April 23, 2009
Beware of Fake Bank Profits
Over the past couple of months, we have seen a sucker's rally in bank stocks that is not going to last. We believe many bank stocks that have doubled or tripled from their lows, will soon fall to new lows.
Recent easing of "mark-to-market" accounting rules have allowed banks that previously wrote down mortgage-backed securities at huge losses, to write them back up at huge profits. Mark-to-market forced banks to value toxic assets on their balance sheet based on their last sales price in the market. Many people on Wall Street complained this was unfair because the markets for these assets are illiquid and many of the financial institutions selling them are distressed.
It is our belief that there is no better way to determine the value of mortgage-backed securities than the free market. If there is no liquid market for these assets, it is probably because they don't have much value. By easing mark-to-market rules, banks now have the ability to value these assets based on other factors like cash flow analysis. This is allowing them to artificially inflate their earnings and balance sheets.
Even if a mortgage is being paid on time today, there is a good chance it will no longer be paid in the future once the home owner is underwater. Nobody is going to pay a $400,000 mortgage on a $200,000 house when you can rent that same house for a fraction of the mortgage payment. Therefore, a mortgage-backed security should not be worth its full face value when there is a high risk of default down the road.
By pretending assets are worth more than they are, banks are only setting the stage for much larger losses down the road. There are a couple of other factors that are also playing a role in creating the phony profits being reported by banks.
AIG recently used $50 billion in bailout money from the government to unwind credit-default swaps with their U.S. bank counterparties at 100% of their face value, without any attempt to renegotiate them. AIG took on huge losses which allowed some of the major banks to report huge profits. AIG was effectively used as a toxic dumping site for bad assets, to give the appearance that the financial strength of banks was improving.
We are also seeing many banks report huge earnings from mortgage refinancings that are taking place as a result of the Federal Reserve artificially suppressing interest rates. This short-term boost in refinancing fees is temporary and it will come at the expense of lower income from these mortgages in the future.
We believe the current financial crisis, which has been largely contained to mortgages, will soon spread to credit card loans and student loans. Credit cards are being used as a last lifeline for those who are unemployed and can no longer take out home equity loans. Students graduating from college are finding it difficult to get a job, which will make it impossible for them to pay back their student loans.
Ultimately, trillions of dollars more will need to be spent on bailouts and it will lead to a currency crisis. Americans need to prepare now for a U.S. dollar collapse and hyperinflation.
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