Most analysts agree that a sustainable economic recovery can’t take hold until the financial sector returns to health. So if the recent rally in global markets is any guide, you’d think that banks must be well on the mend. Don’t be fooled. The problem of hefty unrealised bank losses, which in turn squeezes bank lending and undermines economic growth, looks far from over.
Take America. The banking stress tests reckoned that there was still a $75bn capital shortfall across the 19 major banks examined by the Federal Reserve. But the tests assumed there would be rapid rebounds in housing, growth and employment, says David Roche of Independent Strategy. This is way too optimistic. Even former Fed chairman Alan Greenspan wasn’t convinced. With unemployment heading above 10% this year and foreclosures up 32% year-on-year in April, there is a “very serious potential mortgage crisis ahead”, which could hit banks hard.
The key trouble zone is the prime mortgage sector, a much bigger part of US banks’ loan book than subprime. From November to February, the number of distressed prime loans rose by around 40% to 1.5 million. All told, there were four million distressed mortgages, worth $717bn, in February, says Barry Ritholtz on Ritholtz.com. Expect “a lot more distressed sales”, lower house prices and “further stress to banks’ already ugly balance sheets”.
So much for the US. But things look even more uncertain in Europe. There has been no continent-wide stress testing, and the International Monetary Fund (IMF) reckons that eurozone banks have so far taken just a fifth of their potential losses, compared to 50% in the States.
Yet, if anything, European banks are even more vulnerable. They were far more leveraged than their US peers, and their assets are worth about 330% of GDP, compared to 50% in America, reckons John Mauldin of Investorsinsight.com. They’re also more exposed to developing countries. European banks will cost “massive amounts” to bail out, or else their economies will “implode”.
Note, too, that the wholesale market is still largely frozen, says Roche. As things stand, it will provide only a fraction of the funding the 22 biggest global banks will need from it by 2011, which means lending will be restricted for years. Rather than a return to “healthy credit growth”, we look set for a “Japanese-style zombie banking structure”. Not exactly the prospect envisioned by bulls hoping for a V-shaped recovery.