As Asset Valuations Soar, Earnings Wobble: How Safe Is The Banking System?

Despite a surging stock market, renewed trouble is brewing on the bottom line for a big chunk of the financial services industry. That's creating a lot of confusion as to how healthy the overall industry really is.

Last week, Bank of America and Citigroup both reported large losses from making consumer loans and lending via credit cards. In a similar vein, BB&T, one of the early bank success stories this year, announced Monday morning that its third-quarter profit plunged 56 percent, to $157 million, as a result of credit issues.

BB&T was one of the first banks to repay its Troubled Asset Relief Program (TARP) funds this year in June, and later acquired billions in Colonial Bank's deposits after the latter went under this summer. Trouble on BB&T's bottom line is therefore a fairly significant development in the evolution of the financial recovery. Mostly, it implies that the consumer may still not be ready to support the overwhelming surge in financial institution valuations since March.

But while consumer lending and income generated from many banking activities remains weak, there appears to be no shortage of capital waiting on the sidelines to grease the wheels of an eventual recovery. Take for example, CIT Group. After coming back from a near-death experience in July and August, the small business lender has found itself lately scrounging around for billions more to continue its activities. Most recently, the firm turned to its bondholders to secure an additional $5.7 billion.

But apparently, CIT has lots of funding avenues open to itself right now. Former corporate raider Carl Icahn said Monday that he has offered to underwrite the entire $6 billion CIT is seeking, for around $150 million less cost to the company compared to the bondholder financing alternative. Icahn added that there were many more financiers like him who would be only too happy to do the same.

That's similar to BB&T's stance earlier in the year in assuming Colonial's deposit base: at the time, the troublesome exercise (which requires big funding) was largely viewed as a coup for the former (see story here).

In other words, investors couldn't care less about a firm's cash-flow statement right now, if it means getting in on a deal in distress. If that situation continues indefinitely, eventually when the financing dries up everything comes toppling down. But for now, plenty of investors and institutions are willing to take the risk that by the time they run out of money to continue to finance a firm's day-to-day operations, the consumer will resume borrowing and spending once again.

This is why the number of bank bankruptcies is so important: as BB&T's lackluster earnings results show, rich firms cannot continue to finance an infinite number of poor (and getting poorer) ones forever -- and maybe not even until the point when there is a recovery in retail banking either. Meanwhile, the one hundredth financial institution bankruptcy is now on the horizon after the failure of San Joaquin Bank Friday.

It is very unlikely that things will get as bad again for banks as they did this time last year. But with the Federal Deposit Insurance Corporation (FDIC) running out of money fast, and another 416 banks still in precarious territory, the consumer will likely need to start borrowing and spending aggressively by spring next year in order for the financial institution recovery to maintain its current pace.