Federal Reserve QE2 Watch: Part 8

I usually do the “QE2 Watch” post in the first week of the new month, but in this coming month I will be a little tied up.  I am having hip replacement surgery on June 28 and will be a little preoccupied for a few days.  I will also write a post on the condition of the banking system that I will post tomorrow.  Then I go “on vacation” for a while.

Chairman Bernanke and the Federal Reserve have signaled that QE2 will definitely end on June 30 and they have indicated that QE3 is not in the works…at least at the present time. 

The stated plans for QE2 included the new purchase of $600 billion in Treasury securities and the purchase of a possible $300 billion more in Treasury securities to replace securities maturing in the Fed’s portfolio of Federal Agency issues and the Fed’s portfolio of mortgage-backed securities. 

From Wednesday, September 1, 2010 to Wednesday, June 22, 2011, the Federal Reserve’s holdings of United States Treasury issues have risen by roughly $816 billion.  During this time period, the dollar volume of Federal Agency issues on the Fed’s balance sheet has dropped by $38 billion and the dollar volume of mortgage-backed securities has declined by $189 billion…a combined total of $227 billion. 

The “net” increase in securities held outright by the Federal Reserve has been $589 billion, pretty close to the $600 billion “net” increase promised. 

Reserve balances at Federal Reserve banks, a proxy for excess reserves in the banking system, have increased by $584 billion to $1,594 billion over this time period.  Actual excess reserves in the banking system averaged $1,610 billion for the two-week period ending June 15, 2011.

Almost all the increase in excess reserves can be attributed to the Fed’s purchase of United States Treasury securities. 

Other factors affected reserve balances within this time period but they tended to be minimized over the period as a whole.  For example, in the first quarter of 2011, the United States Treasury Department reduce its “Supplemental Financing Account” at the Fed by $195 billion, a not inconsequential amount of funds.  This reduction added reserves to the banking system.  However, over time, this movement was offset by other factors and hardly had any net effect on the total amount of reserves being supplied to the banking system.

And, what was the total impact of QE2 on the commercial banking system?

All the reserves the Fed crammed into the banking system went into excess reserves!

Yet deposits in the banking system continued to increase. 

Demand deposits in particular rose at a very rapid pace.  From the second quarter of 2010 when demand deposits at commercial banks increased at a 6.3 percent rate year-over-year, these accounts rose by 8.5 percent in the third quarter and 14.3 percent in the fourth quarter.  But this rate of acceleration jumped to 20.4 percent year-over-year in the first quarter of 2011 and in the month of May was showing a rate of increase of almost 27 percent!

What is happening here?

Demand deposits at commercial banks are increasing at a very, very rapid pace, yet commercial banks do not seem to be lending much at all (more on this tomorrow) and everything the Federal Reserve is pushing into the system seems to be going into excess reserves.  What’s going on?

Basically, what’s going on is the same thing that has been going on for the last 18 months or so.  Because of the poor economic climate and because of the excessively low interest rates people and businesses are moving funds out of interest bearing accounts and into transactions accounts.  These latter accounts are where people are locating their “liquidity” these days so as to pay for necessities and other important things to keep on living. 

For example, Institutional money funds are still losing money…perhaps not as fast as they were a year ago, but they are still contracting by more than 5 percent, year-over-year.  Retail money funds are still declining at a rate in excess of 8 percent year-over-year and small time accounts are declining by more than 20 percent, year-over-year. 

All non-M1 money stock money included in the M2 money stock measure has risen only modestly over the past 12 months and most of this has come in the money market deposit account s included in the aggregate category titled savings deposits.

The result is that the M1 money stock measure is increasing rather rapidly at around a 12 percent year-over-year rate in the last three months.  The M2 money stock measure is increasing by less than 5 percent over the same time period.  The rate of growth of the M2 money stock measure has only increased modestly over the last four quarters. 

People are putting their money into accounts from which they can transact.  They are moving their money into these accounts because they need to stay liquid in order to pay for their daily needs. 

The other indicator of this behavior is the rapid increases that have been made in the demand for coin and currency.  In the second quarter of 2010, the currency in circulation was rising by only about 3.5 percent, year-over-year.  This steadily increased through 2010 until it reached a total of over 7.0 percent in the first quarter of 2011.  That is, the coin and currency in circulation more than doubled its growth rate over this time period.  In May 2011, the year-over-year rate of increase in the currency component of the money stock was rising at almost 9.0 percent year-over-year. 

In the slow economic growth climate we are in, people do not increase their holdings of coin and currency in order to generate new spending.  They increase their holdings because they need these funds to buy necessities in the face of unemployment, foreclosure, and bankruptcy!

The information from the financial system is not very encouraging.  The Fed has tried to push all the funds it can into the banking system.  The banking system is not lending it…both because the banking system is still not in that good of a shape…and because people are not in very good financial condition and are not borrowing.  Thus, reserves pile up at commercial banks. 

If QE2 was supposed to get the economy growing faster, it has failed miserably.  If QE2 served other purposes, like allowing the FDIC to close banks in an orderly fashion, then it has succeeded.  If the Fed used the economy as an excuse to explain QE2 while it was assisting the FDIC in its efforts to close banks in an orderly fashion then it was duplicitous.  It might have done this to avoid people getting overly worried about the condition of the banking system.

But, the more I think about this last statement the more I chuckle because I don’t think that the Fed is that good.

The Number of Banks in US Drop by 77 in the First Quarter

The FDIC just released the financial statistics on the banking industry for the first quarter of 2011.

We knew that through May 20, 2011, the FDIC has participated in the closing of 43 banks.  Through the end of the first quarter of 2011, 26 banks had been closed.

With the first quarter results now available we can observe the actual shrinkage in the number of banks in the United States. 

On March 31, 2011 there were 6,453 banks in the United States, 77 less than existed on December 31, 2010.

There were 6,773 banks in existence a year earlier, March 31, 2010, so the banking system has 320 fewer banks at the end of the first quarter this year than one year ago. 

At the start of the recession in December 2009, there were 7,284 banks in the banking system, 831 less independent units than exist at the end of the first quarter of this year. 

The largest drop in banks in the first quarter was in the smallest institutions: there were 51 fewer banks with assets of less than $100 million at the end of the quarter than at the end of 2010.

Banks between $100 million in asset size and $1.0 billion in asset size dropped in number by 34 units.

Banks that had more than $1.0 in assets actually rose as the number of banks in this category increased by 8 banks. 

The consolidation in the banking industry continues.  If the number of banks continues to drop by about 80 banks per quarter, this would mean that the decline in the number of banks in the United States in 2011 would be roughly the same as the decline that took place between March 31, 2010 and March 31, 2011. 

However, the composition of the decline in the number of banks in existence seems to be changing.  Whereas the number of banks that failed in 2010 was about half the decline in the number of banks in existence, in the first quarter of 2011, the number of failed banks was only about one-third of the decline in the total number of banks in existence. 

This would seem to be a healthy development.  The banking system is still expected to shrink, but maybe we have passed the peak of bank failures and most of the contraction in the future will be in consolidations coming through acquisition and merger. 

If the number of banks in the banking system does drop by around 320 this year, that would put the number of banks at about 6,200 on December 31, 2011, a reduction of almost 1,100 banks since the recession began in 2007.

If one of the goals of the Fed’s quantitative easing 2 (QE2) was to provide enough liquidity to the banking system so that the FDIC could close banks with the least disruption possible, then QE2 has seemingly been a success.  The goal of the FDIC, of course, is to close banks in an orderly fashion and the excess liquidity in the banking system may be seen as the means that allowed many of these banks to stay open…especially the smaller ones…before either the bank was closed or an acquirer was found.

Obviously, the banking system is not “out-of-the-woods” yet.  I believe the behavior of the banks indicates the continued fragility of many banks…especially the smaller ones.  The banking system should have begun lending now, almost two years into the current economic recovery.  Yet the banks continue to “hold on” to the reserves the Fed in pumping into the banking system.  Excess reserves are closing in on $1.6 trillion…with still only modest increases in lending…and this increase is just coming in the largest 25 banks in the country. 

I am still seeing only 4,000 banks or less in the United States banking system in the relatively near future.  I believe that the financial condition of domestically chartered banks in the United States, the movement of more foreign banks into the United States banking system, and the changes that are taking place in the use of information technology in the banking system are going to result in a continued decline in the number of banks that exist.     

I do believe that this re-structuring of the banking system will result in a stronger and more vibrant banking system, one prepared to compete in the twenty-first century.  The transition to this “new” system, however, is slow and tenuous.  Tenuous, because creating a “new” banking system, one that is much more technologically advanced will not come about easily…especially given the road blocks the politicians and the regulators will put in the way of the evolving system. 

Commercial Banks Closures in 2011

The Federal Deposit Insurance Corporation oversaw the closing of six banks on Friday, April 15.  This brings the total for 2011 up to 34 banks, a pace of about 2.3 banks per week. 

In 2010, 157 banks were closed, a pace of about 3.0 banks per week.

The problem bank list published by the FDIC every quarter rested at just under 900 banks (out of 6,529 banks in the banking system) on December 31, 2010.  We are waiting for the release of this number for the March 31, 2011 date.

The other number that is important in this respect is the number of banks that were acquired or merged into other banks.  Last year there were 153 banks dropping out of the industry due to such consolidations. 

Thus, the number of banks in the commercial banking system declined by 310 units last year or at a rate of approximately 6.0 banks leaving the system per week.

Most of the banks dropping out of the banking system are smaller institutions.  However, last week a $3.0 billion bank was closed so it is not all just the very smallest banks that are leaving the system.  Still, it not the largest 25 commercial banks in the banking system, the banks that control almost 60% of the total assets of the industry, that are departing.

The question still remains about the health of this industry.  Is the number of problem banks in the industry going to remain around 900 institutions?  Are bank departures going to continue to run off at the rate of 5 to 6 banks a week?  Will these rates lessen this year?  Or, will they increase?

Supposedly, the condition of the smaller banks is getting better.  But, as we saw with Bank of America last week, the overhang of bad mortgage loans still plagues some institutions.  Right now, I believe that the drop off in foreclosures on residential mortgages is misleading because the whole foreclosure issue has become so political that we probably won’t really have a good idea about the situation in the housing industry and in loan writeoffs for some time. 

We do know, however, that there are a lot of commercial real estate loans coming due over the next twelve months and the word I hear about the refinancing of these loans is not good.  Vacancies in commercial properties remain high and cash flows have not picked up significantly.  Furthermore, as more and more political entities downsize, more and more office properties used by these state and local governments are being vacated.  This was not expected a year ago.

In addition, I am also hearing that more small- and medium-sized businesses have exhausted their efforts to re-structure and just cannot go on much further.  As their loans come due, they are informing their banks that they are not going to be able to pay off their loans and must re-finance.

Thus, the banks have to make a decision about whether or not they roll over the loans for another period of time.  Or, do they “bite the bullet” and say they just cannot keep the loan going with no real sign that things are going to get better.

Then there are the examiners looking closely over the shoulders of these bankers.  The regulators are still running scared and, given all the restructuring of the regulatory institutions, don’t want to have the people in the new regulatory alignment holding them accountable for being too easy on these “failing” banks.  There is enough finger-pointing going on with respect to the “lax” regulatory environment that existed in the past. 

Bankers, especially from the smaller banks, feel caught in the middle of this exercise.  They want to do what they can to help their customers survive.  Yet, they are being pressed by the regulators, who also feel they are under excessive pressure, to not show overly-optimistic hopes about the ability of these businesses to repay.   In fact, the result may be that a too pessimistic approach is taken toward the quality of the bank loans. 

As a consequence, we will probably see the list of problem banks remain somewhere around their current highs and we will probably see business loans and commercial real estate loans continue to decline on the balance sheets of the banking industry. 

And we will continue to experience a decline in the number of banking institutions in the United States. 

The crucial element of this decline is that it is that the decline takes place in an orderly fashion. 

I believe that the Federal Reserve has contributed greatly to the achievement of this orderly reduction in the number of commercial bans in the banking industry.  Keeping short-term interest rates so low and pumping so much liquidity into the banking industry has reduced what could have been a very chaotic evacuation into a relatively peaceful exodus. 

Of course, there are other consequences to the Fed’s policy and we will have to deal with those in the future.  For now, the Federal Reserve has kept the banking system open.

Until the history of the recent financial collapse is fully understood and written up, most of us will probably not know how serious the banking crisis has been.  We get bits and pieces of this seriousness, but government officials have not really believed that the depth of the problem should be presented to the rest of the world.

For example, buried in the column Global Insight by Tony Barber in the Financial Times this morning is this observation: “For the truth about the eurozone’s crisis…is that the rescues of Greece, Ireland and Portugal are at heart rescues of European banks…Restructuring these countries debts would involve losses for German banks…” (http://www.ft.com/cms/s/0/4ed1d54a-6915-11e0-9040-00144feab49a.html#axzz1JsjXsOj5).   But this is not what is expressed in most governmental commentary. 

It appears as if the credit inflation of the past fifty years in America, and in Europe, seriously infected the banks and the cure for this infection is taking a very long period of time to achieve and is creating, in the process, economic and financial dislocations that we may not fully recognize for many years. 

For now, however, we can only hope that the cure takes place in an orderly fashion. 

FDIC Bill for Loan Losses at Failed Banks to Reach $30 Billion

The good news is that the FDIC payments to those organizations and institutions buying failed banks during the present crisis are smaller than the regulatory officials anticipated. The FDIC has paid out $8.89 billion to “cover losses” at 165 banking institutions that have failed during the recent financial crisis. (See Wall Street Journal article: http://professional.wsj.com/article/SB10001424052748704396504576204752754667840.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj.)

The reason for this good news, I believe, is the monetary policy followed by the Federal Reserve over the past three years, now captured in the quaint symbol QE2. Excess reserves pumped into the banking system by the Fed now total around $1.3 trillion.

I have argued for at least a year-and-a-half now, that the Federal Reserve is pumping all these reserves into the banking system to help the FDIC close banks in an orderly manner. The basic premise is that if the Fed can provide sufficient “liquidity” to the financial markets in order to maintain the value of financial assets it wil give the FDIC breathing room to close banks as rapidly as they can without causing major disruptions to the many other troubled banks in the system.

The Federal Reserve has argued that it has pumped all these reserves into the banking system to help stimulate the economy. The economic recovery has almost reached its two-year anniversary, although there is general dissatisfaction with the speed of the recovery, and looks likely to extend beyond this milestone.

However, the recovery seems to have taken place without the Fed’s help except for the argument that there have not been further disruptions to the recovery due to major cumulative banking failures. Certainly, one cannot argue that the Fed’s actions have provided banks with the incentives to increase their lending activity for they have not. Commercial banks are still sitting on the money.

This is exactly my point! The policy of the Federal Reserve has been to support the FDIC and allow the FDIC to close insolvent banks in an orderly manner.

Thus, the monetary policy followed by the Federal Reserve over the past three years has succeeded.

Added evidence that the policy of the Federal Reserve has been successful is that reported above: the FDIC payments to those acquiring banks have been “smaller than FDIC officials anticipated.” Without the market liquidity, results would have been much worse.

The Wall Street Journal even reports: “Some executives at U. S. banks that bought failed institutions using the FDIC lifeline agreed that losses on the troubled loans aren’t piling up as high or as fast as they previously anticipated.”

The bad news?

“FDIC officials expect to make an additional $21.5 billion in payments from 2011 to 2014. More than half of that total is predicted for this year, followed by an estimated $6 billion in loss-share reimbursements in 2012, according to the agency.”

According to my calculations, $21.5 billion is almost two-and-one-half times the $8.89 billion the FDIC has already paid out during this cycle of bank failures!

This would bring the total of FDIC payments up to more than $30 billion!

It also seems to mean that we have a lot of bank failures that still have to be resolved!

The banking system now has less than 8,000 banks in it. Over the past year or so, I have argued that this number will drop to less than 4,000 by 2015.

I see nothing inconsistent between my forecast about the number of banks that will be in the banking system and the estimates made by the FDIC, itself, concerning the amount of payments it will need to make to those that acquire banks to cover loan losses.

Bottom line: there are still a massive amount of bad loans that still reside on the balance sheets of commercial banks!

Consequently, there are still a lot of commercial banks that need to be closed!

And, what does this mean for the Fed and QE2? The Fed claimed on Tuesday that the economic recovery is picking up. However, QE2 will need to continue, as planned, through June. Also, the Fed will maintain its interest rate targets at current levels for “an extended period”. NO CHANGE IN MONETARY POLICY!

If I am correct the Fed will only change its monetary policy when it…and the FDIC…believe that problems connected with bank closings have receded sufficiently so that more normal operations can be resumed.

Since the Fed…and the FDIC…have never claimed that the excessively loose monetary policy over the past few years has been to assist the regulatory closing of commercial banks, any statements about changing policy will not be worded in a way that ties the policy with the closing of banks.

Maybe it has been just as well for us…that we have not really known how bad off the banking system has been. But, so much for openness and transparency.

Federal Reserve Continues to Underwrite Big Companies and Big Banks

Economic spokesperson for the Obama administration, Ben Bernanke, and the Federal Reserve System continue to underwrite “big”…Big Companies and Big Banks.

The Federal Reserve has just released its survey of senior credit officers. The headlines, “Large United States Banks are Starting to Ease Credit Terms.”

Terrific!

“Large companies may also be finding an appetite to borrow, especially for mergers and acquisitions…The start of January was marked by a record level of M&A and 77 per cent of banks that reported an increase in loan demand said deal financing was a somewhat to very important reason for it.” (See http://www.ft.com/cms/s/0/6dbf2546-2d71-11e0-8f53-00144feab49a.html#axzz1Chh2pOYC.)

But wait…”A flood of cash by investors seeking to profit from rising interest rates is having an unintended effect in the deal world, where this money is being recycled into corporate buyouts.

Investors have been selling bonds which typically lose money when interest rates rise and putting their cash in funds that invest in bank loans that finance corporate buyouts. The loans have floating rates, so the interest they pay investors rises as rates go up.” (http://professional.wsj.com/article/SB10001424052748704254304576116542382205656.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

Wow! Have I got a deal here!

And, what about big banks? Well, Bloomberg has an answer for that: “Fed’s Easy Money Helps European Banks Refinance.” (See http://www.bloomberg.com/news/2011-02-01/fed-s-easy-money-helps-european-banks-refinance.html.)

Seems as if European banks are selling record amounts of dollar-denominated bonds to refinance almost $1 trillion of their debt maturing this year. “As a result of the extra dollars created (by the Fed’s quantitative easing), cross-currency basis swaps show that it’s cheaper for European banks to sell bonds in dollars and swap the proceeds back to euros than it was at the same time last year.”

European lenders “sold $43.8 billion in investment-grade bonds in the U. S. (this January), beating the previous record of $42.4 billion last January.”

So the Federal Reserve’s quantitative easing is doing good!

Yes, but what about economic recovery and the smaller banks and smaller businesses?

The Financial Times article continues: “If most of the increased loan demand is for M&A, it may be slow to feed through into higher investment in the economy.

The scope of easier credit also remains limited: Large banks say they are lending more to large companies, but life has become no easier for small companies and small banks.

There was also little sign of any improvement in lending for either commercial or residential real estate.”

It is in the smaller banks and the smaller businesses that solvency concerns still reign. It is in
commercial and residential real estate that economic conditions remain depressed and credit woes abound.

Big banks and big corporations have lots and lots of cash. The reason for this build up in my mind has been for the “Great Acquisition Binge” of the 2010s. (See my post “Where the Real Deals will be in 2011: http://seekingalpha.com/article/244709-where-the-real-deals-will-be-in-2011.) And the bank lending reported above is just adding to the acquisition cycle. The big banks are now increasing lending and, it looks as if the increased lending is going for more and more buyouts. The hedge funds and private equity funds are now stepping up their involvement in this exercise as is evidenced by the interest in floating rate loans.

And, how is this banking activity helping to get the economy growing more rapidly and reduce unemployment?

If anything, the increased merger and acquisition activity will result in a “rationalization” of business which will mean that the acquiring firms will engage in more downsizing of the acquired firms and this will mean that more workers will be laid off.

Companies will become bigger…there will just be fewer companies around.

If this is the case, why does the Federal Reserve continue to underwrite the big banks and the big corporations?

I continue to argue that the Federal Reserve is pursuing quantitative easing as aggressively as it is doing in order to keep the smaller banks going as long as possible so that the FDIC can close as many as they need to in an orderly fashion. Eleven banks have already been closed this year.

Last year the FDIC formally closed a little more than 3 banks per week throughout the year. However, the number of banks in the banking system dropped by two to three hundred (we don’t have the final numbers on this yet) when you count the mergers and acquisitions that took place in the banking industry.

My guess is that we will experience the same amount of contraction of the banking system in 2011. The monetary stance of the Federal Reserve is crucial for the banking system to continue to contract in an orderly fashion. But, this is not necessarily spurring on economic growth.

Until this contraction is over, the feast will continue for the biggest banks and the biggest corporations.

Where is Banking Headed? Not Up!

The biggest problem in the economy, I believe, is the banking system. The government recognizes this and that is why the various agencies within the government are following such bizarre policies. The Federal Reserve has kept its target interest rate below 20 basis points for over twenty months now and it appears as if it will maintain this target for at least six to twelve more months. The FDIC, as of March 31, 2010, had 775 banks on its list of problem banks and Elizabeth Warren claims that at least 3,000 banks are facing severe problems relative to commercial real estate loans. The United States Treasury Department is tip-toeing around banking issues and especially around the government agencies called Fannie Mae and Freddie Mac.

I sure would NOT want to be a bank regulator now. The workloads must be enormous and the pressure must never ease. And, in my view, this situation is not going to change for another three years or so.

For one, the industry is bifurcating. The big institutions are winning. The smaller institutions are going down the drain. One figure I am fond of quoting is that the largest 25 commercial banks in the United States control two-thirds of the assets in the industry. (This is from Federal Reserve statistics.) On March 31, 2010 there were 6,772 commercial banks in the industry (according to the FDIC) so that about 6,750 banks control only one-third of the assets in the industry.

Note this, however. On December 31, 2002 there were 7,888 commercial banks in the United States and on December 31, 1992 there were 11,463. So the number of banks in the US declined by more than 40% in the past 18 years.

But, commercial banks with more than $1.0 billion in assets increased from 380 at the 1992 date to 405 at the 2002 date to 523 this year.

Banks that had less than $100 million in assets fell dramatically during this time period: in 1992 there were 8,292 banks; in 2002 there were 4,168; and in 2010 there were 2,469.

Banks between $100 million and $1.0 billion in asset size rose from 2,791 in 1992 to 3,315 in 2002 and to 3,780 in 2010.

However, check this out. In terms of full time equivalent employees, banks with less than $100 million in assets averaged 24 employees in 1992, 20 employees in 2002, and 17 employees in 2010. The middle size of banks averaged 121 employees in 1992, 90 employees in 2002, and 72 employees in 2010.

It appears as if the part of the banking system that controls less than one-third of the banking assets in the United States has gotten smaller and smaller in terms of size of institution and employment. Yet, during the last fifty years, the people in these institutions have been asked to do more and more in terms of the environment they are working within and the pressures they feel. Banks, throughout this time period, have not been able to just live off the interest rate spread they earn between loans and deposits.

Furthermore, the thrift industry has also shrunk. The Savings and Loan industry is dead! (http://seekingalpha.com/article/214460-so-long-to-the-savings-and-loan-industry) The numbers support this demise. On December 31, 1992 there were 2,390 savings institutions in the United States. This number dropped to 1,466 at the end of 2002 and fell to 1,160 at the end of March 2010. The Office of Thrift Supervision (which was a part of the Treasury Department) is to merge into the Office of the Comptroller of the Currency (which is a bureau of the Treasury). Thrift institutions will become more and more like commercial banks and the idea of the thrift industry will fade into memory. Most of these are very small institutions, not unlike the smaller commercial banks listed above with very few employees.

I go through this list because many of the problems that now exist within the banking system are concentrated in these smaller institutions, formerly the heart-beat of Main Street America. In the last fifty years the financial environment changed substantially and a large number of these depository institutions were just not able to make the transition. We are going through the final stages of the current restructuring of the banking industry. What we will see in the next five to seven years will be difficult to compare with what existed in the last half of the twentieth century.

What changed? Well, the inflation of the 1960s and 1970s brought about higher and higher short term interest rates. For many institutions, the comfortable interest rate spreads the banks and thrifts worked with disappeared and even went negative in some instances. The government’s response was to open up the balance sheets and allow these institutions to diversify and create more services that could earn fee income. Also, new financial instruments were created to allow these depository institutions to get into more exotic types of investments.

A typical situation was one in which a depository institution had only 15 people or less with most of them being tellers or clerks and only two or possibly three that had executive authority. Most of these employees had been with the institutions for a decade or more. These institutions were flooded with investment bankers and others with all kinds of sophisticated ideas about how a $50 million organization could get into high-yielding assets or buy cheap deposits or do many other very innovative things so as to regain profitability. The late 1970s and 1980s are full of stories about how the managements of small institutions were “educated” in the ways of Wall Street. The thrift crisis resulted.

In the 1990s and 2000s even more sophisticated instruments and opportunities were brought to the smaller institutions that thought they were getting good advice to help them operate in the twenty-first century. Part of what the managements got into was commercial real estate deals. This is what Elizabeth Warren has alerted us to. But, there are many, many other institutions that have securities or other assets on their balance sheets that are not performing or are damaged in one way or another.

What is Ms. Warren talking about when it comes to the magnitude of the problem? Is she talking about a 20% write down of some assets? A 25% write down? Do these “small” banks have sufficient capital to take such a write down? Can these small banks raise sufficient new capital to cover such a write down?

Can the banking industry handle another 40% decline in the number of banks in the system? Can the banking industry absorb this contraction in the next three to five years not in 18 years? This would mean a loss of more than three thousand commercial banks and savings institutions in this time period.

This is the environment that the Fed, the FDIC, and the Treasury Department is currently working within. They have not really let us know how serious the problem is. Elizabeth Warren has perhaps given us more information than others within the government would like us to have. Maybe this straight talking is why many people are reluctant to put her in charge of a government agency. She might tell us what is really going on.

Whatever, it just looks as if the banking system has a long way to go in order to regain its health.

The "Sound and Fury" of Banking Reform

Well, the Senate finally passed a banking reform bill. It is said that President Obama wants to sign the final bill around July 4.

All I can really say about the bill is that it represents a lot of “sound and fury signifying nothing.”

The bill will be costly. The bill will result in a lot of inconvenience.

But, banking and finance will recover and will continue on their merry old way!

The reason that I say this is that finance is just information and with the accelerating pace of information technology in the United States and the world, finance will continue to expand and prosper. The regulators cannot control how information is used or transformed!

History has shown that information spreads and although the pace of its spread can be slowed down, it has never been stopped. Just ask all the religious medievalists in our world today that are fighting a losing battle and are defensively striking out at everyone else.

I have stated some of the reasons for my position in a series of posts beginning January 25, 2010: see “Financial Regulation in the Information Age”; http://seekingalpha.com/article/184153-financial-regulation-in-the-information-age-part-a.

I have also highlighted the place of information in the practice of modern finance in my review of the book “The Quants”: see http://seekingalpha.com/article/188342-model-misbehavior-the-quants-how-a-new-breed-of-math-whizzes-conquered-wall-street-and-nearly-destroyed-it-by-scott-patterson.

Furthermore, attempts to reform and re-regulate the banking system will ultimately do more damage to banks that are not among the 25 largest banks in the country than it will do to those banks that the administration and Congress are really after. And remember, the largest 25 domestically chartered commercial banks in the United States control about two-thirds of the banking assets in the country.

Another factor that I have tried to stress over the past year is that the largest banks have already moved on. The legislation in front of the Congress is aimed at preventing the last financial crisis from occurring again. In my estimation, the largest banks are beyond this feeble effort and are moving into areas we will learn about in the next round of “popular” books explaining what has happened to our financial system.

An example of this was a recent report in the press about how Congress is trying to alter the status of how hedge funds reward their managements so that more of this income is taxable. The response of the industry was to have already hired scores of lawyers to “get around” any legislation about hedge fund fees.

Can you imagine any other kind of response from the financial industry…or, for that matter, any industry?

Reform and re-regulation face a moving target and, consequently, they are aiming their efforts at the past, not the future.

The financial reform package will change the playing field for a limited amount of time. However, in this age of information you can bet that the lag between what “the Feds” do now and how the financial system reacts to these actions will be shorter than ever before.

NOTE: we now have 775 commercial banks on the list of “problem banks” put out by the FDIC, up from 702 banks at the end of 2009. When this latter list was presented, I argued that the FDIC would close between three and four banks a week for the next 12 to 18 months. We have been averaging 3.8 banks closed every week this year through May 14. Using a rough “rule of thumb” my estimate now is that at least four banks will be closed every week through the end of 2011.

I still have grave concerns about the solvency of the 8,000 “smaller banks” in the United States. I define the “smaller banks” as any bank below the top 25 largest banks in the country. These 8,000 “smaller banks” control only one-third of bank assets in the United States. I derive this concern from the actions of the Federal Reserve who continues to subsidize the banking system with extremely low interest rates, and the FDIC. Although the Fed and the FDIC are not “owning up” to this problem, everything they are doing raises questions about how solvent these smaller 8,000 banks really are. I guess the big issue concerns what would happen to the value of bank assets IF interest rates were to rise. Would this result in a “cascade” of “small” bank failures?