How Are The Banks Doing? It Depends Who You Ask

What is going on with the banks? What are they doing with all that government TARP money? Are they crumbling, are they lending, are they solvent, are the toxic assets causing them to fail or are they just fine? As usual the answer isn’t simple and depending who you ask you will get a different answer. It all depends on your perspective.
As a bank executive your job is keep your bank alive. The primary reason companies fail is they spend more cash than they collect, In other words, they are cash flow negative. Based on recent financial reporting announcements, banks are cash flow positive due to increased fees from transactions they have facilitated and increased deposits. Many still have negative earnings due to write downs (on bad loans) but they can pay their bills and keep the lights on. So bank executives are relieved that the panic seems to be over and their banks can remain viable ongoing concerns.
However bank executives aren’t happy that their pay has been limited by government regulation related to the TARP funds. They also don’t like being lumped in with big bad wolf - AIG. So they want to give the government back its TARP funds as quickly as possible. Bank execs could care less about lending more money and stimulating the economy because there few incentives to make a lot of new risky loans. From a bankers perspective it would be better to hold on to the cash and use it to pay back the government’s TARP funds.
To make matters worse for the bank execs, the government wants the banks to sell their troubled (toxic) assets in order to free up capital to make new loans. These toxic loans have not been written down to their current market price because execs view these prices as just a market glitch. The current market for these assets is essentially frozen. The few transactions that take place are at a greatly discounted price. Many of these securitized investments are receiving a large portion of the interest and principal payments on time. So bank executives see no reason to sell these assets for a loss when they are generating an adequate cash flow. Now that the panic in the credit markets has subsided, the bank executives see no reason to cooperate with the government if it is not in their best interests.
The government’s objective is to get the economy up and running. To do this they need the banks to be lending. It is the lack of liquidity in the markets that caused most of the panic. The banks were leant the TARP funds to show the financial markets that the Treasury and the Federal Reserve had no intention of letting any more of the larger banks fail. In return, the banks were supposed to increase lending to consumers and companies thereby stimulating the economy. However, the banks are not cooperating and lending has fallen. An analysis by the Wall Street Journal of Treasury Department data showed that the largest banks refinanced 23% less in new loans in February than in October 2008 when TARP was launched.
Supposedly the government is stress testing the banks to see if they can survive tough market conditions. However, it is not in the governments best interests to have any of the banks fail this test. If most of the banks failed the government would not be able to prop them up again. The stress test may only be a political tool the administration is using to make the banks keep the TARP funds.
The Treasury Department wants to avoid any political backlash stemming from the banks reduced lending. The Obama administration wants the banks more accountable. It wants them lending. Currently, the government has little say regarding how the banks operate due to how the TARP legislation was structured by former Treasury Secretary Paulson. Since bailout funds are dwindling the Treasury has few options and little clout with the banks. One option that the Treasury has begun to consider is turning the TARP loans into equity (stock in the banks). This costs the taxpayers nothing. The losers in all this will be the investors that own bank stocks. Investors will find their ownership positions diluted and the value of the stocks would fall substantially.
So how are the banks doing? It depends who you ask and what metric you use.

Bank Loan Investment Funds

Two years ago I started investing in bank loan mutual funds for many of our clients. They are a great way to diversify a portfolio without giving up bond income. Last year our bank loan investments earned approximately 9% versus the Lehman Bros Aggregate ishares which earned only 4%. Not bad for a bond fund that is senior secured debt and regularly resets for interest rate changes.

Senior floating rate loans are loans made by U.S. Banks and other financial institutions to large corporations. Floating rate funds are less susceptible to interest rate risk than fixed rate bonds because rates are periodically reset to the prevailing interest rate. So if interest rates increase slowly this fund is less apt to generate a negative return. These loans are the senior source of capital in a borrower’s capital structure (they are first in line if the company goes bankrupt) and have some of the borrower’s assets (real estate, machinery, investments) pledged as collateral.
So if the borrower defaults on the loan the assets become the property of the mutual fund. The value of the collateral may not offset the full value of the loan but the Eaton Vance fund has tried to minimize the risk of default by monitoring creditworthiness of the borrowers carefully and spreading risk by investing the fund in over 450 separate loans. Rarely does a loan represent more than 1% of the fund’s assets. This broad diversification helps to minimize the impact of default.

Year-to-date the Instituional shares are up 2% versus the Lehman Bros Aggregate ishare ETF (AGG) which are up 1.7%.

Attached is a write up by Eaton Vance regarding bank loans.

http://www.eatonvance.com/alexandria/2096.pdf

The Financial Pragmatist
Libby Mihalka