Five worst industries for 2009 (5)

This is the last installment. Check out the previous posts on retailing, private equity, newspaper publishing, and advertising.


5. Banking

It’s hard to argue that any year could be worse than 2008 for the banking industry.

Investment banking – at least, the version of it practiced on Wall Street – doesn’t even exist any longer. All five major Wall Street banks are radically different today than they were at this time last year. Lehman Brothers went kaplooey; Bear Stearns and Merrill Lynch stumbled down the aisle to a government-arranged marriage with JPMorgan Chase and Bank of America, respectively. Morgan Stanley and Goldman Sachs, fearing the worst, became bank holding companies, essentially allowing the US government to regulate Wall Street into oblivion.

Commercial banking still exists, but is on life support. Washington Mutual went bankrupt. To avert ruin, Wachovia was sold to Wells Fargo. Mergers saved others as well – National City comes to mind. Survivors are badly shaken and many are technically insolvent.

Government bailout money meant to be dispersed throughout the economy has instead landed in bank vaults, much to the consternation of taxpayers, but the problem in the banking industry – and the economy at large – is not chiefly a liquidity problem…it’s a solvency problem. Small wonder, then, banks chose to sit tight on the windfall from Uncle Sam.

It’s amazing to me, as I’ve watched the financial crisis unfold (and I date it from June 2007, when those two Bear Stearns’ hedge funds failed), the biggest problem is still dogging us – the solvency of the banks. When the challenge was merely a “financial” crisis, our main problem was figuring out how to price and dispose of the structured financial instruments at the heart of the crisis, but that seems like an age ago, as the crisis jumped the track – particularly after the Lehman debacle – and has destroyed economic activity at quite a rapid clip.

Still, there are the banks at the center of the drama, unable to adequately recapitalize and incapable of shedding the bad assets that keep fracking up their balance sheets. The government gave them money because, frankly, no one in the administration knew what else to do. It is wise to give blood transfusions to trauma victims, but eventually some surgery is required. We gave the transfusion, but no one had the skill, power, or accountability to begin cutting, and in some cases, the government has acted in a manner not always conducive to the good health of the patient.

Take, for instance, the notion of “cram-down” mortgages. Under the terms of legislation currently pending, a bankruptcy judge would have the authority to alter the terms of mortgage loans essentially by fiat. This authority would be exercised in an effort to curb the rising number of foreclosures. But what is good for homeowners isn’t necessarily good for the banks. Succumbing to intense political pressure, Citigroup declared earlier this month that it supported cram-downs, a position clearly against the interests of the bank’s shareholders (excepting the government, of course). No one should have been surprised when the value of Citigroup’s loan and derivative portfolio sank even further, putting even greater pressure on the bank’s already weak balance sheet.

Preventing foreclosure seems like a noble end, but doing it through cram-downs is simply robbing Peter to pay Paul. This situation highlights everything that is wrong about government-owned banks. It also highlights the government’s very first misstep in this crisis, which was to commit to buying significant chunks of the banks’ mortgage-backed assets and not following through on the commitment. Doing this would have essentially put a price floor beneath the banks’ assets, allowing each bank to determine with greater accuracy its solvency problem. As things are, the banks are still hemorrhaging value at an alarming rate and hoarding cash, and we are still very much threatened by a cyclic and global meltdown of the financial system. The cram-down legislation makes this worse by artificially deflating the market value of the already deflated mortgage-backed securities. After all, what investor would take a gamble on these securities if a bankruptcy judge has exclusive and final authority to alter the loan terms of mortgages sliced into the securities?

This is but one area afflicting the banks. Loan portfolios across most major lines of business are also performing poorly. There is nothing in the offing that would suggest such a rapid rise in profitability t offset rotting assets, especially so since we have not begun any real workout of the bad debt. The banks are underwater and are likely to remain so for 2009.


The Survivors

Your guess is as good as mine. I can’t decipher a bank balance sheet, and the truth of the matter is that most bankers can’t either. There is zero transparency in the industry. Witness the recent bait-and-switch job performed by Ken Lewis at Bank of America (BoA), which posted fresh losses of $15 billion, allegedly due to its exposure to Merrill Lynch’s business. If an army of due diligence professionals can’t uncover $15 billion in liabilities in a merger scenario, how the hell am I supposed to?

Of all the industries I’ve examined in this five-part post, banking is the one that, in its entirety, is too hot to handle. A sane investor would not touch any of them, included the purported kings of the hill like JPMorgan, Goldman Sachs, and Wells Fargo. And, as the BoA losses and the bizarre Citigroup announcement attest, once the government gets involved, there doesn’t seem to be any rhyme, reason, or regulation as to why the banks act the way they do.