America’s two biggest banks are fighting for the right – to be zombies. You wouldn’t know it by last week’s rally in bank stocks. But it’s a plausible interpretation of recent comments by the chief executives of Citigroup and Bank of America. Both played up the impressive earnings power of their respective institutions.
Citi boss Vikram Pandit, in a memo to staff, noted the bank had booked $19bn of revenues in the first two months of the year. Annualised, that would be $114bn – impressive given the state of financial markets and not far from 2007’s top line. That sparked the “Pandit rally” in the market. Citi alone surged 75% last week.
BofA chief Ken Lewis told the Boston Chief Executive Officers’ Club his bank should generate $50bn of profit before taxes and any provisions. He said “that kind of cash flow can solve a lot of problems, given time and an improving economy.” And with that, BofA shares rocketed 86% for the week.
The message seems to be clear from both bankers: give us time and we will be able to handle the write-downs we will need to take on the tens – perhaps hundreds – of billions of dollars of sketchy assets we’ve got on our books. That may in fact be right, though it’s hard to say for certain not knowing what the write-offs might be.
With its acquisition of Merrill, BofA has a balance sheet of around $2.4 trillion. Assuming $50bn of pretax earnings, the bank could write off a full 2% of its balance sheet every year before chewing into its Tier 1 capital. A similar hit to Citi would sacrifice something in the neighbourhood of $40bn of pre-tax earnings.
So, even the poster children of the current banking crisis could have the capacity to grind their way through the recession. That should be cause for celebration, right? Not quite. In a sense, that’s what the Japanese banks did in the 1990s. As a consequence of permitting its zombie banks to plod forward, Japan’s economy lost a decade.
The alternative – and one the US consistently urged on the Japanese at the time – is to bite the bullet, recognize bad assets and recapitalize. That would, of course, entail wiping out equity investors like Lewis and Pandit, replacing the management and possibly inflicting pain on bondholders.
Pandit and Lewis are probably right that their companies can muddle through. But whether the country’s key engines of credit creation should be left to that fate is open to debate. And until that is resolved, investors should remain on their toes.