US bank profitability
From anecdotal evidence, there appears a general reluctance on the part of both local and global banks to extend new advances. This is understandable following the aftermath of the credit crunch. But how then does this line up with announcements, especially from the US, of record second quarter profits.
US banks have mostly reported large increases in second quarter profits. These have come in ahead of profit forecasts and have definitely helped boost share prices over the last few months.
Wells Fargo one the US’s largest mortgage lenders, which acquired Wachovia in January, reported second quarter profits yesterday up 81% to $3,17 billion.
Bank of America, which itself acquired Merrill Lynch and Co earlier in the year, reported a 5,5% drop in profits, but still coming in at $2,42 billion.
Citigroup profits came in at $4,28 billion, but this was due to the profit on the sale of the Smith Barney brokerage.
JP Morgan Chase reported a rise in profits to $2,72 billion on record trading fees and stock and bond underwriting.
Investment bank and the fifth biggest in terms of assets, Goldman Sachs, recorded record profits 2 weeks back, with net income coming in at $3,44 billion
Credit Suisse has reported profits up 29% to 1,57 billion Swiss francs or £890m.
How have these banks generated these profits in an environment where they are not extending credit, bad debts or non performing loans are rising and the economy is still very weak?
A big area is the wide spreads from the virtually 0% on money market to the 4,5% on US long bonds. A report from offshore Standard Bank said the following on bank profitability, “Banks are going to try and make profits in the safest way they can and the safest way is simply to use the steepness of the yield curve that has been created by the central banks. The safest way is not to go out and extend credit to companies that might go to the wall”
In essence then banks have been given easy and virtually free capital as short term rates have come down close to zero. Instead of lending this out in the normal course, they have typically invested slightly longer and at higher rates and banked the differential as huge profits.
Nouriel Roubini, professor of economics at New York University’s Stern School of Business, aptly summed up the state of affairs as follows: “In brief, banks are benefiting from close to zero borrowing costs and fewer competitors; they are benefiting from a massive transfer of wealth from savers to borrowers given a dozen different government bailout and subsidy programs for the financial system; they are not properly provisioning/reserving for massive future loan losses; they are not properly marking down current losses from loans in delinquency; they are using the recent mark-to-market accounting changes by FASB to inflate the value of many assets; they are using a number of accounting tricks to minimize reported losses and maximize reported earnings”
The lending environment to corporates and the private market will normalise, but it may take a bit longer than the record profitability US banks seems to indicate.
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