Are Banks Really on the Mend?

You can rest easy today… the financial crisis is over.

CIT Group, the new epicenter of systemic financial risk, got thrown a lifeline this week from its bondholders. As we reported Friday (link), the company needed $3 billion — fast — in order to stay afloat. It was rightfully denied a government bailout, but was able to strike a last-minute deal with holders of its debt. Of course, the market rejoiced… the S&P 500 rose 1.1% yesterday largely on the news.

But again, we’re calling the market’s bluff. Anybody read the fine print of this deal? The loan was secured by “substantially all unencumbered assets.” That lawyer talk means CIT will have no collateral left over for a similar deal in the future. What’s more, the company will have to pay 13% annually on the $3 billion loan… no small order.

But most importantly, the whole deal is an ugly microcosm of 2008-2009. No problem has actually been fixed at CIT. The business still finances loans to tens of thousands of small businesses by borrowing from the credit market. CIT’s business model is still broken. They are still massively in debt. All they’ve done is create another liability.

(Just as we were about to publish today, CIT filed a warning with the SEC, saying that their bondholder rescue might not keep them out of bankruptcy. Wouldn’t you know it – they’ve got more bills coming due! On August 17th they’ll have to cough up another $1 billion. And so the madness continues.…)

Nevertheless, coupled with the recent earnings surprises from JP Morgan, Goldman Sachs and Citi, “investors were encouraged to see that the financial sector can take care of itself, without government bailout funds,” as CNN put it. Heh… right.

“Anyone who takes this as evidence of a recovering economy should work for the government,” sneers Bill Bonner. “Only a government economist or a mental defective (excuse us for being redundant) could believe that genuine prosperity can be built on a foundation of speculating by large financial institutions. You can see why by asking a simple question: Whom were they trading against?

“The banks’ core business is actually getting worse! The core business of banking is lending to people who are capable of paying it back — out of earnings. If the borrower is counting on higher house prices… or higher stock prices… to allow him to refinance on better terms, the lender is asking for trouble. Prices may go up… or they may go down. And if they go down, down goes the lender’s collateral too… and his hope of getting repaid.

“The banks made big mistakes in the bubble years. And now they’re paying the price. But so far, they’ve only made the first installment payment. Subprime loans started going bad two years ago. Then, people began losing their jobs… and loans of all sorts were in trouble.

“There is no sign that this process is over. Instead, it is merely proceeding in good order… just as you’d expect.”

The Daily Reckoning