Wells Fargo recently made a preliminary report that crushed analysts’ estimates. Goldman Sachs is expected to complete a stock sale to repay the Treasury. There was quite an impressive rally last week, adding to an already impressive move up from the recent lows. This has lead some to declare that the worst is behind us. If that’s true, then it’s worth examining the mechanism for our salvation, the business model for banks.

I’ve previously mentioned that enough time can heal banks’ balance sheets:

Banks actually have a few ways to make money. They can short treasuries and buy agency debt. They charge fees for everything. They could lend (ha, that was a joke). Over time, the bank can write down the value of the assets as the new money comes in. Given enough time, insolvent banks can become solvent. Of course, the banks won’t actually function well during the process.

Despite the fact that I ridiculed the idea of banks lending, and despite the rather obvious examples of the lending crunch in commercial real estate, there is ample motivation for banks to lend to creditworthy borrowers. I stole the idea for the following graphs and analysis from this post, which strikes me as a bit nut-jobby (I don’t see calling bankers “gnomes” a good tool for persuasion). Still, kudos for pointing out the evidence.

Mortgage rates are low right now, but the Fed rate is lower. Banks have short term borrowing privileges at the Fed, where the money is effectively free right now. Banks can take this money and loan it out for mortgage refinancing at rates that are about 5%. Borrowing short and lending long … this always ends well (as both the savings and loan crisis and the current crisis in investment banking illustrate). But, the spread between their borrowing rates and their lending rates are near the all-time high (which was 2002-2004, so banks that started lending in 2001 were getting richer by the day). Here’s the graph of all data since 1971:

Let’s zoom in on the current data:

This data tells me two things:

1. Banks can make money lending right now.

2. Banks might be in for a world of trouble if/when the Fed starts raising rates.

Of course, the corollary to 2 is: the Fed is going to avoid raising rates as long as possible. Unfortunately, that would put us in a bind as well. Keeping the rates too low for too long was a contributing factor to the present crisis.

What does it mean?

As long as the regulators are willing to help the banks hide their current problems, the banks can try to repair their balance sheets through the following techniques:

1. Charging fees

2. Borrowing short, lending long

3. Treasury/Agency arbitrage

4. Stock sales

For this to actually work, banks have to make money faster than they are losing money. Commercial real estate is going to be a problem (check out the Calculated Risk links above). Residential real estate isn’t exactly solved. Another wave of foreclosures is potentially starting next year (California is expected to get hit particularly hard sooner). Credit card defaults are up. Student loan defaults are up. Personal bankruptcies are up. Business bankruptcies are high. There are a lot of headwinds.

It’s possible, though. We could recover from this crisis without fixing anything. We’ve had banking crises in the past. Some economists think that nothing has fundamentally changed from the savings and loan crisis. If that view is accurate, then it would be pretty reckless to state with certainty that things are different this time, and somehow the problems can’t be swept under the rug again. We did it with S&L. We did it with the dot com bust. Why shouldn’t we be able to do it this time?