Can an Economic Expansion take place without the Banking Sector?

The Obama team has put forward the outline of its economic stimulus plan. The United States Congress has released the last $350 bill of the TARP funds. Will this get the United States economy going again?

It seems to me that the answer to this depends upon whether or not the United States economy needs a banking sector to accompany the journey. Again, the earnings reports coming out of the financial sector last week hardly gives us much confidence that banking institutions are in any kind of shape to contribute to a regeneration of economic growth.

Losses are still huge…and one doesn’t gain much confidence from the executives running these institutions that the flow of losses is over. And, it is in the larger financial institutions that the problems are so great. But, this doesn’t mean that smaller institutions are out of harm’s way.

The fundamental issue is about the value of the assets the banks are holding. I don’t see or hear anyone claiming that bank managements really have their arms around the valuation problem. And, after all we have heard from bank presidents trying to build up confidence in their institutions, very little faith can be taken from anything else they might say. My strong feeling is that banks still do not know how deep their problems are right now and whether of not many of them are still solvent. This is a scary fact.

But, that is the past. We are only at the beginning of the real economic slowdown. Bankruptcies are on the rise and will continue to do so through the first half of the year. With the tremendous slowdown in retail sales in the fourth quarter of 2008 the accounting results for the end-of-the-year are bound to be horrible. What will be the fallout from these results is any one’s guess right now. There will not be bail outs for many or most of these poor performers and so there will be more and more doors shut going forward.

One suggested solution to arrest some of these closures is mergers or acquisitions. However, given all the uncertainty that exists in the economy at the present time…who wants to buy anything…and at what price.

Two cases, both in the news, should serve as examples: first the acquisition of Merrill Lynch by Bank of America; and second, the liquidation of Circuit City. The case of Bank of America is a sad one indeed…regardless of how you read the tea leaves. Merrill Lynch…like Citigroup…like AIG…and so on…didn’t know the value of its assets. The CEO of Bank of America wanted Merrill…very badly. Did BOA not do its due diligence? Did it do a crappy job? Did the hubris of the chief executive, as in many other cases in both good times as well as bad, go into the deal with blinders on? Did BOA try to get out of the acquisition of Merrill and the government would not let them out?

Whatever, the Bank of America/Merrill Lynch is a deal that went very, very badly. But, I go back to my main point…Merrill Lynch did not have a good handle on the value of its assets. They may have thought that they did…but they didn’t! And, this seems to be the story over and over again.

Financial institutions do not seem to have any real idea of what is the value of their assets. So, beware…mergers and acquisitions are dangerous to your health!

And, hence, we can move on to Circuit City. The rumor was that Circuit City had three parties that were potentially interested in acquiring the company. All three apparently were not willing to pay a price sufficiently high that would exceed what Circuit City thought they could gain by selling off inventories and closing their doors. Again, here is a bet the potential acquirers were not willing to make…a bet on the value of the assets of Circuit City. And, this seems to be the other side of the Bank of America/Merrill Lynch transaction…how can a company buy someone else when they don’t have a good feel for what the underlying assets are worth.

This gets us into the second part of the dilemma of the banks…making loans. If the banks don’t know the value of the assets on their books, how likely is it for potential borrowers to know the value of the assets on their books…consumers as well as businesses? Not very likely at all!

Why should banks get criticized for not lending to potential borrowers and potential acquirers of businesses be excused from any criticism? What is the difference between a potential acquirer that is not willing to pay very much to obtain the assets of another company and a bank that is not willing to loan money to someone because if, in both cases, the value of the assets of the potential acquisition or the potential borrower is highly uncertain? What I am saying is that right now there is so much uncertainty over who is going to be around in the future and what can be salvaged from existing economic units the people are unwilling to commit any more resources for lending or for acquiring.

Furthermore, why should banks be lending more when they are facing over the next two years or so at least two periods where there will be major adjustments of interest rates on mortgages and other loans on assets. These repricings may create many more foreclosure or bankruptcy problems on the banks and this would mean that banks would need even more resources to back up the decline in the value of their assets.

The question that still remains to be discussed is the solvency issue. Financial crises generally follow the pattern that first there is the liquidity crisis. Then there develops the asset crisis. Finally, there is the solvency crisis.

We finished with the liquidity crisis in December 2007. The asset crisis hit in March 2008 and grew into and through the fall of that year. We are, I believe, in the period of the solvency crisis…the life and death struggle of a large number of financial institutions.

Hopefully, TARP has provided a little relief toward the solvency of banks. The big question is whether the funds that have gone to bank capital have reached any where near the total that will be needed. If banks do not know the value of their assets now, there are still big holes to be filled in balance sheets…existing bank capital may be no where near that needed to keep the banking system going. In addition, if there are still shocks that the banks must face in terms of future bad loans…even more pressure is going to be added to the capital needs of the banking system.

There are two issues here. First, how is the government going to keep those banks that are relatively healthy going? Second, how is the government going to close those banks that are not healthy and how is the government going to dispose of the assets of these banks? In the first case…and I never ever thought I would ever be in a situation where I would be saying this…the government may have to nationalize a fair portion of the banking industry…more than it already has.

In the second case, the government is going to need something like the Resolution Trust Corporation (RTC) to manage the assets it takes over from the banks that have to be closed. Furthermore, it would seem as if the government would have to come up with a relatively large amount of funds to cover the losses on assets that would have to be shelled out in the closing of these banks. Many analysts have argued that this is not such a bad solution since the original RTC, formed in 1989 actually made money in its asset sales. However, this organization sold into a rising housing market. A rising market does not seem likely in the near future.

Now back to the original question. Can an economic expansion take place without a banking sector to support it? My feeling is that it would be very hard for an expansion to take place under such circumstances. If the banking system is not functioning…even a large economic stimulus package will not be very effective in getting the economic system going again.