Bottom Shekel / The future of bank stocks

Decades before the current meltdown, during a lecture delivered in 1984, Yale economist and Nobel laureate James Tobin said he suspected "we are throwing more and more of our resources into financial activities that generate high private rewards disproportionate to their social productivity."

Prescient, that Tobin - he certainly did identify the trend. Based on figures from The Economist, in 2007 the American financial industry was responsible for no less than 40% of the profit generated by the entire business sector, compared with 10% in the early 1980s, when Tobin said what he said. The financial sector's share of the stock exchange's market capitalization increased from 6% to 23% during that time.

Did the financial sector indeed mushroom disproportionately to the economic reality? Did the banks, investment banks, brokers, stock exchanges, insurance companies and mortgage industry all turn into one gigantic bubble that's now exploding before our very, appalled, eyes?

With each day, more and more economists and pundits think that's a yes. That is not good news for people holding bank stocks.

We all know by now what happened. The biggest banks in the world (and smaller ones too) leveraged their capital by as much as 30 to 1. Then they invested the money in a wide range of horribly complicated derivatives.

At the base of the derivatives were loans extended to companies and homebuyers. Then the banks built a whole industry from creating weird financial instruments - broadly called credit derivatives - based on those loans. There were all sorts of credit derivatives like CDSs, credit default swaps, a form of insurance policy (or gamble, depending on how you see things) against the financial collapse of a company.

A particularly toxic example of a popular derivative was the CDO, collateralized debt obligation, just one type of asset-backed security and structured-credit product. You take a bunch of ordinary bonds, package them together and issue a bunch of new bonds based on them. Then you can stitch together these secondary bonds and issue them as a new security, too.

But all this could only go on as long as credit flowed and bankruptcies were scarce. Come the crunch, as the economy started to contract, the whole thing fell apart.

The result was that the asset value of the banks collapsed. Some banks found that their asset value had been completely wiped out.

How much asset value in total vanished? That's another problem - evaluating the losses. As confidence in the financial system evaporated, the markets seized up. By now nobody can tell how much the banks and their assets are worth.

It can be said, though, that as far as the big banks are concerned, the drop in value was enough to wipe out their entire shareholders equity.

As last week rolled to a close, Nouriel Roubini of New York University sounded a pessimistic note: The financial crisis may lead to $3.6 trillion dollars in losses and writedowns for the global banking sector, he said. In fact, the American banking system is "borderline insolvent."

By now, any non-affiliated economist would admit that some of the banks are dead broke, and the only reason they're still alive at all is that the governments of the world aren't letting them fall. Despite the general outrage at the way bankers soaked the rest of the world with their fat salaries and bonuses, the truth is that economies can't function without financial systems, banks and bankers. The governments know it, too, and will do what it takes to keep the banks alive.

The question is what they can do and what the upshot will be for bank stocks.

There are three paths to rescuing the tottering banking sector. The first involves outright nationalization of bad banks, in which case the state assumes their management. The second solution involves capital infusions in exchange for shares, hoping that everything will work out.

The third is to take the toxic assets (all those weird derivatives that can't be priced anymore because there's no market for them) out of the banks and hand all the garbage over to a "bad bank" financed by and backed by the government. The bad bank will hold onto the garbage until it can be recycled and sold. Then the bad bank can be wound down.

Each government is using a different combination of those options and soon enough we'll know what methods President Barack Obama plans to adopt.

But even in these days of fog, the one thing we know is that saving the banks will cost hundreds of billions of dollars of taxpayer money, and taxpayers will insist that the banks' owners bear at least some of the cost. By bank owner, read shareholder.

The banks' shareholders, from the loftiest of tycoons to the smallest saver, are going to take a hit. In some cases their investment will be completely wiped out.

What about the banks in relatively decent condition, the ones that didn't blow everything on ill-advised investments? There are some like that. But they have a problem, too. In a world where some banks are backed by government and some aren't, the public will naturally tend to invest in banks in which the government is involved, assuming them to be more reliable. The "private" banks will lose customers, who will also assume that the government-backed banks are safer.

The upshot is that whether in Israel or Europe or America, even after the plunge in bank stocks, anybody with holdings in banks is taking an especially large risk.