Further Deleveraging Threatens Health of Banking System As Risk of Writedowns Intensifies

(MoneyWatch)  Prepare for another round of deleveraging. That's the message going around Wall Street, just as some banks have paid their TARP funds back early.

In a typically extensive, dry, and informative piece Tuesday, Howe Barnes Hoeffer & Arnett suggested in Barron's that banks may need to write down bond losses. For its significance, the passage is worth quoting at some length:

Near term, banks' ability to monetize unrealized gains in their portfolios and thereby convert the gains to regulatory capital has declined sharply; or, from a more functional perspective, harvested gains have been a source of income to partially offset heavy provision expense, which has not yet peaked for the industry.

First-quarter results were supported via sizable bond gains and big gains from mortgage-origination activity. No doubt heavy harvesting occurred during April as treasurers moved to lock in gains for the second quarter, but barring a rally we would look for this source of income and capital augmentation to evaporate in the third quarter.

In other words, the income banks showed and which most of us suspected was fleeting in the first and second quarters of this year, is in fact, just that. Or to put it more bluntly still: most banks' profits are entirely dependent on risk appetite right now.

At Seeking Alpha, Bill Zielinski asks: "Are The Banks Paying Back TARP Money Too Soon?" That's a question I pondered here at BNET Finance a week ago when Morgan Stanley, Goldman Sachs, and JP Morgan announced they were paying their loans back to the government. Actually, it's hard to believe more people haven't been pondering the same point until now.

That's especially true since even as the early applications for TARP loan repayments were being approved by Treasury, the program's congressional oversight panel was asking for another round of stress tests.

Zielinski is primarily worried about what he sees as huge pending mortgage writedowns:

The big question is will the banks be able to earn enough to offset the huge amount of future write downs that will be needed on their troubled loans? Earlier this year, Bloomberg reported that the International Monetary Fund (IMF) estimated U.S. banking losses through 2010 at $1.06 trillion. To date, the banking industry has taken write-downs of only half that amount, indicating further write-downs of an additional $500 billion will be necessary.

In addition, delinquency rates on $1 trillion of commercial real estate loans held by banks have been increasing at a higher rate than anticipated. Credit card losses for the banks have also been rapidly mounting from previous estimates.

What is worrying is that a mixture of bond writedowns followed by mortgage writedowns six to twelve months later could easily contribute to a second round of massive deleveraging. In that instance, banks all begin to reduce their loan exposure to one another, and the whole financial situation goes back into near-collapse. The only party liquid enough to save the day again will be the government, which will have to print even more money to do so.

For now, there's little sign that this process is getting underway yet. But one of the most startling things about deleveraging is how quickly and severely its jaws enclose on the financial system. That's the reason Bear Stearns and Lehman Brothers went from being reasonably-capitalized to insolvent in a number of weeks.

Allowing some banks to repay their TARP funds early looks more and more like a short-term momentum strategy with potentially catastrophic long-term consequences.

Related Reading at BNET Finance:

• Banks' Optimism Is Too Much, Too Fast
• As Treasury Mulls TARP Payback, Congressional Panel Asks For More Stress Tests