The question of the day is “Are banks a good buy?

The answer as well as the thought of the day comes from John Succo at Minyanville. Professor Succo talks about Deutsche Bank but the implication are much further reaching.Let’s tune in.

Succo:

Deutsche Bank (DB) is an important tell…

DB lost money in their capital markets division. Simply put, they lost money “trading.” They are not alone.

Banks and dealers are having trouble making money the old fashioned way, so they are taking much more risk trading these days. I mentioned last week that while regional banks do not have near the ability to do this, large money center banks and dealers often increase their risk to make money just at the wrong time.

DB lost money doing it. Many other banks like JPM and BAC have so far been doing OK, trading (at least what they have admitted to for these banks can remark their loans and derivatives for a while to make things look good), but it does not mean they have not increased their risk.

While DB lost money this time, these other banks might next time.

Risks have increased significantly in owning bank stocks.

Mish:

What we do know (if indeed we know anything at all) is what Deutsche Bank is willing to admit.

Deutsche Bank on Tuesday reported a 29% rise in second-quarter net profit, but losses from the bank’s proprietary equity trading unit took the shine off a strong performance from its debt sales and trading team.

The division’s results were helped by a 46% rise in revenue from debt sales and trading to 2.4 billion euros.

“But there was a substantial swing in equity proprietary trading,” Anthony Di Iorio, chief financial officer, told an analyst conference. Iorio said the proprietary trading unit, which uses the bank’s own money to play the stock market, recorded a loss of almost 100 million euros in the quarter, compared to a roughly 400 million euro profit in the first quarter of the year.

“The proprietary trading unit takes on risks, if you do that you have to expect there will be at times positives and at times negatives,” said Iorio.
“The markets were not very favorable, but we managed and hedged the positions as best we could,” he added.

What we do NOT know is what Deutsche Bank, Citycorp, JP Morgan and others are not willing to admit. Banks do not have to mark to market derivative or trading losses quarter to quarter. Ultimately that is one of the things that got Fannie Mae and Freddie Mac in trouble.

Paper reporting is one thing, real profits are another. Unless and until disclosure rules are changed no one can really say for sure what is going on in the banking sector.

I suspect (but can not prove) that many US banks were essentially insolvent in 2001 in the wake of 911. Interest rates were not slashed to 1% to ward off “an unwelcome decrease in inflation” as Greenspan was touting but rather to bail out banks that were in hock to dotcom companies that were on the verge of blowing up.

Some might even think that banks are insolvent now based on poor real estate loans. I do not think that is the case (yet), but it could easily come to that.

In addition, the banking sector has been a prime target for a whole slew of hedge funds and mutual funds touting “income strategies” by selling puts and calls. There is nothing “income” related by this practice at all. What the practice does do however, is lower volatility to the point that more and more leverage (risk) has to be taken just to hit the same profit levels.

The strategy works until it doesn’t. When it fails it will likely fail in a spectacular fashion. Does anyone remember Long Term Capital Management? What LTCM did was actually peanuts compared to the risks being taken today.

The banking sector is probably one of the most overrated sectors in the S&P; 500. Yet because of herding factors (It’s going up so hedge funds and mutual funds “must own it”), the funds will keeps plowing into it until it breaks. Is this anyway to run a business? Can everyone get out at once?

No one can predict the timing of a “credit event”.
But I do know three things:

  1. The likelihood of a “Credit Event” increases every day
  2. Banking exposure to real estate loans has never been higher
  3. Risk to bank stocks has not been greater since 911

Mike Shedlock / Mish/