The big banks have been reporting big earnings this quarter so far. However, the vast majority of their profits come from trading, not traditional banking activities like lending. In the real banking functions, the big banks are still losing their shirts. Citigroup just announced a $4.4 billion dollar profit this quarter. Eight billion of revenues came from trading, especially bond trading. Citi borrows from the Federal Reserve at near zero percent and purchases Treasuries yielding 3.5% or so. It is easy to make money that way. Citi is still losing money on its lending operations. It lost $8.4 Billion on loan losses though this is down from $10 Billion last quarter.
As you can see, the banks made quite a bit of money by reducing their loss provisions. In order to cover losses on mortgage, credit card, and other defaults, the banks must set aside money to cover these expenses. As you can tell, the more they set aside, the less profits for shareholders. J.P. Morgan made $3.3 billion this quarter – again mostly from trading activities. Their earnings also comprised of a much smaller loss provision amount. In the fourth quarter of 2009, JP Morgan set aside $8.9 billion to cover losses. This quarter that dropped to $7.0 billion. Effectively, $1.9 billion of the $3.3 billion of earnings came from a lower loan loss reserves. The same is true for Bank of America, which reported profits of $3.2 billion for the quarter with $3.6 billion in lower loss reserves.
Many analysts look at the lower loss reserves and conclude that the banks balance sheets are improving. Before jumping for joy that credit fundamentals are improving, we still face a situation where the banks are not realizing their losses. Just take a look at the number of foreclosures and delinquencies 90 days past due for mortgages.
We have more homes in the foreclosure pipeline than we did at the peak of the housing crisis. However, the Federal Reserve and government has created a game of chicken. The Fed and the government altered the rules so banks don’t have to mark assets to market prices. This allows banks to keep assets artificially inflated so they do not have to raise capital to improve their balance sheet. It also allows the banks to hold the assets, meaning mortgages, so the banks don’t have to foreclose.
Essentially, it is cheaper for the banks to let someone live rent free than foreclose and lose 25% on the asset. If they had to mark the asset to market prices, the banks would have already written the asset down by 25%. The Fed is hoping that the banks can make enough profits over the next few years from trading activities to raise enough capital to cover the losses from the mortgages. So banks will probably slowly foreclose on homes as they have the profits to cover the losses. To date, the banks have billions in cash to cover these losses, which is good.
In theory, this seems to be a great plan. Slowly leak foreclosures on the market so the banks can take advantage of the Fed’s low rates to make money from trading activities. However, it seems like a game of chicken to me. If the banks put their assets in Treasuries and don’t lend to consumers and businesses, we will experience a slow growth, or worse, a no growth economy. The only party that will get capital in this arrangement is the government. The government is not going to create anywhere near the economic growth of small business or the private sector. A slowing economy will mean more foreclosures and debt defaults, which only extends this game of chicken and perpetuates a low growth economy.
The other reason this is a game of chicken is we are in a debt deflation environment. We have too much debt, and it is time Americans reduce their debt burden. This can be done over time as more money goes towards paying debt as opposed to spending. Or, it can be done through default.
So what happens if the amount of debt defaults overwhelm the banks’ loss reserves? What if the trading activity slows if the market takes a turn for the worse? If trading revenue declines, earnings will get crushed. While the Fed and banks hope to recapitalize over time, they may be playing a game of chicken that could get ugly real fast. Only time will tell. In the meantime, I recommend you Move Your Money from the big banks. For more on that please visit, “Move Your Money.”