The Financial Sector Is Still In Big Trouble

Last week the stock market took a big hit, largely as a result of continued problems in the financial sector. The short version of what is happening is not good: banks of all sizes are taking big hits to their capital which will restrain their ability to make loans for the foreseeable future. That, in turn, will add to an already slow economic environment.

First, let's start with the series of news events.

From CNN/Money:

Analysts at Goldman warned U.S. banks might need to raise as much as $65 billion in new capital, with losses in the financial sector not expected to peak until next year.

"What Goldman is pointing out falls into the dog bites man category. They are reminding us that there is a reason we're down. In general, it's too early to get into financials," said Art Hogan, chief market strategist at Jefferies & Co.

As the analysts points out in the second paragraph, this news pointed out that the financial sector still has profound and deep problems. More importantly, these problems will not easily go away. They are structural problems that go to the core of banking -- namely, that financial institutions of all sizes have more losses. This will force them to increase their loan loss reserves and constrain their future lending going forward. This in turn means the Federal Reserve could lower rates to 0% (which is where they already area after adjusting for inflation) and it wouldn't make a difference.

These problems are hitting banks of all sizes. It's hitting big banks:

Citigroup Chief Financial Officer Gary Crittenden yesterday predicted ``substantial'' additional writedowns and more losses on consumer loans. The bank has booked more than $42 billion of credit losses and writedowns since last year because of the credit market contraction, or about 10 percent of the $396 billion racked up by banks worldwide

And smaller banks:

But Wednesday was just one more bad day in what has been a horrible year for small and midsize banks. Their descent in the stock market has been remorseless, reflecting the economic pain in their own backyards. Weakening housing and construction markets in regions like the Midwest, Southeast and Southwest have hit lenders in those areas hard.

For the banks' shareholders, the numbers tell a sad story: Wednesday's decline brought the loss for the S.& P. bank index to 39.3 percent so far this year. Fifth Third's odd name almost seems like a bad joke. Fifth Third has lost two-thirds of its value this year. Shares of two other banks based in Ohio, the National City Corporation, of Cleveland, and Huntington Bancshares, of Columbus, have suffered similar declines.

Banks based in the Southeast are hurting, too. The Regions Financial Corporation, the biggest bank in Alabama, has lost half its value. Standard & Poor's predicted this week that Regions would cut its dividend to conserve its capital in the face of rising losses on real estate loans. The share price of SunTrust Banks, which operates across the Southeast, has fallen almost 41 percent.

Small and midsize lenders are in far less danger than they were during the 1980s and early 1990s, when about 1,600 federally insured institutions failed during a savings and loan crisis. But the breadth and depth of the current troubles have caught bank executives by surprise. Federal regulators are particularly concerned about the exposure of smaller banks to the commercial real estate market, which has softened in some parts of the country.

As a result, yesterday Merrill Lynch downgraded the regional banks:

Large and regional bank stocks took an initial nosedive after Merrill Lynch cut earnings estimates for 12 companies including Bank of America(BAC - Cramer's Take - Stockpickr), BB&T(BBT - Cramer's Take - Stockpickr), Fifth Third Bancorp(FITB - Cramer's Take - Stockpickr), National City(NCC - Cramer's Take - Stockpickr), Regions Financial(RF - Cramer's Take - Stockpickr), SunTrust Banks(STI - Cramer's Take - Stockpickr), Wachovia(WB - Cramer's Take - Stockpickr) and Wells Fargo(WFC - Cramer's Take - Stockpickr).

To get a good idea about what is going on here, let's turn to the FDIC's Quarterly Banking Profile. This document is released every quarter (duh!) and it provides a great overview of the banking industry.

From the report:

Deteriorating asset quality concentrated in real estate loan portfolios continued to take a toll on the earnings performance of many insured institutions in first quarter 2008. Higher loss provisions were the primary reason that industry earnings for the quarter totaled only $19.3 billion, compared to $35.6 billion a year earlier. FDIC-insured commercial banks and savings institutions set aside $37.1 billion in loan-loss provisions during the quarter, more than four times the $9.2 billion set aside in first quarter 2007. Provisions absorbed 24 percent of the industry's net operating revenue (net interest income plus total noninterest income) in the quarter, compared to only 6 percent in the first quarter of 2007. The average return on assets (ROA) was 0.59 percent, falling from 1.20 percent in first quarter 2007. The first quarter's ROA is the second-lowest since fourth quarter 1991. The downward trend in profitability was relatively broad: slightly more than half of all insured institutions (50.4 percent) reported year-over-year declines in quarterly earnings. However, the brunt of the earnings decline was borne by larger institutions. Almost two out of every three institutions with more than $10 billion in assets (62.4 percent) reported lower net income in the first quarter, and four large institutions accounted for more than half of the $16.3-billion decline in industry net income.

Let's take this apart piece by piece.

Higher loss provisions were the primary reason that industry earnings for the quarter totaled only $19.3 billion, compared to $35.6 billion a year earlier.

In other words, losses nearly cut earnings in half on a year over year basis. That's a very sharp reduction.

FDIC-insured commercial banks and savings institutions set aside $37.1 billion in loan-loss provisions during the quarter, more than four times the $9.2 billion set aside in first quarter 2007.

Financial institutions are anticipating far more losses - nearly four times as much -- than they were a year ago. That indicates the credit quality of the underlying loans is cratering.

Provisions absorbed 24 percent of the industry's net operating revenue (net interest income plus total noninterest income) in the quarter, compared to only 6 percent in the first quarter of 2007.

Loan loss provisions now consume four times the industry's net operating income. That's a huge year over year increase.

The average return on assets (ROA) was 0.59 percent, falling from 1.20 percent in first quarter 2007. The first quarter's ROA is the second-lowest since fourth quarter 1991.

The industry's return on assets is almost 50% lower on a year over year basis. Again -- that's a precipitous drop in a short time.

The downward trend in profitability was relatively broad: slightly more than half of all insured institutions (50.4 percent) reported year-over-year declines in quarterly earnings. However, the brunt of the earnings decline was borne by larger institutions. Almost two out of every three institutions with more than $10 billion in assets (62.4 percent) reported lower net income in the first quarter, and four large institutions accounted for more than half of the $16.3-billion decline in industry net income.

This is a very troubling development. If a large institution fails it will send a ripple effect through the entire financial industry.

So, the short version of the FDIC report is clear: the financial industry is still in serious trouble.

I want to caution, we're nowhere near meltdown mode. There is no panic, not should there be one. The sector is still working. However, instead of being able to get to fifth gear it can only get to second gear.

Let's look at two charts for the industry.

The XLFs represent the large financial institutions. On the yearly chart, notice the clear down up down pattern. Prices have continually moved through support to make new lows. Prices have been in a clear downward trajectory for the last year indicating this problem has been around for some time.

On the three month chart, notice the following:

-- Prices are below the 200 day exponential moving average (EMA)

-- All the EMAs are moving lower

-- The shorter EMAs are below the longer EMAs

-- Prices are below all the EMAs

This is a bearish chart, plain and simple.

The year-long regional bank chart is just as bad as the XLFs (unless you're shorting the market). Prices have continually moved lower, breaking through resistance to make new lows.

-- Prices are below the 200 day exponential moving average (EMA)

-- All the EMAs are moving lower

-- The shorter EMAs are below the longer EMAs

-- Prices are below all the EMAs

This is a bearish chart, plain and simple.

So, the short version of all this is simple. The financial sector is hurting from all the bad loans it has written over the last decade. Now the sector is paying the price in the form of lower earnings, lower stock prices and higher loan loss reserves. Considering the amount of bad debt in the system, we won't see the end of this for some time. That's what the overall market realized last week: this will be with us for awhile.

Comments

[flatus]

Retirement is for sissies, anyway. Thank goodness that we will all have an excuse to keep on humpin' it!

[opines]

Future economic historians will conclude that the first 'depression' since the Great Depression began in 2007 with the bursting of the housing bubble.

It was not until late 1931 that the term 'depression' was used by the NY Times in describing the economic turmoil that began with the Stock Market crash of November 1929. For two years their business pages echoed Hoover's "Prosperity is just around the corner" theme. Articles of the period took the line that each new quarterly downturn was good news because the imminent recovery would start from an even sounder base.

Their hope in broadcasting such contra-reality analyses was that Main Street would support the market and that employers who were losing money would not cut back or close their operations because a recovery was imminent.

Future economic historians will disagree with Mr. Stewart's statement that "we are nowhere near the meltdown mode".

My advice? Stock up on canned foods.

[Sciguy]

"losses nearly cut earnings in half"

These banks are still making profits - just smaller profits. The tellers are getting smaller raises and the execs are still getting huge bonuses. Stockholders are still earning dividends by doing the painful manual labour of simply having stock. Credit card offers are still flying through the mail, and usurious rates are still making money for bankers. What else is wrong with this picture?

Disclaimer: I own stock in a couple of banks. Excuse me while I do the highly skilled but back-breaking labour of e-mailing my broker... (In other words, I'm part of the problem, although I wouldn't mind getting smaller dividends.)

[themodernleader]

Dugan, et al. I heard some expert claim that his research supported the finding that commerical real estate has been over-built by abour 49 %. Clearly, based upon the number of for rent signs, housing and rental property has been over-built about as much.
Economic bubbles, government induced, have been disasterous for our economic well being. A decade ago, the telecom bubble produced 100 years more of redundant communication capacity then was needed. Billions of dollars were squandered.
Now the real estate bubble has squandered trillions of dollars that have been borrowed. The productive farm land, raw materials and labor squandered on this over-capacity of supply versus demand is the consequence of short term political gain reflecting short term prosperty at the expense of America's future.
A new economic policy of producing and creating new technologies and sources of energy and other pressing enviromental needs must replace consuming and borrowing. And most likely we must default on our national debt to be able to recover, so our military must be second to none. Our national security must be of highest priority. Nations that default on their obligations have few friends.

[memphispaul]

This article does not address the implications of the downgrades at MBIA & AMBAC.
Costs for municipal borrowers are skyrocketing. An estimated 100+ billion of these bonds have clauses that require banks to be the purchaser of last resort. This will place further constraints upon big banks as they face additional write downs on their hedged positions through holding Credit Default Swaps.
The merry go round continues as the financial system continues to unwind.

[cylindar]

You stated "I want to caution, we're nowhere near meltdown mode. There is no panic, not should there be one. The sector is still working. However, instead of being able to get to fifth gear it can only get to second gear.I want to caution, we're nowhere near meltdown mode. Well if that's the case we do not have anything to worry about. All is well. Not! We are at the beginning of a very big meltdown. It won't seem like one for a while because the financial gangsters have the tools available to make it happen a little slower and there are a lot of ways to hide things . Things are a lot worse than anybody has been told.

[tribalypredisposed]

The dam burst on Friday with the downgrade of Ambac from AAA, which will force many banks to lower the book value of many of their portfolios. The bond insurers have been keeping a finger in the dyke here, and now they just got their arms cut off. This will have very far reaching effects, all of them bad. If you have to be in financials, get in on Warren Buffet's new bond insurer. But I think it is hard asset time here. Land, food, gold....

[olephart]

The Federal Reserve has shown that it is quite willing to bail out the befuddled, bamboozling, bond barons and bankers bemoaning bare bottomed bottom lines, but that will just keep the pampered princes precious positions piloting prestigious but precariously profitless private institutions heads above water. All the money that they made by dealing in fraudulent securities has been pocketed and the institutions are left with the bleached bones of their junk bonds. In short, what they have sown that they will also reap. Is it also coincidental that the financial institutions and many others have had seven years of plenty? Now in the eighth year of Bush, there came a great famine. Thus from this historical precedence the obese female won't grace the stage with song for another six years. It was also written that for those who listened and wisely prepared there was no famine. So it is all a matter of perspective. For all those who take up debt perish by debt.

[Rule Of Law]

Delightful use of alliteration. You would be a great addition to our writing group here in beautiful wine country.

Rule

[flatus]

Just a minor correction: "..... what THEY have sown that WE will also reap."

It seems to me that there just is not enough frog marching going on here. Hmm.. maybe when we get our Department of Justice cleansed next year?

[wldnswmmr]

The federal reserve's report on depositary institutions in the United States indicates a negative swing of $170 billion from May 2007 to May 2008, from positive $40 billion in 2007 to negative $130 billion in unborrowed reserves. So yeah, they're in terrible shape, much worse than we're hearing on feel-good business channels like CNBC. No one wants to talk about how far underwater all these banks are. The soaring cost of oil is going to hammer the airlines into oblivion, cause massive shortages because truckers can't afford to drive, tear into the tourism industry, drive the cost of food still higher and cause large-scale unemployment. California's unemployment rate just shot up .8% in one month, and we're the farming capital of the nation and completely dependent on the automobile for getting around. What starts here will soon be everywhere. I don't know if offshore oil coming on line in 2018 is really the complete answer to the immediate problem. I don't think there is an answer, except get used to austerity now. The practice will come in handy.

[outnow]

Fogbelter has a point about kiting but the problem is leveraging and ignoring risk. There will be a downward adjustment in asset evaluations. Therefore, the banks lack funds to lend since the derivatives are "junk equities." With as much as a quadrillion in these derivatives world wide, a ten percent "hit" is a very large number. Unless the securitized debt instruments produce a stream of income, such as people paying their mortgages and credit card payments - at least 90% of the time to produce a cash flow, the assumptions underlying the securitization do not make sense economically speaking - if it ever did.

Bundling bad loans given to bad credit risks and taking the risk off the balance sheet of the bank may be clever accounting, CDS and other ploys are just bad banking. Using one's home as a debt card for illusory consumer-based economy spending to cover up massive debt and unending wars for oil are doomed.

The economy must be managed for the benefit of the middle class, not for unlimited corporate profits, or the society envisioned by men like Henry Ford will be replaced by the economy run in post-World War II by dictators to combat hyperinflation and excessive militarism.

[researcher]

capitalism self destructing

americans will blame the people and not the system

the system's influence on human behaviour is huge

like communism capitalism must self destruct

with communism man exploits man with capitalism it is the other way around

deregulated capitalism leads to wars for profits which lead to imperialism which leads to war mongering

welcome to america where americans think they are the greatest country on earth and the rest of the world sees them as the greatest threat to peace in the world

the giant super power has been living on borrowed money for 3 decades to maintain its war mongering machine and standard of living

the end result bye bye middle class hello have mores and have nots.

give the have mores credit they suckered the middle class good with reagan economics.

the trickle down trickled up.

[seawolf77]

You said it. The utter stench of mendacity is revolting to all but the most hardened stomachs.

[Imhotep]

MSOC say's howdy. Peace

[SeenItBefore]

Fogbelter is correct. But I it goes to the fabric of how banks do business. Every 20 or so years this cycle re-invents itself, always to the grief of the little guy. In the 80's, we witnessed S & L executives wheel barrowing tons of cash out the front door, (Charles Keating and Neil Bush as prominent examples) with hardly an inditement of criminal activity issued. The entire S & L industry collapsed and a wonderful time was had by all... except those of us who had homes financed by or monies in these institutions. Interesting that the 1985 "turd in the punch bowl" also saw a Republican President, Administration, and Monetary policy. It saw us involved in crappy wars about the globe, a collapsing oil and gas industry, a lowered CAFE standard, monstrous deficit spending, an over blown and over built housing market and the ultimate "Up Your Nose!" act by Reagan, the removal of hot water solar collectors Carter installed, along with the repeal of most Federal assistance to those who were willing to leave a smaller carbon footprint. As Yogi was fond of saying, "It's deja vu all over again". And will this get worse before it gets better? It depends on the depth of the taxpayers pockets, and their patience.

[FogBelter]

Hale, in 1979, a month after graduating from High School, I began a career in Banking as a lowly Bank Teller. I sat in a small office and studied the ins and outs of credit and debit, proper identification of customers, how to balance a cash sheet ... and was fully versed in the con game of the day, for which tellers were the first line of defense, check kiting.

"Drawing against balances credited to uncollected checks. By writing checks drawn on two or more out-of-town banks, a person temporarily short of cash can write an interest-free unauthorized bank loan or temporarily inflate his account balance to improve his chances of getting a loan. ... Check kiting schemes can be very elaborate, and have been known to cause bank failures. Kiting is best controlled by monitoring unpaid checks in the process of collection." From Answers.com.

Hale, as an old Bank Teller I can only ask ... how is the way unregulated CMOs. CDOs, and CLOs were introduced into the credit market not a high stakes version of Check Kiting? How do the Banks, who are up to their eye-teeth in fraudulent, designer securities, recoup capital that never existed in the first place?

The ship is going down, Hale, and no amount of bailing will change that underlying fact ... the Banks conveniently forgot what they once knew, and will now pay for it along with the rest of us.

[usna73]

Bondad, I agree with almost all of your analysis, but I think a sharp break in the overall market is still coming. It will be precipitated by another "crisis" in banking, probably the failure of a major bank ( Wachovia?). This will expose the inevitability of bige decline in corporate profits, since the consumer is not going to save the day. A reversion to near mean on P/E will take the Dow down 10-10.7K.

We are really seeing a deflationary process in slow motion. This is not inconsistent with the CPI inflation that we have all experienced. It is just the markdown of assets to their true value. Houses are just one indicator; the dollar currency another.

Everyone should remember that the Great Depression didn't hit full stride until 1932, nearly 3 years after the initial stock market break. We are only one year into this process, with the worst yet to come. I expect that Bush will be scorned more than Hoover when history is written. Bush even used the war machine, not just economic war on the middle class. The Bush regime looted the Treasury and know the price is being paid by us all.

[Dugan]

usna73, you sound like the typical short-seller. The good news on the economy is that job losses have been moderate since the late October/early November economic downturn and exports and corporate profits continue to increase. As long as worldwide growth continues continues for the duration of the financial and housing correction - in my estimation another nine months- the economy may skirt recession and power forward. Housing starts are already sitting at cyclical lows and we're probably in the 6th inning of the write-downs. Once housing construction turns up, the home related industries (including furniture, chemicals, Home Depot) will turn up and employment will increase fairly significantly and consumer spending will turn up. And maybe around that point, worldwide interest rates will finally slow enabling inflation, particularly commodity prices to come down. Overall, to compare the current economic situation to 1932, or anything close to that, is ridiculous. And there has been no war on the middle class. In fact, if you take into account asset values and fringe benefits (in addition to simply hourly wages), the "middle class" has seen unprecedented prosperity over the past decades in most the country (at least outside pockets of Michigan and Ohio). Have you been to Florida, Georgia, Texas, Nevada, California, Arizona, Virginia, DC, or New York City in the past years? Prosperity there has been unbelievably and undeniable.

[tjfxh]

"Prosperity there has been unbelievable and undeniable."

Dream on. This prosperity was due debt-financing from the housing market bubble. Now that the bubble has burst, the home equity ATM has shut down, and rising wages aren't making up the difference. Foreclosures are increasing, and construction is on hold. In addition, the commercial real estate market is severely overbuilt also. I'd say we are at most in inning three.

Banks are now decreasing credit lines and increasing loan reserves. This is a deflationary trend.

[wheaties]

and you sound like Larry Kudlow...