Friday, December 18, 2009

Headlines of the Day: How Are Governments to Finance Themselves?

More and more attention is being directed toward the problems that governments are having with their financial situation. We have spent so much time this year discussing the problems in the financial industry, in housing, in credit cards, in consumer credit, in business bankruptcies, in debt-swaps, and in commercial real estate, that the plight of governments, other than the federal government, has taken a back seat.

Is 2010 to be dominated by the financial problems of government: federal, state, and local?

The cloud is certainly on the horizon.

Budget and debt problems on the national level have risen to prominence in the last few weeks. Just to list a few, you can start with Ireland, Greece, Spain, Mexico, and Dubai.

Yeah, and what about California and New York?

More and more we are hearing about the sagging prospects for the states and for cities and other local administrative units. See, for example, “States Scramble to Close New Budget Gaps” in the Wall Street Journal,

In almost all states, there is some kind of balanced budget requirement. This is also true of many local government bodies. This means that attempts must be made to bring budgets under control.

The problem is on the revenue side; funds are just not coming in at the rate even severely revised budget projections anticipated. And, all of these shortfalls cannot be filled by federal stimulus monies. Certainly some jobs, especially in education, were maintained by federal funds, but this source cannot be continually relied upon.

And, the situation is a cumulative one. Unemployment and non-existent economic growth have caused the revenues of these entities to slow down. This is resulting in more budget cuts, primarily in programs and layoffs which just exacerbate the problem in unemployment and slow economic growth. This in turn slows down the revenue flow even further. And, so on, and so on.

Just as businesses and households are doing, state and local governments are re-thinking what it is they do, what they can do, and how they are going to go about doing it. The de-leveraging and down-sizing are coming after 50 years or so of relatively constant expansion of budgets and programs.

The inflationary-bias that has existed in the United States for the last 50 years resulted in a very prosperous public sector to go along with the very prosperous private sector. As I have stated repeatedly in my posts over the last two years, inflation is wonderful for the creation of debt and for financial innovation, in the public sector, as well as in the private sector.

Ah, thank goodness for gambling, for it seems to be one of the “gap-filling moves” that states are relying on to replace revenue shortfalls. The problem with this is that “planned gambling expansions” are zero-sum games if people, on the whole, don’t increase their gambling activities. And, do we really want people to increase their gambling activities, especially at this time?

But, this leads us back to the federal sector. It seems as if future inflation is the only answer to the consequences of past inflation.

The latest official estimate for the federal deficit for 2010 is $1.5 trillion, up from 1.4 trillion the year before. Even scarier is that the Gross Federal Debt is projected to increase by $2.2 trillion this year, an increase of 18.6% from last year. Even shakier is that the public is supposed to absorb more of the increase in the federal debt than ever before: a rise of $2.0 trillion or 26.9% ahead of last year.

And, these budget figures don’t include the Pentagon “bill” that was passed yesterday with much pork and “earmarks”, buying things that the Pentagon didn’t even want! And, it doesn’t include the new Pelosi “jobs bill” which just passed the house last week. And, it doesn’t include real numbers for the health care legislation. Oh, yes, and where is the $100 billion going to come to help finance the climate concerns of the emerging or developing nations? This was just proposed two days ago. Also, where is the cost of the increased troop commitment to Afghanistan? And, there are four or five other things that could be included in this list.

Where are the funds going to come from to finance all of these expenditures?

In addition, we have a Federal Reserve System that is on the verge of “exiting” from the excessive liquidity that it has injected into the financial system over the past 15 months. The Fed has a portfolio of securities that amounts to $1.835 trillion. The composition of this portfolio is U. S. Treasury securities, $777 billion, Federal Agency securities, $158 billion, and Mortgage-Backed securities, $901 billion.

How is the government going to finance all of the new debt it must place on the market at the same time the Federal Reserve is trying to reduce the size of its balance sheet by selling off these securities?

Furthermore, the Congress is not going to be happy with the Fed selling securities to “exit” its current bloated balance sheet which will cause interest rates to rise at the same time that massive amounts of new federal debt is going to be hitting the financial markets.

Well, the Bernanke Fed is not independent of the government anyway.

So, inflation is the answer! Bring it on!

The interesting thing about the international concern over the financial health of the nations is that the value of the United States dollar has risen. International finance seems to be saying that maybe things in the United States are not that bad when you consider the state of other nations in the world.

As I wrote above, maybe in 2010 a lot more of the concern in credit markets will be with the status of government budgets and government debts. The question then becomes, how long can governments continue to bail out other governments? Maybe as long as some governments can still print money.

Thursday, December 17, 2009

Will Bernanke Never Learn?

The report from the Federal Reserve yesterday was positive. The headline in the Wall Street Journal was typical: “Fed More Upbeat, but Keeps Lid on Rates.” In other Federal Reserve news we hear that the Fed is going to phase out the special facilities set up during the financial crisis.

So, what else is new? (

Our fearless leader, Time’s Person of the Year, POTY, Chairman Benjamin Shalom Bernanke, was an avid supporter of Alan Greenspan and low, low interest rates earlier this decade, rates that spurred on the credit bubble in housing and elsewhere. In 2007, Chairman Bernanke was late in identifying the fact that the economy was slowing and that there was a looming financial crisis on the horizon. Then, Time’s POTY seemingly panicked after the bailout of AIG in September 2008 and this resulted in the rushed passage of TARP. (

Once it was finally accepted that there was a financial crisis, POTY saw to it that just about everything that could be thrown against the wall, was...thrown against the wall. In this he has been deemed a savior. The balance sheet of the Fed ballooned from about $900 billion to roughly $2.1 trillion.

Now, POTY is seeing that the target rate of interest for the conduct of monetary policy can hardly be differentiated from zero and this target has been maintained since December 16, 2008.

WOW! The Fed’s zero target rate of interest was one year old YESTERDAY!

Excess reserves in the banking system have gone from about $2 billion to over $1.1 trillion!

And, what is the result?

Big banks are eating this up! There are two articles in the morning papers that attest to this. See the column by John Gapper in the Financial Times, “How America let banks off the lease”: Gapper writes, “As the FT reported on Wednesday, banks and hedge funds have made huge profits in distressed debt trading in the past year, aided by the Federal Reserve keeping short-term interest rates low. Meanwhile, the banks that turned out to be too big to be allowed to fail are bigger than ever.”

Next, the op-ed piece in the Wall Street Journal by Gerald P. O’Driscoll, Jr., “Obama vs. the Banks”: O’Driscoll states “that banks can raise short-term money at very low interest rates and buy safe, 10-year Treasury bonds at around 3.5%. The Bernanke Fed has promised to maintain its policy for ‘for an extended period.’ That translates into an extended opportunity for banks to engage in this interest-rate arbitrage.” He then asks, “Why would a banker take on traditional loans, which even in good times come with some risk of loss?” Seems like I have been arguing this point for at least six months now in assorted blog posts.

But, of even more importance is the attitude of the bankers toward financial innovation.

There is no better environment for financial innovation than the one that we are now experiencing. I would argue very strongly that financial innovation is taking place right now even though we may not see all the different forms the innovation is taking. And, the current round of financial innovation is coming at the expense of regular borrowing and lending. And, the financial innovation is benefitting the large, financially savvy financial institutions and not the small- and medium-sized organizations that don’t have the resources, or, the inclination, or, the freedom, since they still have plenty of questionable assets to deal with. Hail, Wall Street! See you later Main Street!

For the past fifty years or so, the government of the United States has basically followed an expansionary economic policy that has provided a safety-net to the financial system, and established an inflationary bias within the economy. There is no better environment for financial innovation than this!

The banks, the financial system, the non-financial system, and governments have innovated like mad during this time period.

The current federal government is just continuing to underwrite this practice at the present time.

POTY and the current administration are just exacerbating the situation they are so heavily criticizing.

And, as Gapper states, "the banks that turned out to be too big to be allowed to fail are bigger now than ever."

POTY and the current administration may win, politically, in the short run because the big bankers seem to have a deaf ear: See

In the longer run, the victory may go to another side. Paul Volcker seems to be taking the other side of the argument. See the article by Simon Johnson in The New Republic: “Is History on Paul Volcker’s Side?”

The bottom line, however, is that Benjamin Shalom Bernanke doesn’t seem to get it…once again! Time after time, the Fed Chairman has seemed to miss the mark. Because of this record, one, I think, can seriously ask the question: “Why should we expect Bernanke to be correct this time?”

In nominating the Chairman for another term, President Obama seems to believe that Bernanke will be correct this time. More than anything else the president has done, even sending more troops into Afghanistan, his bet on the re-appointment of Chairman Bernanke may determine how his presidency is perceived by future historians. A lot is riding on Chairman Bernanke.

Tuesday, December 15, 2009

Banking, Banks, and the President: Defining the Issues

The side that wins the political battles is usually the one that presents the issues in such a way that the “public” responds to this presentation and goes with them rather than with the “other side.”

There is an election coming up next year and the campaigning has already begun. The battle: whether or not the Democrats are going to be able to maintain a large enough majority in Congress to control the action in Washington, D. C. Already, the Democrats are looking back over their shoulders to 1994 mid-term election and their loss of control of Congress at that time. And, they are scared.

The way to operate in politics is to “frame” important issues in such a way that they will resonate with a majority of the electorate. It takes time for specific issues to “take hold” with the public so the framing effort must be started well in advance of the election. The process of “framing” is moving ahead, full steam.

The economy is obviously going to be an issue. How it is framed will determine the result. It appears that the banking industry is going to play a big role in how the discussion on the
economy evolves. The battle lines: Main Street versus Wall Street. The issues: an unemployment rate of 10% and an underemployment rate at 17-18% versus lots of taxpayer money to bail out the banks and the subsequent profitability of the big banks. A further issue: people losing their homes through foreclosure versus the payment of large bonuses by the big banks to their executives.

Sure the meeting between the President and the heads of the major banks in the United States was a great photo op. But, what did the photo op turn into? Let me just say that a headline like “Bankers Put Obama on Hold” accompanied by a picture of the President at his desk holding a phone does not create a very favorable image of the bankers (see the article by Andrew Ross Sorkin in the New York Times:

Paul Volcker, former Chairman of the Board of Governors of the Federal Reserve System, is still a hero to many people, myself included, and is perhaps the most respected person in finance in the world today. He stated very bluntly in West Sussex, England this week that the bankers just didn’t get it. Great headlines!

In debates like this it doesn’t always matter who is right and who is wrong. We have seen over and over again that in economics, identifying the cause and effect of an economic situation is so difficult and the lags between the cause and the effect are so long, that explaining a situation to the public in terms that they understand is almost impossible.

Here I am specifically writing about the run-up to the financial collapse of 2008. To me the causes of this collapse go back to the almost 50 years of inflationary finance perpetrated by the United States government, Republican and Democratic alike, on the American people. This includes the huge deficits run up by the federal government since 9/11 and the inexcusable monetary ease that kept real interest rates negative for two to three years in the 2002-2005 period. The financial bubbles that resulted in housing and the stock market this decade produced the conditions that led to the subsequent events.

An economy with an inflationary bias is ideal for the evolution of financial innovation. It is ideal for leveraging up the balance sheet. It is ideal for assuming more and more risk.

It is difficult, however, to explain this cause and effect to the public.

Financial innovation looks like greed run amok. Assuming more and more risk looks like greed run amok. And, excessive amounts of leverage looks like greed run amok.

But, what about the government policy makers that created the incentives that made financial innovation valuable? What about those that contributed to the inflation that made high degrees of leverage worthwhile and edgy risk taking more attractive?

The connection is very difficult to put into sound bites and win the hearts and minds of voters.

In terms of financial regulation? My belief is that banks, especially the big banks have moved beyond the recent financial collapse. Congress and the regulators are always fighting the last war. The goal of Congress and the regulators is to not let the events of 2008 and 2009 happen again.

Guess what? The events of 2008 and 2009 will not happen again. The banks have moved beyond that. The reformed regulations will probably hurt the smaller banks much more than the larger banks. The smaller banks are still the ones dealing with the past, the questionable commercial real estate loans, the residential mortgages that are in arrears or are not paying at all, the consumer credit, the credit of state and local governments and so on and so on.

But, the big banks. They are already into 2010 and 2011 and beyond! More on this in another post.

This is why the banking industry must be careful at this time. In a real sense, Volcker is right; the bankers just don’t get it!

They can’t afford to look as if they are making the President look silly. They can’t afford to make themselves look like they are “fat cats.” Whoops, that is what the President called them Sunday night and it is all over the country. The bankers can’t afford to look as if they are staunchly against regulation reform. The bankers can’t look like they don’t care about mortgage foreclosures, or small-business loans, or getting people back to work.

The issues are being “framed” right now. The bankers cannot put themselves in a position to be characterized as “Scrooge” while the Obama administration comes on as “Tiny Tim.”

Monday, December 14, 2009

Federal Reserve Exit Watch: Part 5

Something new this week: the Fed started to see how the financial markets would accept its strategy for reducing the size of its security portfolio. At the close of business on Wednesday December 9, 2009 the Federal Reserve showed $180 million on its balance sheet under the line item “Reverse repurchase agreements”.

The Federal Reserve had warned us that it was going to start “testing” the use of reverse repos as the mechanism for reducing the size of its securities portfolio. It had also informed us that a “test period” would begin last week.

It has begun, albeit in a very small amount.

Reserve balances with Federal Reserve Banks changed by only an insignificant amount last week.

Reserve balances did rise over the past 4 weeks and the past 13 weeks. In the last 4-week period reserve balances rose by a little more than $60 billion, $52 billion coming from factors supplying reserves and a negative $10 billion from factors absorbing reserves.

The $52 billion increase in factors supplying reserves was centered on an $85 billion increase in securities held outright ($79 billion in Mortgage-backed securities and $6 billion Federal Agency securities) and a $36 billion reduction in two accounts associated with the insertion of funds into the banking system early in the financial crisis last year. The Term Auction Credit Facility (TAF) dropped by almost $24 billion in the last four weeks and Central Bank Liquidity Swaps fell by about $13 billion.

The rest of the items connected with the innovative market facilities that the Fed created during the time of financial distress changed very little.

So the “Special Facilities” continue to wind down and the Fed continues to substitute marketable securities in its portfolio for the funds that were injected into the banking system to stem the crisis.

In terms of factors absorbing reserves at this time, the general account of the U. S. Treasury Department, its operating account at the Fed (it pays its bills out of this account), dropped by about $8 billion and this added reserves to the banking system and was the primary factor in the additional $10 billion increase in Reserve Balances mentioned above. The Treasury writes checks, they get deposited in banks, and bank reserves increase.

Over the longer term, the last 13 weeks, the government accounts have played a big part in the injection of reserves into the banking system. There is an account titled “U. S. Treasury, Supplemental Financing Account” which has been around since October 2008 (and reached a maximum of about $560 billion in November 2008 (Connected with TARP?). This account declined by $185 billion over the last 13 weeks.

The U. S. Treasury general account rose by $51 billion during this time, apparently the funds from the supplemental account were transferred to the general account so that they could write checks on it. Consequently, the net of the two, $134 billion got into the banking system and ended up as a part of Reserve Balances with Federal Reserve Banks.

During this 13-week period, the Fed also supplied $100 billion in reserves to the banking system through open-market purchases. To do this the Federal Reserve added $281 billion to the securities that it bought outright. The purchases were across the board: $229 billion in Mortgage-backed securities; $33 billion Federal Agency securities; and $19 billion in Treasury securities.)

The run-off in the special accounts over the past 13 weeks is obvious. The Term Auction Credit Facility (TAF) declined by $126 billion and Central Bank Liquidity Swaps fell by $45 billion, a total of $171 billion.

Primary bank loans from the discount window also fell by $10 billion so, over the past 13-week, period the Fed supplied reserves by buying $281 billion in securities and this was offset by a decline in “crisis” accounts of $171 and $10 in bank borrowing so that $100 billion additional funds reached Bank Reserves.


  1. The Federal Reserve continues to let accounts connected with the financial crisis run off. This appears to be going along quite smoothly.
  2. The Federal Reserve continues to substitute funds from open-market purchases to replace the funds that are running-off. This appears to be going along quite smoothly.
  3. The Fed is now testing the mechanism, Reverse Repurchase Agreements, by which it means to reduce its portfolio of securities and drain excess reserves from the banking system. The first test went along quite smoothly.
  4. The U. S. Treasury supplemental financing account is now just $15 billion and will probably not be a big factor in changing bank reserves in the future.
  5. The Federal Reserve is going to be facing a lot of “operating factors” over the next month that may cloud up any other actions that the Fed may be taking. These “operating factors” relate to government deposits and the increased use of currency in circulation during the holiday season. These disruptions should end by the middle of January 2010.

Note: Excess Reserves in the banking system still are running above $1.1 trillion. There is little evidence yet that banks want to do anything with these reserves other than hold onto them: this, in spite of the efforts of the Obama administration to get banks lending, especially to small business.

Thursday, December 10, 2009

Bank Holding Companies and Other Financial Institutions

Bank Holding Companies

The Flow of Funds accounts from the Federal Reserve System just came out today. This gives us a chance to look at parts of the financial system that we do not get to look at on a more frequent basis.

In terms of the banking sector, one area of interest at this time is the activity going on in bank holding companies. In terms of assets, bank holding companies, at the end of the third quarter, 2009, are holding $2.8 trillion in assets, up from $1.9 trillion one year ago and up from $1.8 trillion at the end of 2007. So assets in bank holding companies rose by almost 50% in the past year.

The large increase in assets came in the area of investments in nonbank subsidiaries. The rise from the end of the third quarter of 2008 was $537 billion, or 135%. The increase since the end of 2007 was $592 billion, or an increase of 172%

These holding companies also increased their investment in bank subsidiaries as well, but only by $164 billion or by 14% since the end of the third quarter 2008. The increase since the end of 2007 was $188 billion.

Financing this increase in assets was an increase in bonds issued by these holding companies and in residual equity. The net increase in corporate bonds issued was $508 billion for the year ending in the third quarter of 2009. The net increase since the end of 2007 was $553 billion.
There was roughly an $400 billion increase in the residual equity of these organizations during this time period. The increase in residual equity since the end of 2007 was approximately $500 billion.

These increases in bank holding company assets took place at the same time that total assets in U. S. chartered commercial banking sector rose only by about $139 billion from the third quarter of 2008 to the third quarter of 2009. It should be noted that during this same time period total bank loans in the banking industry declined by almost $383 billion, with reductions taking place in every category of loan.

Note that since the end of the third quarter 2008, vault cash and reserves at the Federal Reserve rose by $384 billion. The increase since the end of 2007 was $540 billion.

It is obvious that banks and bank holding companies are not doing the ordinary business of banking.

The commercial banks, themselves, are becoming “pools of liquidity”, but they are not lending.

It seems that bank holding companies, however, are further diversifying into nonbank subsidiaries because of the tremendous opportunities for profit that are now available to them in these areas. Also, it seems as if this is all happening for the largest banks and the largest bank holding companies.

So, here is the picture: commercial banks are essentially static right now; nothing is happening in the industry as a whole.

Bank holding companies are moving ahead full steam: and what they are doing is very, very profitable!

Saving Institutions

The thrift industry continues to shrink!

In the last four quarters, the total financial assets in savings and loan associations, mutual savings banks, and federal savings banks fell by $145 billion, or by about 10%, to just $1.4 trillion. Since the end of 2007, financial assets have fallen by $442 billion, or by about 25%.

One really has to wonder about the existence of this part of the finance industry and the need for such an expensive regulatory structure to support it.

Its main reason for existence, the issuing of mortgages, continues to erode as mortgages on the books of these savings institutions fell by $155 over the past year, an 18% decline. Since the end of 2007, mortgages at these institutions fell by $367 billion, a decline of one-third. Statistics indicate that, on average, institutions in this industry are just about breaking even, profit-wise.

Although it is not getting a lot of headlines in the press, the savings industry is not doing too well. Maybe it is now too insignificant to warrant much attention!


Credit unions continue to grow. They ended the third quarter at $873.4 billion in total financial assets, increasing by $73 billion over the last four quarters.

One wonders when the total assets at credit unions are going to exceed that at savings institutions.

Although the totals are not large, credit unions continue to increase their loan portfolios across the board.

The total amount of credit extended by credit unions was $592 billion at the end of the third quarter 2009, roughly two-thirds of the $875 billion in loans on the books of savings institutions. Credit unions have only about 63% of the assets that savings institutions do.

Mortgages on the books at credit unions are about 44% of the amount of mortgages that sit on the books of savings institutions, up from 35% at the end of the third quarter in 2008. But, consumer loans are 308% of the total of consumer loans at savings institutions. This is just a little higher than it was one year ago.

Credit unions seem to be doing very well and continue to be on the rise!

Wednesday, December 9, 2009

It Ain't Over Until It's Over

Spain has just had its debt outlook lowered by Standard and Poor’s. In January, Spain’s debt rating was lowered from AAA to AA+. Now, Spain’s debt outlook has been reduced from “stable” to “negative”. The outlook: Spain is now expected to experience a “more pronounced and persistent deterioration” in its budget and a “more prolonged period of economic weakness,” than it expected at the start of the year. Enough said.

Spain now joins Dubai and Greece in the headlines that include the label “sovereign debt.” And, the guess is that this list is going to grow in the upcoming weeks and months.

It’s not over yet!

There are still too many entities that have not fully voiced their precarious financial situation or have not yet fully accounted for their losses.

As I have said many times before that although the bad news is that there are still a lot of write-offs and write-downs that have not been taken yet, the good news is that we are not “surprised” by them and seem to be handling the bad debt problems within the “course of business.”

Many of the people I most respect believe that there will be more nations joining Spain, Dubai, and Greece as problem areas. There will be states within the United States that will be downgraded credit-wise. More corporations and businesses will find their credit rating lowered. Bankruptcies, business and personal, will continue to rise. Foreclosures on homes and commercial properties will keep going up. There will be a lot more bank failures. Remember there are 552 banks on the problem bank list of the F. D. I. C. The credit problems of the world are not going to go away for a while.

And, this is the reason why there is next to no lending going on in the economy and in the world.

Yes, some of the bigger organizations are getting funds. But, the world is bifurcating. As mentioned Monday, many of the bigger banks seem to be thriving, profit-wise, while the smaller ones are on the edge. (See Also, the larger banks are increasing their lending while the small- and medium-sized banks are still contracting their lending.

It seems that at this time there is very little confidence in balance sheets and in people. One just doesn’t know who to trust anymore. And, this lack of confidence extends from the private sector to the public sector and back again.

It is this underlying lack of confidence, this lack of faith that will tend to hinder the recovery and the return to a more “normal” economy, whatever “normal” is going to mean in the future.

The real problem is that I don’t see anything on the horizon that is working to change this lack of confidence. To me, the world has changed, it changed in September 2008. Yet, to a great extent, our policymakers are trying to force the world back into the form it was before these changes took place.

Just in terms of financial regulation, Congress, and many of people that advise Congress, are fighting the previous war.

Haven’t they noticed that the bigger financial institutions have already changed? JP Morgan Chase and Goldman Sachs have moved on. So have many other healthy, large organizations in the United States as well as in the world. Congress will not be able to put them back into their former mold.

In this respect, the only thing one can hope for on the regulatory side is that the Congress will not “muck-it-up” too badly in terms of banking regulation for the rest of the industry.

Remember that there are about $12 trillion assets in the banking system in the United States. Of this amount, the largest 25 domestically chartered banks possess $6.8 trillion and the “small” domestically chartered banks hold about $3.8 trillion. The rest of the assets are in the branches of foreign banks. The largest will find ways around new rules and regulations: the smaller institutions will have to deal with them directly.

The things that the current administration and Congress are doing to try and get the economy moving again lack traction in the area of building confidence where that confidence is needed. This lack of confidence is even coming from within government, itself, as Elizabeth Warren, the head of the Congressional Oversight Panel on bank bailouts, has called the Treasury’s program to restructure mortgages that are underwater so as to prevent foreclosures “ineffective” and something that the Treasury should scrap.
Confidence in the system and trust are going to be slow in coming back. Until these things return, a full recovery will not be forthcoming. It ain’t over until it’s over!

Sunday, December 6, 2009

Big Banks seem to be doing just fine: Smaller Banks, not so well

Last month it seemed as if there was a glimmer of hope for the smaller banks: lending appeared to be picking up across the board. (See my November 9 post, “A Positive Trend in Small Bank Lending”:

Well, the glimmer of hope went away in November. However, lending, and profits, at the larger banks seemed to become more robust as we went deeper into the fall.

Overall, bank liquidity continued to rise as the cash assets in the commercial banking system rose by $290 billion in the latest 13-week period and by $110 billion in the last 4-week period. This increase was, of course, reflected in the aggregate bank data. The Federal Reserve showed that Reserve Balances with Federal Reserve Banks averaged $833 billion in the banking week ending August 26, $1.085 trillion in the banking week ending October 28, and $1.139 trillion in the banking week ending December 2. Excess reserves in the banking system averaged $795 billion, $987 billion, and $1.120 trillion for the two-week periods ending, August 26, October 21, December, respectively. The banking system became more liquid as the fall matured.

Whereas, lending in the smaller banks showed some rise in October, lending was down across the board in the November period and this seemed to drag down the results from the last 13-week period.

The leader in this decline was lending for Commercial Real Estate. Analysts have claimed for some time now that problems were looming in this area for the small- and medium-sized banks. The concern was over timing: when were the problems being experienced by this sector going to show up on the balance sheets of these banking organizations?

Well, they really seem to be showing up now. Commercial Real Estate loans on the balance sheets of “small” domestically chartered commercial banks declined by $33 billion in the 4-week period ending November 25. They dropped by $50 billion in the last 13-week period.

Commercial and Industrial loans also decreased at the smaller banks in the latest 4-week period by $23 billion. (These loans actually had increased in the previous nine weeks.)

Furthermore, as stated in my December 1 post, these small- and medium-sized banks are not doing well profit-wise. The F. D. I. C. reported that commercial banks of $1.0 billion in assets size or less roughly broke even profit-wise in the third quarter of 2009. Banks in the $1.0 billion to $10.0 billion in asset size lost, on average, $3.0 million per bank in the third quarter.

The problem bank list, which consists primarily of small- and medium-sized banks rose to 552 at the end of the third quarter, an increase from a total of 416 at the end of the second quarter, and this is with 50 banks dropping off the list in the third quarter because they failed. (This information is reported in

The blip upwards in lending at the small- and medium-sized commercial banks reported last month is typical of the information flows we are getting these days. Some months the information that is reported looks good and we get excited about it. The next month…well, the information isn’t so good. The concern with the smaller banks is that the future could really be quite bleak.

With 552 banks on the F. D. I. C. problem list, we could see the banking industry taking a lot of hits in the next 12 months or so. If one-third of these banks fail, which is the estimate going around, this would mean that 184 of these banks would be closed or, in a 12-month period, roughly 3.5 banks per week would be closed. In the third quarter of 2009 three banks a week, on average, were closed. And, this assumes that no other banks come onto the problem bank list.

What about the big banks?

The big banks, except Citigroup, seem to be doing just fine. Even Bank of America is going to pay back the money it received from the federal government and it has raised additional capital.

Evidence that big banks are doing OK is present in the F. D. I. C. data just released. Commercial banks with assets in excess of $10 billion reported profits, on average, of $42 million per bank in the third quarter.

This prosperity seems to be translating itself into the performance of these larger banks. The assets of large commercial banks rose by $202 billion in the last 4-week period, whereas total assets actually dropped in the smaller banks and in foreign-related banking offices.

Loans and leases at the bigger banks surged by $163 billion in the last four weeks. This is the first substantial increase in activity in these banks this year!

Whereas the increase in loan volume was registered in all categories of loans, of particular note was an increase in Real Estate loans of $125 billion. And, the increase was distributed across residential mortgages, $80 billion, commercial real estate loans, $29 billion, and home equity loans, $16 billion. Business loans and consumer loans lagged these totals, but increased by $12 billion and $10 billion, respectively.

The bottom line:

Big banks, in general, seem to be doing very well;

Small- and medium-sized banks, in general, are not doing so good.

This presents quite a dilemma for the Federal Reserve. The bailouts of the big banks have seemingly worked. The big banks were saved from the systemic risk that existed within the financial system (yes, Mr. Goldman Sachs, you too would have failed if we had done nothing—Tim Geithner) and are now doing quite well. The Fed’s policy of keeping short term interest rates close to zero seems to be lining the coffers of these banks in record amounts.

The small- and medium-sized banks are another issue. These organizations, on average, do not seem to be making profits yet. Their loan losses really seem to be piling up and more is going to be asked of them in terms of reserves in anticipation of further losses. External capital does not seem to be readily available to them. And, they have more than 25% of their assets in cash and securities to help them through this period and to be able to pay off their own debt as it matures.

The Federal Reserve must take the condition of these smaller banks into consideration when considering a way to “exit” from its bloated balance sheet. Too quick of an exit could just exacerbate a situation that is already taxing the resources of these institutions.

Friday, December 4, 2009

Plenty of Work Still to Do

The United States economy lost only 11, 000 jobs in November and the unemployment rate dropped to 10.0% from 10.2%. Good news!

There is still plenty of work left to do, however.

President Obama held a summit on jobs yesterday, bringing together many leaders from business, economists, labor leaders, and others to discuss the state of the jobs market and what can be done about it. To the President, this was just an “idea seeking” exercise.

Thomas Freidman, editorial writer for the New York Times, was in attendance at this jobs forum. I just happened to catch his appearance on Chris Matthews’ “Hardball” program yesterday afternoon.

Matthews asked Friedman what impression he took away from the summit. Friedman replied that the impression he walked away from the summit with was one of the uncertainty that existed among the participants. People didn’t know what health care reform was going to be and going to cost; people didn’t know what would be the full cost of the added troops going to Afghanistan; people didn’t know what carbon emissions were gong to cost; people didn’t know what more economic stimulus was going to cost; people didn’t know how the financial system was going to be regulated; and he mentioned two or three other unknowns.

Friedman argued that so much was being done and none of it was fully defined and none of it was fully costed. As a consequence, people didn’t really know what to do. They didn’t know what direction to move in.

We read that the President, himself, presented another problem: he said that “our resources are limited.” We only have so much money.

Unfortunately, I take this statement with the same seriousness that I do the statements of Treasury Secretary Geithner and Fed Chairman Bernanke when they say that they are for a strong dollar.

Washington D. C. seems to have adopted the wisdom of the world famous philosopher Winnie-the-Pooh who, when asked, “What will you have, Honey or Milk?” replied “Both!” This attitude is just another sign of the hubris of the leadership of the United States. They believe that they can go after anything they want and there will be no consequences.

We are near the end of a 50-year period in which the government of this country, Republican as well as Democrat, has constantly advocated a bias toward inflation. This bias has distorted the economy in such a way that we have plenty of excess capacity in our businesses and a labor force that is trained for jobs that existed years ago but are not trained for where things need to go. (There were several newspaper articles this week about plant closings and employees that had no where to go because they only had “one skill.”)

The inflationary bias has encouraged individuals, families, businesses, and governments to “leverage up” and this drive to achieve additional leverage has underwritten the growth of the financial industry to its present size.

The structural changes in the economy that have resulted from this bias are substantial. A lot of the uncertainty that exists, both in the private sector as well as the government, is a consequence of these changes that have taken place in America.

Even now, another structural shift in the society is being recognized. Elizabeth Warren, Professor of Law at Harvard and Chair of the Congressional Oversight Panel, overseeing bank bailouts, has highlighted another change needing consideration. See her “America Without a Middle Class,” .

“Families have survived the ups and downs of economic booms and busts for a long time, but the fall-behind during the busts has gotten worse while the surge-ahead during the booms has stalled out. In the boom of the 1960s, for example, median family income jumped by 33% (adjusted for inflation). But the boom of the 2000s resulted in an almost-imperceptible 1.6% increase for the typical family.

Today, one in five Americans is unemployed, underemployed or just plain out of work. One in nine families can't make the minimum payment on their credit cards. One in eight mortgages is in default or foreclosure. One in eight Americans is on food stamps. More than 120,000 families are filing for bankruptcy every month. The economic crisis has wiped more than $5 trillion from pensions and savings, has left family balance sheets upside down, and threatens to put ten million homeowners out on the street.”

Our leaders are uncertain because they are facing something they have not faced before. And, the problems that are being faced are numerous. But, the old thinking and the old policies just don’t work like they used to, if they ever did work the way they were supposed to. As a consequence, they are running around looking for an answer, but everything they do is incomplete and unfinished.

On one side, people are saying that we are trying to do too much. On the other side, people are saying that we are not doing enough. It is not surprising that a “jobs summit” like the one held yesterday can result in someone like Thomas Friedman saying that people really didn’t know where the train is heading.

The economy seems to be improving but everyone is still very cautious. There are just too many dark clouds that are hanging over the horizon. Readers of this column know that I am still very anxious about the health of the banking industry. Also, profits, in general, have risen, but the improvement has been because of cost cutting. Little strength has been registered in revenues, for the reasons given above by Elizabeth Warren. And, the value of the United States dollar continues to slide. The rest of the world is telling us that our “Winnie-the-Pooh” philosophy of government debt creation cannot go on forever.

Yes, there is still plenty of work to do in the economy. However, right now, our leaders don’t seem to have a very good focus on what it is that needs to be done.

Tuesday, December 1, 2009

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!”


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”, 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.