Commentary: The road to another painful lesson

Commentary The road to

By NITZAN COHEN
After almost eight months of a strong rally in the US stock market, there are many indicators - including the GDP of the world's biggest economy, developments on Wall Street and shifts in the banking sector - that can tell us a lot about where we are standing. Indeed, Wall Street's leading financial behemoths are being traded below their book equity, usually being a benchmark for their long-term market cap, but that is far from suggesting that today's market prices are anywhere near their true value. Last quarter's reports showed us that most banks still suffer from extremely high leverage, and that real cash held by banks covers only a fraction of their enormous balance sheets. It is clear to everyone that without the massive $2 trillion injection from the government, most US banks would have been wiped out. What seems less clear in today's cheerful Wall Street spirit is that even after the massive bailouts some major banks still face the danger of total collapse. This is exactly the case with titans such as Bank of America and Citigroup, and to some extent with more successful entities like JP Morgan or Wells Fargo. Let's take JP Morgan as an example. The biggest US bank in terms of market cap, and the one (apart from Goldman Sachs, which isn't really a commercial bank) that showed the most impressive resilience so far, presented very good results for the third quarter. Net profit hit $3.6 billion and its shares soared. But most of the profit, almost $2b., came from the investment unit, which enjoyed a wild rally in the capital markets. The credit segment, which is in charge of the bank's main business, showed far less impressive results, and losses from bad loans continued to accumulate at a frightening pace, bringing it to a net loss. It is hard to believe that the current rally has much more fuel left, so those wonderful earnings from investing activities are not supposed to repeat themselves during the coming quarters. So what will happen then? Right now, JP Morgan's strong position compared to its crippled peers has brought investors to value it at about $180b., almost 10 percent above its book equity value. It is very unlikely this high ratio will remain when the stock-market rally stalls or reverses into a downward slide. But the real risks are still hiding in the banks' prime asset portfolios: the loans they gave to the public. JP Morgan has $622b. in loans. BofA still leads the sector with $908b., and Citigroup has about $590b. In an environment of a bleeding labor market shedding jobs, and when US private bankruptcy filings this year alone are about to exceed 1 million, it is easy to see how hundreds of billions of dollars of these loans will never be paid. Add that to the enormous time bomb hiding in the value of the banks' derivatives portfolios, where some believe hundreds of billions of dollars are to be written down, and you get the real gloomy picture of the US financial sector, even after the biggest government bailout ever. So, you might wonder, why do investors still value banks at such high levels? BofA is worth about $140b., Citigroup $100b. and JP Morgan $180b. The reason is probably the strong belief that the worst part of the crisis is behind us and that, in any case, the US government has proved to investors it will save the bankers, regardless of the cost. Both assumptions should be carefully reexamined. It is way too early to presume the worst crisis in 80 years is over, and there are also signs that politicians will be reluctant to repeat schemes like TARP in times when public opinion never has been so hostile toward banks and their shameless compensation system. When the federal government is more occupied with major issues such as reforming the health care system, extending unemployment benefits and dealing with the poor financial position of states, counties and local municipalities, offering another trillion dollars to the fat cats of Wall Street probably isn't the right political choice. When you take all these factors into consideration, and when you remember that significant segments of the credit market - including commercial real estate loans, credit-card delinquencies and student loans - have not reached their worst point yet, the conclusion is clear: banks are seriously overpriced, and some of them are really worth zero. The financial sector is the cause of this horrible crisis. Bankers are the ones who corrupted the system; they pumped the credit and derivative bubbles and crashed both Wall Street and Main Street when their Ponzi scheme blew up. Not surprisingly bankers are the ones who paid the least for the troubles they caused, manipulating governments to make the public pay for that. As long as the sickness that stands in the heart of the world's financial system isn't cured, a real recovery cannot occur. I am not talking just about regulating bonuses and compensation. This is a hot issue, but it is marginal. The real issue is how to reestablish a less greedy system, something that will stand on real ground of real businesses and not on financial pyramid games. It is about setting a limit to leveraging and speculation, about returning to conservative values in the lending business and about retreating from manipulative currency-control policies by central banks, which are no better than their good friends in the private-banking sector. Will it really happen? Can it really happen? I seriously doubt it. But the way things are going, it is more likely that investors will have to swallow another painful lesson when the banking sector finally drags the entire stock market with it into the abyss. Maybe then, some serious changes will be made.