Tuesday, May 31, 2011

How Long Will The Bailouts Continue?

How long will the bailouts continue in Europe and the United States? 

As long as the banking systems or large parts of the banking system in these areas remain insolvent.

We wonder about the public officials in Europe and in America and question why they continue to do what they do.

And, what they do only makes sense if their banking systems or large parts of their banking systems are insolvent. 

Jean-Claude Trichet, President of the European Central Bank, went ballistic and recently walked out of a meeting when the subject of restructuring the debt of Greece was brought up.  “On May 24, Christian Noyer, of the ECB’s Governing Council, described the idea of any debt restructuring as a ‘horror story’.  Big losses on Greek government bonds would devastate Greek banks and threaten the health of the ECB, which has been propping up Greece by investing in its debt.” (Bloomberg Businessweek, May 30-June 5, 2011)

“The case for delaying a default is that European banks need more time to repair balance sheets that were devastated by the 2007-2009 financial crisis.  The profits they’re earning now are rebuilding their capital.  The longer that Greece can be kept afloat, the better Europe’s banks will be able to withstand the losses they’ll be forced to recognize if Greece goes under.  European banks and the European Central Bank have a strong incentive to extend and pretend.” 

“Moody’s Investors Service estimates the European banks hold about €95 billion in Greek sovereign and private debt—and could lose one-third of it in a worst case scenario.”  European banks hold some €630 billion in Spanish debt.

If Greece defaults in any way, shape, or form, the question is, “What about Ireland?  And, Portugal?  And, Spain?  And, Italy?  And,…?”

The leaders of the European Union believe that they cannot allow…at this time…any debt restructuring because of the immediate impact it would have on European banks.

This sure sounds like a case of insolvency to me.

And, is the United States in any better shape? 

For at least two years I have been writing that the only way to really understand the behavior of the monetary policy of the Federal Reserve System is to see it as an attempt to keep the banking system liquid enough so that banks can stay open long enough to allow the FDIC to close banks in an orderly fashion. 

Since December 2007, the start of the most recent American recession, the banking system has lost 831 commercial banks through FDIC closure or through FDIC overseeing an acquisition.  From this date through the first quarter of 2011, the banking system has lost about 22 banks per month, which works out to a yearly average of almost 270 banks per year.  Last year, 320 banks dropped out of the banking system and this year we are running at a rate comparable to last year. (http://seekingalpha.com/article/271658-number-of-u-s-banks-drop-by-77-in-first-quarter)  

At the end of first quarter there were still close to 900 commercial banks on the FDIC’s list of problem banks, roughly 14% of the total commercial banks in existence.  So roughly one out of every seven commercial banks is on the problem list.  And, if we believe testimony that Elizabeth Warren gave to Congress last year, we can imagine that at least one out of every four banks in operation are “troubled.”

Should the Federal Reserve, like its sister central bank in Europe, be concerned about the solvency of the banking system?

And, QE2 is scheduled to end in 30 days.  Will there be a QE3? 

My guess is that the employment situation or the growth of the economy will not be the determining factor as to whether or not there is a QE3.  The solvency of the banking system will determine whether or not the policy makers decide for QE3…or some other form of  policy that will provide liquidity to the banking system. 

Can one really claim that unemployment or economic growth is the primary reason for QE2 when over 50% of the reserves the Fed has pumped into the banking system has gone to foreign-related institutions?  And, Mr. Bernanke and other leaders at the Fed, at least on the surface, seem oblivious to this fact.  (http://seekingalpha.com/article/270074-fed-continues-to-pump-reserves-into-foreign-related-institutions-in-the-u-s)

In Europe, the banking structure is somewhat different in that the concern is over big banks for Europe does not have all the small banks that the United States has. 

In the United States the concern for the last two years has been the health of the smaller banks.  That is, in the financial crisis, the Federal Reserve immediately subsidized the largest twenty-five domestically chartered commercial banks in the United States, with roughly 60 percent of the assets in the banking system.

So, the Fed’s main problem, currently, is with the 6,428 commercial banks that make up about 30 percent of the assets of the banking system.  The “problem” banks and the “troubled” banks rest within this part of the banking system.  But, the Fed…and the FDIC…cannot allow these smaller banks to drop out of the system in a dis-orderly fashion.  We are still talking about a pretty large component of the banking system. 

How long will the bailouts continue in Europe and the United States?

Looks like they will continue until the leaders in these areas believe that their banking systems are sufficiently capitalized to absorb the losses that will remain on their balance sheets.

Right now, these leaders do not seem be feel that the banks are sufficiently solvent to absorb such a loss.  

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