U.S. Federal Reserve Chairman Ben S. Bernanke and Congress agreed Friday that the financial system – not the American taxpayer – should bear the costs of bank bailouts. Sheila Bair, head of the Federal Deposit Insurance Corp. (FDIC), wants the banks to ante up $45 billion – three years’ worth of deposit-insurance premiums – to bail out the fund that insures bank deposits.

When it comes to bank stocks, we all know that there were a number of Money Morning readers shrewd enough to buy Citigroup Inc. (NYSE: C) shares when the foundering giant’s stock price was below $1 a share.

If you’re one of those investors, good for you: With Citi’s shares now trading at nearly $4.70 a share, that shrewdness – or courage – has been amply rewarded.

But the question we have to ask at this point is: Why would anyone buy banks stocks right now?

Bailouts Revisited

When the Bush administration bailed out the banks last autumn, I opposed the bailout. But I understood the rationale for it. The Lehman Brothers Holdings Inc. (OTC: LEHMQ) bankruptcy had clearly done a lot of damage to market confidence. Thus, a series of high-profile failures – however well merited – could push the market into a behavioral funk that might take years to emerge from.

After all, as we were incessantly reminded, the banks were all intimately inter-connected – not in the least by the diabolical credit-default-swap market. So a big failure could trigger a mass-market meltdown.

That justified the immediate bailout back then. But it did not justify the continued existence of those banks and other financial institutions – especially Citi, Bank of America Corp. (NYSE: BAC) and insurance giant American International Group Inc. (NYSE: AIG) – a year after the bailout.

Even if there was an argument for preventing the immediate meltdown of those companies – to prevent panic – there was no good argument for allowing them to continue in business as zombies, distorting the market forever after. An orderly liquidation was what was really needed.

But if the plans called for these three bad actors to be liquidated, it should surely be happening by now. Two of the three have even kept their top management for the intervening year. The exception has been BofA, where Chief Executive Officer Ken Lewis is now being shoved – kicking and screaming – toward the exit. (However, I have no doubt he’ll end up being well rewarded for the indignity).

Japan’s ‘Lost Decade’

Economically, keeping banks and other companies alive after they should be dead is the mistake Japan made back in the 1990s. After Japan’s massive stock market meltdown, most of the banks were technically insolvent. A decline in the value of the stocks the banks held had gnawed away their capital, while their assets were shredded by the collapse in the value of their real-estate loans.

Despite this, Japan opted to prop up many insolvent companies, which kept the country’s entire banking system on life support until 1998 – hence the “Lost Decade” of financial legend. And a true resolution of the problem did not come until it was forced by Prime Minister Junichiro Koizumi in 2003. The result was more than a decade of economic stagnation and a mountain of public debt that actually exceeded 200% of gross domestic product (GDP).

For the banks themselves, the fallout can be even worse.

An ‘Artificial’ Market

At first blush, the profits of the last few months look pretty good. And the record bonuses being threatened on Wall Street suggest that all is fine. However, there are two problems. First, bank earnings have been propped up by an extraordinarily bank-friendly monetary policy, keeping short-term interest rates at close to zero and buying up more than $1.5 trillion of bad bank loans from the markets.

That simply can’t last. If it does, we’ll end up with a bad case of hyperinflation.

As for the bonuses, does anybody think that if Citi had gone bust, and ex-Citibankers were now selling apples on the street corners of New York, bonuses would be zooming so high?

If the market for overpaid bankers had been allowed to clear properly, they would no longer be overpaid.

If the Japan’s Nomura Securities (NYSE ADR: NMR) wanted to double its U.S. staff, as it announced Monday (an extraordinarily shareholder-hostile decision, given Nomura’s lousy U.S. track record), it could just lean out of its office and whistle, and a parade of ex-Citibankers, ex-AIG executives and ex-BofA execs would rush in, begging for scraps.

It appears that the concerns that Soros expressed are well justified.

A Grim Reaping For Bank Investors

Since there are more competitors in the market than there should be, once the Fed’s over-generous monetary policy is corrected, there will be too much competition, so bank profits will be squeezed. Conversely, there will be too many jobs in the industry, so banker pay scales will be artificially propped up.

If that’s a recipe for good shareholder returns, I’m a Dutchman.

There’s more. The populist fury against the banking system doesn’t look like it’s doing much about banker pay. However, it will almost certainly result in special extra taxes being levied on surviving banks, to pay for the bailouts.

The costs of those taxes will be passed through to shareholders, because competition from all the zombies that are still in business will prevent banker pay from being squeezed much. The extra levies that Bair, the FDIC chief, is employing to keep the deposit-insurance fund solvent also will fall on banks, although in this case it will be the small and medium-sized that will suffer the worst.

Squeezed profits, expensive staff, extra taxes and special FDIC levies – it doesn’t look to me as if there will be much left for bank shareholders.

Expect 2010 to be a grim year for them.

Source: Hidden Traps Make Bank Stocks a Bad Deal

REITs are still in the early stages of a huge deleveraging cycle that will last for years, which means that the REITs that concentrate on commercial real estate may be a deceptively dangerous asset class.

Our story begins with the massive credit bubble – and related housing bubble – of the last several years. These twin bubbles powered a dramatic rise in consumer spending. Some significant portion of commercial real estate sprouted up to serve and satisfy this artificial demand. From the top to bottom of the U.S. economy, easy access to credit during the last several years powered excess consumption – and a frenzy of knock-on commercial ventures.

Accordingly, shopping boutiques popped up everywhere, along with restaurants, real estate offices, home-furnishing stores, art galleries, etc. All of these enterprises unwittingly relied on credit-fueled demand, and believed that this demand was “normal.”

But now that credit has disappeared from the U.S. economy, thousands of businesses are discovering that they cannot survive the new normal – the one that relies on actual paychecks and savings, NOT credit. And so, one by one, business doors are closing and the empty commercial spaces are piling up.

“The severity of the recession is turning some malls that were once viewed as viable into potential casualties,” the Wall Street Journal recently observed. “‘Any mall that’s sitting on life support is probably going to get its plug pulled as the economy stalls,’ says Michael Glimcher, chairman and CEO of Glimcher Realty Trust, which owns 23 U.S. properties, including Eastland Mall in Charlotte.”

The distress in the commercial real estate market would be serious, even if credit were still flowing freely. But credit is contracting, which means that commercial real estate is in especially dire circumstances. Refinancing commercial properties has become an extremely difficult task. Without the ability to refinance – or to sell at a profitable level – properties will continue to stumble into foreclosure and liquidation, which will put continuous pressure on property values.

Owners of underwater properties will have to either default and hand the title over to the lender, or they’ll have to inject an impractically large amount of new equity into the property to qualify for refinancing. And in these cases, we are talking about face-to-face negotiations between borrowers and lenders. In the modern “securitized” economy, face-to-face negotiations have become as rare and quaint a concept as the corner malt shop. In the modern economy, most mortgages are sliced and diced into unrecognizable portions of various mortgage-backed securities (MBS).

Think of securitization this way: Image your pet pig ran away from home and stumbled into a sausage factory. If you searched for your pig at the end of the sausage production line, you probably couldn’t find him. He’d be there alright, but not in a form you would recognize. He is there; but he is now everywhere. So is your mortgage.

Securitization is, therefore, a very toxic aspect of this particular commercial real estate bust. Simply stated, securitized mortgage structures are not designed to function in our current environment — one with falling collateral values and soaring defaults. Let me highlight the loan restructuring challenge ahead for troubled commercial property owners and their lenders.

Take just one example of evaporating equity in commercial properties. It shows why stressed property owners cannot easily renegotiate terms with their lenders. A few weeks ago, Sunstone Hotel Investors Inc. defaulted on its mortgage on W San Diego hotel. Sunstone bought the W for $96 million in 2006. The transaction was financed by a $65 million mortgage that was sliced, diced, and sold into the commercial mortgage-backed security (CMBS) market. The W’s value is now below the face amount of the mortgage, so Sunstone will likely write its equity down to zero and turn the deed for the W (i.e., the mortgage collateral) over to creditors in order to eliminate its mortgage obligation.

Sunstone defaulted when it skipped its June 1 payment on the W hotel’s mortgage. Thus, Sunstone basically invited its servicer, Centerline Servicing, to foreclose on the hotel. Centerline represents the interests of the lenders, who are spread throughout the ownership structure of CMBS. Without the chance to renegotiate, the only real option is for lenders to foreclose and auction off collateral. Even worse, if Centerline were to approach the lenders about restructuring the mortgage, the lenders would have different objectives — some would want to liquidate collateral to get paid, while others would prefer to renegotiate and hope for a rebound in collateral value. This is known in the securitization business as “tranche warfare.”

From a legal standpoint, borrowers are too far away from ultimate lenders. The complex legal structure of CMBS practically guarantees that sensible loan restructurings, including debt-for-equity swaps, are very difficult.

Now apply this situation to hundreds of other properties around the U.S., and you can see how securitization (CMBS) practically eliminates the potential for property owners to meet with their creditors and renegotiate. Private sector creditors who want to participate in fire sales and in very attractive loans are waiting for property to fall to more reasonable levels first. Banks are not going to refinance commercial mortgages coming due on properties that are down 50% from peak values, and no equity is left. This means that the foreclosure market will dominate the overall market, pushing values for every comparable property down even more.

There will not be any legitimate bottom in the REIT market until there is a bottom in the prices of commercial real estate mortgages. The smart institutional money will initiate its investment in real estate by buying the distressed mortgages of attractive properties, NOT by buying REIT shares. These investors will want to buy claims on commercial property market that are high up in the capital structure, not gamble on equity in properties, which may be worth a fraction of peak values — or zero. That’s why I’m monitoring transactions in the commercial real estate debt markets, looking for signs of a true bottom.

The “bottom” we saw in early March was almost entirely due to the Fed’s extraordinary commitment to print money in an attempt to prop up old bubbles. This caused a temporary rally in CMBS and REITs. The most stressed REITs used this as an opportunity to de-lever their balance sheets just a smidge by flooding the market with new shares. With the window for REIT secondary offerings closing, by fall we should see another leg down in the Dow Jones U.S. Real Estate Index.

The real buyers for CMBS and commercial property are professional investors – not the Fed or taxpayers. By and large, these professionals are waiting for bargains, with bids far below the current market.

So should you.

Source: Sell REITs

JPMorgan Chase & Co. and American Express Co. were told they need to boost common equity, less than four weeks after being informed they had enough to withstand a deeper economic slump. Morgan Stanley was directed to raise more funds after already selling stock to cover its stress-test shortfall. One firm was told June 1, people with direct knowledge said.

This means two things. 1) That the government’s stress tests were indeed a sham designed to coax investors back into bank stocks. 2) That the government expects more pain for the banking sector and isn’t prepared to have banks get out from under the TARP only to come back begging for federal aid at a later date.

As former New York Fed executive vice president pointed out recently, if banks repay TARP funds next week, “politically, the administration can claim a victory. They can claim TARP is working, we’re getting our money back and making a profit. But there are more shoes to drop in commercial and industrial loans, leveraged loans, and real estate.”

As we have attempted to make clear all along in Notes , this crisis boils down to a battle between hope versus facts. You know which side Team Obama and the mainstream press is on. And you know which side we’re on.

Stress Test A Concoction By Banking Industry

In a nutshell, the banks’ stress test was really nothing more than a fantastic concoction put forward by the U.S. Treasury, the Federal Reserve and the banking industry.

Unemployment assumptions too high in the test? No problem… just amend them to a more favorable number.

GDP growth too low? Ah, no worries… just change it.

Hardly a surprise then that the results are unbelievable. According to the New York Times, these were the assumptions in the test:

• The U.S. economy contracts by 3.3% this year and remains almost flat in 2010.
• Housing prices fall another 22% this year.
• The worst-case scenario for unemployment has the jobless rate at 8.9% this year, rising to 10.4% in 2010.

Here are the problems with assumptions like that…

• GDP Growth: In short, we’ll see anemic expansion at best, with little evidence of the contraction ending this year. Of course, we can hope that growth will return if the government continues to spend like a drunken sailor.
• Unemployment: The April job numbers released last Friday (if you even believe them) showed that the unemployment rate is already at 8.9%. So if that’s the “worst case,” we’re now on the mend, with the rate set to decline from here, right?

I think not. We’ll see the jobless rate in the double-digits this year, not next.

• Housing Decline: This is the only part of the guidelines that makes sense. The market is finally showing signs of bottoming at levels well below expectations – something I warned readers about in late 2006.

As An Investor, Don’t Flunk This “Stress Test”

Notice how the “secret,” yet somehow highly public results were leaked at the end of last week? It worked like a charm. Investors latched onto the result, breathed a sigh of relief that financial Armageddon had been staved off, and gleefully bid up stocks. Financial shares, in particular, rallied on the news.

Funny thing is… as soon as stocks rallied – some by multiples of 100% – the same banks that claimed to be solid suddenly began to raise capital. So far, the amounts raised (and yet to be raised) are nearing the $100 billion mark.

The critics are out in force. Yesterday, Meredith Whitney (the Mark Meeker of financial shares) was adamant that she wouldn’t buy shares here. Moreover, she stated that the stress test was a joke, with banks still under-capitalized and diminished earnings power as a result of the recession and asset sales to raise cash.

So, what’s an investor to do? Are there any opportunities out there at all?

The Best Way To Buy These Three Bank Stocks

Without a doubt, there are opportunities in the banking sector.

But that opportunity is not to buy the shares today. There’s a savvier, smarter way to do it, based on the fact that bank stocks will pull back. And it’s on that pullback that you should look to buy. How?

In my opinion, the best strategy to use when buying bank stocks should be to do it through two-year LEAP options.

Why? Because these bank stocks aren’t paying you dividends these days, why risk all your capital when you can achieve better returns at a lower cost by going long with LEAPS.

However, the options are exorbitant at the moment because volatility is so high. But that doesn’t mean you’re stuck. You just need to use a high delta strategy.

Simply put, this means you should buy deep-in-the-money LEAPS in order to reduce the outlay for time and risk premium. And you should only go for the ones with the highest volatility.

In this case, set your sights on…

• Bank of America (NYSE: BAC) – when it gets back to the single digits.
• JPMorgan Chase (NYSE: JPM) – when the stock trades in the low-to-mid $20s.
• Suntrust Banks Inc. (NYSE: STI) – when shares retreat to the low teens.

However, these banks’ current prices reflect outrageous valuations, based on earnings power and economic uncertainty.

So while the black cloud may have been temporarily lifted from the banking sector, it doesn’t mean that these companies are a sure bet for profits – not at current prices anyway.

Karim Rahemtulla

Source: Bank Stocks: Disregard The Stress Test & Consider These 3 Stocks

Since their March lows, bank stocks, as measured by the Philadelphia Bank Index (BKX), have risen 126%. But aren’t these the same banks that investors sold off in panic back in September of 2008? And don’t they still have the same toxic assets rotting on their books?

The answer, bizarrely, is yes. Nothing has changed at the banks except investors’ perception of them. Of course, the banks, aided and abetted by the Department of the Treasury, the Financial Accounting Standards Board, the Fed and the other failed regulators at the FDIC and the Office of Thrift Supervision in charge of the fudge tests, have sprinkled as much fairy dust in faces of investors as they can get away with.

Starting with a ‘leaked’ memo proclaiming a return to profitability at Citigroup and culminating with today’s fudge test results, the tag teaming between Washington and Wall Street has been a marvel to behold. We take our hats off here at Notes. We enthusiastically applaud the show.

Of course, just when David Copperfield ‘disappears’ the Statue of Liberty in front of gawping crowds, we’re all too aware that what we’re witnessing is sleight of hand, not the real deal. The toxic assets still sit and fester. New capital “cushions” are still desperately needed. Sustainable profits are still elusive.

But like a dues ex machina, the government has changed the rules. And it occurs to our poor abused minds here at Notes that it’s the government, not the banks, that investors are betting on. Mr. Market, it seems, has had its own epiphany. It’s realized that the government has got the banks’ backs no matter what. And the grand finale is yet to come. You see, the bank bulls are true believers. They know that the time is fast approaching when the great prestidigitators in Washington will, with a characteristic flourish, vanish the last remaining toxic assets from the banks’ books and surreptitiously deposit the entire stinking mess in the unwitting hands of the US taxpayers.

If you don’t believe in magic, consider Bank of America’s new plan to raise capital. The government says BoA needs to raise $34 billion in equity capital to absorb future losses. You’d think that would mean the bank would have to go to the market for this money, right? Think again…

Thanks to some high-grade accounting hocus-pocus, BoA can simply convert the $45 billion in preferred stock that it received from the generous US taxpayer to common stock. As Barry Ritholz at The Big Picture says, “Even the magician David Copperfield would be in awe.”

However, Ritholz also points out that “Until the banking system starts replacing debt with equity by either exchanges or by dramatically shrinking their balance sheets, all the capital raises are more about plugging holes and hoping for the rain to stop as opposed to lowering the overall leverage of the banking system.”

Still, you gotta love the spectacle of it all.

On March 4, GS shares hit a low of $73.95. By April 13, they had risen to $130 – a gain of 75% in just five weeks. This allowed Goldman to price its $5 billion share sale at $123/share.

It also allowed the bank to reduce the dilution to its shareholders by 40%. In other words, GS only had to issue 60% of stock at the $123 price than it would have been forced to do at about $74/share.

As China-based securities analyst Ben El-Baz recently pointed out on Seeking Alpha:

Anyone who thinks this is just plain good luck for the financial giants at Goldman should probably avoid investing in the stock market. The big players have immeasurable influence, and this needs to be understood by small investors trying to gauge what’s going on.

El-Baz rather generously calls this “finessing” the markets. It’s certainly one way of putting it.

“Currently, the vast majority of banks have more capital than they need to be considered well capitalized by their regulators,” Geithner said in testimony to a congressional oversight panel on the government’s financial rescue program.

One of these banks, Bank of America (BAC), the world’s second largest in terms of market capitalization, booked a first-quarter net income of $4.247 billion – 6% more than it made in all of 2008.

So is this the turnaround Geithner et al. have been willing to beggar our nation’s future for?

Before calling your broker and placing a big order for bank stocks based on all this “good” news, it might be prudent to answer a couple questions first.

For starters, just where did all this income come from? And has credit quality really improved?

The answers to both can be found buried in a company press release bearing the encouraging title “Bank of America Earns $4.2 Billion in First Quarter.”

I’d like to draw your attention to the four most telling excerpts from this release.
1. “Equity investment income includes a $1.9 billion pretax gain on the sale of China Construction Bank (CCB) shares.”
2. “Noninterest income included $2.2 billion in gains related to mark-to-market adjustments on certain Merrill Lynch structured notes as a result of credit spreads widening.”
3. “Credit quality deteriorated further across all lines of business as housing prices continued to fall and the economic environment weakened.”
4. Nonperforming assets were $25.7 billion compared with $18.2 billion at December 31, 2008 and $7.8 billion at March 31, 2008, reflecting the continued deterioration in portfolios tied to housing.”
Now we see that out of its $4.2 billion in profits, a total of $4.1 billion came from a one-time sale of CCB stock and marking up Merrill’s book of mortgages. If you subtract these one-time gains from net income and include preferred dividends, Bank of America actually lost $1.286 billion.

As far as credit quality goes, I think number 3 above makes the situation as clear as can be.

Importantly, Bank of America is not the only big bank engaged in accounting sleight of hand.

As The New York Times article “Bank Profits Appear Out of Thin Air” by Andrew Ross Sorkin points out:
With Goldman Sachs, the disappearing month of December didn’t quite disappear (it changed its reporting calendar, effectively erasing the impact of a $1.5 billion loss that month); JP Morgan Chase reported a dazzling profit partly because the price of its bonds dropped (theoretically, they could retire them and buy them back at a cheaper price; that’s sort of like saying you’re richer because the value of your home has dropped); Citigroup pulled the same trick.

So what’s the takeaway?

When the Treasury secretary tells you banks are well capitalized and you read in the press that financial institutions have turned a corner, don’t buy it. And don’t buy the stocks of these companies either.

These days, smart investors are well advised to carefully watch the investment as well as the political landscape… because Washington’s movers and shakers’ influence on the markets has never been greater. The Casey Report investigates and analyzes those influences and trends – to find the best investing opportunities with maximum gains. You can try it completely risk-free – check out our 3-month trial with 100% money-back guarantee. Click here to learn more.

Source: Are Banks Going Bankrupt? “NO!”, say Banks

Martin applied four criteria when examining banks’ health:

Banks that made profits in the very difficult fourth quarter of 2008 and first quarter of 2009 are probably in good shape, especially if their loan-loss provisions exceeded their charge-offs (the amount actually lost.)

Banks that lost money in the fourth quarter and first quarter may or may not be in terminal trouble; it depends on the amount of those losses and whether the red ink is expected to continue to flow going forward.

With the run-up in bank stocks in recent weeks, there’s been an accompanying rise in the ratio of share price to book value (stock price per share/book value per share). If that ratio is still below 30% – even after the recent price increases – the market lacks confidence in the bank’s ability to solve its own problems. Unfortunately, the market currently appears to be overly optimistic about some of the banks that still have considerable ongoing problems.

Management’s dividend policy is less of an indicator than it was just a few short months ago; several banks have sharply cut their dividends in order to repay the Troubled Assets Relief Program (TARP) capital they got in late 2008. Reasonably, profitable banks don’t want the government meddling in their business or compensation structures

This research revealed three “hidden gem” banks among the dross. They are (in alphabetical order):

BB&T Corporation (NYSE:BBT) – With $152 billion in assets, and a $3.1 billion TARP investment, this North Carolina-based regional bank has its primary operations in the Mid-Atlantic region. A recent share price of $23.42 meant that BB&T was trading at about 94% of book value. BB&T was profitable in each quarter of 2008 and in the first quarter of 2009, making $1.5 billion for all of last year and $271 million in first quarter of 2009. It maintained its dividend of 47 cents a share for first quarter of 2009, the only bank to maintain its full payout. The question, of course, it whether management will be tempted to follow fashion and cut the dividend next quarter; otherwise, it looks very solid.

State Street Corporation (NYSE:STT) – With $174 billion in assets, and a $2 billion TARP investment, this Boston-based bank is focused chiefly on serving institutional investors worldwide. Its recent share price of $37 meant that State Street was trading at 146% of book value. Its 2008 earnings per share (EPS) of $3.89 represented a year-over-year increase of 13%. First quarter net income down 16%, but State Street still earned $445 million. It pays a quarterly dividend of 24 cents per share. With a global business, conservative leverage and Boston management, State Street is a great risk. But it’s somewhat of an unexciting investment currently as securities issues and trading volume have fallen.

Bank of New York Mellon Corporation (NYSE:BK) – With $237 billion in assets and a $3 billion TARP investment, this New York-based bank has its primary operations in New York and Pennsylvania and has an institutional/corporate orientation. With its recent share price of $26.88, it is trading at 122% of book value. It reported 2008 net income of $1.39 billion, and first quarter profit of $322 million, after which the bank reduced its quarterly dividend from 24 cents to 9 cents a share. Looks solid to me.

U.S. Bancorp (NYSE:USB) has $266 billion in assets, and a $6.6 billion TARP investment and is a regional bank headquartered in Minneapolis that operates primarily in the Midwest and Northwest. A recent share price $18.97 means it is trading at 176% of book value. It reported a 2008 profit of $2.94 billion, and a first quarter profit of $419 million. U.S. Bancorp cut its quarterly dividend from 42.5 cents per common share to 5 cents a share, as it wants to pay back its TARP investment. This bank is in good shape, but its capital base would become too thin if it repaid TARP; I’m not sure I want to pay 11-12 times earnings for this stock when the dividend’s so low and the uncertainties are so high, as there’s still some chance of dilution, should it raise capital.

He may well be right; more interesting is what this tells us about the U.S. banking system going forward.

“The institutions are insolvent,” Roubini said in a Bloomberg Radio interview. “You have to take them over and you have to split them up into three or four national banks, rather than having a humongous monster that is too big to fail.”

But that may be impractical. Citigroup Inc. (C), for example, can sell and is selling peripheral parts of its empire such as Japanese broker Nikko Securities. However, so much of its business involves an international nexus of connections – including its large U.S. operations – that splitting them may be both impractical and excessively value destroying.

However, Wells Fargo & Co. (WFC) showed Thursday what could be achieved by simplicity. It gave investors a preview of its first quarter results, in which it will make record earnings of about $3 billion, or 55 cents a share, after paying preferred stock dividends of $372 million on its $25 billion of preference shares from the Troubled Assets Relief Program (TARP).

Both the old Wells Fargo and Wachovia Bank, which it acquired last year, are showing good results, with $3.3 billion in loan-loss charge-offs for the combined group – down from $6.1 billion in the fourth quarter of 2008. As a result, bank stocks were up sharply Thursday, continuing their healthy rally over the last six weeks.

Wells Fargo is one of six U.S. banks – Citigroup, Goldman Sachs Group Inc. (GS), and Morgan Stanley (MS), Bank of America Corp. (BAC) and JPMorgan Chase & Co. (JPM) – with assets of more than $1 trillion. They are so large they form a separate “top tier” of banks, since the next largest bank, PNC Financial Services (PNC), has assets of only $295 billion.

However, Wells Fargo’s first-quarter success does not mean that all the top-tier banks will do well. Both Wells Fargo and Wachovia were heavily oriented to conventional retail and commercial banking, with massive branch networks all over the United States. The combined Wells Fargo was thus much less reliant on the slumbering investment banking business than other top-tier banks. It was also far less involved in high-risk capital-markets game playing, which got so many other banks in trouble. For example, while Wachovia got $500 million of dubious payouts from American International Group Inc.’s (AIG) dodgy credit default swaps, Wells got nothing, and therefore presumably had no net exposure.

Wells Fargo, in short, is becoming a model of what a nation should require of its behemoths under the “too big to fail” doctrine. It does mostly conventional retail and corporate banking, and provides economically useful services to its nationwide network of clients. It takes few huge risks, and is emerging from 2008’s disaster in pretty good shape. Without the Wachovia acquisition, Wells Fargo could probably have avoided the need for TARP capital.

In my February report on the top 12 U.S. banks, I showed how many of the top banks were in pretty good shape and offered investors good value, which would be demonstrated by higher first quarter earnings going forward. The Financial Select Sector SPDR fund (XLF) is up about 39% since then, so that was a pretty pleasing call.

Of course, what I didn’t get right was that the dogs are up even more in percentage terms than the solid citizens. Citigroup, the biggest bow-wow of them all, has more than doubled. Going forward, I would expect quality to assert itself. While some of the weaker banks should survive, they will be able to take much less advantage of currently juicy lending opportunities than their stronger brethren.

Sorting Out the Winners and Losers

Over the long term, the road forward is clear. Roubini’s suggestion to break up the largest banks – say those with assets of more than $500 billion – may be impracticable. It is also unnecessary. They should simply be tightly restricted, allowed to undertake only “vanilla” banking businesses, without a presence in investment banking, or in high-risk trading.

The market would then sort matters out. Some banks, like Wells Fargo, would probably prefer to remain gigantic, but simple and low-risk – earning a reasonable return, paying their top executives moderately, and having their stock serve as a fine investment for risk-average investors seeking dividend income. Bank of America and JPMorgan might wish to divest their investment banking businesses and move toward this model. The cultural clash between Merrill Lynch and the old Bank of America has been huge, suggesting that their merger has huge negative synergy and that the two institutions would be worth more separated.

The top six’s two investment banks, Goldman Sachs and Morgan Stanley, would have no interest in commercial banking, in which they have little history, so would have to downsize dramatically. One possibility is splitting them three ways – an advisory business, a medium-sized institution with a magnificent client base, and a more or less unregulated hedge fund that could be allowed to bankrupt itself in the shadows. They would not be permitted to retain their current huge positions in “principal trading,” an activity of little economic purpose beyond exploiting the firm’s insider information.

As for Citigroup, it seems likely that its troubles are too great and its culture too aggressive for any Wells Fargo-type solution to be possible. Over time, it should almost certainly be liquidated.

Below the top tier, the U.S. regional banks should mostly be in good shape, with a few exceptions that were based in particularly troubled regions or who had been excessively aggressive. In any case, they would not be “too big to fail” and would be allowed to engage modestly in investment banking if they thought it profitable.

Since they would be allowed higher leverage than the behemoths, they would be more profitable. And over time, the banking business might fragment further, which could only be good for competition.

As the world has seen over the past year, the arguments for creating financial services behemoths were spurious. They were too large to manage, and they survived only because their host country taxpayers gave them an implicit guarantee.

Source:  U.S. Banks: Why Only the Simplest Will Succeed

In 2008, his fund returned 37%  – in a year where the typical hedge fund lost 19%.

Since last September, Paulson earned nearly $420 million shorting the stocks of some U.K.-based bank stocks – specifically Lloyds Banking Group PLC (ADR: LYG), and the former HBOS PLC (which Lloyds absorbed in January).

Paulson clearly does his homework, and now he’s turned his attention to gold.

In a recent move that garnered much industry attention, Paulson acquired an 11.3% stake in AngloGold Ashanti Ltd. (ADR: AU). At $32 per share, that acquisition set him back a cool $1.28 billion. British mining giant Anglo American PLC (ADR: AAUK) was the beneficiary of Paulson’s acquisitiveness, for it sold Paulson the AngloGold shares from its own stake in that company.

So let’s think about this for a moment. A single transaction shifted a significant portion of ownership, and more than $1 billion in cash, strictly between two parties:  No banks and no stock markets took part in the deal.

Besides his 11.3% stake in AngloGold (the world’s fifth-largest gold miner by market cap), Paulson also owns 4.1% of Kinross Gold Corp. (KGC), making him that gold company’s fourth-largest shareholder.

It seems this prescient investor is in good company, too.  David Einhorn, founder of Greenlight Capital Inc., with $5 billion in assets, also began buying gold earlier this year – for the very first time.

Noted value investor Jean-Marie Eveillard holds $1 billion in a vault near Times Square as “calamity insurance.” What’s more, as much as 8% of his First Eagle Global Fund is comprised of bullion and gold miners’ shares.

In the case of Paulson, the billionaire hedge-fund investor, his exceptional skill lies in his ability to foresee extreme financial episodes. From there, he decides how to position his funds to benefit from a likely outcome.

And that’s why we should all pay close attention to his most recent actions.

The very day after Paulson’s acquisition of AngloGold, the U.S. Federal Reserve announced that it would buy back a total $1.25 trillion of long-term Treasury bonds and Fannie Mae (FNM) and Freddie Mac (FRE) mortgage junk. That is essentially a monetization of the debt.  And that’s a red-carpet invitation for inflationary times (which is also the best time to play gold).

Pure coincidence? Maybe. But it’s a lot more likely that one of the savviest investors of our recent era is really onto something.

Source: If You Follow the (Smart) Money, Gold is Clearly the Smart Play