Have banks turned a corner?

The improved earnings reports of recent days are welcome news, but a rising tide of loan losses still threaten the industry.

Eric Risberg/AP
The headquarters of Wells Fargo are in San Francisco. The bank recently forecast a first-quarter profit of about $3 billion, easily surpassing analysts' estimates.

A week of good news about profits doesn't mean that banks are on the road to recovery.

Despite billions of dollars in first-quarter earnings, announced in recent days, troubled loans still pose a major problem for the health of banks.

That's a problem not just for the banks but for the US economy overall as it struggles to emerge from a deep recession. If banks remain fundamentally weak, economists say, it will affect their ability to lend – and a solid economic rebound will be hard to achieve.

So how healthy are the banks, really?

On the face of it, the news in recent days is encouraging. Profits are a sign that bank performance isn't plunging off a cliff. JPMorgan Chase, Wells Fargo, Goldman Sachs, and the credit arm of General Electric have reported billions in black ink. Even the laggard Citigroup cited progress Friday, reporting a smaller-than-expected loss for the quarter.

But the problem is that a rising tide of loan losses still threaten the industry – not just home foreclosures, but also defaults on credit cards and business loans.

"The housing-market decline is not over," says Desmond Lachman, a finance expert at the American Enterprise Institute in Washington. "You've got a commercial real estate bust that we're really just at the start of. You're getting a lot of corporate defaults."

All this, he says, means that banks will need a lot more capital to cover those losses, while also allowing them to fuel a recovery with new loans.

Some banks, it's true, hope to repay the capital invested by the government in recent months from the Treasury's Troubled Asset Relief Program (TARP). They want to get out from the stigma and constraints that go along with that money.

But whether the funds come from government or private investors, banks' need for capital remains large, say economists who track the industry.

Here are a few gauges of bank-industry health, pro and con. First, some positive factors:

• Profit margins on good loans are rising. Interest-rate cuts by the Federal Reserve are allowing banks to widen their spreads between their borrowing costs and what they earn on loans. Insiders call this a boost from the "yield curve" – the difference between short- and long-term interest rates.

• There's no "run on the bank" by depositors. The Federal Deposit Insurance Corp. (FDIC) has bolstered its guarantees, insuring accounts up to $250,000 for this year, up from $100,000 normally.

• Banks can still borrow by issuing bonds. Since the launch last fall of a special FDIC program, banks have been able to issue $269 billion in new bonds with a federal backstop.

• Some banks are able to raise capital in private markets, a stamp of solvency. Goldman Sachs, which converted last year from an investment bank to a bank holding company, announced plans this week to offer $5 billion in new stock.

• Banks are selling or writing off many of their bad assets. Citigroup, for instance, said that a pool of its riskiest loans declined in size from $227 billion at the end of 2007 to $101 billion now.

In addition, banks have been cutting expenses through layoffs. All this helps explain the recent news: Wells Fargo forecast a profit of about $3 billion for the quarter, JPMorgan Chase reported earnings of $2.1 billion, Goldman earned $1.8 billion, and Citigroup lost money but at a slower pace than last year – red ink of $966 million for the quarter.

Now, the negatives:

• The value of key collateral on loans is still falling. About half of bank lending is tied to real estate, which shifted from boom to bust in many parts of the United States. The typical home price is down more than 20 percent nationwide, and lately, it's been falling by about 2 percent a month. If that continues, it boosts both the likelihood of defaults by borrowers and the losses for banks when they resell those homes after foreclosure.

• Loans are going delinquent faster than banks are adding to reserves to cover those losses, the FDIC finds. That could hit bank profits down the road.

• Accounting methods may be hiding key problems. Banks say that a shift away from so-called mark-to-market accounting is a more accurate reflection of the assets' worth, and they may be right. But the resulting values could also prove to be too rosy. Take that pool of risky assets at Citigroup, which the bank is valuing at $101 billion. A mark-to-market approach would put the value at $29 billion, Citigroup says.

• Losses could outweigh capital on hand. Collectively, US banks have equity capital of $1.2 trillion, or about 10 percent of their loans, the FDIC says. Economists including those at the International Monetary Fund (IMF) warn that bank losses – including those not yet recognized in charge-offs – are larger, possibly exceeding $2 trillion.

"It could wipe out their equity capital," says Peter Nigro, a former economist at the Office of the Comptroller of the Currency, now at Bryant University in Smithfield, R.I.

Taken together, the negative forces make it very hard for banks to earn their way out of losses by relying on their interest-rate spreads.

"What the yield curve is doing is ... mitigating those losses a little bit," says Mr. Lachman, who has worked at the IMF.

Moreover, he expects that European banks will see rising loan problems this year, with ripple effects that hurt US banks as well.

All these challenges don’t mean that some of America’s large banks will fail. The Obama administration has tried to put in programs to bolster the biggest ones with capital as needed.

In one part of the plan, Treasury Secretary Timothy Geithner has created incentives for private investors to buy troubled assets from banks. By absorbing much of the risk, the Treasury may succeed in boosting the price of those assets from what investors would ordinarily pay.

The other Geithner bank-rescue plan involves a “stress test” of the biggest banks. If the result is that some banks need more capital to weather the recession, they will be asked to raise it in the private markets or to receive an infusion from the government.

In a speech at Georgetown University in Washington this week, President Obama responded to critics who say this approach will cost more, or be less effective, than a tougher tactic in which troubled banks are taken over by the government and restructured.

“We will do whatever is necessary to get credit flowing again, but we will do so in ways that minimize risks to taxpayers and to the broader economy,” he said.

Still, any further assistance for banks faces a steep political hurdle. Congress and the American public have little appetite for more bailout money. And there’s not a lot left in the $700 billion TARP.

“I’ve got a lot of sympathy for Geithner,” Lachman says. “This is complicated stuff that is highly politically charged.”

For the economy to stage a strong recovery, banks need enough capital to lend strongly, economists say. That’s especially true because other channels of credit that were strong before the recession – debt securities funded by nonbank investors – have withered.

The risk, they say, is that the political pressures will prevent or delay an accurate assessment of bank losses – how big their write-downs should be and how much capital they need.

“The issue that still remains is, what are these assets on the bank balance sheets actually worth?” Mr. Nigro says. “We have to wait for results of the stress test.”

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