Banks led us into this mess, and banks will lead us out
Foreclosures caused worldwide weakness in the banking sector over the last several years. This sector needs to strengthen before wide spread economic expansion can exist.
In 2008, we started to see the banking sector have an erosion of their earnings due to the rise in foreclosures. Their balance sheets weakened substantially as more and more of their loans became questionable. The banks had to write these assets off their balance sheets at ‘fire sale’ values. As these loans became more and more delinquent, the bank was required to hold more cash in reserves. These reserves are money that the bank cannot loan out to individuals or businesses. Moreover, these banks were not making any profits on these delinquent loans and were becoming very cash strapped. One analyst commented that Bear Stearns had a very high Net Asset Value but was sold for a fraction of that Net Asset Value. I would argue that they had ‘dead assets.’ They had plenty of assets (they owned homes that they had foreclosed on) and therefore had a high Net Asset Value. However, these assets do not pay the bills. Cash pays the bills and these assets were not creating any cash. Therefore, these banks had plenty of assets but could not pay their bills and were essentially bankrupt.
In addition, the Federal Reserve has lowered interest rates to the point that many banks are seeing an increase in mortgage applications. While some of these are to 'buy' a house, many of these applications are to refinance their existing mortgage. Nonetheless, this increase will help the banks create revenues and fees.
The balance sheet of banks should improve starting in the 2nd quarter of 2009 and improve going forward. FASB has changed the rules for how banks should account for their foreclosed assets. As previously discussed, the banks had to account for these assets according to ‘fire sale’ prices. Now a foreclosed asset can be recorded at its observable market price (or fair value of collateral). Therefore, because these assets are now going to be valued at a higher level, the balance sheet of many of these banks will improve.
Many of the large banks such as Goldman Sachs, JP Morgan, Citibank, Wells Fargo, and Bank of America have either shown nice profitability, or at least they have shown stability in their business. Most of these companies have seen nice improvement in their stock price recently. My opinion is that these stocks will continue move upward through the summer. Wall Street analysts will like to see the growth from last year and start upgrading the stocks. These companies will see improvement in their profitability due to low interest rates and individuals refinancing their mortgages. Lastly, the balance sheets of these businesses will improve so the companies will look more stable than they did last year.
Fire sale: drastically reduces prices, the price you could get by selling an asset out on your lawn today.
Net Asset Value: the value of Assets minus the value of Liabilities
Dead asset: An asset or investment that is not creating any income or dividends. An example would be a rental property that has no tenant.
Balance Sheet: Assets minus Liabilities equals Owners’ Equity.
FASB: Financial Accounting Standards Board