The Secret No One Wants to Tell

The one thing that seems to provide an explanation for a lot of the things going on today is the continued weakness of the banking sector. It explains the actions of the Federal Reserve System. It explains the actions of the Treasury Department. It explains much of the data that are being released. And, it explains much of the behavior of the banking sector, itself.

The secret: the banking sector is a lot weaker than the government is letting on and the government does not want to publically recognize the fact.

The FDIC recently released numbers on the banking industry for the third quarter. Profit-wise, the industry is very skewed. It is skewed toward the larger banks. The results have been summarized this way:

• Banks with assets less than $1 billion in assets roughly broke even in the third quarter;
  
• Banks with assets between $1 billion and $10 billion, on average, lost $3 million apiece;
  
• Banks with assets in excess of $10 billion recorded an average profit of nearly $42 million each.
  

The big banks, the banks that the regulators were most concerned with, are reaping a bonanza. And, why not? The Fed is keeping short term interest rates down: financial institutions can borrow for three-months in the range of 20-25 basis points in the commercial paper market and the large CD market; they can borrow for six-months in the 30-65 basis points in the CD market or the Eurodollar market. They can buy Treasury bonds that can yield 330 to 400 basis points. This is a nice spread. Plus these banks are traders and there has been plenty of volatility in the bond market in recent months. And, this does not even include the possibilities that exist in the carry trade.

As Eddy, Clarke's brother-in-law, remarked in the movie “A Christmas Vacation”: “This is the gift that just keeps on giving!”

Why?

Because the Fed is going to keep short term interest rates low for an “extended period” of time.

This effort is just another way to “bail out” the big banks!

But, what about the banks that are smaller than $10 billion in asset size?

Here the commercial banking industry has been given a gift of $1 trillion in excess reserves.

And, what is going on in this part of the banking industry? The FDIC released the third quarter information on problem banks. The total of problem banks in the country is 552, up from 416 at the end of the second quarter. Almost all of these banks are of the smaller variety. Given that 50 banks were closed in the third quarter this means that 186 new banks achieved the honor of being placed on the problem list in the third quarter.

It is estimated that at least one-third of the 552 “problem” banks, or 182, will fail in the next 12 to 18 months. If this is true then the United States will experience 2.5 to 3.5 bank closures a week for the next year to a year-and-a-half. This is slightly below the rate of 3.8 bank closures per week that was achieved in the third quarter. The hope is that this situation won’t get worse.

The path ahead for even those banks that are not on the problem list is treacherous. Real Estate Econometrics released information that the US default rate for commercial mortgages hit 3.4% in the third quarter of 2009. This is a 16-year high. The company also released projections indicating that this default rate could rise to more than 5% in 2011. Many of the banks in the middle tier possess millions of dollars of these loans on their balance sheet, relatively more so than do the big banks.

The huge debt of Dubai and Greece and others hang over this market.

In terms of residential mortgages, the picture does not improve. First American CoreLogic, a real-estate information company, recently released data that indicated that roughly one out of four borrowers is underwater in terms of their mortgages. Even 11% of the borrowers who took out mortgages in 2009 owe more than their home’s value.

The Treasury continues to push mortgage firms and others for loan relief. There is an indication that some borrowers are not really helped by the relief measures already promoted and that many who have been helped still face the possibility of re-default going forward.

And, layoffs continue in large numbers, foreclosures continue to take place at a high rate, and large numbers of bankruptcies, both personal and business, continue to occur. Another fact, out this morning, is that delinquencies on auto loans are on the rise.

And, banks are not really lending in any form. The Federal Reserve continues to pump funds into the banking system, yet commercial banks seem to be very content to accept the funds and just hold onto them in the most riskless way possible. If you don’t make a loan, it won’t turn bad on you. Furthermore, commercial banks face the situation in which the longer term liabilities they had accumulated earlier in the decade are going to be maturing. They will need money to pay off these liabilities without replacing them.

Charles Goodhart, Senior Economic Consultant at Morgan Stanley, writes in the Financial Times that central banks should declare victory in the war against financial collapse and cease their policy of quantitative easing. (See “Deflating the Bubble”, http://www.ft.com/cms/s/0/2b7b26de-ddcd-11de-b8e2-00144feabdc0.html.) He writes, “If the authorities go on blowing up financial markets too much, at some point yet another bubble will develop. The last time the financial bubble burst, the taxpayers got soaked...Certainly, we can never get the timing exactly right, but now does seem the moment to declare victory for (Quantitative Easing) and withdraw.”

That is, unless there is something we don’t know and the government is not telling us, like the extent of the weaknesses that exist within the banking sector.