Bank Lending and the Banking System Remain Weak

Bank lending remained weak during March and the assets of the banking system, on average, continued to follow a downward path, resuming their decline from the November total after bouncing around for a month or two. Banking assets were down 5.8% in 2009 from 2008.

The commercial banking figures for the banking week ending March 31, 2010 were impacted by changes in accounts that were related to the adoption of FASB’s Financial Accounting Statements No. 166, Accounting for Transfers of Financial Assets and No. 167, Amendments for FASB Interpretation No. 46(R).

The first statement “improves financial reporting by eliminating (1) the exceptions for qualifying special-purpose entities from the consolidation guidance and (2) the exception that permitted sale accounting for certain mortgage securitizations when a transferor has not surrendered control over the transferred financial assets. In addition, comparability and consistency in accounting for transferred financial assets will be improved through clarifications of the requirements for isolation and limitations on portions of financial assets that are eligible for sale accounting.”

The second was aimed to bring FASB and IASB treatments together and “addresses the potential impacts on the provisions and application of Interpretation 46(R) as a result of the elimination of the qualifying special-purpose entity concept in Statement 166.” Ultimately, FASB and IASB will seek to issue a converged standard that addresses consolidation of all entities.

The overall affect: assets and liabilities that banks were holding “off-balance sheet” were brought back onto the balance sheets of banks.

The impact of the adoption of these rules is to increase certain asset and liability classes of commercial banks. In aggregate, domestically chartered commercial banks saw a net increase in assets and liabilities of $378 billion. The major asset items increased were consumer loans, credit cards and other revolving credit, an adjustment of $324 billion, and other consumer loans, an adjustment of $41 billion. The major memoranda items affected were securitized credit cards and other revolving plans which were reduced by $351 billion.

As one might imagine, these changes occurred primarily in the large domestically chartered banks which are defined as “the top 25 domestically chartered commercial banks, ranked by domestic assets.”

In the banking week ended March 31, total consumer loans increased by $321 billion and were up $364 billion from four weeks earlier. Small domestically chartered banks recorded an increase in total consumer loans by $46 billion in the banking week ended March 31 but increased by only $28 billion from four weeks earlier. The primary source of these adjustments came from how securitized credit card debt was treated on the balance sheets of commercial banks.

The result of this change was a $26 billion decrease in the residual (assets minus liabilities) of domestically chartered commercial bank, with most of the decline found in the large banks and not the smaller ones. That is, the capital of the banking system declined.

Taking these changes into account leads one to the conclusion that there was still little or no increase in consumer lending during this time period.

In other lending areas, the trends were still mostly down, especially in business loans. Commercial and Industrial loans were down by almost $26 billion over the last four weeks and were down $71 billion in the past 13-week period. Most of the former decline ($23 billion) was registered at the large commercial banks.

Real estate loans were roughly constant over the latest four week period although the smaller banks increased their portfolio of real estate loans by about $31 billion with $19 billion of the increase coming in commercial real estate loans. Home equity loans and residential mortgages both increased in the neighborhood of $6 billion.

Interestingly, real estate loans at large commercial banks declined by $32 billion with about $26 billion of the decline coming in commercial real estate loans.

One item we have been watching pretty closely has been the cash assets of the commercial banks. Over the last four weeks, commercial banks decreased their cash holdings by almost $180 billion. Only about $60 billion of this came in the large banks. A $30 billion decline occurred in the smaller banks, but foreign-related institutions in the United States reduced their cash balances by $90 billion. It appears that a large part of the latter decline came as these foreign-related banks reduced their borrowings from institutions other than banks.

In conclusion, if appears that lending was roughly the same as in past months. Commercial banks, as a system, are not lending much, if at all. Thus, the banking system is still not playing the role of underwriter of the economic recovery. We continue to wait for banks to become more open to making loans, especially to businesses. However, given our concerns about the solvency of the smaller banks, this may not occur any time soon.

The movement on the part of FASB to bring memorandum items onto balance sheets is a healthy move and long overdue. Efforts like this may still be an inhibiting factor as far as bank lending is concerned, but it is still vital for us to understand the financial condition of the banking system. Off-balance sheet items need to been brought into the light, just as the book value of assets needs to reflect the real market value of the underlying assets. The sad thing is that many banks (not all) have abused the trust of the public by manipulating their balance sheets. Until these abuses get cleaned up, we will not fully understand the state of the banking system and the decisions that are being made by these bank executives.

The more we learn about what bank managements have done…or, what they haven’t done…the more we fear that the real reason the Federal Reserve is not anxious to end its period of quantitative easing is to maintain the solvency of the banking system itself. Does the Federal Reserve need to maintain this policy of quantitative easy for as long as the FDIC needs to reduce the number of insolvent banks in an orderly fashion.

As I projected, the FDIC continues to close 3 to 4 commercial banks every week. I have argued that this pace may be kept up for at least 12 months if not more. Is the banking system really that weak?

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.