If you want to see the future of banks, take a look at how Morgan Stanley did this past quarter. Last week some of America’s biggest banks trotted out short-term profits that hid deeper and longer-term problems. For the most part, they did better than expected. A few even made money. Some people will take solace in that. Since the banks got us into this mess, they want them to get us out. I think that’s asking far too much of banks. Banks have their hands full just trying to save themselves. Saving the economy would be asking too much.

The rule of thumb is, as the economy goes, so goes the banks. Can the banks even save themselves while households absorb the $15 trillion hit they’ve taken to their net worth?

Morgan Stanley gives us some clues. And we’d be foolish to ignore them. It did the worst of the six big banks which reported last week. So what was its main fix?  It’s replacing the head of its trading desk with a top hedge fund performer. This desk trades bonds, currencies and equities (sort of like what hedge funds do). Morgan Stanley’s trade desk didn’t do very well, especially in comparison to the smart guys at Goldman Sachs…

Goldman Sachs lost more than $100 million on six trading days over the quarter and earned more than $100 million on 23 days. Morgan Stanley lost more than $125 million on four days (including losing $390 million in one day in August) and made more than $125 million on eight days.

Goldman Sach’s ratio of big winning days over big losing days was 3.8. Morgan Stanley’s was two. Morgan Stanley says they’re going to start to take on more risk. Hey, guys, great idea. But you need to get better doing your trades first.

This is how banks are now making profits … not from loans but from risking taxpayer-paid TARP money, guaranteed Fed-backed loans and money from depositors and risking it on trades where you can make over $100 million in a single day but also lose $100 million (or in Morgan Stanley’s case $390 million) in a single day.

If you’re good at this sort of thing, like Goldman Sachs and JP Morgan are, then you can ignore your poorly performing portfolio of loans and tell shareholders that banking is still a good business even though it’s not exactly true. If you’re not that good, then like Morgan Stanley you can talk lamely about taking on more risk.

Before banks leveraged up and paid less attention to asset quality, banking used to be a good business. Borrowing low and lending high was a sure-fire way to generate profits. You can’t get more simple than that. But that wasn’t good enough for bankers. They lobbied for and got the repeal of the Glass-Steagall in 1999. Glass-Steagall had separated deposit banks from investment banks. After 1999, banks could take the tens of billions of dollars from depositors and invest it in anything and everything, from low-yield but safe Treasuries to risky but high-yield derivatives.

As you know by now, not enough went into safe Treasuries and too much went into risky derivatives. A few bubbles later banks were forced to write down about $1.6 trillion on their investments.

The one thing banks couldn’t talk about last week is improving loan portfolios. American Express hinted that their consumer loans may start to default at slower rates in the second half of the year. But Capital One and every other bank refrained from making such bold claims.

Consumers are in debt rehab. It’s hard to overestimate how bad it’s getting for consumers right now. But it’s going to take a while. They’re still spending much more than they make. In the first quarter they borrowed 128 percent of their income.

There’s absolutely no way that banks can separate themselves from this consumer squeeze. And I don’t see accelerating foreclosures and credit card default reversing this year or next…

•    Foreclosures will go up as long as the economy keeps shedding jobs. Whether the economy loses jobs at rate of 450,000 a month or 300,000 a month doesn’t matter.

•    Credit card defaults won’t improve either. People without jobs run up more card debt than people with jobs. And they have less money to pay back what they owe. And even though refinancing is up, homeowners have already cashed out most of the equity in their houses.

•    In Fed Chief Bernanke own inimitable words, “The possibility that the recent stabilization in household spending will prove transient is an important downside risk to the outlook.”

The Obamarons want banks to lend more so consumers can spend more so the economy can get better. Somebody should write them a memo and point out that consumers aren’t looking for loans and banks shouldn’t be forced to lend to cash-squeezed consumers (isn’t that how we got into this mess in the first place?).

But the real scary ticking time bomb is in banks’ commercial real estate loans. Most commercial real estate loans are balloon loans. Companies only have to pay the interest until the full amount is due. And the expiration dates for many of these loans are now coming due.

There’s a cynical saying in Russia which made the rounds during the good ol’ years of communist rule. It went like this: You pretend to pay me and I’ll pretend to work. Russians barely worked and they barely got paid. You could say the same thing about banks and their corporate customers. Banks pretend that the real estate loans to customers are still good, and these customers pretend that they will pay them back. It’s playing out right now, in broad daylight…

Florida-based resort developer Bluegreen Corp. just got an extension on $130 million worth of loans.  Toys R Us, Tanger Factory Outlets and Washington Real Estate Investment Trust also all recently got loan extensions.

How far has commercial real estate fallen? Even Morgan Stanley’s highly regarded Crescent portfolio of properties has taken a big hit. I had been following Crescent for about five years. Before Morgan Stanley bought them out a couple of years ago, Crescent was a Texas-based real estate company. It owned some of the most prestigious office buildings and hotels in Houston and Dallas. Two years ago, its rents were high and vacancies low. Now, Morgan Stanley’s $2 billion exposure to Crescent’s portfolio is seen as a big albatross as tenants look for lower rents in the cheaper side of town.

The $6.7 trillion commercial property market is slipping fast. Prices have fallen about 35% since the market peaked. Morgan Stanley’s chief financial officer said he did not see the light “at the end of the commercial real estate tunnel yet. Peak to trough, you have already had a pretty nasty correction in the market but it is still not looking very good at the moment.”

It doesn’t look good for banks when it comes to their consumer or commercial borrowers. Sure, some of these big banks made loads of money from their inhouse hedge funds. But that stuff can turn on a dime. Last quarter is already ancient history. Next quarter may be entirely different. And next year who knows. Banks are crossing their fingers and hoping for the best. But the economy isn’t cooperating. Banks are playing a dangerous game. They’re walking a tightrope in a stiff breeze, hoping they won’t fall off.  And I think that breeze is going to get a lot stronger over the 12 months. The banks aren’t through falling yet.

To your investing success,
Andrew