The Financial Sector Is Still In Big Trouble

Last week the stock market took a big hit, largely as a result of continued problems in the financial sector. The short version of what is happening is not good: banks of all sizes are taking big hits to their capital which will restrain their ability to make loans for the foreseeable future. That, in turn, will add to an already slow economic environment.

First, let's start with the series of news events.

Analysts at Goldman warned U.S. banks might need to raise as much as $65 billion in new capital, with losses in the financial sector not expected to peak until next year.

"What Goldman is pointing out falls into the dog bites man category. They are reminding us that there is a reason we're down. In general, it's too early to get into financials," said Art Hogan, chief market strategist at Jefferies & Co.

As the analysts points out in the second paragraph, this news pointed out that the financial sector still has profound and deep problems. More importantly, these problems will not easily go away. They are structural problems that go to the core of banking -- namely, that financial institutions of all sizes have more losses. This will force them to increase their loan loss reserves and constrain their future lending going forward. This in turn means the Federal Reserve could lower rates to 0% (which is where they already area after adjusting for inflation) and it wouldn't make a difference.

These problems are hitting banks of all sizes. It's hitting big banks:

Citigroup Chief Financial Officer Gary Crittenden yesterday predicted ``substantial'' additional writedowns and more losses on consumer loans. The bank has booked more than $42 billion of credit losses and writedowns since last year because of the credit market contraction, or about 10 percent of the $396 billion racked up by banks worldwide

For the banks' shareholders, the numbers tell a sad story: Wednesday's decline brought the loss for the S.& P. bank index to 39.3 percent so far this year. Fifth Third's odd name almost seems like a bad joke. Fifth Third has lost two-thirds of its value this year. Shares of two other banks based in Ohio, the National City Corporation, of Cleveland, and Huntington Bancshares, of Columbus, have suffered similar declines.

Banks based in the Southeast are hurting, too. The Regions Financial Corporation, the biggest bank in Alabama, has lost half its value. Standard & Poor's predicted this week that Regions would cut its dividend to conserve its capital in the face of rising losses on real estate loans. The share price of SunTrust Banks, which operates across the Southeast, has fallen almost 41 percent.

Small and midsize lenders are in far less danger than they were during the 1980s and early 1990s, when about 1,600 federally insured institutions failed during a savings and loan crisis. But the breadth and depth of the current troubles have caught bank executives by surprise. Federal regulators are particularly concerned about the exposure of smaller banks to the commercial real estate market, which has softened in some parts of the country.

But Wednesday was just one more bad day in what has been a horrible year for small and midsize banks. Their descent in the stock market has been remorseless, reflecting the economic pain in their own backyards. Weakening housing and construction markets in regions like the Midwest, Southeast and Southwest have hit lenders in those areas hard.

For the banks' shareholders, the numbers tell a sad story: Wednesday's decline brought the loss for the S.& P. bank index to 39.3 percent so far this year. Fifth Third's odd name almost seems like a bad joke. Fifth Third has lost two-thirds of its value this year. Shares of two other banks based in Ohio, the National City Corporation, of Cleveland, and Huntington Bancshares, of Columbus, have suffered similar declines.

Banks based in the Southeast are hurting, too. The Regions Financial Corporation, the biggest bank in Alabama, has lost half its value. Standard & Poor's predicted this week that Regions would cut its dividend to conserve its capital in the face of rising losses on real estate loans. The share price of SunTrust Banks, which operates across the Southeast, has fallen almost 41 percent.

Small and midsize lenders are in far less danger than they were during the 1980s and early 1990s, when about 1,600 federally insured institutions failed during a savings and loan crisis. But the breadth and depth of the current troubles have caught bank executives by surprise. Federal regulators are particularly concerned about the exposure of smaller banks to the commercial real estate market, which has softened in some parts of the country.

As a result, yesterday Merrill Lynch downgraded the regional banks:

Large and regional bank stocks took an initial nosedive after Merrill Lynch cut earnings estimates for 12 companies including Bank of America(BAC - Cramer's Take - Stockpickr), BB&T(BBT - Cramer's Take - Stockpickr), Fifth Third Bancorp(FITB - Cramer's Take - Stockpickr), National City(NCC - Cramer's Take - Stockpickr), Regions Financial(RF - Cramer's Take - Stockpickr), SunTrust Banks(STI - Cramer's Take - Stockpickr), Wachovia(WB - Cramer's Take - Stockpickr) and Wells Fargo(WFC - Cramer's Take - Stockpickr).

To get a good idea about what is going on here, let's turn to the FDIC's Quarterly Banking Profile. This document is released every quarter (duh!) and it provides a great overview of the banking industry.

Deteriorating asset quality concentrated in real estate loan portfolios continued to take a toll on the earnings performance of many insured institutions in first quarter 2008. Higher loss provisions were the primary reason that industry earnings for the quarter totaled only $19.3 billion, compared to $35.6 billion a year earlier. FDIC-insured commercial banks and savings institutions set aside $37.1 billion in loan-loss provisions during the quarter, more than four times the $9.2 billion set aside in first quarter 2007. Provisions absorbed 24 percent of the industry's net operating revenue (net interest income plus total noninterest income) in the quarter, compared to only 6 percent in the first quarter of 2007. The average return on assets (ROA) was 0.59 percent, falling from 1.20 percent in first quarter 2007. The first quarter's ROA is the second-lowest since fourth quarter 1991. The downward trend in profitability was relatively broad: slightly more than half of all insured institutions (50.4 percent) reported year-over-year declines in quarterly earnings. However, the brunt of the earnings decline was borne by larger institutions. Almost two out of every three institutions with more than $10 billion in assets (62.4 percent) reported lower net income in the first quarter, and four large institutions accounted for more than half of the $16.3-billion decline in industry net income.

Let's take this apart piece by piece.

Higher loss provisions were the primary reason that industry earnings for the quarter totaled only $19.3 billion, compared to $35.6 billion a year earlier.

In other words, losses nearly cut earnings in half on a year over year basis. That's a very sharp reduction.

FDIC-insured commercial banks and savings institutions set aside $37.1 billion in loan-loss provisions during the quarter, more than four times the $9.2 billion set aside in first quarter 2007.

Financial institutions are anticipating far more losses - nearly four times as much -- than they were a year ago. That indicates the credit quality of the underlying loans is cratering.

Provisions absorbed 24 percent of the industry's net operating revenue (net interest income plus total noninterest income) in the quarter, compared to only 6 percent in the first quarter of 2007.

Loan loss provisions now consume four times the industry's net operating income. That's a huge year over year increase.

The average return on assets (ROA) was 0.59 percent, falling from 1.20 percent in first quarter 2007. The first quarter's ROA is the second-lowest since fourth quarter 1991.

The industry's return on assets is almost 50% lower on a year over year basis. Again -- that's a precipitous drop in a short time.

The downward trend in profitability was relatively broad: slightly more than half of all insured institutions (50.4 percent) reported year-over-year declines in quarterly earnings. However, the brunt of the earnings decline was borne by larger institutions. Almost two out of every three institutions with more than $10 billion in assets (62.4 percent) reported lower net income in the first quarter, and four large institutions accounted for more than half of the $16.3-billion decline in industry net income.

This is a very troubling development. If a large institution fails it will send a ripple effect through the entire financial industry.

So, the short version of the FDIC report is clear: the financial industry is still in serious trouble.

I want to caution, we're nowhere near meltdown mode. There is no panic, not should there be one. The sector is still working. However, instead of being able to get to fifth gear it can only get to second gear.

Let's look at two charts for the industry.

The XLFs represent the large financial institutions. On the yearly chart, notice the clear down up down pattern. Prices have continually moved through support to make new lows. Prices have been in a clear downward trajectory for the last year indicating this problem has been around for some time.

On the three month chart, notice the following:

-- Prices are below the 200 day exponential moving average (EMA)

-- All the EMAs are moving lower

-- The shorter EMAs are below the longer EMAs

-- Prices are below all the EMAs

This is a bearish chart, plain and simple.

The year-long regional bank chart is just as bad as the XLFs (unless you're shorting the market). Prices have continually moved lower, breaking through resistance to make new lows.

-- Prices are below the 200 day exponential moving average (EMA)

-- All the EMAs are moving lower

-- The shorter EMAs are below the longer EMAs

-- Prices are below all the EMAs

This is a bearish chart, plain and simple.

So, the short version of all this is simple. The financial sector is hurting from all the bad loans it has written over the last decade. Now the sector is paying the price in the form of lower earnings, lower stock prices and higher loan loss reserves. Considering the amount of bad debt in the system, we won't see the end of this for some time. That's what the overall market realized last week: this will be with us for awhile.