During the financial panic stage of the global financial crisis, banks wrote down some $1 trillion in securities. Much of this came as banks took losses on thin to trade or never traded securities. What President George W. Bush’s Treasury branded “toxic” assets.
Now it looks like banks will have a chance to write back up some of those securities when they report results for the third quarter, which ends for the majority of companies on September 30. The Market ABX index, which tracks the price of such assets as mortgage-backed securities based on a portfolio of subprime mortgages, is up 30% in the last three months.
So some banks will be able to report big gains on their portfolios of damaged assets when the release third quarter earnings. And that has the potential to get investors really excited about the recovery in the financial sector. A rally in financials, one of the sectors that have led the stock market higher since the March 9 low, would put new momentum behind a rally that has started to look shaky recently.
The question for banks is how much of this 30% gain should they book now. And the question for investors is how excited they should get over what is essentially an accounting gain.
Here’s my take.
I think many banks know that the same market that produced this 30% gain in these toxic assets can take it away again. Investors pushed up prices of these securities as part of a global increase in the willingness to take on more risk. The same increase in risk tolerance is behind the fall in the safe-haven U.S. dollar and the huge move up in emerging country stock markets. From experience, though, bankers should know that this can reverse in a moment sending the prices of these toxic assets back down. The last thing they want to do is to book gains in their portfolios of toxic assets this quarter that they have to reverse in December or March.
In other words, investors should watch out for banks that take a very aggressive stance toward booking gains this quarter. Look at the banks that came through the crisis in decent shape such as JP Morgan Chase (JPM) and Banco Santander (STD) for guidance on the difference between booking reasonable gains and being too aggressive.
Investors should restrain their enthusiasm over the gains booked this quarter. There’s still a lot of toxic paper out there that could yet blow up–just look at continued deterioration in the credit card and commercial mortgage portfolios of banks in the last few months. The companies with the most to gain from the rebound in the price of toxic assets are also the most likely to have big problems to come in their other portfolios. After all, they got into trouble in the first place because they didn’t control for risk very well.
And investors should remember that any gains booked this quarter don’t necessarily have anything to do with success in the long run. Many of the banks that book big gains in the short-term are exactly those that are just hoping to scrape by. They don’t have a future strategy in the changed banking sector. They’re just hoping that they can get to the point where they have a future.
Even though the crisis isn’t over, I think we can pick out a few banks that are already grabbing future profits from the troubles at other banks. I’ll post later today with the names of some of these sector winners.