Shooting Against the Messenger

In the Emperor-has-no-clothes Department (and you thought E.D. stood for erectile dysfunction), financial analyst Meredith Whitney has been opening eyes ever since credit markets went limp in August 2007. Until then, big investment banks ruled. They were posting huge profits by peddling risky derivatives to greedy investors, as well as to unsuspecting state treasurers (that means you, Dave Lemoine) reaching for a few extra basis points of yield on cash reserves. But then skeptics like Madame Whitney began looking closely at (and behind) the banks' balance sheets and said "Hey, guess what, you guys are technically insolvent!" The CEOs at Citigroup and Merrill Lynch soon lost their jobs.

So began a cascade of defaults and bank runs that resulted in the disappearance of some of the biggest names on Wall Street--Bear Stearns, Lehman Brothers, even Mother Merrill. Executives in Brooks Brothers suits began jumping out of windows. Some had parachutes; some hit the pavement. It got so bad that bank operators masquerading as government officials (stand up, Henry Paulson) devised all sorts of taxpayer-funded programs to bail out their brethren. Rarely have acronyms sparked such acrimony: TARP, TALF, and TICKED OFF, to name a few. Congress went along, as it is paid to do.

Is the worst now behind us? Whitney thinks not, despite the fact that bank stocks have pulled out of their nosedive to zero. She believes the recent rally has been cleverly orchestrated by Oligarchy Inc. to provide a brief window of opportunity for teetering banks to issue new stock to smitten investors. Financial statements for the first quarter were massaged, nipped, and tucked to look almost good, earning most banks passing marks in the so-called "stress" tests just concluded by the Treasury Department. Those getting "Incompletes" were given time to raise additional capital. Capital requirements were calculated by extrapolating those puffed-up Q1 earnings.

Whitney insists that those "earnings" are not replicable. She points out that banks are sucking liquidity out of consumers' wallets, cutting credit lines to cardholders by $1 to $2 trillion. And as consumers retrench, sales-tax collections by state governments shrink (never mind the meltdown in income-tax payments caused by nearly 6 million layoffs in the past sixteen months). State and municipal spending accounts for 12% of GDP, so the wind-down becomes self-reinforcing. A V-shaped recovery, in Whitney's view, is highly unlikely. So, for that matter, is an L-shaped recovery.

She is thinking of a shape that is more, um, flaccid. Her pessimism, it must be acknowledged, has begun to grate on some industry cheerleaders. Despite her prescience thus far, she is bound to get it wrong at some future point. It happens to the best of them. But if you're thinking about betting against Whitney and buying into the financial-sector euphoria, you have to ask yourself, "Do I feel lucky today?"

[update, 05-27-09:]
The Federal Deposit Insurance Corporation just released its Quarterly Banking Profile, which shows that the number of "problem banks" in the U.S. increased in the January-March period from 252 to 305, with combined assets at risk approaching a quarter of a trillion dollars. Another 21 banks failed during the same period, the largest number since Q4 1992, shrinking the Deposit Insurance Fund from $17.3 to $13 billion. One bank in five lost money during the quarter. "Noninterest revenue is up at larger banks," pointed out FDIC Chair Sheila Bair, "particularly trading revenues"--meaning that profits were made not by floating a sinking ship, but by rearranging the deck chairs. Even after first-quarter charge-offs of $37.8 billion in bad loans, non-current loans and leases rose by $59.2 billion, or 26%. Of all loans and leases, 3.76% were non-current, the highest level since Q2 1991.