Why the Bank rally will not last

NEW YORK (Fortune) -- Vikram Pandit, Jamie Dimon and other CEOs say their banks are doing fine, but few people seem to believe them.

Pandit, the Citigroup (C, Fortune 500) chief, said two weeks ago that the bank is having its best quarter in two years. Dimon, the CEO of JPMorgan Chase (JPM, Fortune 500), said his bank is headed for a first-quarter profit.

The optimism has helped to lift bank stocks out of their worst rut in more than a decade. Shares have bounced sharply off the 15-year lows they hit two weeks ago, though they gave back some of those gains Thursday.

And even after the recent rally, the big banks continue to fetch half or less of what they were worth a year ago.

In part, that's because even as bank CEOs put an optimistic spin on forthcoming first-quarter numbers, it has been some time since investors put any stock in the numbers the banks publish.

This loss of trust dates back to the megafailures of last year and owes much to the collapse in asset values over the past two years. There was a widespread failure to predict how bad the damage would be at big institutions.

"People are looking at the balance sheets but have little confidence in the values," said Tanya Beder, a risk management expert who runs the SBCC Group financial consultancy in New York. "The problem is that 25%-40% of the assets have been difficult or impossible to fair value for 18 months or more -- which means the valuation uncertainty is bigger than the bank's equity."

Some critics of so-called fair-value accounting -- the guidelines that oblige banks to value certain securities at the price they would fetch in a sale today -- say the use of these rules has made the crisis worse by forcing banks to take unrealistic paper losses on assets that aren't so deeply impaired.

Earlier this week, The Financial Accounting Standards Board, the private sector group that sets accounting rules, proposed two changes to the fair value rules that should quiet claims that regulators are forcing bankers to mark their books to fire sale prices.

That said, it's hard to ignore what happened at Bear Stearns, Lehman Brothers and Washington Mutual, the three biggest financial institutions to collapse last year.

All three had long been criticized for making overly optimistic assumptions as they marked their books. Nothing that happened after their failures did much to counter that argument.

JPMorgan, which bought WaMu for $1.9 billion after the Seattle thrift was seized last September by regulators, took a $31 billion writedown on the WaMu loan portfolio after making the purchase.

That isn't to say that banks like Citi, Bank of America (BAC, Fortune 500) and JPMorgan are being unduly aggressive in their accounting. The problem is that the last year has created uncertainty about the reliability of banks' books - which now threatens to further undermine the effectiveness of bank bailouts.

The government has intervened numerous times on behalf of big banks like Citi and BofA. In those cases, regulators pumped in new capital and offered guarantees that payments will be made on some loans and securities.

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Yet even after the government has put more than $300 billion into Citi, questions continue to swirl about the firm's exposure to troubled asset classes. Citi "remains one of the largest holders of both on and off balance sheet illiquid assets that may still require marking," Bank of America analysts wrote in a report Wednesday.

The uncertainty about the reliability of banks' financial statements is far from the only factor weighing on these stocks.

Financial companies have typically traded at a discount to industrial or services firms, because of their heavy debt loads, volatility and complexity. And details on the Obama administration's response to the banking crisis - such as the public-private investment partnership that is supposed to take care of bad assets in the banking sector - remain scarce.

What's more, the economic downturn is deepening, which will mean more loan losses ahead - and, perhaps, raise even more questions about the prospects for the hard-hit sector.

In a note to clients Wednesday, prominent bank analyst Meredith Whitney wrote that there is "stress on U.S. consumers across a number of data points" and specifically noted "deteriorating credit quality, higher unemployment, and lower home prices" as concerns for banks.


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