By Binyamin Appelbaum
Washington Post Staff Writer
Saturday, July 18, 2009
The huge profits reported this week by some of the nation's largest banks showed that the government is succeeding in its rescue of the financial industry, but the details of those earnings reports made it clear that the broader economy is not seeing the benefits.
Bank of America and Citigroup yesterday became the latest megabanks to report multibillion-dollar profits in the second quarter, joining J.P. Morgan Chase and Goldman Sachs. The four banks together earned $13.6 billion only half a year after they lost a combined $20.8 billion.
Washington once celebrated such profits as evidence of economic strength, but the current round of earnings has instead become a political problem.
Simmering public anger over the pay practices of large financial companies has been fanned by the news that banks rescued so recently are now profiting so massively, particularly because trillions of dollars worth of federal aid has yet to revive lending, a critical step toward economic recovery.
The Obama administration moved yesterday to harness that anger in the service of its proposal to reform financial regulations.
The president's chief economic adviser, Lawrence H. Summers, said after a speech at the Petersen Institute for International Economics that the profits were made possible by "the extraordinary public support provided by the federal government." While he welcomed the performance as "a positive indicator for the economy," Summers said that the government still needs to reform financial regulations to prevent companies from engaging in the kinds of excesses that produced the crisis.
"No one should be confused about the extent to which the public sector has provided a foundation for financial recovery," Summers said. "And in that context, it is the obligation of the public sector to insist that reforms be put in place so that the mistakes of the past are not repeated."
The earnings reports also showed that the recovery is incomplete. The core business of banking -- lending money to companies and consumers -- remains deeply troubled. The number of borrowers defaulting on existing loans continued to rise rapidly, and the banks continued to respond by shrinking the total volume of their lending.
There are few signs that it is getting easier for Americans to borrow money.
Administration officials and financial experts said that the profits were a necessary step forward: The banks led the economy into recession, and now they must lead the recovery.
"It's a prerequisite for that augmented lending to have the restoration of health, which seems to be happening," said Douglas J. Elliott, a financial expert at the Brookings Institution.
But Elliott and others noted that the problem cannot be solved by the banks alone. Before the recession, about 40 percent of lending was funded by investors. Lenders went to Wall Street to raise the money they provided to borrowers. But it has been two years since investors have been willing to provide significant amounts of money, a point underscored this week by the death throes of small-business lender CIT Group, which depended on those capital markets and now faces the prospect of bankruptcy.
Experts say that lending cannot recover completely until investors start providing money again.
Bank of America posted earnings of $3.22 billion for the second quarter, or 33 cents a share. That was down from $3.41 billion (72 cents) in the period last year, but it represented a large turnaround from the bank's struggles in the fall. Citigroup reported a $4.3 billion profit, or 49 cents a share, reversing a loss during the comparable period last year of $2.5 billion (55 cents). As with reports earlier this week from Goldman Sachs and J.P. Morgan Chase, the earnings exceeded analyst predictions by a wide margin.
Despite offering emergency aid to the firms, the government gets little direct benefit from their profits, which go mostly to employees and common shareholders. The government will soon hold common shares in Citigroup, which could increase in value, and it still holds preferred shares in Bank of America, which do not fluctuate in value but do pay a regular dividend. Officials have said the investments were intentionally structured to produce modest returns because the real goal was increased lending.
The two companies reporting yesterday earned large sums from the sale of business units and other investments. Bank of America made $5.3 billion by selling part of an investment in China Construction Bank, and $3.8 billion from the sale of a merchant-processing business. Citigroup booked a $6.7 billion gain on the sale of a majority interest in its Smith Barney brokerage.
The companies also benefited from a revival in the investment-banking business. The value of investments started to rebound, and investors started to spend money again. The big banks all benefited from the absence of former rivals such as Lehman Brothers and Bear Stearns, but the strongest banks benefited the most. Goldman Sachs and J.P. Morgan Chase also were able to draw business away from Citigroup and Bank of America, according to financial analysts and executives.
The revival, however, was a product of federal intervention as much as economic recovery. The Federal Reserve provided all the banks with vast sums of cheap money, and the Federal Deposit Insurance Corp. helped banks to borrow from private investors.
"The reason we have strong capital markets is because the government is guaranteeing everyone's liquidity," said Paul Miller, a financial analyst at FBR Capital Markets.
Citigroup has required the most help. The government has invested a total of $45 billion, guaranteed to limit the company's losses on a huge portfolio of troubled loans, and allowed the company to repay the government with common stock, rather than requiring the regular dividend payments that other banks are required to make.
Bank of America is a close second. The company also got a $45 billion investment and a government guarantee to limit losses on troubled loans.
J.P. Morgan Chase last month repaid $25 billion in federal aid, and Goldman Sachs repaid $10 billion, but both companies continue to rely on the emergency borrowing programs.
The aid has allowed the banks to survive despite suffering major losses on loans made during the economic boom.
Bank of America said it had abandoned efforts during the second quarter to collect on almost 14 percent of its outstanding credit card loans, almost doubling its loss rate during the period last year. Its loss rate on mortgage loans increased more than sevenfold. Unlike in past downturns, the rate of defaults has continued to increase more rapidly than unemployment, as many Americans who still have jobs still prove unable to repay loans.
Bank of America chief executive Kenneth D. Lewis said he does not expect the numbers to improve until next year.
"We have to get through the next few quarters," Lewis told financial analysts on a conference call yesterday.
Government officials have repeatedly said that the aid programs are designed to spark new lending, but experts said that was never a realistic goal.
"This is all about survival at this point. You look at all these balance sheets, they're shrinking. Nobody's really adding liquidity to the system," Miller said. "It's going to take a while for this system to heal itself. There's a lot of damage out there, and it's going to take a while to get through it."