Toxic Assets Still Pose Serious Risks To Banks

The Congressional oversight panel (COP) of the TARP program is just out with its August report http://cop.senate.gov/documents/cop-081109-report.pdf in the report there are some troubling details:

“Treasury‘s choice to pursue direct capital purchases resulted in a notable stabilization of the financial system, and it allowed the write-down of billions of dollars of troubled assets and reserve building. But, it is likely that an overwhelming portion of the troubled assets from last October remain on bank balance sheets today.

“If the troubled assets held by banks prove to be worth less than their balance sheets currently indicate, the banks may be required to raise more capital. If the losses are severe enough, some financial institutions may be forced to cease operations. This means that the future performance of the economy and the performance of the underlying loans, as well as the method of valuation of the assets, are critical to the continued operation of the banks.

“For many years, banks were required to mark their assets to market, meaning they listed the value for many assets based on what those assets would fetch in the marketplace. In response to the crisis, banks have been allowed greater flexibility in the way they value these assets. In most cases, we would expect the new rules to have permitted banks to value assets at a higher level than before. So long as they do not sell or write-down those assets, they are not forced to recognize losses on them."

“The recently conducted stress tests weighed the ability of the nation‘s 19 largest bank holding companies to weather further losses from the troubled assets and assessed how much additional capital would be needed. However, the adequacy of the stress tests and the resulting adequacy of the capital buffer required for future financial stability depend heavily on the economic assumptions used in the tests. As more banks exit the TARP program, reliance on stress-testing for the economic stability of the banking system increases.”

“If the economy worsens, especially if unemployment remains elevated or if the commercial real estate market collapses, then defaults will rise and the troubled assets will continue to deteriorate in value. Banks will incur further losses on their troubled assets.

“The financial system will remain vulnerable to the crisis conditions that TARP was meant to fix.
“The problem of troubled assets"

What does it all mean? It means that the banks still have a whole lot of junky loans that will not be repaid. The main improvement in the large banks is due to a change in accounting rules. In other words, make believe. This does not really improve a banks balance sheet it just pushes the problem into the future, financial kick the can if you will.

The next wave down is going to be ugly, much worst than last year's meltdown. Use the historic bear market rally as an opportunity to lower risk and for those who are speculators short the financials using the ultra short ETF SKF. I added to my position yesterday into the market rally. I paid 28.94/share. These shares were trading at 300 at the March market lows, it looks like a pretty good entry point to position for a big market decline this fall.-Lou