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March 11, 2009

Reports of Profits While Banks Fail
by John Browne

This week Citigroup shocked Wall Street by announcing that the company would be profitable in the current quarter. At the same time, the Obama Administration indicated that it would be unlikely to nationalize American banks, preferring to provide low cost funding to encourage the private sector to buy distressed assets from the banks. The two developments sparked a vigorous rally in financial stocks, which had been drifting downward for weeks, caught in what appeared to be an unending death spiral. But have the good times really returned?

On the surface at least, there are some promising points. Based on current income, and an upward trending yield curve (that will allow banks to borrow at nearly no cost from the Fed and lend to borrowers at a good profit) the banks should generate strong cash flow. But that is hardly the full story.

Write-downs in the value of toxic assets already held on bank's balance sheets will continue to explode like ticking time bombs. These debts may be too large to be overcome by a positive cash flow fueled by cheap access to short-term funding. If banks were simultaneously forced to write down assets, they could be rendered insolvent from a capital balance sheet point of view. This is the underlying problem that America and the much of the world face with their banks: banks can be trading with positive cash flow but from a technically insolvent capital position - which is illegal.

Some argue that toxic assets make up only a very small part of the total assets of the banking system. That may be so, but the real issue is the enormous size of the toxic assets in relation to both the capital of the banks and the funding ability of the government.

According to the Bank of International Settlements, the world's total of derivatives investments, including the poorly understood credit default swap (CDS) market reached some $700 trillion at its height, or more than 20 times the world's total annual production! The American portion was about $419 trillion, or some 40 times America's annual production.

The essential problem is that these inherently risky securities were used as collateral for loans. The fall in their value resulted in massive deleveraging. Of course, not all derivatives are yet flawed, or toxic. So, it can be assumed that, in the absence of a total financial collapse, only a limited number will default.

However, if a conservative assumption were made that only some two percent of derivatives fail, it would still amount to some $14 trillion. The American share would be about $8 trillion, or almost one year of GDP once that figure declines to a sustainable level. The estimated total capitalization of all U.S. banks is some $1.6 trillion. But, this amounts to only 20 percent of the potential American liability.

So far, American citizens have been forced to provide financial institutions with nearly $2 trillion in additional bailouts. This brings the total of current U.S. banking capital to some $3.6 trillion, still less than half of the potential problem, leaving a massive $4.4 trillion shortfall. In light of this, even noted bearish economist Nouriel Roubini's estimate of a $3.6 trillion shortfall appears to be too optimistic.

Of course, not all American banks are in trouble. There are a number of local and regional banks whose managements did not participate in gambling away America's financial future. Nevertheless, investors should ask themselves some hard questions. What if the government is forced to face the fact that the U.S. banking system, as a whole, is already fundamentally insolvent? What if the Administration is therefore forced, despite its expressed disinclination, to nationalize the problem banks?

Most importantly, while the good banks are being separated from the bad in the FDIC's 'coral', will all American banks be forced to close? Worse still, after the forthcoming G-20 meetings, will all international banks be closed on a temporary basis, on a long bank holiday, as happened in the Great Crash? If so, what would happen to consumer confidence and the price of gold?

Citigroup says that it is profitable. At the same time, most banks are in dire straits. Until Citigroup is able to put its capital where its mouth is, investors in U.S. financials should remain cautious.

For a more in-depth analysis of our financial problems and the inherent dangers they pose for the U.S. economy and U.S. dollar, read Peter Schiff's newest book "The Little Book of Bull Moves in Bear Markets." Click here to order your copy now.

For a look back at how Peter predicted our current problems read the 2007 bestseller "Crash Proof: How to Profit from the Coming Economic Collapse." Click here to order a copy today.

More importantly, don't wait for reality to set in. Protect your wealth and preserve your purchasing power before it's too late. Discover the best way to buy gold at www.goldyoucanfold.com. Download Euro Pacific's free Special Report, "Peter Schiff's Five Favorite Investment Choices for the Next Five Years", at http://www.europac.net/reports.asp. Subscribe to our free, on-line investment newsletter, "The Global Investor" at http://www.europac.net/newsletter/newsletter.asp. And now watch the latest episode of Peter's new video blog, The Schiff Report, at http://www.europac.net/videoblog.asp.

John Browne, Senior Market Strategist
Euro Pacific Capital, Inc.

John Browne is the Senior Market Strategist for Euro Pacific Capital, Inc. Mr. Brown is a distinguished former member of Britain's Parliament who served on the Treasury Select Committee, as Chairman of the Conservative Small Business Committee, and as a close associate of then-Prime Minister Margaret Thatcher. Among his many notable assignments, John served as a principal advisor to Mrs. Thatcher's government on issues related to the Soviet Union, and was the first to convince Thatcher of the growing stature of then Agriculture Minister Mikhail Gorbachev. As a partial result of Brown's advocacy, Thatcher famously pronounced that Gorbachev was a man the West "could do business with." A graduate of the Royal Military Academy Sandhurst, Britain's version of West Point and retired British army major, John served as a pilot, parachutist, and communications specialist in the elite Grenadiers of the Royal Guard.

In addition to careers in British politics and the military, John has a significant background, spanning some 37 years, in finance and business. After graduating from the Harvard Business School, John joined the New York firm of Morgan Stanley & Co as an investment banker. He has also worked with such firms as Barclays Bank and Citigroup. During his career he has served on the boards of numerous banks and international corporations, with a special interest in venture capital. He is a frequent guest on CNBC's Kudlow & Co. and the former editor of NewsMax Media's Financial Intelligence Report and Moneynews.com. He holds FINRA series 7 & 63 licenses.

Copyright © 2008-2009 Euro Pacific Capital, Inc.

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