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Banks Upgrade From Catastrophic to Awful

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Institutions still in no condition for recovery.

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The recent rally in equity markets -- the largest for decades -- was predicated, in part, on the improving fortune of banks.

Banks reported better-than-expected profits. US banks seem likely to pass the stress test. Repayment of taxpayer funds by some institutions, at least, seemed imminent. Scrutiny suggests that the episode reflected Adlai Stevenson's logic: "These are conclusions on which I base my facts."

Banks beat "well-managed" low-ball expectations. In the last quarter of 2008, publicly traded banks lost $52 billion. Despite a return to profitability for some institutions, in the first quarter of 2009, banks are still expected to lose around $34 billion. For example, UBS (UBS) and Morgan Stanley (MS) recorded losses.

The quality of earnings was questionable. Core businesses declined by 20-30%. Trading revenues, especially fixed income, rose sharply at most big banks, reflecting high volumes of bond issuance - especially investment-grade corporate issues and government-guaranteed bank debt.

Corporate issuance was the result of the continued tightening in credit availability as banks reduced balance sheets. The issuance of government-guaranteed bank debt provided underwriters with a "double subsidy" - the government guaranteed the debt, but then allowed the banks to earn generous fees from underwriting government-guaranteed debt.

High volatility generated strong trading revenues. Key factors were increased client flows and increases in bid-offer spreads (by up to 300% in some products). High trading revenues also reflect principal position taking and trading. It will be interesting to see if trading revenues are sustainable.

Questions remain about the impact of payments by AIG (AIG) to major banks. Conspiracy theories notwithstanding, it seems likely that these were collateral amounts due to the counterparty, or settlement of positions that were terminated. At a minimum, the banks benefited from a one-off increase in trading volume and also larger-than-normal bid-offer spreads on these closeouts - reflecting the distressed condition of AIG.

The banks also benefited from revaluing their own debt where credit spread widened. The theory is that the bank could currently purchase the debt at a value lower than face values, and retire them to recognize the gain. Unfortunately, banks aren't in position to realize this "paper" gain, and ultimately, if the debt is repaid at maturity, then the "gain" disappears. If you're confused, then revaluation of issued debt worked differently at Morgan Stanley. The bank would have been profitable without a $1.5 billion accounting charge caused by an increase in the price of its debt from lower credit spreads.

Earnings were also helped by a series of one-off factors. Bank of America (BAC) realized a large gain on the sale of its stake in China Construction Bank, and also revalued some acquired assets as part of the closing of its Merrill Lynch acquisition.

Goldman Sachs (GS) changed its balance date, reporting results to the end of March rather than February. Given that its last financials were for the year to the end of November 2008, Goldman separately reported a loss for December 2008. It's not clear how much Goldman's profit benefited from the change in the reporting dates.

Barclays (BCS) recently sold its iShares unit (a profitable unit that contributed around 50% of the earnings of BGI (Barclays Global Investors) to a private-equity firm for $4.2 billion, allowing the bank to book a gain of $2.2 billion that boosted capital ratios. CVC Capital only paid $1.05 billion with the rest ($3.1 billion) being borrowed from Barclays itself. The loan was for 5 years, and Barclays is required to keep the majority of the debt on balance sheet for at least 5 years.
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No positions in stocks mentioned.

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