Small Banks Are Getting Smaller

Check out the Wall Street Journal article “Ax Falls at Smaller Banks.” (http://professional.wsj.com/article/SB10001424052970203764804577060752595022804.html?mod=ITP_moneyandinvesting_0&mg=reno-secaucus-wsj) And, the subtitle to the piece: “Cuts at Lenders as Industry Job Growth Slows: ‘There will Be More to Come.”

This article is right in line with my Monday post “While Small Banks Disappear, Big Banks Get Bigger.” (http://seekingalpha.com/article/310644-while-small-banks-disappear-big-banks-get-bigger)

“Smaller U. S banks and savings institutions are cutting jobs in a sign of a deepening financial industry retrenchment that is shaking firms from Main Street to Wall Street.”

“Banks that cut jobs in the third quarter outnumbered those that added jobs by 605, according to data from the FDIC.”

“Overall, banking industry employment rose slightly in the third quarter due to continued growth at the nation’s biggest banks.”

“Small banks are under especially intense cost pressure because they are as a group less efficient than larger rivals.”  And, they cannot achieve the economies of scale that larger banks can experience. 

“In the third quarter, about 76 cents of every $1 in revenue at banks with $100 billion or less in assets was consumed by expenses…. At the biggest banks, the figure was 58 cents.  The efficiency gap has widened by 50 percent in the past decade.”  

Many of the smaller banks just cannot compete in today's environment.

And, the recognition of the industry problems continues to grow as Standard & Poor’s “downgraded some of the world’s largest financial institutions.”  (http://dealbook.nytimes.com/2011/11/29/s-p-cuts-ratings-on-big-banks/?ref=business)

The line I like best in this article is “This is confirmation that rating agencies are lagging indicators.”  These downgrades should have taken place a long time ago.  But, I have written about this many times over the past three years and even suggested how market instruments might be used to provide an “early warning indicator” for the purposes of bank regulation. 

The banking industry still has a ways to go to regain its health.  Until then, the economic growth of the economy will continue to be mediocre…at best.

Big Banks Get Bigger While the Smaller Banks Disappear

The FDIC released data on the state of the banking industry last week.  And, we see that the size and number of the bigger banks increase while the size and number of the smaller banks continue to decline.

Let’s look at the number of banks in the United States first.  The number of banks in the United States dropped by 61 from June 30 to November 30 leaving only 6,352 banks still in existence.  Note that the FDIC closed only 26 banks in the third quarter of 2011.

Over the past 12 months, the number of banks in the banking system dropped by 271 banks. 

Obviously, if we focus on just the number of banks that the FDIC closed, we are not getting the whole picture as many unhealthy banks that might eventually be closed are being acquired.

The number of banks on the FDIC’s list of problem banks dropped to 844 on September 30, down from 865 on June 30.  So, the number of banks on the problem list dropped by 21, the number of failed banks was 26, and the number of banks leaving the banking system was 61.  Seems like more banks went on the problem list than left it in the third quarter of the year.  Maybe the statistics on problem banks is not as "jolly" as indicated. 

Over the past 12 months, however, the largest bank classification, banks with assets in excess of one billion dollars rose by 10.  Banks with less that $100 million in assets declined by 176 over the past year and banks with assets between $100 million and $1.0 billion dropped by 105.

Whereas the average size of banks in these last two categories remained about the same over the past year, the average size of banks over $1.0 billion in rose by $1.5 billion to $22.0 billion.

At the end of September 2011, there were 2,208 banks that were less than $100 million in asset size and these banks represented about 1.0 percent of the assets in the banking industry.  On the same date, there were 3,626 banks with assets ranging from $100 million to 1.0 billion, and all of these banks just controlled slightly more than 8.0 percent of the assets in the banking industry.

There were 518 banks in the United States that had assets in excess of $1.0 billion, and these 518 banks controlled 91.0 percent of the assets in the banking industry.

In terms of loans, Net Loans and Leases at the smaller commercial banks declined by almost $8.0 million over the past year, by $2.5 million over the past quarter.  The Net Loans and Leases at the middle range of banks dropped by a little less that $50.0 million over the past year and by about $4.0 million over the past quarter.

In the larger banks, Net Loans and Leases increased by more than $70.0 million over the past year and by about $36 million over the past quarter. 

The bottom line is that commercial banks with assets totaling less than $1.0 billion continue to produce statistics that cause one to question the health of this segment of the banking industry.  In addition, given the decline in total assets in these banks, the sector has not observed a consistent reduction in noncurrent assets (past due loans).  That is, there has only been a modest reduction in the average amount of noncurrent assets to total assets over this time period. 

Consequently, the larger banks are getting larger and becoming more dominant all the time.  And, if one looks at Federal Reserve statistics, the largest 25 domestically chartered banks in the country control about two-thirds of all the assets held by domestically chartered banks.  Thus, if the largest 518 banks in the country control 91.0 percent of the banking assets, this means that 493 banks that are larger than $1.0 billion in asset size but are not among the 25 largest, control about 24 percent of the assets. 

All the statistics show that the small- to medium-sized banks are really becoming insignificant in the United States banking industry and, given the troubles that many of these banks still face, will become even less significant in the future. 

An article in the Monday edition of the Wall Street Journal presents research showing that the health of the banking industry is being questioned by the stock markets.  Andrew Atkeson and William Simon write that “The recent volatility in bank stocks is a signal that U. S. banks, large and small, are not as healthy as many analysts assume.” (http://professional.wsj.com/article/SB10001424052970204531404577052493270860130.html?mod=ITP_opinion_0&mg=reno-secaucus-wsj)

“The dynamic has played out twice before over the past 85 years—in the Great Depression and the panic of 2008-09—with devastating consequences for the broader economy.  Over the past three months, investor uncertainty about the soundness of bank balance sheets, manifested in the daily volatility of stock prices is back up to levels seen historically only in advance of these two great crises.”

“This extraordinary volatility is not limited to the stocks of large banks but extend to small and midsize banks as well.”

So much has been written about the condition of the banking industry in Europe.  Very little has really been written about the condition of the banking industry in the United States.  Investors in the stock market seem to have picked up this concern.

And, I have argued for more than two years now that the major reason that the Federal Reserve has pumped so much money into the banking system is that the United States banking industry has severe problems.  And, the fact that banks have held onto these funds as excess reserves and have not loaned them out is an indication of the fact that many of the banks are still not solvent.  However, the fact that the Fed has provided so many excess reserves to the banking system has allowed the FDIC to either close banks or approve acquisitions of weak banks as smoothly as possible.  The Fed and the FDIC have, so far, prevented any panic from occurring. 

However, problems remain. 

The Smaller Banks Continue to Lose Ground

First, we need to define what the Federal Reserve calls “Small” banks.  The Federal Reserve defines small banks as domestically chartered banks that are not counted among the largest 25 domestically chartered banks in the United States.  Hence, “Large” domestically chartered banks are the largest 25 domestically chartered banks in the United States. 

As of September 7, 2011, the largest 25 domestically chartered commercial banks in the United States account for 56 percent of all the banking assets in the United States.  The smaller banks represent about 28 percent.  Foreign related financial institutions control about 16 percent.    

From August 2010 to August 2011, the total assets held by the small banks in the United States grew by one-half the rate at which the total assets in the largest 25 banks.  The “large” banks grew at a 1.4 percent annual rate while the “small” banks grew by 0.7 percent.

Over the last calendar quarter from the banking week ending June 1 through the banking week ending September 7, the smaller banks actually shrank by almost $20 billion while the larger banks grew by about $165 billion. 

Over this last quarter, “Loans and Leases” at the smaller institutions dropped by almost $70 billion.  At the largest 25 banks, “Loans and Leases” rose by over $130 billion.  At the smaller banks, loans fell in ALL categories. 

From the banking week ending August 3 through the banking week ending September 7, “Loans and Leases” at the smaller banks rose by only $1.5 billion while they rose by more than $30 billion at the 25 largest banks. 

One could say that lending activity is increasing on Wall Street but not on Mail Street.   One could ask questions, however, about the type of loans that the larger banks are initiating.  See my posts from last week: http://seekingalpha.com/article/293657-bankers-expect-weak-profit-performance-in-the-future and http://seekingalpha.com/article/293893-some-banks-are-stretching-for-risk.   

But, business loans are not suffering the most at the smaller banks.  Over the past year, residential real estate loans (home mortgages) at these smaller banks have declined by more than 6 percent, year-over-year.  Over the past quarter these loans have fallen by $12 billion. 

And the smaller banks still are suffering through the commercial real estate decline as these loans declined by almost 7 percent, year-over-year through August.  Commercial real estate loans at these banks declined by more than $40 billion over the last quarter alone. 

The FDIC reports that there were 6,413 commercial banks in the banking system as of June 30, 2011.  Of this number, 865 banks were included on the FDIC’s list of problem banks for this date, more than 13 percent of the banks in insured at that time.  Troubled banks total even more than this, some estimate that more than twice this number are very fragile institutions. 

From these data one can argue that bank lending activity may be picking up, but it is not picking up among many of the smaller banking institutions that still face serious balance sheet troubles.  These organizations are not going to participate in any economic recovery and, in fact, are going to have to be closed or absorbed into the banking system that will remain.  As mentioned above, even though loans may be picking up in the largest 25 banks in the country, the loans may not be going into the physical investment that would cause the economy to grow faster than it is. 

FOREIGN RELATED INSTITUTIONS, QE2, AND THE EUROPEAN BANKING CRISIS

Dollar deposits continue to flow out of the United States into foreign banking offices through domestically located foreign related institutions.  From August 2010 through August 2011, cash assets at these domestically located foreign related institutions rose by about $470 billion!  This increase in cash assets tracks closely the Federal Reserve’s implementation of QE2 and represents about 75 percent of the roughly $630 billion rise in cash assets of the whole United States banking system. 

The interesting thing for our purposes is that the item on the other side of the balance sheet that most closely tracks this increase in the cash assets of foreign related banking institutions is “Net Due to Foreign Offices.”  That is, this money is going off shore. 

From August 2010 through August 2011, this account, “Net Due to Foreign Offices”, rose by almost $540 billion.  In the last quarter it rose by over $160 billion.  In the last month it rose by $112 billion. 

Can the rise in this this account be associated with the sovereign debt crisis in Europe and the recent problems faced by many of the large European banks?

I believe one can make a pretty strong case for this conclusion.  The Fed’s QE2 preceded the agreements that the central banks made last week to provide more US dollars to European banks. 

Of course, this provision of US dollars to the world is not spurring on economic growth although it may be helpful to preventing another Lehman Brothers meltdown.  

The Smaller Banks and Rising Interest Rates

The “sure” bet over the past year or so has been that the Federal Reserve would keep short term interest rates as low as they could for a long time.

In fact, the Fed told us they would keep short term interest rates low for “an extended period” of time, guaranteeing speculative bets on interest rates.

Long term interest rates have also been “low” during this time as liquidity splashed over from the shorter end of the financial markets to the longer end.

However, the spread between long term interest rates and short term interest rates have been very, very nice for a lot of investors and certainly, the bank regulators have not been displeased by the interest rate spreads that have been available to investors, particularly commercial banks and other financial intermediaries who have been able to build up profits to strengthen their institutions.

This spread has been nice for profits but this was not exactly all that the Federal Reserve wanted throughout this period of quantitative easing. In fact, the Fed was very clear that one of the main reasons it was engaged in quantitative easing was that by flooding the financial markets with liquidity, longer term assets, which under other circumstances proved to be very illiquid, could be disposed of when the markets were in a much more fluid situation. The banks were supposed to sell off a lot of their long-term or less-liquid long-term securities.

Furthermore, this would ease the pressure of “mark-to-market” accounting on the banks since such sales at prices closer to purchase value would allow the banks to escape the need to write down other, similar assets even though there was no intent on the part of the banks to sell the securities in the near term.

The larger commercial banks in the system took advantage of this interest rate spread in the earlier stages of the recovery to generate healthy profits and get themselves back on the way to greater solvency, with reduced regulatory oversight.

Then, the larger banks moved on to other things, once the regulators backed off and government money was repaid. The biggest banks are not nearly as mismatched as they were two years ago.

In my opinion, the interest rate policy of the Federal Reserve did more to help the biggest banks regain their “mojo” than did any other part of the bailouts. The Fed’s policy was a grand subsidization program carried out under the cover of helping to get the economy moving again.

The smaller banks, however, have not prospered from the quantitative easing. The maturity mis-match has allowed these smaller organizations to counter some of the enormous losses in commercial and residential mortgages they had to absorb.

But, offsetting these loses did not get the smaller banks back to a robust profitability and, since it was the only game in town, did not allow these banks to deleverage their balance sheets in the way that the larger banks did.

It was the “only game in town” because this maturity arbitrage was profitable, whereas the banks had a lot of bad assets to work out, and making new bank loans, in many markets, were either difficult in terms of finding credit-worthy borrowers or were not guaranteed profit-makers.

As we have seen, the smaller commercial banks in the United States have not been lenders over the last two years or so. Since July 2008, the smaller commercial banks have grown in asset size by about 5 percent, but the increases have come in cash assets and securities holdings. Interest rate arbitrage has been more important to them than initiating new loans, especially with so many existing loans to work out.

Total loans and leases at the smaller commercial banks peaked in February 2009, commercial and industrial (business) loans peaked in November 2008. Both of these categories have been on a downward trend ever since.

The smaller banks still suffer and continue to face the close scrutiny of the examiners in terms of their viability.

Thus, we are sitting on the edge of a rise in interest rates, both long- and short-term, and many of the smaller banks have not gotten out from under the cloud of the longer term assets they hold on their balance sheets.

Of course when interest rates begin to rise, short-term interest rates will rise faster than will longer-term rates and spreads will decline. But, with the specter of interest rates rising, selling long term securities will not be as easy as it has been to sell them over the past year or so.

The smaller commercial banks have benefitted over the past two years by the Fed’s policy of quantitative easing in the sense that they have been able to arbitrage long-term and short-term interest rates. It has provided earnings through the maturity mis-match and it has allowed the banks time to work out some of their assets, charging others off in an orderly fashion. But, this has resulted in few new loans.

As a consequence, the prospect for strong earnings in this sector is slim. The question then becomes, “What are the regulators going to do as the asset portfolios of these banks lose market value as interest rates rise?”

The Federal Reserve cannot continue to keep quantitative easing going, underwriting short term interest rates that are near zero! On this see my recent posts, http://seekingalpha.com/article/262788-fed-s-monetary-policy-cannot-be-conducted-in-isolation, and http://seekingalpha.com/article/262429-trichet-delivers-ecb-hikes-its-interest-rate.

Or, can it?

This would allow the smaller banks the opportunity to carry on with their interest rate arbitrage. However, what really needs to change for many of these smaller banks to survive the times is for real estate prices to rise enough so that the banks’ portfolios of residential loans and commercial real estate loans become solvent again.

We probably will get the rise in prices. But, will the rise really help the properties behind the banks’ problem loans?

The Small Banks Are Going Nowhere

Over the past six months or so the total assets of the smaller banks in the United States (smaller than the largest 25 banks) have remained relatively constant. Total assets averaged about $3.6 trillion in September 2010 and they averaged just below this number in March 2011.

And, given the Federal Reserve’s QE2 policy which has caused the cash assets of commercial banks in the United States to increase by almost $350 billion over this time period, the cash assets of these smaller banks remained roughly constant.

Over the past 13-week period, total assets at these smaller banks increased a modest $3 billion, but over the last 4-week span of time, total assets dropped by almost $10 billion.

Cash assets (over the past 13 weeks) rose by slightly more than $3 billion at a time when the total cash assets of the whole banking system were increasing by more than $480 billion.

The smaller commercial banking sector seems to be going nowhere.

What about credit extension amongst these banks?

Loans and leases at the smaller banks dropped by more than $8 billion over the last four weeks. The drop over the last thirteen weeks was slightly more than that.

And the largest 25 banks?

Total assets at the largest banks have increased by $60 billion over the past four weeks and by almost $90 billion over the last thirteen weeks. Most of the growth these largest institutions have come in cash assets. However, the increase in cash assets at the largest 25 banks in the United States has been small relative to the increase in the cash assets of foreign-related financial institutions in the United States. (See http://seekingalpha.com/article/262788-fed-s-monetary-policy-cannot-be-conducted-in-isolation.)

And, what about bank loans at these larger banks?

Since the end of 2010, loans and leases at commercial banks in the United States have declined by about $105 billion; and over the last four weeks of the first quarter, loans and leases at large commercial banks have declined by about $11 billion.

Business loans have rallied some over the last thirteen weeks, up a little more than $12 billion, but $10 billion of this increase has come in the last 4-week period.

Real estate loans have plummeted at commercial banks both over the last four weeks and the last thirteen weeks. The declines have come in both residential and commercial real estate loans.

And, what asset class, other than cash assets, has increased the most at the larger financial institutions? The securities portfolio.

So, the update on the banking industry as of the end of the first quarter of 2011?

The smaller banks, as a whole, continue to be in a holding pattern. And, QE2 seems to be doing little or nothing for these institutions. The cash reserves the Fed is pumping into the banking system is going to either the foreign-related financial institutions in the United States or the largest 25 commercial banks in the United States.

The smaller banks are not increasing their loan portfolios.

For the larger banks, QE2 is having some impact as cash reserves at the largest banks are increasing and the securities portfolios of these institutions are also increasing.

However, loans, as a whole, are not increasing…although there seems to have been a little pickup in the area of business loans.

Overall, one sees very little evidence that the Fed’s QE2 is having any impact on bank lending which, of course, does not provide much evidence that economic growth is going to begin accelerating in the near future.

Not very encouraging.

The Two Banking Systems in the United States

More and more it appears as if the banking system of the United States is bifurcating into two parts, the largest 25 banks and the rest. These designations, large and small, are used by the Federal Reserve System for the data they release for the whole commercial banking system.

Over the past year, the total assets of the domestically chartered commercial banking system in the United States hardly grew at all. Yet, throughout the year, the smaller banks made their balance sheets much more conservative than did the largest banks.

For one, the smaller commercial banks increased their holdings of cash assets by 10% from December 2009 to December 2010; the largest banks decreased their cash holdings by more than 21%.

Both the large banks and the smaller banks increased their securities portfolios over the year, but the smaller ones increased their securities portfolios by almost 9% while the largest banks increased theirs by only about 3%.

Over the whole year, Commercial and Industrial Loans declined across the board with the larger banks portfolio of C&I loans dropping by almost 5% while in the smaller banks, C&I loans fell by only about 3%. Real Estate loans also fell during the year dropping about 4% and 5% at the largest and the smaller institutions, respectively. Consumer loans were re-defined over the year for this Federal Reserve release so that the data year-over-year growth rates are not meaningful.

The largest declines since December 2009 came in commercial real estate loans. At the largest banks, commercial real estate loans dropped by almost 11%; at the smaller banks they fell by 8%. The troubles in the commercial real estate area show up very clearly in the banking statistics.

The conservative movement in the balance sheets of the smaller banks was continued over the last 13 weeks ending with the banking week finishing on January 5, 2011. Total banks assets fell during this time period, but not by very much. Over this time period, however, the smaller banks increased their holdings of securities by over 7% while their loan portfolios fell by more than 3%.

During this time period, loans making up the loan portfolios of the smaller banks fell across the board: C&I loans dropped by 4%; real estate loans fell by 3%; and consumer loans declined by about 4%.

The loans at the smaller banks also continued to drop through the Christmas season with C&I loans falling by over 2% in the five-week period ending January 5, 2011; real estate loans fell by just 2% during this time period; and consumer loans dropped by almost 5%.

Interestingly enough, there was a front page article in the Saturday Wall Street Journal with the title “Banks Loosen Purse Strings” which reported data from Equifax Inc. and Moody’s Analytics. (http://professional.wsj.com/article/SB10001424052748704637704576082300851916930.html?mod=WSJPRO_hps_LEFTWhatsNews) In this article the claim is made that “In the third quarter (of 2010), lenders made more than 36 million consumer loans, up 3.7% from a year earlier...That is the first year-over-year gain since the crisis began. Consumer-loan originations are expected to climb 5.9% this year, much higher than the slim 1.1% increase in 2010.” The article goes on to say that “The totals include bank-issued and retail credit cards, auto loans, consumer-finance loans, home-equity lending and student loans”. Whoops, these are not all banks are they!

But, the commercial banks do not seem to be opening their purse strings when it comes to consumer lending. Besides the drop of 5% in consumer loans at the smaller commercial banks, the Federal Reserve data also showed that consumer loans fell by 5% at the largest 25 commercial banks over the past 5 weeks.

Again, the largest declining loan class over the last 5 weeks was still the commercial real estate loan area. The decline at the largest banks in the last 5 weeks was a little under 1%, while the decline at the smaller banks in this area was over 2%.

Everywhere, the aggregate banking statistics can be interpreted as showing that the smaller commercial banks continue to “tighten up” their balance sheets. The loan portfolios of these banks experienced further declines while the banks keep building up their cash positions and the size of their securities portfolios. The largest contractions have come in commercial real estate, the area that seems to have the biggest cloud over it for the next year or two.

Generally, the largest 25 domestically chartered banks in the United States seem to be doing well.

Of course, we all heard about the 47% profit jump at J.P.Morgan Chase which was announced on Friday. This week we will get more information on how the other “large” commercial banks are doing. It is expected that the reports coming out this week will show that the bigger banks are pulling ahead.

Of interest is the areas of lending that seem to be picking up at these larger banks. For one, commercial and industrial loans are, indeed, starting to increase. Over the past 13-week period, the largest 25 banks saw their portfolios of C&I loans increase by more than 3%; these loans also showed a gain over the past 5-week period.

The one other lending area that seems to be picking up at these larger banks is the area of residential loans, mortgages. (Note: this does not include equity-line loans.) Over the last 13-week period, residential real estate loans have picked up by slightly more than 3%; these loans also registered a modest increase over the last 5-week period.

So, I still firmly believe what I wrote in my January 3, 2011 post, “Four ‘Uncomfortable Situations’ to Watch in Early 2011,” (http://seekingalpha.com/article/244531-four-uncomfortable-situations-to-watch-in-early-2011). Two of these four “uncomfortable situations” are the health of the commercial real estate area and the solvency of commercial banks that fall into the small- and medium-size category.

The small- and medium-sized banks continue to “pull-in-the-carpet.” That is, these banks continue to shrink their balance sheets and they continue to re-allocate assets to either cash or “safe” Treasury securities. They have been doing this for more than two years and show no signs of acting any differently in the near future. To me, this behavior is a real “red flag” that these institutions are not doing well.

And, these smaller banks seem to be getting commercial real estate loans off their balance sheets as fast as they can just re-confirming the problems that exist in this area.

The Federal Reserve continues to pursue the policy they call “Quantitative Easing.” Perhaps a better name for it would be “Keeping the Smaller Banks Liquid.” The reason, I have argued, for keeping the smaller banks liquid is that this allows many of these smaller banks to keep their doors open in the short run so that the Federal Deposit Insurance Corporation (FDIC) can close as many of these banks as they need to in as orderly a fashion as possible. The data continue to support this conclusion.

Commercial Banking in 2011

Commercial banking in the United States is going to change substantially in the next five years.

Most of my comments on the banking industry over the past year have been spent on the “smaller” banks, the banks are not among the 25 largest commercial banks in the industry, the banks that control about 30% of the banking assets in America. At last count there were a little less than 7,800 of these banks. The average size of the banks in this category is about $480 million, pretty small.

My concern about these banks is their solvency. The FDIC placed 860 commercial banks on its list of problem banks at the end of the third quarter. The question that is still outstanding is how many more banks are seriously challenged to remain in business. That is, how many banks are not on the problem list but “near” to being on the problem list. Elizabeth Warren gave testimony in front of Congress in the spring and stated that 3,000 commercial banks were threatened by bad loans over the next 18 months.

Commercial banks have been closed at the rate of approximately 3.5 per week during 2010 and many other acquisitions have taken place. So, the industry is shrinking. I still believe that there will be fewer than 4,000 commercial banks in the United States by the end of the upcoming decade.

However, something new is going to happen at the other end of the banking spectrum. International banks are going to play a much bigger role in the United States in the future and this is going to substantially change the playing field and will help to accelerate the decline in the number of banks in the American banking system.

What’s going on? Just in the recent past we have had the news that the Bank of Montreal, the fourth largest bank in Canada, acquired the banking firm of Marshall and Ilsley Corp., which has $38 billion in deposits, 374 branches throughout the Midwest, and is the largest lender in Wisconsin. Then we learned that TD Bank, the second largest bank in Canada, is acquiring Chrysler Financial, the former lending wing of the Chrysler Corporation.

We also learn that Deutsche Bank AG and Barclays PLC have moved up the rankings of global business when compared to other Wall Street organizations. (See the Wall Street Journal article “New Banks Climb Wall Street Ranks,” http://professional.wsj.com/article/SB10001424052748703581204576033514054189044.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj.) These organizations have grown substantially filling in some of the hole left by the collapse of Lehman Brothers, and the moving of Bear Stearns and Merrill Lynch into other banking firms.

The point is that the American banking scene is much more open to foreign competition on its own turf in the 2010s than it was previously. This has the potential for causing even more changes in the structure of banking in the United States and in the world than we have seen over the last fifty years.

If we go back to the start of the 1960s, the United States contained some 14,000 commercial banks and a large, prosperous thrift industry. But, things were changing. Let me point out just three of the major factors impacting the banking and thrift industries by the start of the 1970s. First, was the beginning of the credit inflation that was to spread throughout the economic system that would result in the rising interest rates which would eventually bankrupt the thrift industry and drive it out of business.

Second, the United States commercial banking system at the start of the 1960s was a mish-mash of banking rules. For one, the branching laws were such that banks could not branch across state lines, and in some states banks could only have one office, in others they faced severe limits on the number of branches they could have, while in other states there was unlimited state-wide branching.

What broke this structure down? Information technology. With the spread of information technology banks could not be constrained from branching across state lines. The death knell for state control and limited branching was sounded. National competition became the new norm and banks had to compete.

The third factor was the freeing up of the flow of funds internationally. By the end of the 1960s the capital flows were basically unrestricted between the United States and Europe. One of the major signs of this openness was the creation of the Eurodollar deposit which became an important tool in the move to “liability management” which freed up American commercial banks from limits on their ability to grow their balance sheets. This factor contributed to the demise of the “Bretton Woods” system of international finance.

All three of these factors played a big role in the changes in the financial system of the United States and the world and to the movement away from “relationship finance” and “arms-length finance”. For more on the changes in the banking system and the growing “impersonal” nature of the financial system see the book “Saving Capitalism from the Capitalists” by Raghuram Rajan (the winner of the Financial Times/Goldman Sachs award for the best business book of the year, “Fault Lines”: http://seekingalpha.com/article/224630-book-review-fault-lines-how-hidden-fractures-still-threaten-the-world-economy-by-raghuram-g-rajan) and Luigi Zingales, both of the University of Chicago.

All of these factors are still at work but we are now seeing another important factor coming into play, “competition from the outside.” Just as the forces inside the United States have been attempting to build up walls to constrain the finance industry, America is now coming to experience a breaking down of the barriers. Unless the Congress puts up restrictions on foreign financial interests acquiring domestic companies, it seems as if the door is opening for more and more banks from outside the United States to come knocking.

The result of this “opening up” according to Rajan and Zingales is that the new competition really “shakes things up.” I have contended throughout the events which began in late 2008 that by the middle of 2009 the largest 25 commercial banks in the United States had moved beyond most of the structural problems that contributed to the financial collapse. Furthermore, by the time that the Dodd-Frank Financial Reform bill got passed, these banks had moved beyond most of the onerous portions of the legislation.

Now with these foreign financial organizations moving into the competitive space of the United States banks, all banks will be using information technology and uncontrolled capital flows throughout most of the world to further outpace efforts of regulatory reform.

Another consequence of this will be the pressure on the larger banks to continue to merge and acquire and diversify their businesses in ways we have not yet imagined. And, when one brings into the picture the things that information technology can do and the progress the “Quants” have made in finance, one can only guess at how exciting the near-term evolution of the banking system is going to be.

Merry Christmas and Happy New Year to Everyone!

The Number of Problem Banks Rise in the Third Quarter

The number of problem banks, as listed by the FDIC, continued to rise in the third quarter of 2010. The number went from 829 at the end of the second quarter to 860 in the third quarter.

Forty-one banks failed in the third quarter, an average of about 3.2 banks per week. A total of 149 banks have been closed through the first three quarters of 2010, an average of 3.8 per week. Thus, the pace of bank closings has been relatively steady throughout the year, somewhere between 3 and 4 banks per week.

The total number of FDIC-insured commercial banks in the system was 7,760 at the end of the third quarter. This is down from 7,830 at the end of the second quarter and 8,195 at the end of the second quarter of 2009. So, the number of banks in the system dropped by 70 banks in the third quarter. Since June 30, 2009, the number of banks in the system has fallen by 435.

The decline in the number of banks in the banking system is not all failures as some banks are merged into other banks before the bank is closed by the FDIC. For example, in the third quarter of 2010, 30 mergers took place.

So, the industry is shrinking by bank failings and by the consolidation of healthy banks with banks that are not in very good shape. From June 30, 2009 to June 30, 2010, the number of banks in the banking system dropped by 365 banks, an average of 7 banks per week. In the third quarter of 2010 the number of banks dropped by 70 banks, an average of about 5.5 banks per week.

This fact raises concerns not only about those banks that are listed on the problem list, but what about those banks that are in serious trouble but do not “qualify” to be on the FDIC’s problem list?

How many surprises are out there?

Wilmington Trust, in Wilmington, Delaware, was considered to be doing OK. Then, the bombshell hit. Wilmington Trust ended up being sold at a 45% discount. (See http://seekingalpha.com/article/234027-wilmington-trust-sold-at-45-discount.)

How many more banks in the system are facing the same fate as Wilmington Trust?

Earlier this year Elizabeth Warren told Congress that as many as 3,000 commercial banks were facing real problems over the next 18 months.

My prediction is that the total number of banks in the banking system will drop to 4,000 or so over the next five years. This is down from 7,760 at the end of the third quarter of 2010, a reduction in the number of banks of 3,760 banks or of approximately 750 banks per year for the next five years.

There is good news:
“Banks and savings institutions earned $14.5 billion in the third quarter, $12.5 billion more than the industry’s $2 billion profit a year ago, the FDIC said yesterday. The third-quarter income was below the $17.7 billion and $21.4 billion reported in this year’s first and second quarters, but agency officials said the shortfall was attributable to a huge goodwill impairment charge at one institution.

A reduction in loan-loss provisions was the primary factor contributing to third-quarter earnings…. While third-quarter loan-loss provisions were still high, at $34.3 billion, they were $28 billion -- or 44.5 percent -- lower than a year earlier. Net interest income was $8.1 billion -- or 8.1 percent-- higher than a year ago, and realized gains on securities and other assets improved by $7.3 billion, officials said.”

This was from the American Bankers Association release, “Newsbytes”.

But, the good news was not for all sectors of the banking industry. As I have been reporting in my posts, the largest twenty-five banks continue to prosper at the expense of the smaller banks. One must report that the “good news” presented above is for the industry as a whole. For the largest twenty-five banks, the news is “good”. For the other 7, 735 banks…the results are really “not-so-good”.

And this is why the worry is focused on the smaller banks.

We keep getting bits of news like that reported in the NYTimes this morning, “Large Banks Still Have a Financing Advantage” (http://www.nytimes.com/2010/11/24/business/24views.html?ref=todayspaper):

“What happened to ending ‘too big to fail?’ That was one objective of the financial overhaul bill, the Dodd-Frank Act, that was passed this year. Central to the legislation were rules intended to make big banks less exciting and safer. It also created an authority meant to smoothly wind down even the largest institutions without greatly disrupting the financial system.

Five months after the bill’s passage, big banks should have lost at least some of their financing advantage over smaller rivals. But as the latest quarterly report from the FDIC shows, too big to fail is still very much alive and well.”

The point being made is that the average “cost of funding earning assets” for commercial banks in excess of $10 billion (109 banks out of the 7,760 banks in the system) was 0.80 percent. The average cost of the 7,651 smaller banks was an average of 1.29 percent so that the bigger banks had a 49 basis point advantage over the smaller banks. (Note that the gap was 69 basis points a year ago.)

The average cost of funding earning assets was even lower for the largest 25 banks in the country!

It seems like everything the policy makers are doing is benefitting the largest banks in the country.

And, what is being done for the smaller banks…the other 7,735 banks?

The Federal Reserve is pumping plenty of liquidity into the banking system so that the FDIC can reduce the number of banks in the banking system as smoothly as possible. (See my post “The Real Reason for Fed Easing”: http://seekingalpha.com/article/237834-the-real-reason-for-fed-easing-debasement-inflation.)

In reducing the number of banks in the banking system we don’t want disruptions and we don’t want panic. If this is the goal of the Federal Reserve and the FDIC, then they are doing a good job. The bank closure situation has, so far, neither resulted in major disruptions to the financial system or the economy or panic over the state of the banking industry.

The dismantling of the former United States banking system is going quite smoothly, thank you.

The future United States banking system is going to look entirely different. What might that banking system look like? Try the Canadian banking system or the banking system in Great Britain…a few very large banks dominate these systems. Is that what the United States system is going to look like?

Coming Crunch for Smaller Banks?

Two months ago I was hoping I was seeing some “Green Shoots in Smaller Bank Lending,” (http://seekingalpha.com/article/220685-green-shoots-in-smaller-bank-lending). Last month I found very little encouragement in the banking data released by the Federal Reserve: “Still No Life in Banking,” (http://seekingalpha.com/article/224851-still-no-life-in-banking).

The most recent data seem to indicate that things may be getting worse.

Remember, as of June 30, 2010, the FDIC listed 829 banks on its list of problem banks, and these banks are the smaller ones. Note that this is more than ten percent of the commercial banks in the banking system. Elizabeth Warren, in congressional testimony, has stated that there are at least 3,000 commercial banks facing major problems in the future, primarily in the area of commercial loans, (http://seekingalpha.com/article/215958-elizabeth-warren-on-the-troubled-smaller-banks.) I have made my own forecast that the number of domestically chartered banks in the United State will drop from around 8,000 to less than 4,000 in the next five years or so (http://seekingalpha.com/article/223340-say-goodbye-to-the-smaller-banks).

Total assets in the smaller banks in the United States (the smaller domestically chartered commercial banks consists of all banks below the top 25 in asset size and make up about one-third of the banking assets in the United States) are about the same this year as they were last year. Yet, cash assets in these banks increased by almost 38% from August 2009 to August 2010 and by more than 2% in the four week period ending September 29, 2010.

The concern, of course, is that the smaller banks are preparing for more trouble in the future. The larger banks are now in the process of reducing their cash assets: the cash asset at large, domestically chartered banks are down about 4% over the last four weeks; down about 5% over the past thirteen weeks; and down about 6% over the past year.

Thus, the decline in excess reserves that has occurred in the banking system over the last six- to eight-week period, has come in the big banks indicating that they are prepared to adjust to a new lower level of liquidity in the banking system.

However, the smaller banks are not ready to become less liquid, just the opposite. This, to me, indicates that the Federal Reserve is staying “extremely loose” not so much because the economy is weak, but because the solvency of the smaller banks in the banking system is in question.

There is no doubt that the smaller commercial banks in the United States are getting more conservative. Loans and leases at these smaller institutions continue to decline; they have dropped about one percent in the last four weeks.

The thing to keep an eye on, however, is the commercial real estate portfolio. In the smaller domestically chartered banks, the decline in these loans on the bank balance sheets seem to have accelerated in the past four weeks and in the past thirteen weeks from earlier time periods.

Commercial real estate loans have declined across the board, but the concern is that commercial real estate loans make up about 26% of the assets of the smaller domestically chartered banks and only are about 8% of the assets of the large banks. The declines in the smaller banks have a proportionately larger impact than does a similar decline in the big banks. Furthermore, this is where Elizabeth Warren pointed us to in her congressional testimony.

The two categories of loans that have recently increased at the smaller banks are “Revolving home equity loans” and “Credit card and other revolving plans.” The home equity loans at these smaller banks have risen by about 2% over the past 13-week period and are up slightly over the past 4-week period. At the big banks these loans are down by over one percent for the longer period and down slightly less than one percent for the shorter period.

Credit card and other revolving debt at the smaller institutions is up by over 4% in the past 13-week period and up by about 3% in the past 4-week period. At the larger banks, these numbers are down 3.5% for the longer period and down one percent for the shorter period.

Recent analysis of credit card debt indicates that, for the larger issuers, much of the decline in credit card debt has come because of these organizations charging off bad debt.

Could it be that the smaller banks are not charging off their delinquent home equity loans and credit card or revolving consumer debt because they don’t have the capital to absorb the losses? Could this be the reason that these loans are increasing at the smaller banks and not at the larger banks?

If one accepts this analysis, then the smaller banks have a lot to do on their balance sheets in the future to handle not only troubled commercial real estate loans but to handle revolving credit debt. Do the smaller commercial banks have the capital to go through this process?

There remain many concerns about the commercial banking system. Now that people expect that we will go through a period in which the profit performance of the larger banks is to be relatively flat, might this put even more pressure on the overall United States financial system?

My guess is that the big banks will do just fine. The problem is with the smaller banks, and the situation does not look encouraging for them. I still believe that this is the main reason why the Federal Reserve is keeping excess reserves in the banking system at such a high level. The Federal Reserve, in my mind, is scarred silly that there still may be massive bank failures in the future. The FDIC has been smoothly working through bank closures and helping many distressed institutions to find partners to absorb them. The question remains as to whether the massive amounts of liquidity in the banking system will allow this “work out” to continue its smooth and quiet pace in the face of growing problems with commercial real estate debt and consumer revolving debt?

Some Sustained Lending Activity at Smaller Banks

In reviewing the banking data put out by the Federal Reserve System last month, I titled my post “Grasping at Straws” because there was some indication of an increase in lending at the smaller banks. (See http://seekingalpha.com/article/215058-grasping-at-straws-in-the-banking-data.) In that post I made the following statement: “An interesting pattern is showing up in the data, however, and gives us something to look for going forward. The smaller, domestically chartered banks in the United States increased their loan balances a little bit over the four-week period ending in the week of July 7, 2010.”

In these releases the “smaller banks” are defined as all domestically chartered commercial banks in the United States with assets less than the largest 25 domestically chartered commercial banks in the United States. The largest 25 domestically chartered commercial banks in the United States hold roughly 67% of the banking assets in the United State while the other roughly 8,000 banks in the United States make up approximately 33% of the banking assets.

Focus is placed upon the smaller banks because this is where the vast majority of “troubled” banks in the United States reside and the concern about these troubled banks is significant enough that Elizabeth Warren has stated in Congressional testimony that there are serious problems which still persist in the smaller banks in the country and the Federal Reserve continues to keep its target interest rate low in order to help the process of bank consolidation flow smoothly. (See http://seekingalpha.com/article/215958-elizabeth-warren-on-the-troubled-smaller-banks.)

The increase in bank lending at the smaller banks seems to have continued through July according to the latest data released by the Federal Reserve. Loans at small domestically chartered commercial banks in the United States rose in the four weeks ending August 4, 2010, by about $16 billion or roughly 0.7%. Loans at these banks are still down, year-over-year, by about 3%, but we are looking for “green shoots” and this represents the second consecutive four-week period in which we have seen an increase in small bank lending.

The gains are concentrated in the consumer area as residential loans rose by over $13 billion in the last four-week period, consumer loans added about $10 billion over the same period, and home equity loans increased by a little more than $1 billion during the time.

Business lending continued to fall as commercial and industrial loans dropped by about $8 billion and commercial real estate loans fell by $3 billion. Furthermore, these latter loans are down by more than $16 billion over the last 13-week period. It is in the area of commercial real estate that Elizabeth Warren and others believe continued problems will plague the smaller banks in the United States.

One can draw the tentative conclusion from these data that some of the smaller banks are beginning to lend, but primarily to consumers and mainly in areas where real estate can serve as collateral. But, this is good news.

Still, in the aggregate, the smaller commercial banks are managing their balance sheets in a very conservative manner. Cash assets at these institutions rose by more than $23 billion or by about 8.5% over the past four weeks, and by almost $30 billion over the past 13 weeks. Total assets at these institutions increased by $46 billion and $70 billion, respectively, over the same time periods.

Overall, however, commercial banking shows very little life in the lending area. Year-over-year, the total assets of all commercial banks in the United States rose by less than one percent and total loans at these institutions fell by a little more than one percent. Commercial and industrial loans were the hardest hit category, falling by almost 15%, followed by commercial real estate loans, which dropped by more than 8%. Shorter periods of time do not present a much different picture.

In my post “No Banks, No Recovery” (http://seekingalpha.com/article/218027-no-banks-no-recovery) I presented the following argument: “It is very difficult to see the United States economic recovery accelerating if the banking system is sitting on the sidelines. The part of the banking system to worry about is the 8,000 banks that do not make the list of the 25 largest domestically chartered banks in the country.”

This is why I am giving so much attention at this time to the smaller banks. We have looked for “Green Shoots” before in this economic recovery and have been disappointed. We continue to look for positive signs that are not just of a passing nature. Hopefully, the data on the commercial banking system contain some positive signs that will continue to show indications that the economic recovery is, in fact, progressing.

The Banking System Continues to Shrink

According to the latest statistics of the Federal Reserve on the banking system, the banking system, as a whole, continues to shrink. Over the last 12 months, the total assets of all commercial banks in the United States banking system shrank by $560 billion or by about 5%. In the three months ending in January 2010, total bank assets dropped about $170 billion, with about $40 billion of the drop coming in January, itself.

Concern is still focused on the small- to medium-sized banks. Last week additional attention was focused specifically on 3,000 of these banks in terms of the problem loans they have on their books. (http://seekingalpha.com/article/188074-problem-loans-still-weighing-on-small-and-medium-sized-banks)

Elizabeth Warren, who heads the TARP oversight panel, is quoted as saying: “The banks that are on the front lines of small-business lending are about to get hit by a tidal wave of commercial-loan failures.”

There are a little more than 8,000 banks in the United States banking system and they had about $11.7 trillion in assets in January 2010. The largest 25 banks in terms of asset size held about $6.7 trillion in assets or about 57% of the assets in the banking system. “Small” domestically chartered banks held about $3.6 trillion in assets or around 31% of the assets in the United States banking system while the assets of foreign-related institutions amount to $1.4 trillion or 12% of the assets of the banking system.

So, there are a very large number of very small banking institutions that make up only about one-third of the bank assets in the country.

The total assets at these “small” banks dropped by $42 billion in January 2010, although by only about $14 billion in the last three months. The more interesting thing, however, is in the composition of this decline.

During this time period the loans and leases at these “small” banks fell by $20 billion in January and by $36 billion over the past three months. These banks are just not lending!

The primary decline came in real estate loans: they dropped $12 billion in January and $22 billion over the last quarter. We have, of course, heard of the problems these banks are facing with respect to commercial real estate loans and the numbers support this concern. At the “small” banks, commercial real estate loans fell by $10 billion in January and by $21 billion since October 2009.

Things were not very robust in other lending areas, but the declines reported in these other loans were not nearly so dramatic. I will call attention to the fact that consumer loans dropped by about $5 billion at these small institutions in January, a rather substantial decline.

Another indication of the difficulties “small” banks were facing is the decline in the securities portfolios at these institutions. Securities dropped by $31 billion in January, a time in which the “large” banks and the “foreign-related” banks both added securities to their asset portfolios.

And, where were the “small” banks building up their assets? In Cash Assets! Cash assets at “small” banks rose by $8 billion in January, and the increase totaled $21 billion over the last three months.

The smaller banks in the United States are putting more and more assets into cash as their balance sheets and loan balances shrink. This certainty supports the idea that many of these banks are in severe straits.

Large banks, on the other hand, actually reduced their holdings of cash assets in January by a whopping $71 billion. Over the past three months they reduced they cash assets by $118 billion.

These banks were not putting funds into loans, however. They were putting funds into their securities portfolio, adding $17 billion in January and increasing the portfolio by $60 billion over the last three months. The vast majority of these funds went into United States Treasury securities or federal agency securities. One can certainly sense a riskless arbitrage-type of strategy going on here.

Loans and leases at these large banks actually dropped in January by $46 billion, being spread fairly broadly over Commercial and Industrial loans (dropping $11 billion), Real Estate loans (dropping $18 billion) and Consumer loans (dropping $11 billion). It should be noted that in the consumer loan area there have been massive declines in credit card and revolving credit, $14 billion in January alone, but $27 billion over the last three months.

American commercial banks are not lending…period!

The largest banks seem to be living off of the riskless arbitrage situations that are available. They are doing little to nothing to help stimulate the economy along. But, why should they get into risky business and real estate loans when they can earn a pretty handy return without risking anything? Thank you, Mr. Bernanke!

The smaller banks seem to be drawing up the ramparts, becoming more and more conservative. This is where the loan problems are and the behavior of these organizations certainly lend credence to that belief. The fact that these banks are even getting out of their securities raises additional concern about the seriousness of their situation.

Note: The behavior of foreign-related institutions during this time period is also of concern. In the last three months, foreign-related institutions reduced their securities portfolio by $19 billion, their trading assets by $26 billion and their loans and leases by $33 billion, a total of $78 billion.

And where did they put the proceeds of this reduction in assets? They increased cash assets by $73 billion!

Foreign-related institutions in the banking week ending February 3, 2010, held $473 billion in cash assets, 38% of all the cash assets held by the banking system in the United States.

I don’t know right now, whether or not this fact should be a concern, but I would like to understand a little bit more about the situation of these banks. The “small” banks in the United States are moving in this direction because of the “poor” state of their loan portfolios. Is this move on the part of the foreign-related institutions of a similar nature? Or, are they going to move assets out of the United States?

Small Bank Loan Problems

A set of findings that will be released today by the Congressional Oversight Panel which oversees the TARP effort highlights exactly the problem I have been focusing on for the past year. The problem is the health of small- and medium-sized banks.

“Nearly 3,000 small U. S. banks could be forced to dramatically curtail their lending because of losses on commercial real-estate loans.” This from the article by Carrick Mollenkamp and Maurice Tamman in the Wall Street Journal, “TARP Panel: Small Banks are Facing Loan Woes.” (http://online.wsj.com/article_email/SB20001424052748703455804575057851154035196-lMyQjAyMTAwMDEwMTExNDEyWj.html).

Elizabeth Warren, who heads the TARP oversight panel is quoted as saying, “The banks that are on the front lines of small-business lending are about to get hit by a tidal wave of commercial-loan failures.”

My question is, why has it taken so long for this concern to surface at this level? This is vital information!

There are just over 8,000 in the United States. This means that from one-third to two-fifths of our banks face serious troubles with regards to their commercial loan portfolio, let alone any other problems they might face in their loan portfolios.

At the end of the third quarter, the FDIC had 552 banks on their list of problem banks. We will not get the report on the number of banks on the problem list for the end of the fourth quarter until later this month. The number of problem banks was expected to rise this year anyway before this information came out, but this is certainly not good news.

The rough rule of thumb is that one-third of the banks on the problem list can be expected to fail, and, using the third quarter figures, this means that two to three banks will fail each week for the next twelve to eighteen months. So far this year, we are roughly on track with this pace.

There are two problems here. First, the number of failing banks. The deposits and loans of these banks have to be absorbed into the banking system and this represents a de-leveraging of banks and the banking system that is consistent with the de-leveraging that is going on in the rest of the economic system.

Secondly, and this is what the Wall Street Journal focuses on, is that this atmosphere is not conducive to an expansion of loans. Whereas most of the big banks, (remember that the top 25 banks in the country have over 50% of the bank assets in this country) have become very active again, the small- to medium-sized banks do not have neither the resources nor the markets to pick up their lending or deal-making activity.

Unless you have worked in a smaller bank, you don’t realize the effort and the commitment of resources that is needed to work with troubled-lenders, especially if a substantial part of your portfolio is in loans that are having problems. You have neither the will nor the means to give much of your attention to making new loans.

Furthermore, even if you are not a part of the 3,000 banks facing a large amount of loan problems, why should you be lending much now? First of all, if you seem to be surviving, you are probably very, very thankful that you are not in the same position of these other banks and are feeling a great deal of relief. Yes, relief, but you are still wary, because the whole thing is not over yet.

Second, and I know this from my experience in turning around banks, if you don’t make a loan, that loan cannot go bad on you. The probability of this is 100%. That’s about as close to certainty that you can get in these very uncertain times.

The other side of this is something that I have said this many times before in these posts. The good news is that things seem to be pretty quiet on the banking front. Let’s hope that this quiet continues. Quiet is good, because it can mean that the bad and the not-so-bad situations are being worked out. And, if the economy continues to improve, some of the bad situations will become not-so-bad situations and some of the not-so-bad situations will actually become acceptable situations.

So, keep your fingers crossed.

This whole situation is further evidence of the extent that credit inflation enveloped the United States (as well as the world). In a credit inflation, it pays to go further and further into debt and to make more and more loans. At least, as long as the credit inflation can continue.

The leveraging and the moves to riskier assets usually begins with the larger institutions and then works its way through the economy. In most situations, the smaller institutions are the last ones to really follow the increased exposure that has been taken on by larger banks. However, more and more people and institutions succumb to the environment the longer the credit inflation continues. But, the increased risk taking does spread throughout the economy.

When the credit inflation stops, then de-leveraging must take place and this can be a long, slow process. And, again, the smaller institutions tend to trail the larger institutions. Thus, it is not surprising that the small- and medium-sized banks are still dealing with these problems even though the larger institutions have moved on.

Unless, of course, the government is able to “goose up” credit inflation again and eliminate the need to de-leverage.

The extent of the problem relating to “loan woes” is still substantial. The existence of this problem will weigh on the officials in the Federal Reserve System because a tightening of credit will just exacerbate the existing fragility of the banking system. The Fed does not want its “undoing” of the excessive amount of excess reserves in the banking system to be the “undoing” of the commercial banking system, itself.

The commercial banking system has always been a part of any economic recovery in United States history. It is hard to see how much of a recovery is possible if the commercial banking system, this time around, is “frozen”. At least for the small- and medium-sized banks.

Guess the loans to small- and medium-sized businesses will just have to come from the government!

(Please accept this last statement as being ironic!)

Something is Wrong!

A headline in the New York Times, “Walk Away From Your Mortgage!”

Why not?

The best remedy for the current economic malaise?

Since there is too much debt, let’s all just walk away from our debt.

And, if the New York Times is printing such material, then it must be OK! Right?

As we “recover” from the Great Recession we see pockets of problems all over the place. Things just don’t fit together the way they used to. And, what we are doing to combat these problems doesn’t seem to be relieving the suffering. The whole world seems to be dislocated.

There is too much debt outstanding. No one disagrees with that, but how do you get people and businesses and governments to start spending again when they are desperate to reduce their outstanding debt?

Other headlines this morning point to the problems in commercial real estate. In “Delinquency Rate Rises for Mortgages” we read that “More than 6% of commercial-mortgage borrowers in the U. S. have fallen behind in their payments, a sign of potential troubles ahead as nearly $40 billion of commercial-mortgage-backed bonds come due this year.” (See http://online.wsj.com/article/SB20001424052748704130904574644042950937878.html#mod=todays_us_money_and_investing.) Also, “Further Slide Seen in N. Y. Commercial Real Estate” points to the fact that 180 buildings totaling $12.5 billion in value, are in trouble in Manhattan. (See http://www.nytimes.com/2010/01/08/nyregion/08commercial.html?hp.)

But, the problems don’t seem to be just in commercial real estate. The New York Times article cited above states that at least one quarter of all residential mortgages in the United States are underwater and that 10% of the mortgages outstanding are delinquent. Another round of foreclosures and bankruptcies seem to be on the way.

Which brings us to the banking system: here the difficulties bifurcate depending upon size. If you are really big you seem to be doing very, very well these days. In fact, it seems as if the “good ole daze” have returned for these bankers. Risk-taking and speculation in the carry trade abound. Simon Johnson, an economist at MIT issued a warning on CNBC yesterday morning that the next phase of the financial crisis could be just beginning and this gets back to the risk-taking of the six major banks in the US whose combined balance sheets exceed 60% of United States GDP.

If you are smaller, however, your problems are immense. The smaller banks are carrying the burden of the commercial real estate problems and consumer debt and mortgages still present these banks with problems because these loans represented “Main Street” and were not all packaged and sold to investors in Finland. Remember there are 552 banks, all small- and medium-sized banks that are on the FDICs list of problem banks and this is expected to grow this year before declining, generally do to actual failures.

There are more dislocations throughout the economy that point to persisting problems. For example, in manufacturing, since the 1960s the unused capacity of United States industry has continually declined from peak usage to peak usage of that capacity The latest peak utilization of capacity still saw that about 20% of the industrial capacity of the United States remained unused. Unused capacity for the past thirty years seems to average around 23% to 24%.

We see unused capacity in the labor force as well. Since the 1970s under-employment of labor has grown quite consistently. Attention is focused upon the unemployment rate, but this measure does not include those individuals that have left the labor force because they are discouraged and those that are only working part time but would like to work more. We have seen estimates that 17% to 20% of the employable people in the United States are under-employed. Another dislocation that is not comforting.

Then we hear about the problems in state and local governments. Reports indicate that there are more than 30 states that are currently experiencing fiscal difficulties. We hear most about California and New York, but there are many other states particularly in the west and southwest that are having real problems. One estimate is that the states will have a combined budget shortfall of at least $350 billion in the fiscal years of 2010 and 2011. And, this doesn’t even get to the difficulties that are being faced by local governmental bodies.

And, there are the dislocations being created by the federal government. Budget deficits for the next ten years have been placed in the range of $15 trillion. The United States is fighting in three wars throughout the world. The government is passing health care legislation that has been justified fiscally by postponing start dates of programs from three to five years. There is climate control efforts being considered along with regulations, like anti-pollution controls, that will just exacerbate the economic and fiscal problems of the country. Then there are other changes in the rules and regulations that apply to industry that will further change the playing field and create greater uncertainty about what management’s should do.

There is the problem of unemployment, the number one issue among the American voter. (And, you thought the number one issue was health care or pollution or terrorism or the war in Afghanistan.) But, there is a dislocation problem relating to federal government stimulus programs.

For fifty years or so, the federal government has attempted to stimulate the economy to put people back to work in the same jobs that they were released from. The government has sought to put unemployed people back to work in the steel industry, in the auto industry, and in other jobs that are the backbone of American industry (according to the labor unions and others). As a consequence, the steel industry lost competitiveness, the auto industry lost competitiveness, and so do many other industries.

This effort to stimulate the economy and put people back into the jobs that they had lost has contributed greatly to the increase in the unused industrial capacity and to the increase in the under-employed in this country. The effort to constantly maintain a low unemployment rate by putting people back into the jobs they have lost has resulted in a massive slide in the competitive position of the United States.

The point of this discussion is my concern with the huge dislocations that now exist within the country. Things are out-of-whack and it is going to take us quite a while for us to get things back together again. Yes, we can try and “force” the economy back into a position of higher employment and greater capacity utilization, of lower debt burdens and greater solvency. But, this would just postpone, once again, the need to realign the country to deal with the pressures of the 21st century.

Something has changed, however. The United States is now facing a more competitive and hostile world economy. The government may not be able to “force” the economy back into its old mold.

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? (http://seekingalpha.com/article/178117-federal-reserve-exit-watch-part-5)

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. (http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic)

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”: http://www.ft.com/cms/s/0/0ad195f8-ea7a-11de-a9f5-00144feab49a.html. 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”: http://online.wsj.com/article/SB20001424052748704398304574597910616856696.html#mod=todays_us_opinion. 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 http://seekingalpha.com/article/178269-defining-the-banking-situation-as-a-political-issue.

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?” http://www.tnr.com/blog/the-plank/history-paul-volckers-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.