Can Banks Keep the (Relatively) Good Times Rolling?

For banks, March was as kind as February was punishing. Valuations have skyrocketed as favorable accounting regulations have been approved by FASB, while investor confidence over lending is on the rise.

Even before Wells Fargo announced a bullish first-quarter profit forecast last week, the bank noted that despite a bad fourth quarter in 2008, it managed to increase lending activity by 11 percent in that period and turned a profit for the year. Wells is also now planning to open a unit that will provide funding to independent mortgage bankers.

In the meantime, Citigroup added around $10 billion to its valuation in March, while Bank of America is $23 billion pricier than it was at the beginning of the month.

But while the news may look good for the moment, it's far from clear it can continue. "One part of banks is stabilizing out, but corporate loans are about to come under a lot of pressure," says Justin Urquhart-Stewart, director of Seven Investment Management in London. "They aren't out of the woods yet, and may need further government funding."

Indeed, Jonathan Finger, a major shareholder at Bank of America, announced this week that even after taking $45 billion of taxpayer money, the bank still needs to raise another $2 billion to $6 billion to shore up its thin capital base.

At the same time, JP Morgan Securities has forecast a further $17 billion of bank writedowns in 2009; Deutsche Bank and Barclays Bank will be the most significantly affected, according to analysts.

What's more, after speculation that Citigroup would be able to mark up first quarter profits by as much as 20 percent on the back of FASB's recent ruling, the bank said that the accounting change will have no impact on its financial statements.

Analysts at investment bank Goldman Sachs concur. "Our core view is that banks will not bottom until underperforming asset growth decelerates. Loans are going bad faster than banks earn money," wrote one of Goldman's New-York based analysts Thursday.

The question, of course, is whether the share prices of banks have been rising purely on the back of hype over last week's FASB rule changes or whether a longer-term buying trend is underway. That's not just important for investors looking to book quick profits off beaten-down valuations. If banks are able to support themselves without more government financing, and equally importantly, to lend to one another freely, they need capital to do so.

The debate came to a crux last week when two prominent Wall Street analysts disagreed openly with one another about the financial health of U.S. banks. While ex-Deutsche Bank analyst Mike Mayo said that banks would end up taking losses of 3.5 percent on their government loans, ex-Bank of America head of research Dick Bove said that he believed the economy has now turned and that the loans will be honored. (Both Mayo and Bove perhaps tellingly left their former employers for smaller financial firms when those banks agreed to accept bailout funds).

Inflection point?

While the banks will still have to face further pitfalls, these are probably manageable as long as none of them are unexpected. What sent banking shares tumbling in 2008 was to a large degree the fact that investors had no idea writedowns would be so large, or that the assets on the banks' balance sheets were so toxic. That sudden fall in share prices set off a domino-effect of the tightening of credit which nearly crippled the broader economy.

As long as the banks can show that they are able to manage their debt, we should be at an inflection point in terms of confidence, according to Barclays.

The coming month is an imperative potential turning-point for the confidence banks begin to have in one another again, so that corporate lending can resume and in the process the economy can begin to recover. April may not be as overwhelming as March for the banks, but it probably won't be as dreadful as previous months have been, either.