If You Think the Worst Is Behind Banks, Read This

With the banking stress tests now completed, investors are finding it more sensible than it's been in months to invest in banks. Clarity, they'll tell you, is returning to the industry. We can now make informed estimates as opposed to the blind guesses we were stuck with in months past. Not only do we have a roadmap of a bank's future, but heck, the stress tests prove that no big bank will completely bellyflop and go under, right?

Kinda. Sorta. Not really.
Some will say yes. I still think the recent rally in bank stocks is grossly overcooked. Contrary to the litany of comments and e-mails, it's not because I'm a "paid basher trying to cover my shorts." It's because the stress test data that's been behind banks' explosive run is blindly running in the face of two objecting points:

  • Investors misinterpreting the data as meaning that the worst is over.
  • The forward-looking assumptions used in the stress tests may have been far too optimistic to begin with.

Here are two points you should consider before assuming banks are out of the woods.

1) What did the stress tests really show?
Last week I wrote, "Raising capital is designed to help [banks] through the 100-year storm, but that storm will still make their lives miserable for years to come." 

In other words, the stress tests demand that every major bank wear a bulletproof vest, but just the fact that they're wearing bulletproof vests should tell you something. They're marching straight into a war zone, and it ain't going to be pretty.

To see what I mean, look at the estimated losses the stress tests assume that major banks could face over the next year and a half:

Bank

Estimated Losses Through 2010

Citigroup (NYSE: C  )

$104.7 billion

Bank of America (NYSE: BAC  )

$136.6 billion

JPMorgan Chase (NYSE: JPM  )

$97.4 billion

Wells Fargo (NYSE: WFC  )

$86.1 billion

Goldman Sachs (NYSE: GS  )

$17.8 billion

Morgan Stanley (NYSE: MS  )

$19.7 billion

American Express (NYSE: AXP  )

$11.2 billion

Source: Federal Reserve.

Note that the estimated potential losses over the next 18 months are considerably larger than the losses taken over the past 18 months. In fact, the cumulative loss estimates of the 19 banks that underwent the stress test is $599 billion by the end of 2010, compared to less than $400 billion that the same banks have recognized since mid-2007.

Don't confuse what that's saying: In terms of losses and writedowns, the next 18 months are expected to be worse than the preceding 18 months.

Take that any way you wish. I don't see how you can put a positive spin on it, regardless if the said banks now have enough capital to avoid death. The ability to avoid death doesn't mean you're healthy. Nor does it make you worthy of an investment. Not by a long shot.

Granted, some banks were pricing in death before the rally began. But that's far from the case today: Wells Fargo trades where it was in late 2007; Bank of America trades where it was before we realized what a mess Merrill Lynch is. Banks aren't pricing in death -- they're pricing in perfection. That's scary.

2) Besides, who says the stress test assumptions will be accurate?
A more pressing question might be whether the assumptions -- and that's all they are -- were stressful enough. Bank CEOs will tell you they were. Bank of America CEO Ken Lewis said of the stress test: "Never has a test been so aptly named."

But many less-biased analysts feel quite differently. As the Wall Street Journal recently wrote:

… the Fed used a different measurement of bank-capital levels than analysts and investors had been expecting, resulting in much smaller capital deficits … Bank of America's final gap was $33.9 billion, down from an earlier estimate of more than $50 billion … Citigroup's capital shortfall was initially pegged at roughly $35 billion, according to people familiar with the matter. The ultimate number was $5.5 billion.

The old saying about financial modeling, "garbage in, garbage out," should start resonating right about now.

Another, more shocking example of how optimistic the stress test assumptions are comes from estimated unemployment rates. The Treasury's "worst-case" scenario used in the stress tests assumes that unemployment could hit an average of 8.9% in 2009. (Have a look.)

This should sound quite peculiar to anyone who saw last week's labor report, which shows unemployment currently sitting at 8.9%.

When the "worst-case" scenario is already happening, it's disturbingly obvious that the stress test aimed low in order to achieve the desired results. This should be unsettling for anyone taking the stress test's word as gospel.

And judging by banks' recent performance, many people are.

For related Foolishness:

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. American Express is a Motley Fool Inside Value recommendation. The Fool owns shares of American Express. The Fool has a disclosure policy.


Read/Post Comments (38) | Recommend This Article (235)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 12, 2009, at 11:23 AM, megabuc wrote:

    Citibank is broke and will close. The Tarp money will be taken over by the Fed when it put Citibank into Nationalization very soon. Citibank is done in 2009. The massive losses at Citibank are mind blowing as the creation of a madman have come to its end.

  • Report this Comment On May 12, 2009, at 12:36 PM, g2knee wrote:

    You are silly. If Citi is going down, BofA is DEFINATELY going down. If both those banks are going down, we probably have more to worry about than our stock portfolios.

    There is a long, rocky road ahead, but we are doing just for the future. Citi is doing fine too. Hard work will pay off a year or two down the line.

  • Report this Comment On May 12, 2009, at 1:02 PM, jstr2 wrote:

    Even if you take at face value the results of the tests, there is just too much optimism floating around the banking industry to warrant a rational investment decision.

    Things will get much worse, as they should, before they get better. The problem arrises as to the timing of "worse" and "better".

    In my opinion, "worse" is on the short-term horizon while "better" is still a very distant, dim light away.

  • Report this Comment On May 12, 2009, at 2:13 PM, PricePro12 wrote:

    The banks' i feel that the "Worse" is over and there is only one way it can go from a bottom and that is up.

  • Report this Comment On May 12, 2009, at 3:18 PM, Rubini wrote:

    I am short, history repeats itself and this is exactly what happened during 1929, but most people are too foolish to learn from the past. It is possible that everything continues to climb a little before all you fools realize that unemployed people cash out, funds are dried up and a simple supply and demand mismatch sends all stocks tumbling down upon the realization that everything will not be OK in 6 months and that the whole foundation of the economy has now changed. Of course I wouldn't overleverage myself until panic returns. I expect it to be soon. Cheers.

  • Report this Comment On May 12, 2009, at 3:33 PM, FleaBagger wrote:

    g2knee -

    What do you mean "If... [then] we probably have more to worry about than our stock portfolios." If nothing: we DEFINITELY have more to worry about than our stock portfolios. Our jobs, for one thing, as unemployment climbs into double digits and up, up, and away. Our housing, as home prices go down and foreclosures and rents go up. Our ability to buy food, as we have no job and no house, and government inflates the currency in desperation to save crap-@$$ banks, robbing us of the purchasing power of our savings, which is either in inflation-vulnerable cash, more inflation-vulnerable bonds, or falling stocks. You and I have a lot more to worry about than our stock portfolios, but that's a good place to start.

    Rubini -

    There are a lot of similarities between now and the Great Depression, but there are a lot of differences, too. The severity of our situation, I think, is equal, and the failure of the people to realize that is based on a misplaced confidence in those in power. The confidence of taxpayers and voters in their government to do the right thing to save the economy is similar to the confidence of Citi and BofA shareholders in their respective CEO's and boards. And, after all, after something as bad as the Great Depression happened, who, being trusted to prevent it from recurring, would be foolish enough not to learn about it and stop it from getting that bad? They fail to realize that the people in power in government have a vested interest in misunderstanding the causes of the GD.

    By the way, the stock market rallied big throughout the Great Depression. You would be wise to be careful how you short it. There will be a bottom in the stock market, and those who are short after that will feel quite a sting between rising stock prices and rising inflation. This will be well before the actual economy and the labor force recover.

  • Report this Comment On May 12, 2009, at 4:01 PM, Deepfryer wrote:

    I have an issue with the very first sentence of this article:

    "With the banking stress tests now completed, investors are finding it more sensible than it's been in months to invest in banks."

    But they FAILED the stress tests! So how is it now more sensible to invest in the banks?? They're INSOLVENT!!! That's why Obama and the rest of Washington aren't talking very much about the stress tests... they were a complete disaster!

    The stress tests weren't even stressful enough to reflect the reality of the economic situation that we are already in ("worst-case" unemployment estimates were too low). The point is, the stress tests were too easy, and the banks still failed them! The worst is yet to come...

  • Report this Comment On May 12, 2009, at 5:15 PM, AWF wrote:

    Based on the "new" FASB rulles the banks are just fine!

    If the banks are fine then aren't the companies that rely on the banks for capital just fine too!

    If the companies are fine then is'nt the economy just fine!

    If the banks ,the companies and the economy are all fine then the "Stockmarket " is way undervalued!!

    Don't you feel better now?

    BTW-- I have some recently cleared property on Crystal Beach (Galveston) for sale--beautifull ocean view!!

  • Report this Comment On May 12, 2009, at 5:15 PM, hooooon wrote:

    all the worst is over comments are comedic, at best. these banks still trade for billions of dolloars. they are crap. buy "low" and sell when? lower or never?

  • Report this Comment On May 12, 2009, at 5:52 PM, whypher wrote:

    Who is foolish to buy banks for the long term, no one! Who is foolish to short the banks, I am. For now!

  • Report this Comment On May 12, 2009, at 5:58 PM, johnd99 wrote:

    If some you think the worst is over for the banks, you will find out the hard way.

    A potential collective TRILLION dollars in losses coming.

    But hey, they passed the stress test right?

  • Report this Comment On May 12, 2009, at 6:01 PM, kyddfool wrote:

    the best advice: DON"T BUY BANK STOCKS! and be sure the one that holds your cash/savings are strong enough - There is a web-site www.moneyand markets.com/banks where you can check the safety of your bank.

  • Report this Comment On May 12, 2009, at 6:09 PM, nwobo wrote:

    I'm not the brightest crayon in the box but I think the worst is yet to come.We have a whatever trillion debt,taxes are going up,oil is going back up and people are still losing jobs.I have a funny feeling this rally will come to a screeching halt and the banks that passed the so called "stress test" will be in even worse shape.

  • Report this Comment On May 12, 2009, at 6:16 PM, Seano67 wrote:

    I've been reading a lot about these stress tests over the past week from people who are really in 'the know', analysts who are intimately tied into the US banking and financial systems (including former officials of the Federal Reserve and Treasury Department), and the consensus viewpoints about these tests is an overwhelmingly negative one, coming from these people who are non-biased and are more qualified to judge this particular thing than anyone else out there.

    You see some of the ways they describe these stress tests, and I'm quoting here, 'a fiasco', 'a complete waste of time', 'a bad joke', and on and on and on. So yeah, Barack and Ben and little Timmy can try and polish up this piece of poo however much they'd like, but in the end it'll just be a little shinier piece of poo.

    **and not to be crude about it, but the analogy does seem to fit.

  • Report this Comment On May 12, 2009, at 6:53 PM, zanemorris wrote:

    Sounds like it is time to short the financials. Long on SKF even it Cramer says its evil..

  • Report this Comment On May 12, 2009, at 7:25 PM, Dart65GTConv wrote:

    One comment JPM lights out!

  • Report this Comment On May 12, 2009, at 7:26 PM, jbrt wrote:

    gloom , doom , gloom and more doom , go build an ARK ! don't pay your mortages, insurance , taxes, car payments . Bury your moneies in a waterproof container in the yard . Yeah Right ! the banks are going under, blah blah blah , you lost in November , get over it, money will be useless blah blah blah , whoever subscibes to this crap out to have their head examined.

  • Report this Comment On May 12, 2009, at 7:27 PM, jbrt wrote:

    whos kidding who

  • Report this Comment On May 12, 2009, at 7:30 PM, Dart65GTConv wrote:

    JPM GOING UNDER TO BIG TO SAVE. WILL BE TIME TO BUY STOCKS AGAIN.

  • Report this Comment On May 12, 2009, at 7:34 PM, Dart65GTConv wrote:

    Have no quams with bank problems FAS bought Me a sailboat access condo in se fl this is hope for me. Love these idiots. They make me wonder why I do this crap full time.

  • Report this Comment On May 12, 2009, at 7:38 PM, Dart65GTConv wrote:

    Also, let me Thank our hosts Motley Fools for turning me on to this perfect buy sell buy sell etf. Was tuned in right on that one, learned some trading skills there.

  • Report this Comment On May 12, 2009, at 7:56 PM, afamiii wrote:

    Citi and BoA are broke, but they won't go bust. The USA will be broke at the end of this, but they won't go bust either.

    The working people of USA, China and to a lesser extent Europe and India will end up paying the true cost of this fiasco. By having to work harder and longer for less reward. www.smartinvestorafrica.com

  • Report this Comment On May 12, 2009, at 9:05 PM, Dannysea wrote:

    Work in the foreclosure industry for years. The banks are losing about a million on every 3-5 houses, depending on the community. That is the bottom line strain. And the Fed is making them give out loans right now to the same people. These same people will not be able to hang on any easier when they are faced with new roofs, well equipment replaced, AC systems worn out, etc. They can hardly afford the 3% down to get in now.

    And have you tried to get a loan if you are white and have 800+ credit rating?

    This pres thinks he is the Jimmy Dean breakfast sandwich.

    One of the best articles coming out of MF.

  • Report this Comment On May 12, 2009, at 9:07 PM, RaptorD2 wrote:

    I find it incredible that anyone would argue that the banks are "better than expected" or that this article is headed in the wrong direction. Don't we all read basically the same news and reports?

    So rather than chastise anyone, I will say that I am loading up on SKF, and if you must buy the banks, I am on the other side of your trade and I thank you for your donations.

  • Report this Comment On May 12, 2009, at 9:09 PM, paultaut wrote:

    It Must be April Fool Again, Right?

    What utter foolhardiness. There Will be no Bank failures. Where have you been for the past few months? Banks will appear to prosper whether they really do or not..

    The Government has learned that they can do what they want with nary a whimper out of the Media. They can alter Contracts after the fact, they can Change accounting Rules to hide what they want hidden. Judges will do as asked. They can replace managements that don't do their bidding.

    There isn't anything that can't be renamed, backdated or quarantined. Variable option Arms can be renamed as Fixed Rate mortgages. You name the problem, it will be fixed.

  • Report this Comment On May 12, 2009, at 9:43 PM, drbob22 wrote:

    I'm not surprised when readers misinterpret bank stress tests, but when the author does, what's going on? The words "estimated losses the stress tests assume that major banks COULD face over the next year and a half" suddenly morph into "In terms of losses and writedowns, the next 18 months are EXPECTED to be worse than the preceding 18 months..." No one expects the stress test scenario as the most likely outcome. That's why it's called a STRESS test. C'mon, get it right.

  • Report this Comment On May 12, 2009, at 10:30 PM, CAPTAINWACK wrote:

    Good to see that a few fools can still read between the lines. Citi and B/A are both done. I closed my accounts with B/A last year due to the lack of fair loan practices they follow. They saw a way to capitalize on low income people and now it's back to bite them in the nuts. HA HA HA

    But wait? where has all the TARP money gone? Why do these banks still need money?

    This is how it's being spent....first you get a no interest loan from the government (AKA bailout). Then you use the financial arm of a banks business to invest it in stocks and bonds. (which is why we have the current rally on Wally Street)

    But first we'll have a few of the top banking officers invest in these same stocks and bonds before we go on this massive spending spree so these officers can reap huge amounts of profits. (this is not insider trading). It's time fools to take a closer look to see why this rally is happening in the first place and who is benefiting from it.

    The rich are getting richer, the middle class and poor are going nowhere fast.

  • Report this Comment On May 13, 2009, at 6:03 AM, 7footmoose wrote:

    what will happen to the banks and to the economy, I cannot predict, no one really knows exactly where the financial system or the economy will be in six months or a year, what i do know is that there needs to be a working financial system for the economy to prosper, 4000 small banks each with assets of $1.0 billion are not prepared to take over for even one of the "Zombie Banks" mentioned above, if any of you expect to remain employed or to be reemployed or to have any of your current stocks retain any of their current value you'd better hope that at least part of the US financial system is viable because without a working system to move money around the country and the world we are destined to a DOW 4000 and an S&P of 300

  • Report this Comment On May 13, 2009, at 9:11 AM, jesse2159 wrote:

    Does anyone who is not in an insane aslyum, actually believe that banks that were "insolvant" on March 1st, suddenly, and without any rational reason, suddenly become profitable three weeks later? This economy is like turning around a supertanker. It will take years, not weeks or months to see the actual turn around.

  • Report this Comment On May 13, 2009, at 9:40 AM, wasmick wrote:

    Hi! I don't know anything about this either so obviously I'm required to comment here. Plpus I just never get tired of reading the same old hash getting slung around for the millionth time.

    Oh can we please, please, please have an article tomorrow on the automakers? There's another topic that needs to be front and center because I'm sure everything is different in that space now.

  • Report this Comment On May 13, 2009, at 1:21 PM, PricePro12 wrote:

    I read this morning something about Commodities are rising, the dollar is falling and the trade deficit is growing. Everything bad is good again, thanks to the Feds. It is a great article on this matter i heard it from a friend of mine pretty cool site check it out www.greenfaucet.com hope this helped anyone

  • Report this Comment On May 13, 2009, at 2:10 PM, Bonefish100 wrote:

    GEEZ! Let's get off it. We're trapped into thinking that "big" corporations and banks are the bread and butter of everything. The facts don't support this supposition. 75% of the employment in this country is by companies of 50 or fewer employees. While we're all gawking at BofA, Wells Fargo, Citigroup and the lot, there are THOUSANDS of community banks that are solid and doing well.

    Whatever happened to perspective?

  • Report this Comment On May 14, 2009, at 6:27 AM, marktsgooch wrote:

    First - good article.

    Second - observation from 'other side of pond'.

    The way the US government is throwing money at the banks reminds me of the UK government trying to keep the GBP in the ERM by pouring money into it.

    The expensive lesson we (hopefully) learned was: "Even governments aren't big enough, and don't have deep enough pockets, to beat Mr Market".

    The US government does not have enough money to rescue the financial system. Eventually it will have to stop pouring money in and let the market take its course. At that point the US will realise that all the money poured in is lost. Wasted. But still has to be paid back.

  • Report this Comment On May 16, 2009, at 2:06 AM, Nosnikta wrote:

    Curiosity begs why are Dow 30 orgs that have been nationalized still Dow 30 orgs? I believe that any firm whose financials can be manipulated by government is not a true representative component of the nation’s industrial market profile and should be removed from the 30. If you challenge that view, why not include the Postal Service or the Coast Guard.

  • Report this Comment On May 16, 2009, at 9:59 PM, Matt8265 wrote:

    S&P down to 450 as the pumpers at GS short.

  • Report this Comment On May 18, 2009, at 5:44 AM, catnapper06 wrote:

    Have been "away" from Motley Fool for quite some time, due to a growing sense in early '07 that storm clouds were gathering and MF was entirely too optimistic at that time (no offense to anyone, really - I have much respect for the Fools.) About that time I discovered Minyanville, and if I may say so, their collective commentaries got me completely out of the markets prior to the eventual collapse in Sept. '08 (I even briefly shorted and profited with SDS.) When I left the Fool, I noted to the staff that they might benefit from having at least one subscription service dedicated to a contrarian opinion, just in case buy and hold didn't quite work out as everyone seemed to think it always would.

    Having noticed this article on MSM money and wound up here, I am glad to see so much evidence that many posters are seeing things with their own eyes and not buying into the idea that what we are being told by Main Stream Media is always true. And I agree that as strange and problematic as things have been over the course of the last year, we can expect them to get even stranger and possibly worse before this is over, whatever "this" is.

    Be safe. It ain't over.

  • Report this Comment On May 18, 2009, at 5:20 PM, Joewantswork wrote:

    If You Think the Worst Is Behind Banks, Read This.

    "Signs you may be on the next RIF list" at http://joewantswork.blogspot.com/

  • Report this Comment On May 19, 2009, at 1:45 AM, oldchecker wrote:

    Long on SKF. Need I say more?

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