We’ll see if the rally in Aussie shares can keep on keeping on this week. We have our doubts. Not least because the optimism surrounding bank share is not only misplaced. It’s naive.
So the banks have returned to profitability have they? That was the theme on the market last week. And if it were true, a recovery in bank balance sheets is just the sort of thing that might precede a recovery in the economy. But it probably isn’t true. Here’s why…
The big three banks reporting last week-Citibank, Goldman Sachs, and JP Morgan-all reported huge revenues from their trading desks. As we reported last week, Goldman’s $6.6 billion in trading revenues was not only 70% of total revenues, but it was also a ten billion dollar improvement on a $4 billion loss in the fourth quarter.
JP Morgan reported nearly $5 billion in revenues from fixed income securities trading. And Citigroup reported $4.69 billion in fixed income trading. In fact, all of Citigroup’s other major operating segments reported declining revenues for the quarter. Its global credit card revenues fell by 10%. Consumer banking revenues were down 18%. And Citi’s Global Wealth Management revenues were down 20%.
But something magic happened in the fixed income trading group for Citi. This is pure gold if you like arcane financial statements packed with fictional earnings. If you dig into the quarterly report, you’ll learn than fixed income trading revenues were boosted by a “net $2.5 billion positive CVA on derivative positions, excluding monoclines, mainly due to the widening of Citi’s CDS spread.
That takes some sorting out. A CVA is a “credit value adjustment.” As you can learn here, it’s the credit risk premium of a derivative contract. Once you sort it out, you learn that Citi “made” $2.5 billion on a derivatives position designed to profit when the companies own credit default swaps spreads widen.
Or, in plain English, Citi profited because it made a bet that the cost of insuring itself against a default would go up. The credit default swap market is the place where you can bet on the credit worthiness of a firm, or, essentially, the chance that a firm might default on its bonds. Citi appears to have reported a $2.5 billion trading gain in the fourth quarter precisely because the market thought the company stood a good chance of failing (hence the widening CDS spread).
As far as we can tell, if you use this kind of perverted logic, the closer Citi gets to bankruptcy, the more money it would “make” on its derivatives. That shows you how bogus the quarterly number was. The company reported declining revenues in its core banking and lending activities. But thanks to fixed income and this handy $2.5 billion CVA, the company was able to report $1.5 billion in net income.
Also, don’t forget that all of the banks benefitted from what financial sector analyst Meredith Whitney called “back door financing.” Whitney described what amounts to Fed-sanctioned front-running of the fixed income market by the banks. The Fed publicly telegraphed its intention to buy $750 billion mortgage backed securities from Fannie Mae and Freddie Mac and $300 billion in U.S. Treasury bonds. And that was AFTER it announced in late November of last year it would be wading in as a buyer for all agency bonds to support the U.S. mortgage market.
Since the financial statements of the banks don’t break trading revenues out a line item basis, it’s hard to say how much money each bank may have made by front running the Fed’s actions in the bond market. And of course, there was nothing really illegal about it that we can gather.
But from the looks of it, what we have here is a kind of back door subsidy to bank profitability provided by the Fed. First quarter earnings were strongly boosted by an increase in the valuations of mortgage backed securities that went up with Fed buying. Before you get all excited about the recovery in financial stocks, you may want to keep that in mind.
May I add an important point from the ABS Housing Finance report, which you seem to have missed? In the report it stipulated that, “In original terms, the number of fixed rate loan commitments as a percentage of total owner occupied housing finance commitments decreased from 3.8% in January 2009 to 2.7% in February 2009.”
This alludes to the fact that, not only are the FHBs propping up the housing market on their own (with govt. support of course), but they seem to be doing it with variable rate borrowings. This is a recipe for disaster.
We are at or very near the bottom of the interest rate cycle, and people are taking on more variable rate borrowings? Are they mad? Wouldn’t it make more economic sense to lock in a low fixed rate for the next 15 years, or more, at this time?
There is much more upside potential on interest rates than downside. Why are borrowers not using the low rate environment, currently offered, to lock in a low fixed interest loan for as long as possible? The RBA cash rate is only 300 basis pts from ZERO, and I highly doubt that the RBA is even willing to cut another 150 basis pts.
I’m sure that the IRSwap books of every major Australian Bank cannot forever suppress the upwards pressure, currently building on medium & long term interest rates. Although that will not stop them from trying. It looks like this could get very, very ugly indeed…
—Your well drafted article on the relaxing of the FAS 157 rules on security values seems to not want to acknowledge that this latest adjustment is to actually to correct yet another stupidity. Any lender who intends to hold the security for the life of the loan and has no need to sell while those about him are scrambling to shore up their balance sheets, should in my view feel free to snub their nose at the market price and soldier on.
These almost arbitrary market values now being set are a very recent innovation and almost coincide with the magical disappearing balance sheets that have been shrinking since mid 2007.
Why not get rid of the rule altogether and let the institution make its case in the market – transparency could be in vogue and investors and borrowers alike could judge the book by its contents.
More transparency? Now there’s a thought…
for The Daily Reckoning Australia