Just How Bad Off Are the Banks?

Here we are, how many years after the start of the financial crisis, and we still have questions about the status of individual banks and the banking system…in both the United States and Europe.

European banks have gone through two “stress” tests.  The United States banks have gone through their own “stress” tests.  And, still, there are questions about the solvency of individual banks and the banking system. 

Christine Lagarde, Managing Director of the International Monetary Fund, received all sorts of criticism from the remarks she made last Saturday concerning the status of the European banks and the fact that they “need urgent recapitalization.” 

Early this week we read about how various European banks are writing down the values of the distressed Greek government debt they hold.  Some banks are taking have taken a 50 percent write down while others have taken haircuts of slightly more than 20 percent.  There are no standards for taking such write downs leaving each bank to follow its own path. (http://professional.wsj.com/article/SB10001424053111904199404576540291609289616.html?mod=ITP_moneyandinvesting_2&mg=reno-secaucus-wsj)

American banks are not coming off much better.  One looks at the discounts being assessed against US banks in the stock market and the legal efforts that they face and one wonders what is real.   Are these banks really solvent?

Bank of America has become the poster-child of the mismanaged large banks in the United States.  Warren Buffett brought it some relief with his “pussy-cat” deal.  Yes, Mr. Buffett can say that he (and other wealthy people) should pay more taxes as he cuts such sweet deals with such nice tax benefits for himself.  Yet, some are taking the Buffet bailout of Bank of America as a signal that maybe a closer look needs to be given the position of Bank of America. (http://dealbook.nytimes.com/2011/08/31/buffett-investment-could-erode-confidence-in-wall-st/)

Just look at some of the numbers.  Bank of America has  stated that slightly less than 20 percent of its residential mortgage loans as either delinquent or nonperforming, a rate that is similar to that of Wells Fargo.  JPMorgan Chase has about 24 percent falling in this class while the fourth of the big four, Citigroup, has less than 14 percent. 

And, “Not only does the bank still face billions in legal settlement costs from Countrywide Financial deals, but it also has to buy back billions in faulty mortgages.  Bank of America’s questionable foreclosure practices continue to drag it down, and, in addition, it faces Securities and Exchange Commission investigations into the actions of its subsidiary, Merrill Lynch, in the lead-up to the financial crisis.”

In addition, bank profits are falling (http://www.nytimes.com/2011/08/29/business/top-banks-confront-leaner-future-by-cutting-jobs.html?_r=1&scp=1&sq=profits%20falling,%20banks%20confront%20a%20leaner%20future&st=cse) and with the Fed promise that it will keep interest rates low for the next two years, bank interest rate margins and, hence, bank profits can be expected to remain squeezed for the near term. 

And, why is the Federal Reserve keeping interest rates so low for the next twenty-four months?

One reason for keeping interest rates so low is that the Fed will continue to provide the banking system with substantial liquidity so that banks can work themselves out of their bad loan situation and that failing banks can be removed from the banking system with the least disruption possible.

Furthermore, commercial banks in both Europe and the United States are cutting back on their employment by not just thousands of people, but tens of thousands of people when all the layoffs are added together.   

We look at all this information and we wonder, “Just how bad off are the banks?”  The regulators have been working on this situation for at least three years.  And, we still have all these questions?

The only conclusion one can draw from this is that the regulators and the people “in the know” did not want us to know how bad things were.  And, they still are reluctant to let any of this information out.  Notice how upset people got when Ms. Lagarde let the “cat-out-of-the-bag” on Saturday.

So much of this dilemma goes back to the discussion about the need for financial institutions to mark their assets to market.

I know how hard this is to do in the case of some assets without active markets.  And, I know how painful this is to do “after-the-fact”, that is, after the asset values drop underwater.

But, this is a lame excuse that has been allowed to go on for too long!

If banks take risky bets on interest rate movements, they should only do so with the knowledge that if the markets move against them they will have to pay a price by marking the assets to market.  I also don’t buy the argument that they will hold the assets to maturity.  If the banks “place the bet” they must pay the consequences.

Same thing with risky assets: as banks take on more and more risky loans in an effort to “beef-up” their return on capital they are overtly exposing the bank.  Again, when the assets go south the banks need to own up to the bets they placed. 

And, if these mark-to-market efforts are done on a more timely basis then the banks will have to move to correct their asset problems earlier and they will not get into the deep “doo-doo” they now find themselves in.

Sooner or later these bank problems are going to have to be taken care of.  Stringing things out as the regulators and politicians have done only postpones the day we can move off into the future.  It is a prerequisite for finally achieving more robust economic growth. 

The fact that the problems we continue to read about still exist three years after the financial collapse took place only raises further questions and continues to add uncertainty to the economic climate.  No wonder that people are so risk averse today and only want to buy US Treasury securities or gold. (http://seekingalpha.com/article/290934-struggling-with-a-great-contraction)   

European Credibilty

In a solvency crisis, the question of credibility always arises.  The issue is one of trust…who can one trust?

The European Banking Authority (EBA), which opened for business this year, is now under the gun.

One of the jokes of the earlier European sovereign debt meltdown was the stress test that was administered to European banks.  The “stress” of the tests were not that stressful and the results were dismissed as irrelevant.

One goal the EBA set out to achieve was to administer a stress test that was credible and would provide a “realistic” view of how European banks would weather a new round of financial distress.

The tests were begun in March…the results of the stress tests were to be released in June.

The EBA has now asked banks to resubmit their information because “The EBA is currently assessing and challenging the first round of results from individual banks.  This will mean that another round of data will be required…Errors will have to be rectified and amendments made where there are inconsistencies or unrealistic assumptions.”

That is, there are “concerns that some countries and institutions made mistakes or used overly rosy assumptions.” (http://www.ft.com/intl/cms/s/0/cf770d00-8c6f-11e0-883f-00144feab49a.html#axzz1O1hWLIwZ)

But, there seems to be another problem imbedded in these European stress tests.  “As with 2010, the EBA has also failed to include the possibility of a sovereign debt default, in spite of bail-outs in Greece, Ireland, and Portugal.”

What?

Much of the discussion surrounding the issue concerning what the European Union should do about Greece and the restructuring of Greek debt hinges on the inability of European banks to handle a write-down of Greece’s sovereign debt. 

I quote from my Tuesday morning post:

“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…?” (See http://seekingalpha.com/article/272549-how-long-will-the-bailouts-continue.)

Where is the credibility in the stress tests, even if the banks use more pessimistic scenarios in the information they resubmit to the EBA?

And, as I suggested yesterday, leaders in America should be paying attention to the lessons being generated by the events now going on in Europe. (http://seekingalpha.com/article/272746-european-choices-continue-to-narrow-more-debt-is-not-the-solution)

The monetary and banking authorities are facing a situation in which one out of every seven commercial banks in the country is on the FDIC’s list of problem banks.  About one out of every four commercial banks in the country is “troubled.”  The number of banks in the banking system dropped by 320 banks in 2010 and we are on track for the number of banks to decline in 2011 by about the same number, which is about 5 percent of the commercial banks in the United States. 

The American banking system is not that healthy.  And, as a consequence, commercial banks, as an industry, are not lending.  The housing market continues to sink.  And, commercial real estate continues to be listless.  There are big pieces of the economic picture missing.

Maybe the leaders in the United States need to admit to these problems.  Maybe they need to learn something from the European situation in which the severity of the banking problems are hidden in incomplete stress tests while the whole “relief” program for Greece…and others…are being based upon the weaknesses in the banking system. 

The credibility of the European leadership is not doing well in the face of their lack of transparency.

The credibility of American leadership is facing similar shortcomings.

Maybe this is why Sheila Bair is leaving the FDIC…the end of her term of appointment being just a convenient excuse.  Maybe Sheila Bair knows something that the current administration does not want out in the public domain. 

My friends tell me that if the way a person talks does not match up with the way a person walks…then there is a credibility problem!  That is, watch the hips…not the lips!

I see this problem in Europe.

I see this problem in the United States.  President Obama and others in his administration, Ben Bernanke and Tim Geithner, are explaining their actions in ways that do not seem to be consistent with the facts.  The result is public and investor confusion, uncertainty…and discontent…with their policies.

Europe does not seem to have anyone that can provide the leadership it needs…and this does not bode well for its future.

One keeps hoping that Obama will step up and provide the leadership for the United States.  But, I am afraid that this will not happen.  After all the number one responsibility of any government official is to get re-elected.  And, we are in that season.