- The Washington Times - Sunday, March 15, 2009

Some rare good news from banks last week spurred hopes that the battered financial sector may be starting to heal.

Citigroup and Bank of America helped spawn powerful stock rallies by asserting that so far this year they are running operating profits, although the banks did not disclose what are likely to be big losses on loans in the first quarter that could largely offset those profits.

The banks themselves and most analysts credit the government’s extensive rescue efforts for helping keep the ailing giants afloat since last fall. Those include more than $200 billion in cash investments by the Treasury, massive cash infusions into bank funding markets by the Federal Reserve along with record low interest rates on loans to banks, and government guarantees on the banks’ debts and some loan assets, among other unprecedented rescue efforts.

But analysts say the big banks are not out of the woods yet, as they still have not disposed of the huge toxic loan portfolios that originally caused their troubles, while the deepening recession is worsening their problems with souring loans to consumers, real estate firms and businesses. And since the large banks have lent extensively overseas, another serious threat looms if a full-scale debt crisis breaks out in Eastern Europe or elsewhere.

“The bear took a long overdue respite, allowing the market to stage a modest rebound” last week, said Ashish Shah, analyst at Barclays Capital.

Several developments aided banks, in particular a move by legislators and regulators to speed adjustments in accounting rules that have forced banks to deeply devalue their loan assets. But the markets also benefited from a lessening of fears that the big banks eventually will be taken over and nationalized by the government, Mr. Shah said.

Top executives at both Citigroup and Bank of America declared their intent to avoid nationalization by not asking for any more capital funds from the Treasury - a move that would increase the government’s ownership of the companies. Beyond that, Mr. Shah said, investors seem more comfortable with assurances from the Obama Treasury Department that it does not want to take over the banks.

“The clearly articulated administration plan is to provide support to a private-sector-owned financial system,” he said. And as long as investors aren’t too worried about being wiped out by the government, they see the banks’ greatly depressed stock and bond prices as extremely attractive, he said.

Still, “even though the tone is clearly better, the financial sector remains a dark cloud hanging over the broader market,” he said, and the markets will continue to react to any changes or perceived changes in the government’s policies toward the banks.

Bank stocks got a lift in part because of a push by Federal Reserve Chairman Ben S. Bernanke and House Financial Services Committee Chairman Barney Frank, Massachusetts Democrat, to ease accounting rules that have forced banks to value their loan portfolios at today’s depressed market prices. Critics charge those rules have driven some banks to the point of near-insolvency and forced them to seek government aid.

Mr. Frank’s committee extracted a promise from accounting regulators to ease those rules within three weeks - earning plaudits from many banks and investors.

Mr. Bernanke said the rules need to be changed so they do not punish banks when asset prices fall steeply during market busts, as they are now, and at the same time should temper the high values of assets that come with market booms, which led banks in the past to lend promiscuously.

Bob McTeer, former president of the Federal Reserve Bank of Dallas, said that suspending the rules would have an immediate and buoying effect on financial markets and banks.

“It is the only low-hanging fruit that hasn’t been tried” to stem the banking crisis, he said. He contended that if a foreign power had destroyed a fraction of the wealth that mark-to-market accounting has in the past year, “we’d go to war.”

Most analysts do not expect a wholesale suspension of the rules, however. And accounting purists insist that even small changes would only be cosmetic and would not cure the underlying problems at banks.

“Any modification to fair-value accounting standards will only exacerbate the problems investors and public companies currently face and will reduce investors’ willingness to invest in the securities of banks and other financial enterprises,” said Kurt N. Schacht, managing director of the CFA Institute, an accounting group.

“Fair-value reporting did not cause our current crisis. Rather, the crisis resulted from poor lending practices,” among other problems at banks, he said. “Investors continue to wonder why some banks, when they look in the mirror and don’t like what they see, prefer to remove the mirror and scapegoat accounting standards instead of acknowledging the truth about their financial position.”

While banks are still struggling under the weight of investments in subprime and exotic loans that went into default in past years, their problems with loans are only growing by the day as a result of the deepening recession and sharp rise in unemployment to 8.1 percent.

Harm Bandholz, economist at Unicredit Markets, estimates that bank charge-offs for defaults on credit cards and all types of mortgages will jump by nearly $80 billion this year if the unemployment rate rises to 10 percent, as many economists now project. And those additional losses do not include burgeoning losses on commercial real estate and business loans, which are another big part of the banks’ business.

“The risks for the economic outlook are clearly skewed to the downside,” he said, and the loan losses could go much higher.

Because the fate of the nation’s banks - like every other business and individual - lies to a large extent on a recovery in the broader economy, news last week of some stabilization in the economy helped banking stocks as well as the overall market.

Bank stocks also got a lift from a pledge by the Securities and Exchange Commission to consider reinstating a stock exchange rule that would limit short-selling - that is, trading that profits from driving stocks lower. Banks have been plagued by short-sellers since last summer, with a legion of profiteers helping to drive Citigroup’s stock below $1 for the first time earlier this month.

Doug Roberts, chief investment strategist for Channel Capital Research, said the government’s strenuous efforts - particularly the Fed’s extensive efforts to revive bank funding and loan-securitization markets - have helped, but will not cure the fundamental problem with mounting losses on loans.

“Triage alone will not resolve the insolvency of the banking system,” he said. “As of now, the toxic assets remain on the books of the major banks. Addressing this problem is a huge and extremely painful process,” which the administration has not even yet begun.

“The toxic assets lie at the root of the problem,” because no one knows what they are worth and no one wants to invest in banks that hold large amounts of them, he said. Eliminating the mark-to-market rule would only temporarily solve the problem, he said.

“A long-term solution needs to be found to prevent Japanese-style stagnation from taking hold,” he said.

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