Big American Banks – reasons to be worried

I think the big American banks are beginning to panic.  I have zero inside knowledge so take what I say as possibly interesting speculation, nothing more.

My starting place is JPM’s recent, much trumpeted earnings report.  It seemed to be greeted as sure proof that the recovery and the banks were on healthy.  Except that on closer inspection it wasn’t.  Yes, JPM did make a $4.42 billion profit, but, as the Bloomberg headline said, it did this largely, “on lower credit costs.”

Basically JPM made a lot less money from banking (total net revenue down 11% YoY, corporate/private equity income down 73%YoY – and in ’09 this used to provide a third of their income) BUT their own borrowing costs were low courtesy of the Fed’s nearly zero percent lending.  JPM’s profits were thus very largely a function of low interest rates and very little else.

This tells me two things.  First it explains why keeping interest rates at near zero is paramount for the Fed and its clients the Big Banks.  Without low interest rates the banks die. It is as simple as that, because it is clear that most of the bank’s profits come from that Fed provided, always on tap, no questions asked, ultra low interst rate, source of funding.  Second it says that apart from the low interest rates, things are NOT going very well for the banks at all.

In fact, things are suddenly going rather badly on several front at once.  First there is a the darkening  and choking legal storm concerning: fraudulent foreclosures and the spreading enthusiasm for contesting them,  securities that may have been illegally constituted and which therefore may be null, and possible mis-pricing of the mortgages underlying the securities which could allow many securities to be forced back on the banks who securitized and sold them.  These are different problems but are so tangled together a generation of lawyers will be made wealthy trying to sort them one from the other.  In the meantime foreclosures have stopped.  And with them any hopes the banks had of getting their hands on CASH.

Which brings me to a second bit of news.  Late today, JPM, flush with its wonderful earnings put out a three line wire notice that it was offering $1.25 B of 30 year bonds and $2.75 B of 10 year bonds.  So suddenly, this profit making bank, who had also just assured its investors that the amount it thought it would have to set aside to deal with future losses was GOING TO GO DOWN – that self same bank, suddenly thought it prudent to try to raise $4 B in new cash – NOW.

Hmmm!  I smell a ‘well capitalized bank, that has NO need AT ALL to raise cash’.  Much like a whole raft of ‘well capitalized’ banks over the last two years who also ‘didn’t need cash’ shortly before needing a LOT rather suddenly.

Why does JPM feel a sudden urge for cash even though it will increase its burden of debt?  The obvious answer is the foreclosure crisis, the associated legal costs and the huge costs if the banks are found culpable and liable.  Of these however only the legal costs of foreclosures and suits against them are immediate. Are these costs enough to warrant $4 billion in debt?  I don’t think so.

So what else?  Well it turns out that today, probably as a result of all these risks of huge future liabilities, that the cost of insuring JPM and other bank’s debt (CDS costs)  started to rise today.  A bit like, over in Europe, they have been rising for Portugal.

This rise in CDS costs, in turn, raises the likelihood that interbank lending costs could start to move up.  Remember that from the Lehman’s era, when banks started to get nervous about lending to each other?  And what do you do if you think your borrowing costs might go up? You try to issue debt sooner rather than later, so as to get your extra funding sorted before costs go up.  SO might this sudden debt issue from JPM be read as the banks itself signalling its own worry about interbank lending and its ability to borrow?

That is bad sign number two.

Bad sign number three is that today the Fed ran in to seriously unnerving problems with US sovereign debt.  The Fed sold 30 year US bonds and found that there was a distinct lack of bidders.  The bid to cover ratio was 2.49 which is NOT a crisis but also NOT great.  But more significant was the fact that the Primary Dealers (The Big Banks) found they HAD to buy up 58% of the debt on offer because otherwise it would not have got a bidder. And if there was not a bidder at the rate on offer, the Fed might have had to either withdraw some of the debt offered, offer a higher rate or have a no bid.  Each of those is an unacceptable outcome and would have been a crisis. Thus those outcomes were not allowed.  The Primary Dealers made sure. That is their job. Even so the rate was still up on the last auction.

This is NOT any kind of disaster. The bonds sold. The rate was 3.852%.  BUT longer term debt is what determines mortgage rates in the US.  The one thing the Fed cannot allow is for the long term bond rate to go up.  If it did mortgage rates would go up and the ENTIRE U.S. recovery plan would fail in one epic, fiscal grand-mal seizure.

Basically I am saying that all is NOT rosy with American banking, its recovery or the policy supposedly delivering it.