Earnings season is in full swing, with Goldman Sachs, Citigroup, Banc of America, and JP Morgan out last week and more on the way. The problem is, there is still so much noise left over from the crisis and the myriad government bailout programs that it is difficult to disentangle financial fundamentals from hype. It is easy to think of just a few simple issues that could substantially affect recent earnings announcements, including ongoing commercial real estate problems, non-performing consumer loan modifications, and unreported or mis-valued legacy asset burdens. As unemployment continues to tick up, all of those problems are expected to continue to drag bank earnings while government programs are removed. So now, more than ever, we need to parameterize both financial and policy uncertainty in different banks’ earnings announcements.
With regard to financial uncertainty, commercial real estate is still bleeding and the reasons it is doing so are only now becoming apparent. As more people are reading the Treasury Office of Inspector General Material Loss Reviews, the growing realization is that the sector underwent its own bubble in the consumer run-up. According to Bloomberg yesterday, the Federal Deposit Insurance Corp. failed to enforce its own guidelines to rein in excessive commercial real estate lending by limiting commercial real estate loans to 300 percent of capital at more than 20 banks that later collapsed. “The FDIC’s Office of Inspector General analyzed 23 lenders taken over by regulators from August 2008 to March and found that for 20, the agency’s examiners didn’t identify the issue early enough or should have taken stronger supervisory action after recognizing the banks had dangerously high levels of the loans before they failed.” (Alison Vekshin, “FDIC Failed to Limit Commercial Real-Estate Loans, Reports Show,” Oct 19, 2009) Those losses are still bouncing around in bank balance sheets and the economy, overall, as more foreclosed commercial real estate collateral litters the market. Moreover, as commercial real estate occupants learn to economize, the market is inextricably changing. For instance, as retailers adopt “just in time” footprints, renting temporary shop space for holiday sales, the retail landscape can expect to be forever changed following the crisis so that the overhang of retail space will take a long time to burn off.
Consumer loan modifications also continue to drag down performance by an as-yet unparameterized amount. Treasury’s recent announcement that the goals for massive trial modifications are being met only adds uncertainty to the situation, since it is still unclear how many of those trials will bear meaningfully current loans. With one-year redefault rates trending toward 70%, almost double the pre-crisis historical average, success is anything but guaranteed. Worse yet, some institutions are aggressively pushing old affordability plans as new modification tools. It was reported last week that JP Morgan even proposed using POAs as a modification instrument! Underwater borrowers who can’t afford homes will drag on bank earnings for a long time.
Last, substantial legacy asset issues remain after even after the Treasury stress tests and TARP. Recently, even SIGTARP reported that the stress tests were a sham, mischaracterizing bank condition in ways that was not reported to the public. PPIP is now being shut down without any substantial activity. Banks are being left to drag out their legacy asset losses in the spirit of pure forbearance, like the Thrift Crisis and 1990s Japan.
As a result of the above pressures, most institutions have not yet come to terms with their losses, instead continuing where possible to bury those under accounting rules and adjustments. Hence, any recently-announced earnings need to be subjected to several “fudge” adjustment factors that reflect the propensity for additional hidden losses.
One can think of (at least) two parameterizations of such adjustments. The first might be a hard “Texas” adjustment factor, such as the ratio of total cash and cash equivalents to assets (free cash works better, but you get the idea). The second, possibly a soft adjustment factor reflecting institutional aggression, i.e., banks’ strategic approaches to the crisis and associated losses. (I freely admit that I am long Citigroup, but I have no other bank holdings among the institutions below.)
Below is my own characterization of such factors (cash and asset numbers are from June 30, 2009). The interesting result is that the seemingly most satisfying financial numbers are being turned in by the most aggressive bailout participants. While some of those participants may not have taken as much TARP capital as others, the bailout “footprint” among those institutions is potentially larger than the TARP recipients because a large proportion of their current earnings come from “public-private” partnerships in which those banks act as broker-dealers for myriad Treasury and Federal Reserve recovery conduits.
Goldman, for instance, seems to have healthy financials – including a Texas ratio of 76b/890b=8.54% – but their regulatory aggression adjustment factor is huge. While Goldman paid back their TARP capital, a substantial portion of their operations now revolve around broker-dealer relationships with the government that are inextricably buried in various portions of their financials. The principal risk, therefore, is that when those government programs are scaled back in recovery Goldman may not be able to replace them with similarly lucrative operations. Furthermore, while ex-Goldman alums continue to be appointed to high-level government positions in order to defend their market in those relationships, current policy backdraft from executive compensation limits and continued government connections could have dire consequences for the firm.
Citigroup, in contrast, is among those banks that have taken their lumps but… have taken their lumps. While Citigroup registers a Texas ratio of a completely different magnitude than Goldman – 534b/1,849b=28.90% – they have achieved that by massive asset writedowns and asset sales that have shrunk the bank by more than $150b in the last year while increasing cash and cash equivalents by some $400b (as of Sep 30, 2008 their ratio was 141b/2,050b=6.88%). Nonetheless, Citigroup has a far smaller footprint in the government space than Goldman and are therefore poised for more organic growth without a dire risk of policy disruption. You can argue all you want that Citigroup may have been insolvent and should have been closed, but the fact of the matter ex post is that right or wrong they were not closed and now have a long subsidized recovery before them. In fact, the play is what all good finance students learn about how to rig the stock market game: take penny stocks that can only go up and book magnificent returns or go home after losing a small sum – nothing in the in-class application of the game.
JP Morgan has a worse ratio than Goldman – 165b/2,175b=7.59% – but ostensibly only because of digestive problems with Bear Stearns. That said, the firm bought regulatory goodwill with the Bear acquisition and has a reasonable footprint in broker-dealer relationships with ongoing government programs. Overall, in my opinion, Dimon has steered a good path toward recognition and moving beyond losses, setting the stage for growth. Political risks are not as large as Goldman because JP Morgan is not as aggressive in the political space, making me more comfortable with the risk.
Banc of America continues to burn of losses, but like JP Morgan and Citi it is comforting to know that the losses are being exposed and dealt with. Their liberal Texas ratio is the worst of the bunch – 166b/2,254b=7.37 % – but while additional economic shocks are likely, political shocks are probably not. On the economic side, consumer mortgage loan modification redefaults will hurt B of A the most of the four and the industry is already taking down expectations after massive subsidies. (See, for instance, “Servicers Talk Down HAMP Hopes,” American Banker, Oct 19, 2009.) On the political side, B of A build goodwill in the Merrill purchase and is unlikely to be punished despite recent headlines.
In summary, we are far from out of the woods yet. Moreover, the principal risks now are the failure or removal of government programs and high probability of public backlash to the private-public partnership, where – unlike the traditional public-private partnership – the relationship is driven more by private interests than public. While the public bailout and market support programs may have been beneficial in the heat of last fall, their value is dubious at best now and they create substantially lumpy policy risk that affects principal banks’ bottom lines. Hence, why would anyone believe bank earnings yet, without substantial adjustment factors for continued economic risks as well as heightened political risks that still play a large role in idiosyncratic firm performance?
† Hermann Moyse, Jr./Louisiana Bankers Association Professor of Finance, Louisiana State University, Senior Fellow at the Wharton School, and Partner, Empiris LLC. Contact information: [email protected]; (202) 683-8909 office. Copyright Joseph R. Mason, 2009. All rights reserved. Past commentaries and testimony are blogged on http://www.rgemonitor.com/financemarkets-monitor/bio/626/joseph_mason