The Consequences of Debt Are All Around Us

Why isn’t the economy expanding at a faster pace?  Why aren’t consumers spending as robustly as they have in the past?  Why aren’t banks lending?

The answer has to do with either the debt still on the balance sheets of businesses, banks, and households, or the remains left by the debt that was created over the past fifty years.

We see the consequences of the half-century debt binge posted all over…on the Internet, in newspapers, and on radio and television.  Lots and lots of debt or the results of debt everywhere. 

Of course, the Greek debt situation is all over the papers this morning  In addition, the Socialists lost control of many local governmental bodies in Spain on Sunday, giving rise to fears that large amounts of unrecorded debt in many of these units will be discovered as a result of the change in government. (http://seekingalpha.com/article/271083-the-global-economy-debt-and-accounting-gimmicks)   

State and local governments in the United States are offering thanks that the media attention has shifted from them to the European entities.  But, the debt problems of state and local governments will not go away…so just wait!

The most important news this morning, to me, is the attention given to the banking systems of both Europe and the United States.

The headline in the Wall Street Journal proclaims, “Buyers Battle for Europe’s Bad Loans,” (http://professional.wsj.com/article/SB10001424052748704083904576335510788215984.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj) “The push by banks across Europe to clean up their balance sheets is causing a feeding frenzy among hedge funds and private-equity firms hungry for their troubled assets.”

“Banks from the U.K., Ireland, Germany, Austria, Greece, Italy, Portugal and Spain have been unloading tens of billions of dollars worth of assets…”

Marathon Asset Management LP, for example, is reported to have purchased bank assets “usually in batches of $25 million to $100 million, at discounts of as much as 50% of their face value.” 

“European banks are sitting on more than €1.3 trillion ($1.9 trillion) of loans that are considered ‘non-core’ to their businesses and are likely to be put up for sale over the next decade.”

“In the U.S., a similar process has been going on for years…Until recently, European regulators generally were content to let their banks work through their problems over time.” 

Europe’s sovereign-debt crisis put an end to that!

The point is that there is still a “ton” of debt “out there” that is being written down or is going to be written down and still has to be “worked out.” 

In other words, the economies of Europe and the United States are not fully out-of-the-woods.

The “working out” part of this statement is captured in the New York Times headline, “Banks Amass Glut of Homes, Chilling Sales” (http://www.nytimes.com/2011/05/23/business/economy/23glut.html?_r=1&hp). “The nation’s biggest banks and mortgage lenders have steadily amassed real estate empires, acquiring a glut of foreclosed homes that threatens to deepen the housing slump and create a further drag on the economic recovery.”

“All told, they own more than 872,000 homes as a result of the groundswell in foreclosures, almost twice as many as when the financial crisis began in 2007.” 

“The pileup could lead to $40 billion in additional losses for banks and other lenders as they sell houses at steep discounts over the next two years…”

And, this problem is extended to other areas of the real estate market like the commercial real estate sector. 

The good news…”the number of new foreclosures and recent borrowers falling behind on their payments by three months or longer is shrinking.”

Where is the focus of the banks?

The focus is more on attempting to minimize the amount of write down the banks must take and is not on generating new loans to build up revenue streams.  Right now, the balance of effort in banks seems to be on the side of keeping down charge-offs because of the larger impact on solvency, rather than just on earnings.  In fact, the recent increase in bank earnings has been largely due to a reduction in loan charges rather than an increase in revenues. 

If we are to get the focus of banks back on lending and on supporting economic growth we must get through this period of restructuring the balance sheets of commercial banks to remove the bad assets.

But, this presents a problem to the policy makers in Washington, D. C.  If commercial banks, and other economic bodies, must work through their debt problems before they can focus on increasing loans and increasing spending, efforts to stimulate the economy through further governmental credit inflation will have little impact on picking up economic growth.

This factor is not considered in most macro-economic models because the importance of debt on business decision-making will vary from time-to-time.  At lower levels of indebtedness, economic units may not feel that they have to restructure their balance sheets to reduce debt loads and further fiscal stimulus, more credit inflation, will bring about more rapid economic growth.

However, in periods when the burden of the debt loads become too heavy, people will need to re-adjust their behavior and reduce levels of financial leverage to more reasonable amounts.  At these times, further fiscal stimulus, more credit inflation, may have only a modest impact on economic growth.  In situations like these, fundamentalist preachers like Paul Krugman may cry all they like about the need for more and more governmental spending, but even that will not bring on “the Rapture.”

We are in a period when the excesses of the credit inflation of the past must be worked off before people can begin to fully focus again on the future.  The economy is highly bi-furcated, both in Europe and in the United States.  Those people and institutions that are not highly leveraged and have cash-on-hand, will prosper relative to those that are highly leveraged and are short on cash.  The last fifty years has seen a tremendous skewing of the income and wealth distribution in the United States toward the richer end of the spectrum.  My guess is that, given the current situation and the current economic policies, this trend will continue.  Maybe debt is not such a “good thing” after all.      

The Games Banks Play

I would like to recommend another article on bank accounting practices. This is the article by Michael Rapoport in the Monday’s Wall Street Journal titled “’Toxic’ Assets Still Lurking At Banks.” (http://professional.wsj.com/article/SB10001424052748704570104576124701144189910.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj) I don’t want to repeat all that is in the article because I would just copy the article. So, I highly suggest you read the whole thing. But, the issue has to do with when and how do you recognize the value of loans and securities on the balance sheet of a bank.

How does one know what value should be placed on a commercial bank franchise?

The answer: in the current environment, one doesn’t.

I have had my say (once again) on the “mark-to-market” controversy: see “Risk Management: Key in Future Economic Performance for Banks. (http://seekingalpha.com/article/249440-risk-management-key-in-future-economic-performance-for-banks)

In my mind, not only are bankers attempting to fool the regulators and the investment community…they are trying as hard as they can to fool themselves.

Rapoport quotes the banking expert Bert Ely: "In a lot of cases banks are probably deluding themselves" about the future value of those securities, and whether they will ultimately recover as much from those securities as they contend they will”

Bankers are notorious for “deluding “ themselves.

“The sun will come out…tomorrow…bet your bottom dollar…that tomorrow…”

But, Rapoport just discusses information from the top 10 banks in asset size and the data come from the September 30 financial reports.

As readers of this blog know, much of my concern has been with the banks that are smaller than the biggest 10 banks…or the biggest 25 banks.

We just don’t have any idea how deep the pool of trouble is for most of the banking system.

We get some encouragement from a recent Congressional study. Quoting from another Wall Street Journal article: “ A year ago, Elizabeth Warren, who headed the congressional panel overseeing the Troubled Asset Relief Program, predicted a "tidal wave of commercial-loan failures." On Friday, at a follow-up hearing on commercial real estate held by the same oversight panel, Patrick Parkinson, a Federal Reserve official, said that "worst-case scenarios are becoming increasingly unlikely." (http://professional.wsj.com/article/SB10001424052748704843304576126442295848066.html?mod=ITP_pageone_1&mg=reno-wsj)

One year ago, Elizabeth Warren stated at a Congressional hearing that 3,000 commercial banks were going to experience serious problems in their portfolio of commercial real estate. I am glad to hear that “worst-case scenarios are becoming increasingly unlikely.”

So, how many commercial banks are going to experience serious problems in their commercial loan portfolios? How many more are going to experience more problems in their securities portfolios? How many more have not recognized on their balance sheets assets that are still “toxic” or “troubled”?

In order to obtain some idea of how bad the condition is of the “smaller” banks, I look at the behavior of the bank regulators that should know.

First, the Federal Reserve System: the Federal Reserve System has put over $1.1 trillion in excess reserve into the commercial banking system and is still engaging in “quantitative easing” to “get banks to start lending again.” However, the “smaller” banks are still not lending.

Second, the behavior of the Federal Deposit Insurance Corporation: the FDIC continues to close 3 banks per week and it looks as if it will continue to close 3 banks a week for the indefinite future. And, this does not include the banks that disappear from the system because they have been acquired.

These are the two government agencies that really should know how bad off the banking system is...and they are acting in this way?

The Fed is providing funds to keep a lot of commercial banks open so that they can either be closed in an orderly fashion by the FDIC or be acquired outright by another bank, domestically or by a foreign source.

The problem is that because of the accounting rules, investors, regulators, and even bankers don’t know what shape the banking system is in. But, every quarter we seem to get several “surprises”, banks being taken over or acquired because of their financial condition. And, no one seems to have seen these “surprises” coming. How many more Wilmington Trust’s are there out there?

Banks, Disclosure, and Reform

Bankers can’t have it both ways. Either they are going to have to honestly disclose their positions or they are going to face more and more intrusion into their operations.

The honesty factor is a concern if banks continue to publically lie about their balance sheet positions. I have written about this before in my May 5 post “Can the Financial System Still be Trusted”, http://seekingalpha.com/article/203077-can-the-financial-system-still-be-trusted. Others are providing clearer evidence of this behavior. See the Wall Street Journal of May 26, “Banks Trim Debt, Obscuring Risks”, http://online.wsj.com/article/SB20001424052748704792104575264731572977378.html#mod=todays_us_front_section. The Journal followed this with another on May 27, “BofA, Citi Made ‘Repos’ Errors” http://online.wsj.com/article/SB10001424052748704032704575268902274399416.html#mod=todays_us_money_and_investing.

If banks want our trust, they are going to have to be honest with us.

The disclosure factor I am referring to pertains to mark-to-market accounting. The Financial Accounting Standards Board has proposed that commercial banks mark the value of their loan portfolios to “fair value” standards. Banks already use mark-to-market accounting for other assets on their balance sheets, although they basically don’t like this requirement.

The general argument provided by the bankers is that this mark-to-market requirement would require banks to take “big losses” on loans during certain periods of economic distress and this “could” be misleading because the loans “would probably still pay off over time” This analysis is from today’s New York Times: http://www.nytimes.com/2010/05/27/business/27fasb.html?ref=todayspaper.

This argument infuriates me. I have been the President and CEO of two financial institutions and the CFO of a third, all publically traded companies, and if I have heard this argument one time I have heard it a thousand times. And, in most cases, the statement has referred to loans that eventually were written down or written off.

The argument, ironically, is not applied to the loans that do perform! My experience is that the claim is a defensive statement from a loan officer or bank executive that is overly sensitive to the fact that they have not performed and don’t want this fact publically recognized.

I would add two things to this discussion. First, when loans start to go bad, a good management should want to identify the problems as soon as possible so that they can do something about them. Postponing dealing with loans that are experiencing some trouble can only lead to more trouble in the future. Well run institutions are ones that deal with their problems “up front” and do not try and hide them in the hopes that they will go away.

Second, bankers take risks: credit risk, interest rate risk, liquidity risk, leverage risk, and other forms of risk. This is their job. But, there is a cost of taking risk. As we have seen from the recent financial buildup and collapse, during periods of credit inflation, asset bubbles, and other cases of excess, bankers push the edge taking on more credit risk, more interest rate risk, more leverage risk, and so on.

In order to maintain our trust in banks and the banking system we need to know what the banks have done and how their decisions have affected the value of the assets on their balance sheets.

“Critics of applying fair value to loans have said the existing use of fair value has deepened the financial crisis by forcing financial firms to take unjustified losses on assets that shrank in value when market conditions worsened temporarily.” (See http://online.wsj.com/article/SB20001424052748704032704575268962900687370.html#mod=todays_us_money_and_investing.)

Come on, be big boys and girls. You made the decisions! Accept the consequences of those decisions!

In terms of financial reform, I am more in favor of using “early warning” systems like the one recently proposed by Oliver Hart and Luigi Zingales in the journal National Affairs , http://nationalaffairs.com/publications/detail/curbing-risk-on-wall-street, and “To Regulate Finance, Try the Market” in Foreign Policy, http://experts.foreignpolicy.com/blog/5478. But, to go this route, financial institutions should be open to full disclosure and accounting transparency. I will write more on the Hart/Zingales approach in the near future.

I happen to believe that this kind of behavior, the encouragement of openness and transparency, represents good management practices. (See my post “On Audits and Auditors”, http://seekingalpha.com/article/195594-on-audits-and-auditors.) Using a sports analogy again: good teams and good players do not rely on trickery…they just outperform other teams and players that have to use deceit and deception to try and get the upper hand!

Good managers and good managements are not afraid of “the open air”!

The alternative is for there to be more explicit attempts to regulate and control the financial institutions. Going this direction ultimately fails (see my post “The ‘Sound and Fury’ of Banking Reform”, http://seekingalpha.com/article/206341-the-sound-and-fury-of-banking-reform) but it is time consuming, expensive and inconvenient in the process. And, choosing this path leads to ‘cat-and-mouse’ games that do not contribute to increasing the public’s faith and trust in the banking system and the regulators.

This seems to be one of the major problems of modern America. In my memory, there was a time when we could have faith and trust in our business and financial institutions and in our government and in each other. This ‘faith and trust’ is sorely missing now. It would be nice if some leaders appeared that actually tried to restore these characteristics to our national life. I just don’t see any of this kind of leadership on the horizon.

In my mind, banks need to take a leadership position on the “Disclosure” process and assume a stance that is more disciplined than would be imposed by any regulatory standard. In doing this they would take control of the issue.

Or, they must accept the lack of faith and lack of trust that follows a government-led effort to constrain and control them. They cannot fight disclosure and fight greater government oversight at the same time.

Bernanke's Testimony: Reading Between the Lines

Chairman Ben Bernanke gave testimony this past week on the Fed’s semiannual report on monetary policy to the United States Congress. I believe that Mr. Bernanke’s report can be summarized in two sentences. First, the United States economy is recovering, but the recovery will be quite slow. Second, the Federal Reserve will continue to keep its interest rate target at current levels.

This testimony came during a time in which the Federal Reserve has been attempting to reveal and explain how it plans to exit from its current position, a position that includes a banking system with almost $1.2 trillion in excess reserves. Fundamentally, the Fed is ready to begin to “undo” what it has done over the last year and a half. (See, for example, my posts http://seekingalpha.com/article/189547-back-to-business-at-the-fed, and http://seekingalpha.com/article/189547-back-to-business-at-the-fed.)

The implicit contradiction in all of this is that the Fed’s “undoing” is to take place as the economy recovers, but, the Chairman in not willing give a hint as to when the economy will be strong enough to allow the Federal Reserve to start raising its current target level of the Federal Funds rate.

To me, the message that is being conveyed between the lines is that there are still some things so wrong with the economy (that the Federal Reserve is aware of) that the Fed cannot take a chance, even give a hint of a chance, that the target Fed Funds rate will be raised.

And, what is the basis of this fear?

Will, we can start with the state of the banking system. The Federal Deposit Insurance Corporation (FDIC) produced its quarterly report last week and indicated that 702 commercial banks were now on the list of problem banks at the end of 2009. This is up from a total of 552 banks that were on the problem list at the end of September 2009. And, the FDIC closed 2 to 3 banks per week during the fourth quarter of the year.

Given the current list, the expectation is that about 235 banks, one-third of the current total on the problem list, will close over the next 12 to 18 months, a rate of 3 to 4.5 banks per week for this time period.

Remember that there are about 8,000 commercial banks in the United States, with the top 25 accounting for well over one-half the assets in the banking system. Thus, the banks that are failing tend to be small and they tend to be “local” in nature and a failure can cause quite a disruption on “Main Street.”

The problems in the banking system go deep. The insured banks charged off 2.9% of outstanding loans in the fourth quarter of 2009. This is the largest charge off rate in the 75-year history of the FDIC.

At the end of the fourth quarter, 5.4% of all loans were at least 90 days past due, a near-term high. Specific areas of the loan portfolios are showing a large amount of stress. For example, data on construction loans to build single-family loans indicate that about 40% of the loans are either delinquent or have totally been written off. Mortgage loans still remain a problem where about 12.5% of the loans outstanding are past due.

Commercial real estate loans are the looming giant in terms of providing dark clouds for future bank loan performance. Elizabeth Warren, head of the Congressional team that oversees the TARP funds has stated that about 3,000 commercial banks face the possibility of a “tidal wave” of commercial real estate loan problems. At the end of the fourth quarter of 2009, over 6% of these loans were classified as a problem in some way.

Before these problem loan areas can be resolved, the economy must begin to get stronger, people must return to good paying jobs, and real estate values must cease falling. Discouraged workers must return to the workforce and manufacturing firms must increase the utilization of their resources. There is little evidence to indicate that these factors are, in fact, improving to the extent needed to strengthen the loan portfolios of commercial banks.

The Fed, obviously, has a good seat to observe all of these facts. And, I believe, they are very, very concerned. And, I also believe, that bankers are very, very concerned.

Why?

Because the bankers are sitting on their hands and holding onto any type of asset that will not deteriorate in value…cash or deposits at Federal Reserve banks and short term government securities.

Yes, we can say that businesses and homeowners with very good credit are not borrowing. And, we can say that consumers are not borrowing.

I don’t think this is the answer.

I believe that this situation is more like the one that was experienced in the period around 1937. Commercial banks were holding a lot of excess reserves at that time too. Also, there was no lending to speak of during that period. And, the Federal Reserve raised reserve requirements to “sop up” those excess reserves.

And, what did the banks do at that time? They withdrew even further. The banks wanted those excess reserves. They did not want to lend them out. They just wanted the protection and security of having those reserves in their hands. By taking the reserves away, the Fed caused the banks to restrict credit even further in order to return excess reserves to a level more consistent with the safety the banks wanted on their balance sheets.

Ben Bernanke, the student of the 1930s, knows what happened back then. He is, therefore, fighting on two fronts in the current climate. First, there are those that are afraid that the excess reserves the Fed has injected into the banking system will eventually be lent out and this will cause the money stock to expand and this, given the size of the $1.2 trillion level of excess reserves, will result in a higher than desired level of inflation in the United States economy.

Bernanke and the Fed must do enough, talking and maneuvering, to satisfy this crowd. Hence the exit strategy and the efforts to get Federal Reserve’s operations back into a more normal environment.

Second, however, is the fear that the excess reserves in the banking system are “desired” by the banking system and any effort to substantially reduce them in the near future could lead to a further contraction in the banking system that would ensure a “double-dip” Great Recession.

My guess is that Bernanke is not willing to take a risk on generating a further contraction in the banking system by removing bank reserves at this time. This, to me, is the message between the lines of the Chairman’s testimony in front of Congress this past week.

The Fed is ready for the great “undoing” of its balance sheet, but is not going to begin this “undoing” until it is sure that the commercial banks are willing to let go of the $1.2 trillion in excess reserves.

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!)

The Small Banks Are Not Doing Well

This is my monthly report on bank lending. Last month I reported on the continued absence of the commercial banking industry in loan markets. (See my post of September 10, 2009, “Bank Lending Stays on the Sidelines”: http://seekingalpha.com/article/160890-bank-lending-stays-on-the-sidelines.) Bank lending was still absent during the most recent month, but there now seems to be a significant shift in the commercial banking industry: greater changes seem to be taking place in the smaller banks than we have seen during the current economic crisis.

This deterioration in the industry figures coincides with the increasing number of failures that are registering with the Federal Deposit Insurance Corp. (FDIC). This problem made the front page of the New York Times on Sunday: see “Failures of Small Banks Grow, Straining F. D. I. C.”, http://www.nytimes.com/2009/10/11/business/economy/11banks.html?ref=business. And, with more than 400 banks, almost all of them small ones, on the FDICs list of problem banks, we can expect the number of failures to grow and the bank lending figures to continue to shrink.

Total assets at commercial banks declined by $320 billion over the latest 13-week period according to the Federal Reserve. Of this total, the decline in assets over the last 5-week period was $250 billion indicating that the slide at commercial banks is not receding. Although the absolute decline in both periods of time was greater for the large banks, the percentage change was greater for the smaller banks.

What is most interesting is that the absolute decline in bank loans and leases in both periods was roughly the same for the large banks and the small banks. The decline in loans and leases over the 13-week period was $112 billion for large banks: $97 billion for small banks. However, for the last 5-week period the decline in this figure for small banks was $69 billion and $66 billion for large banks.

Commercial and Industrial loans, business loans, continued to drop at a rapid pace over the 13-week time span ($108 billion) as well as in the 5-week period ($50 billion). Relatively speaking the declines were equally divided between the large banks and the smaller banks.

The big difference between the different size banks comes in the area of real estate loans. Overall, real estate loans dropped by $113 billion over the last quarter, $48 billion over the last 5 weeks. But the decline in small banks was $68 billion for the last quarter and $38 billion over the last 5 weeks. The figures for large banks were $41 billion and $6.3 billion, respectively.

Here we find the startling difference: the small banks experienced most of the drop in real estate loans in commercial real estate loans. The drop in commercial real estate loans at small commercial banks was $36 billion for the full 13 weeks, but most of the decline came in the last 5-week period as these loans dropped by $24 billion during this latter time.

We have been hearing for months that there was going to be a problem in commercial real estate lending and that this problem was going to be centered in regional and local commercial banks. It looks as if this problem is finally hitting the banking system and is showing up in the numbers. This is an area that we are going to have to continue to watch for the economic difficulties in commercial real estate could continue to paralyze the smaller commercial banks for quite some time going forward. And, with the large number of problem banks identified by the FDIC being smaller institutions, we could see a rapid increase in the number of these institutions going under.

It should be noted that commercial real estate loans at large commercial banks actually increased over the past 13-week period and roughly held constant for the last five.

Another sign that these difficulties are piling up at the smaller commercial banks is the accumulation of cash assets at the smaller institutions and the timing of this build up. Cash assets at small commercial banks rose by $54 billion over the past 13 weeks. These assets increased by $48 billion over the last 5 weeks. That is, most of the increase in cash assets came at the time that time that the commercial real estate portfolio at these banks were declining the most.

The implication of this behavior is that the smaller banks are really starting to suffer and this is leading them to take a more-and-more conservative position in their balance sheets.

It should be noted that large commercial banks actually reduced their holdings of cash assets during this period. The decline over the 13-week period was about $5 billion, while over the last 5 weeks the decline was a whopping $70 billion. So, large banks build up their cash position over the first 8 weeks of the period and then reduced this position substantially over the last five.

The basic conclusion that can be drawn from this analysis is that the balance sheets of the commercial banking sector continue to shrink and with this shrinkage we see very little new borrowing taking place.

The big story this month is that the smaller banks in the country are really being hit with problems relating to bad assets. As a consequence, their balance sheets are suffering much more than their bigger counterparts and this is especially true when it comes to commercial real estate. Not only are the smaller banks reducing their exposure to commercial real estate loans, it appears as if this retraction from the lending markets is connected with an overall move by these banks to much more conservative lending practices.

Such a move would certainly not contribute to economic recovery, especially on Main Street. It is true that the larger banks are also contracting their balance sheets now, but they will tend to be the first ones to get back into lending when the time is right.

However, if the smaller banks change their “risk preferences” and become more “risk averse” during this period of restructuring it is highly unlikely that we will see them return anytime soon to contribute to an economic recovery in their geographic area. Since these organizations do not have the same access to resources as their larger counterparts, they will probably stay very conservative for an extended period of time.

Just one thing more. Last week Excess Reserves in the banking system reached an all-time high. For the two week period ending October 10, Excess Reserves averaged $918 billion! This, of course, is being allowed to happen by the Federal Reserve System as reserve balances at the Federal Reserve got close to the astronomical figure of $1.0 trillion! This figure only averaged $960 billion in the banking week ending October 7, but daily figures over the past two weeks did reach levels substantially higher.

The banking system is weak. It remains weak. Maybe some of the larger banks, the ones that got bailed out, are doing OK. This does not seem to be the case for the smaller banks. The FDIC knows this. The Federal Reserve knows this. It is not a comfortable situation!

Banks Remain on the Sidelines

The commercial banking system is still holding onto cash rather than lending or investing. Over the thirteen weeks ending August 26, 2009 the assets of the banking system dropped by $246 billion, but the cash assets of the banking system rose by $87 billion. In the most recent four week period bank assets did rise by $85 billion, but cash assets at the banks rose by $183 billion during the same time span.

Overall, banks, during the last 13-week period, have reduced, at a more rapid pace, their holdings of loans and investments as write-offs have increased, as there has been little incentive to make new loans, and as the banks have gotten out of securities that are not issued or guaranteed by the U. S. government. This is evidence that the banks are de-leveraging and are attempting to clean up their balance sheets. More detail of this behavior is presented below.

The total amount of cash assets in the banking system was $1.1 trillion in the banking week of August 26. This amounted to 9.3% of the total assets in the banking system as total assets averaged $11.8 trillion for the week. Note that banks were required to hold an average of only $62 billion ($0.06 trillion) in reserves behind their deposits during the two week period ending August 26. The excess reserves in the banking system averaged around a whopping $0.8 trillion during this same two week period. (The peak level of excess reserves in the banking system was about $0.85 trillion in the month of May.) Also, note that bank reserve balances with Federal Reserve Banks averaged around $0.83 trillion in the banking week ending August 26.

Beginning in December 2008, the banking system has held an average of $0.76 trillion in excess reserves every succeeding month. Before September 2008, the banking system held, on average, $0.002 trillion in excess reserves. To put these figures in context, bank assets in the banking week of August 26, 2009 were only $0.8 trillion larger than they were in the banking week of August 27, 2008. Thus, the entire increase in bank assets over the previous 52-week period was in cash assets!

The banks certainly have not been lending or investing. Over the past 13 weeks, commercial banks reduced their holdings of securities by $335 billion and they also reduced their holdings of loans or leases by $237 billion.

The interesting shift in the investment portfolio is in government guaranteed mortgage-backed securities. These have been increasing over the past 13 weeks. (See the Wall Street Journal article “Banks Load Up on Mortgages, in New Way,” http://online.wsj.com/article/SB125253192129897239.html#mod=todays_us_money_and_investing.) The banks have also been purchasing U. S. Treasury and Agency (non-MBS securities) issues over the same time period.

The big decline in security holdings has been in Mortgage-backed securities that were not guaranteed by the federal government or a government agency. Here it is important to note that the banking system still holds more than $200 billion in non-government guaranteed mortgage-backed securities and over $700 billion in assets that include other asset-backed securities, other domestic and foreign debt securities, and investments in mutual funds and other equity securities with “readily determinable fair values.” The banks were obviously chasing yield by investing in these securities. Over 75% of these holdings are in large commercial banks with small banks primarily investing in this category in state and local government securities, although this may not be comforting.

The decline in loans and leases spans the board. Commercial and industrial loans are down by $57 billion in the last 13 weeks whereas these loans are down by only $68 billion over the past 52 weeks. This decline seems to be speeding up as the decline over the last four weeks totaled about $34 billion.

Real estate loans are actually higher now than they were a year ago, but the volume of these loans is now decreasing. Home equity loans are down by $9 billion over the previous 13 weeks, residential loans are down $40 billion over the same time period, and commercial real estate loans have fallen by $29 billion.

Consumer loans are about the same as a year ago, as is credit card debt and other revolving credit. However, these figures have shown weakness over the past three months with total consumer credit declining by about $39 billion and the credit card and revolving credit debt falling by about $26 billion.

The commercial banking system continues to restructure. It is maintaining high levels of cash and is moving into less risky interest earning assets. The banking system, net, is not lending. We continue to hope that the restructuring will continue to occur without further surprises. Strong economic recovery, however, will not occur with bankruptcies and foreclosures remaining at high levels and with unemployment continuing to increase. Banks are not going to lend into this environment.

The bottom line from this analysis: the economy is recovering but economic growth will be anemic. Economic growth will remain anemic as long as the banking system stays on the sidelines.

Bank Asset Values are a Lingering Problem

Is the recession over? Has the economic recovery begun? Will there be a double-dip recession?
The picture is fuzzy and one reason the picture is fuzzy is because so many banks and other financial institutions, investors, and regulators either don’t seem to have a good grasp of the value of many of the assets on the balance sheets of these banks and other financial institutions or because they are unwilling to confess what the asset values are.

Look at some of the recent articles that have been in the news this week. “Insurers’ Biggest Writedowns May be yet to Come” by Jonathan Weil, http://www.bloomberg.com/apps/news?pid=20601039&sid=a8itsmbfm9qc. “Disclose the Fair Value of Complex Securities” by Robert Kaplan, Robert Merton and Scott Richard, http://www.ft.com/cms/s/0/7eb082d6-8b8e-11de-9f50-00144feabdc0.html. “Citigroup’s Asset Guarantees to be Audited by TARP” by Bradley Keoun and Mark Pittman, http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aiWZXE5RKSCc. “We Need Daily Data to Get Credit Markets Working Again” by Richard Field, http://www.ft.com/cms/s/0/8a9f2906-8d20-11de-a540-00144feabdc0.html.

All of these articles have to do with financial institutions knowing and reporting, as well as possible and as often as possible, the current value of their assets. The managements of financial institutions claim that this will inhibit their actions and force them into decisions that are not in the best interest of their institutions or the financial markets. These managements are wrong!

We are hung up right now because we don’t know the value of those assets either because the banks don’t know what the value of those assets are or the banks are not revealing what the value of those assets are.

I believe that we would face less uncertainty now and may have even avoided a good deal of the financial collapse of the last two years if these financial institutions would have been required to regularly report the fair value of their assets and responded more rapidly to changing market conditions.

Even better, it would have been a sign of outstanding management and real leadership if the banks themselves had been more open and transparent with the financial community, rather than require regulation to force them to release this information.

Alas, this didn’t happen.

This whole dilemma, to me, comes under the “No Free Lunch” argument.

Bankers mismatch the maturities of their assets and liabilities and take advantage of the positive slope to the yield curve. But, in doing so they take on more interest rate risk. Financial markets move against them and the price of the longer term assets decline. Whoops! The benefit the bank got by taking on the extra interest rate risk has backfired. Well, nothing comes for free!

Bankers add riskier loans to their loan portfolio or buy riskier securities to increase their yield. But, in so doing they take on more credit risk. The economy slows down and now these loans or securities face a larger default rate than the bankers had anticipated. Whoops! The benefit the bank got by taking on the extra credit risk has backfired. Well, nothing comes for free!

Financial institutions leverage up their balance sheets in order to squeeze out additional return on their equity position. But, in so doing they take on more financial risk. As assets prices go down the increased leverage backfires and their solvency comes into question. Whoops!

Bankers can’t get something for nothing. And, they can’t hide behind accounting rules in an effort to wait things out until times get better. As Kaplan, Merton, and Richard argue, banks typically fail to act when markets move against the risky positions they have taken and chalk the situation up to “unusual market conditions” or to “just a bump in the road”. And, if economic declines are relatively short and relatively shallow maybe they can get away with waiting the problem assets out. But, in deeper and longer periods of economic and financial dislocation they get trapped in their own failure to act. The asset values do not return to previous levels and the longer they wait to act on the existing problems the worse the situation on their balance sheet becomes.

Richard Field argues, in the article cited above, that banking and credit markets are having problems, not because the loans and securities on the books of the financial institutions are complex, but because they are opaque. This lack of clarity has helped to get us into the current crises and will continue to plague the recovery if it is not corrected. This lack of clarity allows bankers to continue to postpone action, it prevents investors from knowing the value of their investments, and it hinders regulators from in their efforts to understand the true condition of the financial institutions they are regulating.

As I have mentioned in previous posts, I have been involved in several successful bank turnarounds. One of the first things you have to do in turning around a bank is determine the value of your assets and you have to be brutally honest about what the values are. And, in going through this process, in every turnaround I was involved in, it becomes clear that the previous management failed to accept the fact that the value of their assets had declined, they continued to hope that the “unusual market conditions” would pass, and, consequently, by failing to act, the condition of the assets got worse and worse.

Good managements are not afraid of the truth and they are not afraid of releasing that information to the public!

Unfortunately, it is likely that the opaqueness with regard to the value of bank assets will continue.

Are Banks Telling the Truth?

On the front page of the Financial Times this morning we read the disconcerting headlines, “’Tarp cop’ to investigate whether banks have ‘cooked their books.’” (See http://www.ft.com/cms/s/0/163c85c4-2789-11de-9b77-00144feabdc0.html.) Neil Barofsky, special investigator-general for the Troubled Asset Relief Program (TARP), is “seeking evidence of wrongdoing on the part of banks receiving help from the fund.”

The game—“institutions applying for TARP money had to show they were fundamentally sound, potentially prompting them to misstate assets and liabilities.” Barofsky is quoted as saying, “I hope we don’t find a single bank that’s cooked its books to try to get money but I don’t think that’s going to be the case.”

Mr. Barofsky also said the Treasury’s expanded Term Asset-Backed Securities Loan Facility (TALF) was ripe for fraud.

The potential—fraudsters would be receiving indictments!

Two thoughts cross my mind when reading this. First, bankers in deteriorating situations tend to hide their heads in the sand when it comes to bad assets because they keep hoping that things will get better and the assets will recover their value. Having (successfully) completed several bank turnarounds I have found that this is one of the first things that becomes obvious when you initially investigate the loans and other assets of a troubled institution. Bankers, lenders, or portfolio managers continually think that ‘the economy will turn around’ or that ‘the company is getting its act in order’ or that some other event will come along that will result in the ‘asset gone bad’ becoming the ‘asset has become good again.’ And, so the asset is carried along but never comes back to life.

The problem with this is that these bad assets continually undermine the ability of the financial institution to right itself and become profitable again. The example is always there on the books of the banks and whether the executives or officers admit the fact, internally they know that things are not right and this drains efforts to instill a healthy culture to “do the right thing.” Managements that allow this unhealthy culture to continue are just perpetrating a bad situation, one that very rarely ever turns itself around.

The managements that participate in such a charade tend to be desperate and susceptible to moving to the next step when they are thrown a life boat like many financial institutions received in the past nine months or so.

Before following up on this point, let me just say that, historically, the bank either brings in someone to turn the institution around, or, a regulatory agency steps in and dissolves the organization. The American banking system has worked very well in the past with respect to “sick” banks. Contagion has been avoided through quick action connected with the swift resolution of problem assets. Financial institutions that were in trouble were taken care of—period!

But, that is not the case in the current situation. We have had a bailout. The banks have been tossed a life boat. However, financial institutions were supposed to be “fundamentally sound” in order to obtain TARP money. Here we get into the muddy waters of conducting a “general” bailout.

Let me just say that I have been suspicious from the start when government officials claimed that the need for the TARP funds was because the banks were facing “a liquidity problem” with respect to their troubled assets.
Again, my experience in doing bank turnaround’s is that the officers of the bank that claimed their assets were in trouble because of liquidity problems were attempting to cover up the real difficulties connected with the assets which were almost always associated with the issue of solvency.

It would not be much of a surprise to me to hear that the banks justified to the government that they were “fundamentally sound” because their asset problems were associated with liquidity issues rather than ones of solvency. This assessment could perhaps be supported if government officials only took a cursory glance at the assets. But, one could argue that this is the conclusion that government officials wanted to hear at that time.

Is this fraud? That is what Mr. Barofsky is going to have to find out.

Other than outright “cooking of the books”, in many cases the distinction between liquidity and solvency may fall back on an argument about “judgment”, about the “eye of the beholder.” Thus, Mr. Barofsky is going to have his problems proving his case.

In my opinion, many of the banks that received bailout relief had and still have a solvency problem and until the situation is handled that way the dislocations associated with the banking industry and the financial markets are going to continue. Consequently, I believe that Mr. Barofsky and others are going to find evidence that all along the issue has been solvency and not liquidity. If so, then there is a real issue of whether or not that these institutions that received TARP money were “fundamentally sound.”

My second thought on this issue is a very simple one. If people inside the banks covered up the real issues related to solvency heads should roll. Those that committed fraud should be indicted! Those that knowingly misled should be dismissed!

And, top executives, even though they were not directly involved in fraud or in a cover up, should be removed from their positions as well. They have proven that they cannot manage their institutions with sufficient control to justify their ability to move those institutions on into the future. The “buck stops with the top position” and the argument that they didn’t know what was going on is insufficient. It was their responsibility to know what was going on!

Risk management, the other “bug-in-the-coffee”, and financial control are not glamorous pursuits, especially when compared with the “jet pilots” of finance that were tossing around all sorts of money chasing narrow spreads with lots and lots of leverage. Performance over time, however, is closely related to an institution’s ability to successfully exert risk management and financial control.

We have to know what is going on in the banks and other financial institutions. The pressure needs to be stepped up to find out where things are. And, the sooner this pressure is exerted the sooner we will be able to find ways out of the mess we are in.

And this brings me to one final point. The Financial Times also had another headline on its front page that I found disturbing. The article cried out “AIG in derivatives spotlight.” (See http://www.ft.com/cms/s/0/cb2ddafc-278c-11de-9b77-00144feabdc0.html.) “The unit that all but destroyed AIG has failed to sign up for the overhaul of the global derivatives market, which was given added impetus by the troubles at the US insurance group.” The government is involved with AIG—the government owns most of AIG. It is mind boggling to me that a government that supposedly wants to bring greater openness and transparency to the financial markets allowed this to happen!

The Clogged Banking System

The Federal Reserve is doing almost everything it can to get commercial banks to start lending again. Just a quick look at the data reveals what is happening in the banking system where the rubber hits the road. Let’s take a look.

Looking at the figure Total Reserves which is defined as bank reserve balances held at Federal Reserve Banks and vault cash at banks used to satisfy reserve requirements. The year-over-year rate of increase in this figure for February 2009 was 1,538 %. Yes, that’s right, one thousand, five hundred and thirty-eight percent, rounded off! But, this rate of growth is down from the December 2008 year-over-year figure which was 1,823%. Yes, one thousand, eight hundred and twenty-three percent!

In August 2008, before the financial tsunami hit, the year-over-year rate of increase in Total Reserves was – 1%. Yes, that is a negative one percent! And the rate of increase throughout 2008 up to August was modest, at best.

Let’s move up to a larger measure, the Monetary Base, defined primarily as Total Reserves and Clearing Balances at Banks plus the currency component of the Money Stock measures. In February 2009, the year-over-year rate of increase in the Monetary Base was 88%, rounded off. That is, the Monetary Base increased by a little less than two times over the twelve month period ending February 2009. In December 2008, the year-over-year rate of increase was 99%, rounded off.

Going back to August 2008, the year-over-year increase in the Monetary Base was about 2%. Again, the rate of increase in this measure throughout 2008 up to this time was around this magnitude, give or take a percentage point or two.

How did this increase in reserve measures get translated into the Money Stock figures? Well, in the case of the narrow measure of the Money Stock, M1, the year-over-year rate of increase for February 2009 was 13.5%, down from 17.2% in December. In August 2008, the year-over-year growth in the M1 Money Stock was a little less that 2%. The rate of growth of this measure for the earlier part of 2008 was slightly negative to slightly positive.

In terms of the components of the M1 Money Stock, what contributed to this increase in growth? First of all, the Demand Deposit component rose by about 35% on a year-over-year basis in February, but this was down from a little over 59% in December. The interesting thing is that the year-over-year rate of growth of the currency component of the M1 Money Stock was relatively constant through the end of 2008 into February of 2009. For example, the currency component grew at around a 7% rate of growth in December 2008 but grew at a 10% rate in February.

The conclusion one can draw from this is that people and businesses are holding more of their wealth in currency and in demand deposits! That is, the funds that the Federal Reserve is pumping into the banking system are staying in the banking system or going into cash or very liquid transactions balance in the banking system.

One could argue that the public is not spending these cash and transactions balance accounts any more than they have to and are keeping them on hand to meet their uncertain needs for living and conducting business. That is, these holdings are for security in treacherous times.

Just one additional note on Demand Deposit growth and Currency growth: in August 2008, the year-over-year rate of growth in Demand Deposits was essentially zero and the year-over-year rate of growth of currency was slightly over 2%. That is, in August 2008 almost all the growth in the M1 Money Stock measure was coming from the growth in the currency component.

Now, what about the rate of increase in the M2 Money Stock measure? In February 2009 the growth over February 2008 was just less than 10%. This growth rate was exactly the same as the growth in this measure in December 2008. In August, the year-over-year growth rate in the M2 Money Stock was approximately 6%.

The conclusion that one can draw from this is that individuals, families, and businesses are keeping funds in very safe and easily accessible form. Growth in deposit measures or credit measures beyond cash and demand deposits is almost non-existent. People and businesses are attempting to protect themselves, they are not borrowing more than necessary, and they are not spending more than necessary. One guesses that this is not going to change much in the near future.

From the non-bank side of the equation, why should people and businesses be borrowing if they can avoid it? Unemployment jumped to 8.5% in March, and this weekend economists were talking that this number would reach at least 10% before this economic downturn is over.

Furthermore, bankruptcies were up, almost 4% in March and up almost 40% over a year earlier. This measure, too, is expected to rise throughout 2009 and into 2010. And then, housing prices continue to fall. One measure used to judge where housing prices are relative to (estimated) rental payments was reported by John Authers in the Financial Times on last Thursday. He wrote that the ratio of housing prices to rents which had risen by 44% from 2002 to its peak through the credit bubble has returned to about its 2002 level. However, Authers argues that even though it returned to the 2002 level this ratio could still fall another 20% to reach levels of a decade or so earlier.

And, why should the banks lend? For one, they still have a ton of questionable assets on their balance sheets. And, if these banks are worried about their solvency, they need to work these assets out and not add more and more new assets to their balance sheet. Their focus needs to be on regaining financial health now, not expanding their balance sheet and reducing capital ratios further.

And, we still have the commercial real estate problems to go through, as well as the problem implied in the credit card area due to the rising delinquencies in that sector. Furthermore, there are two kinds of mortgage loans that are going to reprice over the next 15 months or so. Analysts are afraid of what this might do to foreclosures and bankruptcies given the rise in unemployment and the decline in household incomes. Also, there are the surfacing problems connected with state and local government finance. This has not really gathered much attention to date.

The Federal Reserve has been pushing about as hard as it can. Yet, the monetary stimulus is not working its way through the banking system. This is obviously a problem. But, banks in the condition described above don’t really want to lend, and consumers and businesses are in the process of consolidating and strengthening their balance sheets and have little incentive to re-leverage themselves at this point.

The Keynesian solution to this dilemma is, of course, government spending, the more the better. The intent of this spending is to get the banking system unclogged. Whether or not this government spending can actually accomplish this is still to be determined? So, we still are faced with enormous amounts of uncertainty. And, this uncertainty, in my mind, is not going to go away soon.