Why Banks Aren't Lending

Remember the old story about commercial banks?  Commercial banks only lend to people who don’t need to borrow.

Well, that seems to be the “truth” about bank lending now.  The story going around is that the larger banks have increased their business lending, but the lending is really only going to those institutions that have a lot of cash on hand.  Otherwise, the commercial banks will sit on their excess reserves.

This also seems to be the story in Europe: commercial banks are just not lending anywhere. (http://www.nytimes.com/2011/09/23/business/global/financing-drought-for-european-banks-heightens-fears.html?ref=todayspaper)

And, the relevant question is not “Why aren’t commercial banks lending?”  The relevant question is “Why should commercial banks be lending at this time?”

The first reason why many banks shouldn’t be lending right now is that there is still a large number of banks who may be severely undercapitalized or insolvent.  Many commercial banks have assets on their balance sheets whose economic value is substantially below the value the asset is accounted for on that balance sheet.

The most notorious case of this is the sovereign debt issues carried on the balance sheets of many European banks.  The values that many of these banks have on their balance sheets for these assets have the credibility that the recent “stress tests” administered to more than 90 banks by European banking authorities. (Note that the European Union moved today to recapitalize 16 banks, http://www.ft.com/intl/cms/s/0/49d6240e-e527-11e0-bdb8-00144feabdc0.html#axzz1Yj4RAJ9F.)    

But, the problem is not limited to Europe.  How many assets on the books of American banks have values that need to be written down to more realistic market values.  For example, small- and medium-sized commercial banks in the United States have a large portion of their loan portfolios in commercial real estate loans.  The commercial real estate market is still experiencing a depression and market values continue to decline in many areas.  The write off of these loans can take large chunks out of the capital these banks are still reporting. 

The bottom line here is that commercial banks that still have problems are not willing to take on any more risk than they have to while they still have to “work out” these depreciated assets, or, at least, wait until the markets recover and asset values rise once again to former levels.  If you don’t make another loan…it will not go bad on you…so why take the risk of making a new loan.

And there are 865 commercial banks on the FDIC’s list of problem banks and many more surrounding that total that have not met the specific criteria of the FDIC to be considered a problem bank. 

The second reason why many banks shouldn’t be lending right now it that the net interest margin they can earn on loans is hardly sufficient to cover expense costs.  I have talked with many bankers now that say the only way to make any money through bank operations is to charge for transactions.  That is, to generate fee income. 

A general figure that represents the expense ratio of a bank is by taking expenses and dividing them by total assets.  Recent data indicate that this expense ratio is in excess of 3 percent, being around 3.15 percent to be more exact.  This means that on basic lending operations a commercial bank must earn a net interest margin of 3.15 percent in order to “break even”. 

Is there a problem here?  You betcha’!

Adding to this dilemma is the fact that the Federal Reserve has added on a new “operation twist” to the mix.  All these banks need is a flatter yield curve. (See my post http://seekingalpha.com/article/292286-will-bernanke-policy-destroy-credit-creation-bill-gross-is-worried-it-will.) 

There are two ways to respond to a flatter yield curve.  First, one can take on more risk in their lending. (See http://seekingalpha.com/article/293893-some-banks-are-stretching-for-risk.) Or, commercial banks can attempt to earn more money through additional fees, or principal investments (private equity or venture capital), or through the assumption of systematic risk taking. (See http://seekingalpha.com/article/292446-will-bernanke-policy-destroy-credit-creation.) 

Is this what the Fed wants?  The Fed seems to be caught in the bind that it must be seen as doing something, even though that something may not be very productive (QE2) or even counter productive (leading to bubbles and other speculative activity). 

The take on Fed behavior during the Great Depression has been that the central bank did not do enough.  Hence, Mr. Bernanke and crew are taking the position that history will not brand them with the same interpretation.  For the past three years they have operated so as to avoid the claim that they did not do everything in their power to counteract the forces causing a great recession, slow economic growth, or economic stagnation.

And, here they face the possibility of “unintended consequences”.  If the flattening of the yield curve results in even less bank lending than would have occurred otherwise, the Fed could actually be exacerbating the situation.  The stock market declined upon hearing the Fed’s policy.

The third reason why banks may not be lending now is the absence of loan demand.  Fifty years of government created credit inflation has resulted in excessive debt loads being carried by individuals, families, businesses, governments (at all levels) and not-for-profit institutions.  People, faced with under-employment, declining asset values, and income/wealth inequities, are attempting to de-leverage.  This de-leveraging will continue until people feel more comfortable with their debt loads, or, the Fed creates sufficient inflation so that people will start to take on more debt again. 

If the Fed achieves the latter, then we have returned to the credit inflation situation that has existed for the past fifty years.  This period of credit inflation has resulted in an 85 percent decline in the purchasing power of the dollar, more and more under-employment of labor, and greater income/wealth discrepancies within the society. 

The fourth reason is the uncertainty created in “the rules of the game.”  The Dodd-Frank financial reform act has created a great deal of uncertainty within the financial community.  For one, only about 25 percent of the regulations have actually been written and only a portion of these have passed.  As a consequence, commercial banks don’t know what rules they will have to follow…or, even more important, what rules they will have to find ways to circumvent.  Another new set of rules, these on taxation, were introduced by President Obama this week.  George Shultz, former Secretary of the Treasury, has argued that new, complex tax proposals not only lead to short-term uncertainty about what must be dealt with, but that over time “the wealthy and GE” will find ways to manipulate the tax laws in their favor. (See my posts of September 20 and 22:  http://maseportfolio.blogspot.com/.)  But, unfortunately, people, families and businesses, will devote time and resources to dealing with these “rules of the game” and not allocate this time and resources to more productive activities.

Again, I raise the question “Why should banks be lending?”, not the question “Why  aren’t banks lending?”   

When Debt Loads Become Too Large

Debt loads become unsustainable when people, businesses, and governments have to make choices…when they cannot just “have it all”.

A case in point comes from a story about the world famous philosopher Winnie-the-Pooh.  In this particular story, Winnie-the-Pooh is presented with the choice: “What would you have, Bread or Honey?”

To this Winnie-the-Pooh replies, “Both!”

During the earlier periods of credit inflation, people, businesses, and governments are able to reply “Both” to all choices and are able to get away with it because the credit inflation “buys” them out of the implied limitation on resources.

Credit inflations are cumulative because choosing almost all alternatives and financing them with debt just builds and builds the expansion.

The problem with credit inflations is that they one day come to a halt…that is the cumulative build up of debt becomes unsustainable and choices have to be made.  “Both” is not a viable answer any more.

The only possible means of extending the period of credit inflation once the debt loads become unsustainable and a “tipping point” is reached is for the monetary authorities to take the credit inflation to another level, a level that might be called “hyper-inflation.”  Hyper-inflations, however, do not have happy endings

Many governments, as well as individuals and businesses, have reached the point where decisions have to be made.  Budgets cannot just continue to be “wish lists” where all parties are satisfied.  Governments cannot create across-the-board job programs because of the need to substantially reduce their budget deficits.  In addition, raising taxes to cover these “wish lists” is just another effort to achieve a “both” outcome.

Keynesian stimulus plans are built on the presumption that the government can harmlessly attain “both” of the consequences of such policies: issuing unlimited amounts of debt and economic vitality.  This type of credit inflation can only succeed for a period of time and then the accumulation of debt catches up with the government.  In the case of the United States it seems as if the successful period of accumulation lasted for about 50 years.

And, we see that governmental hands can be tied in other ways.  President Obama was not able to commit much in the way of resources to the situation in Libya.  He dropped the ball to NATO.  And, the Libyan battle drags on.  And, President Obama cannot get caught up in the conflict in Syria.  In fact, American foreign policy is finding itself short on resources in many cases, a situation not faced by this county in the post-World War II period.

In addition, many state and local governments have promised way beyond their capacities on pensions, water projects, and other large capital expenditures and now face the dire prospect of not being able to cover their commitments.  We are seeing situations over and over again where debates about pension plans were put into arbitration in order to reach a settlement and those deciding the case had the sole objective of getting people back to work as soon as possible.  Thus, generous pension plans were put into place and the governmental unit could justify the “largesse” of the plans by passing on the responsibility for the decision to the arbitration panel.

People in Europe and the United States are now experiencing the very difficult position of having to choose.  And, as we see, having to choose is very painful.  As we are observing every day, politicians and governments will do almost anything they can to avoid having to make a decision. 

The consequence of such behavior?  Decisions get postponed into the future. 

The feeling: “Maybe if we postpone things long enough the problems will go away.”

The world, unfortunately, does not allow you to postpone the day when decisions have to be made indefinitely.  In most cases, if decisions are not made, the time comes when the crisis becomes so bad that decisions “have” to be made.

And, the problem with this is that the burden of the adjustment becomes even greater on those that can least bear them at the “crisis” date than the burden would be had the decisions been made at an earlier time. 

Politicians, however, are too concerned about their own re-electability to worry about this later time.  But, this is true of executives and their teams and of individuals and families.  People have a tendency to cling to the past and put off taking hard decisions.   

So the battle becomes a “war” between those that want to preserve as much of the “wish list” as possible,like Winnie-the-Pooh they want "both" or "all" of the choices, and those that claim that priorities have to be set and decisions have to be made.   

All to often the decision-making is postponed and postponed and postponed…until it becomes necessary to choose. 

The consequence of this in the financial markets…is volatility.  The uncertainty created by the postponement of resolving the situation is the extreme movement of market prices as traders are moved this way and that way by the most recent information. 

Value investing takes a back seat in such an environment for the achievement of long-term objectives requires extreme confidence and patience.  The draw of short-term trading returns is heady…yet extremely risky.      

Right now, there is very little hope for us to see a much better future.  To see an improvement in the future would require some real leaders to emerge from the crowd and I don’t see anyone yet that fits that description. 

Unfortunately, Debt Must Be Repaid

Fitch Ratings Ltd. is releasing a report today that points up the problems of having too much debt. Restructuring the debt of a person or a family (or a business), even when government programs help to formalize and regularize loan modifications, is not a “magic wand” that resolves the issue of debt overload.

Using data from the Obama administration’s Home Affordable Modification Program, Fitch reports that “the redefault rate within a year”, of the loans that are modified, “is likely to be 65% to 75%”. This information comes from the Wall Street Journal article, “High Default Rate Seen for Modified Mortgages,” http://online.wsj.com/article/SB10001424052748703280004575308992258809442.html?KEYWORDS=james+hagerty. “Almost all of those who got loan modifications have already defaulted once.”

The failure rate is likely to be high because “most of these borrowers were mired in credit-card debt, car loans and other obligations.” That is, when a person or family (or business) goes into debt they go into debt “across the board” and do not just limit themselves to one kind of debt or one type of lender.

And, the Treasury Department says, that those given loan modifications under this program have a “median ratio of total debt payments to pretax income” that is around 64%. “That often means little money is left over for food, clothing or such emergency expenses as medical care and car repairs.”

The good news is that the results of the program indicate that around one-third of the loan modifications make it through the first year. This is looked on as “good” by the Treasury Department and by a Fitch representative.

This is the reality of debt creation during a period that can be referred to as a period of credit inflation. At times like these, more and more people, families, businesses, and governments take on more and more debt until it gets to the point that the debt loads become unsustainable in some sectors of the economy.

Thus, to the first point, people and families take on mortgages, as well as “credit-card debt, car loans and other obligations” until, the second point, their “ratio of total debt payments to pretax income” becomes too large. Then, any increase in total debt payments, like a re-setting of the interest rate on a mortgage, or a reduction in pretax income, due to being laid off a job, puts the borrower into a situation in which debt payments cannot be made. Defaults occur, and a foreclosure…followed by a bankruptcy…may follow.

The “macro” government response is to provide fiscal and monetary stimulus to make sure people stay employed and to inflate incomes so that debt loads (debt payments relative to pretax income) decline. This is the Keynesian prescription!

The problem with this solution is that in a period of credit inflation, as incomes and prices continue to increase, debt loads continue to increase. If the government buys people out of their debt burdens by fiscal stimulus and monetary inflation, people (and families and businesses) don’t adjust their behavior to become more financially prudent. They just keep on, keeping on. This is another case of moral hazard.

Even worse, given the belief that government will continue to “bail out” those who have taken on too much debt, we find that those that have taken on too much debt generally go even further into debt. Take a look at what has happened over the last fifty years of credit inflation and this type of behavior is observed everywhere.

The Keynesian prescription of fiscal and monetary stimulus to keep unemployment low and debt burdens manageable only exacerbates the problem over time. That is, governmental efforts to sustain prosperity over time just postpone the consequences of dealing with the debt loads that are built up during these time periods.

Keynesian economic models, with the exception of the maverick Keynesians like Hy Minsky, don’t include the credit or debt aspects of economic activity. As a consequence, they ignore how people (and families and businesses) manage their balance sheets over time. In essence, these models ignore the very real fact that ultimately, debt must be repaid and cannot just increase without limit!

Over the past fifty years we have seen people and families and businesses and banks and governments take on more and more debt. Inflation has risen at an average compound rate of about 4% from 1961 through 2008 so that it has paid people to increase financial leverage, take on more risky assets, and finance long term assets with short term debt. And the federal government has underwritten this inflation by increasing its gross debt by around 7.7% per year for this period of time and the Federal Reserve has caused the base money in the economy to rise by 6.2% per year. The M2 money stock measure rose at a compound rate of 7.0% per year. All roughly in line with one another.

The Fitch report is presenting us with a picture of what happens when debt loads get “out-of-hand”…when there is just too much debt around.

The current response of the Federal government? Official federal government forecasts of the cumulative fiscal deficits for the next ten years runs around $9 to $10 trillion. Some of us believe that the deficits will run more in the neighborhood of $15 trillion. In terms of monetary policy, the Federal Reserve has placed $1.1 trillion in excess reserves in the commercial banking system. The leadership of the Federal Reserve expects us to believe that they will be able to reduce the amount of these excess reserves to more normal levels without the reserves being turned into loans that will expand the money stock measures by excessive amounts. (Just a reminder: excess reserves totaled less than $2 billion…note, billion and not trillion…in August 2008 before the big injection of reserves into the banking system took place.)

For one more time, the federal government is betting that by stimulating the economy and putting people back to work in the “legacy jobs” they were laid off from and by re-inflating prices and incomes that debt burdens will be reduced and we can get back to “spending as usual”. If the federal government is successful, the day in which debt loads are reduced will be postponed…once again!

However, the credit inflation causes other things to change. Over the last fifty years we have seen that in every employment cycle, fewer and fewer people are re-hired in the “legacy jobs” from which they were released. Under-employment, not just un-employment, rises and this puts more and more pressure on incomes. The ratio of debt payments to pretax incomes rise for these people. Right now, I estimate that roughly one out of every four or five potential works is under-employed, the highest level since the early 1950s.

Second, the steady inflation of the past fifty years has resulted in a larger proportion of the capital stock being un-productive. As a consequence, capacity utilization in industry has fallen to post-World War II lows. As we have seen in each business cycle during this last fifty years, less and less of this capacity is used in each recovery. This results in a drag on employment and income.

Eventually, debt must be repaid and debt loads must be reduced. The Fitch report highlights this problem. It is something that all of us should keep in mind in the upcoming months. If the situation with respect to under-employment and capacity utilization don’t change the debt loads will get even heavier.