down 25% will moderate their own decision to buy based on their risk of their capital.

My thoughts are that there are not enough people to purchase homes with current restrictive qualifying standards, in order to restimulate demand and put a floor under the real equilibrium level when ever it is reached.

Yes the crazy lax standards exacerbated the problem, but now we are too far the other way with crazy tight standards creating a whip saw effect. Jobs will increase again if we can stabilize housing. It’s not that there are too many houses for the population.

We can build smaller more frugal homes for a sustained economy. Housing has such a strong ripple effect, its a proven winner to restimulate jobs back into the economy. It just needs to be done on a sustainable level.

2). Yes paper trading wealth was substituted in the economy for creating products and manufacturing. Look at the risks you have to take to be a manufacturer of anything in the United States. Why would you take such risks when you can move your assets in to paper wealth creation by trading. If we are going to move back to a manufacturing society vs. a trading society, then we need to review all the risks and regulations and legislative impairments to manufacturing in the United States and reduce them until they are equal to or less than manufacturing outside of the country. Examples are litigation, all kinds or regulation, etc.

Create a sovereign investment fund to provide low interest loans to American manufacturing and small business, let Citizens invest into it.

Stimulate employee wealth by using stock options in the company instead of higher wages, which would help the company compete and prosper, and the employees to benefit and stimulate savings and some consumption.

Cap executive pay at some level, but allow stock options as payment as reward for success, in some ratio that also requires workers to receive stock as well.

3). Energy policy. Tax oil imports 1$ per barrel for every dollar they go over a fixed dollar amount say $65 for 2009. The tax would need to be used to stimulate alternative energy in some way, so 50% of it would go to that and 50% to the treasury to reduce the deficit, not used to justify more social spending.
A panel independent from Congress, like the Fed, would set the rate for each year. This would need to go up each year to stimulate energy conservation and alternative energy. We could negotiate with OPEC to set the rate no different than China does with iron ore.

We need to rethink and create a new way forward. Reflating the banks and hoping for business as usual is not going to work.


Posted by B Smith | Report as abusive

This Administration may not last another five minutes unless it does something about the thieves that represent the banking system. I have no solution; I’m just like everybody else except that I have the benefits of education and experience. Which says this: Jail the bastards and piece by piece tear the system down and start again. Let China repossess the country.

Posted by Andrew Franks | Report as abusive

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