Call It Hogwash or Headwinds, Biggest Banks Face Tough Times

“The top U.S. financial institutions have become zombie banks that will need a decade to adjust their businesses to the new realities in the industry.”
– Meredith Whitney, CEO of Meredith Whitney Advisory Group, on CNBC Aug. 10, 2011

Zombie banks are ones that are in such financial trouble that they require a bailout or seizure by the federal government. They often have a large amount of nonperforming assets on their balance sheets, which make future earnings very unpredictable and which impede making loans to stimulate the economy.

Jamie Dimon, CEO of JP Morgan Chase & Co., said Whitney’s zombie characterization of banks was “hogwash.”

“All businesses have things that change all the time — interest rates, commodities prices, cost of wages, demand, supply — and you have to manage around that,” Dimon said.

“U.S. banks might be facing headwinds but are not zombies,” Dimon said. “Bad economy is a headwind … people being scared is a headwind.”

Other things he might have listed as headwinds battering banks:

Trading profits have declined and mortgage packaging will not earn the blockbuster fees it did during the housing boom.

Whitney stressed that banks do not have the liquidity or solvency problems of 2008. But she said she instead fears that banks’ exorbitant expense structure exceeds their revenue expectations. And it could take a decade to resolve this mismatch.

Hurt by a weak economy, the nation’s biggest banks are cutting jobs, consolidating businesses and scrambling for new sources of income. Citigroup, Bank of New York Mellon, Credit Suisse, Goldman Sachs, Morgan Stanley and Wells Fargo have in recent months announced plans to cut tens of thousands of jobs. Bank of America has said it will eliminate roughly 30,000 positions.

Banks are trying to cut costs by moving middle- and back-office workers to cheaper locations, redeploying them to understaffed businesses like mortgage servicing or finding ways for computers to replace people.

Banks must comply with added regulations. Following the financial crisis in 2008 and 2009, Congress imposed the Dodd-Frank Act, which raises capital requirements and adds overhead expenses by requiring more risk managers and compliance staff. And in August the U.S. Federal Reserve asked a number of big U.S. banks to undergo “stress tests” in order to judge how their balance sheets would fare in worst-case financial scenarios. All of which are designed to prevent the catastrophic repercussions of the failure of “too big to fail” institutions.

Lending, the prime driver of bank revenue, has been depressed for several years. It is not expected to rise in the near future. Michael Cembalest, chief investor officer of JPMorgan, wrote in a recent essay for his bank’s publication, “Eye on the Market,” that banks have $1.7 trillion of extra reserves that they could lend. To encourage lending, Cembalest indicated that the Federal Reserve could reduce the interest on excess reserves to zero.

Investors’ enormous fears that the biggest banks could face massive legal liabilities. On Sept. 3, the Federal Housing Financing Agency sued 17 large U.S. banks over $200 billion in subprime mortgage-backed bonds now owned by Fannie Mae and Freddie Mac. The government said the securities were sold with registration statements and prospectuses that “contained materially false or misleading statements and omissions.” The government alleges that the mortgages in the securities did not comply with underwriting guidelines and standards.

These headwinds batter the biggest targets worst.

Federal Reserve data show that the top six banks hold two-thirds of all bank assets, close to $9 trillion dollars.

“They are too big right now,” Whitney said. “They need to work off problem assets and reduce their leverage. So you are going to see the big banks look very different over the next 10 years.”

Specifically, she believes they will sell non-core assets.

The stakes are high. Whitney said she fears that the largest financial institutions are still so enormous that their failure could again bring the financial system to the brink of disaster.