Financial Earnings Do Not Equal Solvency

Wells Fargo reported record profits, nearly doubling analyst estimates despite the worst recession in the post-war era. The Fed designed its aggressive policy to slash interest rates over the past year to yield the maximum benefit for banks just as the economy fell of a cliff. The major banks are sitting on a pile of free cash as depositors earn less than 1% on their savings. This steepening of the yield curve has made it impossible for even bankers to lose money. So the Fed's actions have punished savers yet again and transferred a significant amount of wealth from the saving public to the banks. These actions continue to discourage saving while simultaneously encouraging excessive risk taking by lenders and debtors. However, an economy needs a solid savings base in order to encourage sustainable capital investment that is not based purely on debt. This begs the question; why do oil companies reporting record profits infuriate the general public while banks are applauded for producing record quarters? After all, don't both these industries generate their profits at the expense of the general public?

This upcoming week will see financial heavyweights Goldman Sachs, JP Morgan Chase, Bank of America and Citibank all report first quarter results. These companies are all expected to post solid numbers as they will benefit from the same operating environment that Wells Fargo exploited during the quarter. However, the market has priced in a solid earnings season for these banks following the Wells Fargo pre-announcement on Thursday and significant run-up in bank shares over the past four weeks. Do not expect the banks reporting this week to "blow out" the numbers because Wells Fargo achieved its results by under-reserving for future losses. I advised investors to avoid shorting financial stocks ahead of the mark-to-market rule change several weeks ago, and they have rallied sharply since that point.

Let me be as clear as possible. Although the financial sector will produce positive operating cash flow aided by free money, it remains insolvent, sitting atop a pile of bad assets. While bank share prices no longer reflect this reality, it is only a matter of time before the market prices these bank stocks accordingly. With additional capital raises looming and loan defaults accelerating, some excellent long term shorting opportunities are emerging within the sector following this earnings season. No other industry employs the amount of leverage that financials utilize. Even at a 10:1 leverage ratio, banks use $1 in equity to fund $10 in lending. So a small change in the value of the underlying assets can wipe out a large amount of equity. This is exactly what has plagued the sector for the past 18 months. The banks' tangible equity pales in comparison to the size of their actual balance sheets. After all, what is a couple billion dollars in quarterly profit when banks maintain balance sheets in the hundreds of billions? Further, these balance sheets will continue to deteriorate as the economy contracts.