Bailouts don’t help banks’ surprising profits

John W. Schoen Senior producer • Profile • E-mail

This week’s reports on banking industry profits — after a string of money-losing quarters — are certainly good news. But readers are curious where those profits came from. Did the taxpayer-funded bailout put banks back in the black? If so, should that really count as “making a profit”?

In the headlines we see some of the large banks are reporting quarterly profits. My question is are they really making a profit or are they counting the money the government loaned them in these statements?
— Bill M., Stuttgart, Ark.

The government’s response to the financial meltdown has played a big part in the recent round of profits from some of the biggest U.S. banks. But your tax dollars didn’t flow directly to the bottom line.

The roughly $200 billion the Treasury Department has handed out to battered banks was swapped for a special class of stock that pays a 5 percent dividend (rising to 9 percent after five years.) As of April 15, the Treasury had collected about $2.5 billion in dividend payments on its investment.

So in that sense, the bailout money represents an expense for banks. That’s one reason a number of banks have said they want to give the money back as soon as possible.

The government has played a much bigger role in getting some backs back in the black — by engineering a dramatic drop in short-term interest rates to near zero. By borrowing from the Fed at zero and charging 5 percent or so to its customers, U.S. banks have been generating piles of cash. (Some banks also turned a tidy profit trading bonds, which have risen in value as interest rates have fallen.)

The banking industry also caught a break thanks to a change in the accounting rules covering assets backed by mortgages and other consumer loans. With the outlook for loan defaults still very cloudy, these investments have become virtually impossible to sell at a price bankers are willing to accept. Since there’s no “market price,” they’ve had to write down the value of these assets and take big losses. The rule change gives bankers more flexibility when they assign a value to these assets on their books.

The hope is that the Fed’s policy of clamping down on short-term interest rates — with over $1 trillion in fresh cash swapped for bank assets like bonds — will let banks generate their own cash fast enough to get them on a solid footing before a new panic threatens to topple another one. So far that part of the plan seems to be working.

It’s less clear that all that fresh cash is going to start flowing through the system to get the economy growing again. Despite the government’s best efforts, the volume of bank lending is declining. And unless and until it begins expanding, it’s hard to see how the economy can shake off the recession and start growing again.

The banking industry’s strong first quarter performance may be hard to repeat — even if the Fed continues to hold rates low. The trading gains will likely taper off as bond prices flatten out. And the continuing rise in unemployment means banks face more loan defaults this year. Earlier this week, the International Monetary Fund said U.S. financial firms face $2.7 trillion in losses through 2010 — nearly double its projection just six months ago.

That’s why the Treasury is combing through the books of banks that have taken taxpayer bailout money — in hopes of finding which ones face the greatest risk of rising losses. If it looks like a bank doesn’t have enough capital to sustain those losses, the Treasury may take its dividend-paying “preferred” stock and swap it for common shares.

That might help reduce the risk of a bank running out of capital. But it would put taxpayer dollars at greater risk. The government would then be subject to the same stock market risk that has wiped out trillions of dollars of Americans’ retirement savings.

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