Actually, Banks Could Be Very Profitable In Q1

There’s been deep scepticism over whether banks like Citigroup (C) and others should be believed when they say they’re profitable again. An industry insider forwarded us the following back-of-the envelope analysis to explain that yes, in fact, the major banks may be quite profitable in Q1. The key lies in the government’s effort to push down their cost of capital.

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When Lloyd Blankfein says he will be profitable, few people are surprised.  When Jamie Dimon casual mentions that JP Morgan is going to have a great year, the market barely reacts.  But when Vikram Pandit and Ken Lewis make similar statements about profitability, the bears howled in disbelief and the bulls used the occasion as the foundation for a 10 day market rally.

sceptical myself, I began to investigate how such a claim could be made, knowing full well that the price of making the claim without it ultimately being true would be a complete loss of any credibility still remaining at these institutions.  What I found is astonishing and worth thinking about carefully for those still short the financials (or the markets in general).

Financial Accounting Standards Board, the governing body on all things accounting, issued FAS 157 “Fair Value Measurements” to become effective for entities with fiscal years beginning after November 15, 2007.  Banks must use the methodologies outlined in this statement to value their assets thereafter.

The statement separates assets into three groups, called Level I, II or III assets.  Level I assets are stocks and other highly liquid assets for which valuation doesn’t warrant significant discussion.  Level II assets are allowed some degree of freedom based on market inputs but the hard to value assets are pushed into the Level III bucket.

With Level III assets, for which there is no market, the owner is allowed broad discretion in marking the assets to market.  The favoured methodology is a discounted cash flow analysis whereby the holder would estimate future cash flows from the asset and apply a discount rate to calculate the present value of the future payments.  This discount rate is central in understanding why banks will indeed be profitable in 2009.

While the banks were operating using private capital, their cost of capital was likely in the 4% to 6% range.  With the Federal Reserve driving rates down to near zero and providing, along with the Treasury, access to debt capital with very low interest rates, the cost of capital at this institution has come down considerably.  Recall that most of these programs were started late in the banks Q4 reporting period and we have not had a full three months operating under the rates.  Let us look at a simple example of what happens to the value of a 30 year interest only (IO) mortgage paying 6% when the holder’s discount rate changes from 6% to 3%.

Value at 6%: $100.00

Value at 3%: $158.80

So in our scenario, which doesn’t assume any impairment of the asset, the bank would realise a gain of $58.80 on the asset simply from a change in its cost of capital.  While it would, eventually, realise this over time if the mortgage performed and its cost of funding remained the same over 30 years, the statement would allow a bank to recognise the gain immediately.  This is, albeit, a simplistic example and the ultimate calculation would be more nuanced but you can see where this is headed.

With all the low cost funding provided by the Federal Reserve and Treasury, surely the banks will be profitable this year.  It doesn’t take a lot to make even a distressed loan look profitable if you tweak a few assumptions.

The problem comes when the mortgage holder stops making payments and the bank has foreclose and sell on the house.  Now instead of a nice revenue stream to discount, the bank has a real asset that has a value that is less fungible and reality will set in.

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