Can Mark 2 Market Help Against Loan Losses and Credit Card Losses ?

It is a toss up. Plus remember the AIG story of taking a hit on the taxpayers dime for the “profits” that kicked off the recent bank stock rally.

U.S. bank operating earnings are going to have a hard time outrunning credit losses, making the massive rally in bank shares look ready to be marked-to-market.

A series of positive statements about profitability in the early part of the year from major U.S. banks, notably Bank of America, Citigroup and JP Morgan helped to spring a rally in the beaten down sector, as investors bet that with government assistance they could earn their way out of their troubles.

The KBW bank index has enjoyed a blistering rally, rising 51 percent from its March 8 low, though it is still down almost 40 percent from where it ended 2008.

To be comfortable with that, you have to believe two difficult things; that investors will value the earnings banks are now making as if they were sustainable and that banks won’t be swamped by credit losses and potential forced dilutions of shareholders.

“We are unconvinced that the banks have turned a corner,” FBR Capital Markets analyst Paul Miller wrote in a note to clients. “Investors who believe that the recent financial rally is here to stay expect that most banks will remain profitable.

We expect that profitability at these banks will be driven by favorable fixed-income trading revenues, as well as mortgage banking revenues.”

In some ways, balance sheets aside, it’s a pretty good time to be a bank in America. Competition has thinned out and margins should fatten commensurately.

U.S. bank profits from trading and mortgage banking are both problematic. Trading income, because it varies wildly, is hard to predict and hard to value.

If the past two years has taught us anything, it’s that paper profits can evaporate and risks can be hard to spot.

On the positive side, the fact that banks are now putting less balance sheet to work as market makers means that those banks which still operate can make considerably more on the difference between where they buy and sell securities. But given the huge uncertainty about who will be around in a year’s time, especially given the by its nature unpredictable role of government, its hard to know how much competition there will be or even how much capital banks will be forced to hold against trading activities.

LOAN COLLECTING BLUES

Mortgage banking is also going to be bigger this year. The Mortgage Bankers Association predicts refinancing will total $1.96 trillion and purchase loans increase $821 billion, which could make it the fourth-biggest year on record. This is mostly because the Fed has driven interest rates down in a bid to reflate the economy. That makes it profitable for many Americans to refinance their mortgages and is luring a much smaller number back into the house purchase market despite falling prices.

But again mortgage banking is a notoriously tough business, and though a scarcity of lending capital has driven fees up, the record of banks in the U.S. engaging in it profitably is not good.

Mortgage banking, as distinct from mortgage lending, is the business of originating loans, these days almost exclusively for Fannie Mae or Freddie Mac in exchange for a fee and the right to earn more fees by collecting payments in exchange for servicing the loan for the lender.

But the mortgage servicing right that a bank gets when it makes the loan is usually recognized as income based on the current value of the cash it is expected to generate over time.

That means that banks that originate lots of mortgages show huge gains in income during refinancing booms. It does not mean, however, that they necessary make money out of the deal. Servicing rights can go wrong in many ways.

First, people can stop paying their loans back. The servicer usually has to advance the first few payments if a borrower is late and doesn’t get the money back until the loan is resolved. It’s also a lot more expensive to service bad loans than regular payers, making the economics of the business particularly tough right now.

Banks can also lose out if loans are refinanced sooner than they expect, robbing them of the future fees they were counting on.

And what about credit losses? Unemployment, which drives losses on commercial loans, on mortgages and on consumer loans, will be going up for some considerable time.

For example, the baseline forecasts released by the Organization for Economic Cooperation and Development (OECD) this week were considerably more bearish than even the “more adverse” numbers being used to run the U.S. stress tests now being run on banks.

Blog Calculated Risk does a nice job running the numbers here, but the highlight has to be the third q here, but the highlight has to be the third quarter, where the OECD is predicting an economy shrinking by 1.9 percent, as against a rather miraculous recovery to minus 0.2 percent in the “tough” scenario used by Geithner et al. Similarly, the unemployment rates predicted by the severe stress test are lower than the OECD base case all the way out to the end of 2010.

So then, it won’t be the stress test that undoes many banks, it will be reality.