Just How Bad Off Are the Banks?

Here we are, how many years after the start of the financial crisis, and we still have questions about the status of individual banks and the banking system…in both the United States and Europe.

European banks have gone through two “stress” tests.  The United States banks have gone through their own “stress” tests.  And, still, there are questions about the solvency of individual banks and the banking system. 

Christine Lagarde, Managing Director of the International Monetary Fund, received all sorts of criticism from the remarks she made last Saturday concerning the status of the European banks and the fact that they “need urgent recapitalization.” 

Early this week we read about how various European banks are writing down the values of the distressed Greek government debt they hold.  Some banks are taking have taken a 50 percent write down while others have taken haircuts of slightly more than 20 percent.  There are no standards for taking such write downs leaving each bank to follow its own path. (http://professional.wsj.com/article/SB10001424053111904199404576540291609289616.html?mod=ITP_moneyandinvesting_2&mg=reno-secaucus-wsj)

American banks are not coming off much better.  One looks at the discounts being assessed against US banks in the stock market and the legal efforts that they face and one wonders what is real.   Are these banks really solvent?

Bank of America has become the poster-child of the mismanaged large banks in the United States.  Warren Buffett brought it some relief with his “pussy-cat” deal.  Yes, Mr. Buffett can say that he (and other wealthy people) should pay more taxes as he cuts such sweet deals with such nice tax benefits for himself.  Yet, some are taking the Buffet bailout of Bank of America as a signal that maybe a closer look needs to be given the position of Bank of America. (http://dealbook.nytimes.com/2011/08/31/buffett-investment-could-erode-confidence-in-wall-st/)

Just look at some of the numbers.  Bank of America has  stated that slightly less than 20 percent of its residential mortgage loans as either delinquent or nonperforming, a rate that is similar to that of Wells Fargo.  JPMorgan Chase has about 24 percent falling in this class while the fourth of the big four, Citigroup, has less than 14 percent. 

And, “Not only does the bank still face billions in legal settlement costs from Countrywide Financial deals, but it also has to buy back billions in faulty mortgages.  Bank of America’s questionable foreclosure practices continue to drag it down, and, in addition, it faces Securities and Exchange Commission investigations into the actions of its subsidiary, Merrill Lynch, in the lead-up to the financial crisis.”

In addition, bank profits are falling (http://www.nytimes.com/2011/08/29/business/top-banks-confront-leaner-future-by-cutting-jobs.html?_r=1&scp=1&sq=profits%20falling,%20banks%20confront%20a%20leaner%20future&st=cse) and with the Fed promise that it will keep interest rates low for the next two years, bank interest rate margins and, hence, bank profits can be expected to remain squeezed for the near term. 

And, why is the Federal Reserve keeping interest rates so low for the next twenty-four months?

One reason for keeping interest rates so low is that the Fed will continue to provide the banking system with substantial liquidity so that banks can work themselves out of their bad loan situation and that failing banks can be removed from the banking system with the least disruption possible.

Furthermore, commercial banks in both Europe and the United States are cutting back on their employment by not just thousands of people, but tens of thousands of people when all the layoffs are added together.   

We look at all this information and we wonder, “Just how bad off are the banks?”  The regulators have been working on this situation for at least three years.  And, we still have all these questions?

The only conclusion one can draw from this is that the regulators and the people “in the know” did not want us to know how bad things were.  And, they still are reluctant to let any of this information out.  Notice how upset people got when Ms. Lagarde let the “cat-out-of-the-bag” on Saturday.

So much of this dilemma goes back to the discussion about the need for financial institutions to mark their assets to market.

I know how hard this is to do in the case of some assets without active markets.  And, I know how painful this is to do “after-the-fact”, that is, after the asset values drop underwater.

But, this is a lame excuse that has been allowed to go on for too long!

If banks take risky bets on interest rate movements, they should only do so with the knowledge that if the markets move against them they will have to pay a price by marking the assets to market.  I also don’t buy the argument that they will hold the assets to maturity.  If the banks “place the bet” they must pay the consequences.

Same thing with risky assets: as banks take on more and more risky loans in an effort to “beef-up” their return on capital they are overtly exposing the bank.  Again, when the assets go south the banks need to own up to the bets they placed. 

And, if these mark-to-market efforts are done on a more timely basis then the banks will have to move to correct their asset problems earlier and they will not get into the deep “doo-doo” they now find themselves in.

Sooner or later these bank problems are going to have to be taken care of.  Stringing things out as the regulators and politicians have done only postpones the day we can move off into the future.  It is a prerequisite for finally achieving more robust economic growth. 

The fact that the problems we continue to read about still exist three years after the financial collapse took place only raises further questions and continues to add uncertainty to the economic climate.  No wonder that people are so risk averse today and only want to buy US Treasury securities or gold. (http://seekingalpha.com/article/290934-struggling-with-a-great-contraction)   

Response to "The Future of Banking" Comments

In response to two comments on my recent “Future of Banking” post (http://seekingalpha.com/article/287037-the-future-of-banking-looks-grim-again) I would like to make the following additions.

First, in terms of the number of employees in banks, I truly believe that the existing model of commercial banking is “legacy” and is in the process of changing.  The comment was made, for example, that “Until customers don't want to come into bank branches anymore, you will have to retain that model.”

In the past five years, I don’t believe that I have been in a bank branch in which there were more than three customers (including myself) at any one time.  And the branches are of similar size to the ones in which I was a teller back in the 1960s. 

I remember those days.  On a Saturday morning when the branch opened at 9:00 AM we would have eight tellers working eight tellers windows and lines of 10 to 15 people at each window constantly until 1:00 PM when the branch closed.  The weekdays were not so busy, but there was always a constant flow of customers through the banks.

I do not know exactly what the future of banking is going to be, but I am working on it as I write.  I have studied, written about, helped start up companies and worked with early stage companies in the area of information technology.  I am on the board of a newly formed bank and am in the process of starting up a credit union.  The use of information technology is constantly on my mind with respect to its application to the finance area. 

Everything I know and have experienced indicates that banking and finance is going through a quantum leap and, over the next ten years, will evolve into something we may not recognize as banking and finance, given the models we work with today.

In teaching classes in information science, I suggested two places for the students to look for ideas about what the future would be like.  First, I said, look at what the military is doing.  They must be ahead of everyone else in their ability to keep secrets and to fight wars (kill people).  They must have the most advanced technology.  Second, I said, look at what the young people are doing the kids in the 8 to 14 age bracket.  What is ubiquitous to them will be “standard” in five to eight years. 

If your business does not take these two things into account in your operations then you will probably not be around to enjoy this future.

I know young people that have not been inside a bank or the branch of a bank for at least five years.  I seriously doubt that my grandchildren will see the inside of a bank or the branch of a bank more that just a few times in their life. 

Finance is information…and nothing more.  Hence, how information is stored, processed, and used will dominate the practice of finance. 

I hope I find out what the future of banking is going to be before others do. 

Whatever it will be, it will not be as people intensive as it is now.

The second comment had to do with “mark to market” accounting.  The comment correctly indicates that many bank assets are probably over valued and this fact will come to light in the future indicating that many banks are in worse shape in terms of capital than we presented think they are.

The comment concludes: “I have seen very few people focus on this in what I have read over the past 3 years, yet I think what I have spelled out here is a potentially looming 'largely unrecognized' further problem. “

I agree with this analysis but would add that over the past three years I have constantly argued in my posts  (you can look them up on Seeking Alpha) that the commercial banking industry needs to go to a accounting system that does a better job of “marking “ assets to market.  This, to me, is essential for the finance industry to be “open” and “transparent”.

In terms of my recent post, I just did not have time to get into this issue.  Of course, adding this issues to the other two does not make the future of banking look any rosier.

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.      

Why Invest in Commercial Banks?

 Why should anyone invest in commercial banks these days?

My answer is that they should not.

My reason for this is that bank accounting is so screwed up that it is extremely difficult, if not impossible, to place a value on the assets of a bank. 

Now, this is a broad ranging generalization and I know that there are banks who are open and transparent about the value of their assets, but…

A case in point: yesterday, Citigroup released its earnings for the first quarter.  Let’s look at the analysis of these earnings by Francesco Guerrera and Patrick Jenkins for the Financial Times (http://www.ft.com/cms/s/0/8c5fb104-69e0-11e0-89db-00144feab49a.html#axzz1JsjXsOj5).

In order to reduce the impact of the new capital rules, Basel III, Citi has put “up for sale a $12.7 billion portfolio of bad assets that were responsible for some of its huge losses during the financial crisis.”

“Citi said the assets, which are believed to include subprime loans, mortgage-backed securities and corporate bonds, carried a ‘disproportionately high’ risk weighting under the new capital rules…”

Hence the desire to get rid of the assets.

“Citi’s decision resulted in a $709 million pre-tax charge in the first quarter but enables it to take advantage of a recovery in the market for distressed assets and boost capital buffers…”

“Citi said it had already sold about three-quarters of the assets at prices above the levels at which it valued them on its balance sheet…”

But, this background information follows.

“In order to put the assets up for sale, Citi had to reverse an accounting maneuver performed during the crisis, when it moved them from its ‘trading’ book to it ‘banking’ book.”

“Such a shift, which mirrored moves by other commercial banks, helped Citi to avoid suffering quarterly mark-to-market losses on those assets at the height of the turmoil.”

“However, accounting rules require financial groups seeking to move assets back to their ‘trading’ book to show that the facts around their initial decision had significantly changed.”

“John Gerspack, Citi’s chief financial officer, said the company argued that Basel’s higher risk weightings constituted such a change.  Citi’s argument was accepted by the US Securities and Exchange Commission, potentially paving the way for other banks to follow suit.” 

“Several banks have shrunk their balance sheets and shuffled assets in order to cope with the rise in capital requirements demanded in the Basel III regime.  However, their efforts have taken place largely behind closed doors, with very few providing details of their plans.” 

How is an investor really to know what assets will be treated in which way at what time?

And, the question can be raised concerning the treatment of Citigroup or other large banks relative to other, smaller financial institutions.  Smaller banks don’t have the expertise or can’t hire the expertise or don’t really have the ability to maneuver their portfolios in such a way.

However, in many cases in which assets cannot be “re-classified”, asset values have not been written down because “hope” was expressed that many of these assets would improve in value once the economy began growing again.

The ‘hope’ may be wearing a little thin as some borrowers may be running out of time.  See my post “Commercial Bank Closures,” http://seekingalpha.com/article/264104-commercial-bank-closures-2-3-banks-per-week-in-2011.

The situation may be changing in other areas as well.  In some cases, the change is coming from the regulatory side.  Take the case of the rating agencies and the municipal bond market.  In January 2011, Standard & Poor’s cut the rating of DeKalb County, Georgia from triple A to double A and then reduced it to triple B.  Now, S & P has withdrawn rating from it at all. (See http://www.ft.com/cms/s/0/106b35da-69e2-11e0-89db-00144feab49a.html#axzz1JsjXsOj5.)

“Matt Fabian, managing director at Municipal Market Advisors, says one reason why rating agencies may be acting more aggressively with patchy disclosure is regulation.  New rules, set out in the Dodd-Frank Act, have been introduced after rating agencies came under fire for miscalculating risk in mortgage debt before the financial crisis.”

The question now becomes: If Dekalb County was rated triple A in January and currently is not rated at all, what other triple A rated entities…or even A rated entities…might face lower ratings in the near future?

How should these assets be valued on bank balance sheets?

Over the past forty years, too many tricks have been played with bank accounting and bank accounting standards. 

As readers of my blog know, I am a strong advocate of “mark-to-market” accounting.  Bank executives make decisions and they need to be held accountable for them.  If they take risks then they need to own up to the risks that they have taken.  Bank accounting must become straight-forward enough and open enough for people that want to invest in them to have sufficient information to value their assets. 

I would think that the regulators would want this as well.

I am tired of hearing stories like the one on Citigroup reported in the Financial Times.  And, new stories pop up all the time.  In terms of accounting and openness related to the books of banks, there seems to be no difference between the regulators and the banks. 

If we are to have a safer banking system I believe that this situation must end!

The Health of the Banking Systems in Europe and the United States

What still bothers me is that governments in both the United States and Europe have not resolved their problems with the solvency of their banking systems.

The question remains about how long these problems are going to be carried along.

This morning we read, “Ireland’s Largest Banks Given Failing Grades.” It is assumed that the government is going to take over the banks and the price tag is going to be a minimum of about $35 billion. (http://professional.wsj.com/article/SB10001424052748703806304576234180828120692.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

Following up on this there is the article about the bank problems in Spain, “Spain May Take Over CAM as Deal Talks Fail.” Here again we have the possibility of nationalizing another bank. Moody’s Investors Service estimates that the minimum needed to get the Spanish savings banks adequately capitalized at between €40 billion to €60 billion. (http://professional.wsj.com/article/SB10001424052748703806304576234912073054934.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj)

On a smaller scale, we have another fiscal crisis in Portugal as it became known that the government’s financial figures were incorrect and that budget matters are worse than was expected. This news came a few days after Portugal’s credit rating had been downgraded once again. This, and the concern that Portugal may not be able to meet bond repayments falling in April and June, has raised new issues about the solvency of the Portuguese banking system.

In addition, we are still awaiting the results of the recently administered “stress tests” of European banks. There is substantial concern about what these “tests” might show.

And, question marks still hang over the health of the smaller banks…that is smaller than the biggest 25 commercial banks…in the United States banking system. The number of commercial banks on the FDIC’s list of problem banks was just under 900 on December 31, 2010. In all of 2010, 157 commercial banks failed while mergers occurred for 197 other banking organizations, many of them not exactly healthy.

This means that almost 12 percent of the commercial banks of the United States are on the problem list of the FDIC. Some put the number of commercial banks that are facing severe operating difficulties at 40 percent of the banking system.

I have argued that a major reason for the quantitative easing on the part of the Federal Reserve is to provide sufficient liquidity for the “smaller”, “troubled” commercial banks so that the FDIC can close or arrange mergers for as many of these banks as possible in an orderly fashion.

The concern over the health of the commercial banks in American and Europe is real.

And, now we are seeing just how extensive the financial crisis was in both Europe and the United States in 2008/2009. These banking systems collapsed together. And, the banking systems have continued to fail to resolve their issues together.

The release of the Federal Reserve statistics on borrowings from the Fed’s discount window, “Fed Kept Taps Open for Banks in Crisis”, is amazing in many respects. Some of the biggest borrowers, it turns out were from Europe. The Fed certainly became the worldwide “lender of last resort.” And, the Fed added large amounts of “junk” in the process. (http://professional.wsj.com/article/SB10001424052748704530204576235213193119194.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

The problems arose from real estate lending and the problems that continue are related to real estate lending.

The question that remains concerns the depths of the problems that still exist in the European and United States banking systems.

People I know are still in shock over the sale of the Wilmington Trust Company in early November 2010, a bank that everyone thought was in pristine shape. (http://seekingalpha.com/article/234027-wilmington-trust-sold-at-45-discount)

This subject came up again in discussions I was a part of during the past weekend.

The concern? How many more situations like that of the Wilmington Trust Company are there “out there”?

This is the worry that we cannot seem to shake.

And, the debate always seems to come back to one thing: Why is the Federal Reserve acting in the way it is? Injecting $1.5 trillion of excess reserves into the banking system does not make a lot of sense…unless the banking system is less solvent than we are being told.

There is a lot of discomfort… in both Europe and the United States…when it comes to looking at the banking system. Unfortunately, we may never understand how bad off the banks have been until we get more and more information in bits and pieces as things work themselves out.

Is Bank Lending to Business Starting to Pick Up a Little?

Last month I wrote a post about “Why is most of the Fed’s QE2 Cash Going to Foreign Related Banking Institutions.” ( http://seekingalpha.com/article/254004-why-is-most-of-the-fed-s-qe2-cash-going-to-foreign-related-banking-institutions)

This month the Fed’s “cash” injection has ended up at the largest 25 banking institutions in the United States. Cash assets at the largest domestically chartered banks rose by almost $160 billion over the past four weeks.

The cash assets at foreign-related banking institutions dropped modestly (about $4 billion) over the last four weeks but is still up approximately $125 billion since the end of last year.

According to the Fed’s data on the commercial banking industry, cash assets in commercial banks have risen by about $260 billion over the past nine banking weeks, with around $135 billion going to the largest 25 domestically chartered banks, $125 billion going to foreign related financial institutions and roughly zero going to the other 7,600 domestically chartered small banks.

Other than this fact, the interesting change within the United States banking system itself is that although credit extension at domestically chartered commercial banks declined rather substantially since the end of last year, the loans and leases at the smaller commercial banks actually went up.

Overall, loans and leases on the books of commercial banks declined by about $27 billion over the last four weeks and by $61 billion since the end of 2010.

Interestingly, the smaller banks recorded a $28 billion increase in loans over the last four weeks, with commercial and industrial (C&I) loans rising by $5.5 billion and commercial real estate loans increasing by about $18 billion.

It should be noted that residential mortgages fell by about $11 billion over the same time frame.
Is this a sign that commercial lending is picking up for the smaller banks. This is the first time in the last few years that commercial lending has actually shown any sign of increasing at these smaller institutions, especially in the area of commercial real estate.

C & I loans did pick up at the larger banks over the last four weeks and this dominated the activity in this area during the early part of this year.

However, commercial real estate lending declined at the largest banks by $25 billion, so that this category of loans did decline in total. Also, since the end of last year, commercial real estate loans at these large banks declined by $32 billion so that overall, the commercial real estate sector continued to decline throughout the early part of 2011.

So, the question is, “Is bank lending to businesses starting to pick up a little?”
Really, we only have a little information that it might be picking up. But, it certainly is something to keep our eyes on.

The big mystery still seems to be the placement of the QE2 money being generated by the Federal Reserve system. Reserve balances at Federal Reserve banks have increased by about $280 billion from the end of 2010 to March 2, 2011. This increase in Reserve Balances seems to be roughly divided between the largest 25 domestically chartered commercial banks and foreign-related financial institutions. But, loan at these institutions over this time period have actually gone down. What’s going on?

As for the smaller banks, they do not seem to have participated in this round of quantitative easing. Yet, it has been my belief that one rationale for QE2 has been to provide market liquidity for the smaller banks so that it will ease the strain on those banks that are especially having solvency problems. Given recent data released by the FDIC it seems as if there are still a large number of the smaller banks in the country that are still having major problems staying alive.

Thus, at least part of the purpose of QE2 is to help keep these banks open so that they can be closed by the FDIC in an orderly fashion. Through the first nine weeks of the year the FDIC has closed an average of just under 3 banks per week. This is down slightly from about 3.5 banks a week in 2010.

We continue to wait. Believe it or not, the economic recovery is just about a quarter short of being two years old. There are still areas of the economy that remain of concern like the banking industry, the residential housing market, the commercial real estate market, and state and local finances. And, there still are shocks around the world that threaten to bring everything else down: the unrest in the Middle East and arising oil prices; the earthquake in Japan; and the sovereign debt problem in Europe.

So the bad news is that the economic recovery is just about a quarter short of being two years old and underemployment is so large and manufacturing capacity is so low for this time in the business cycle.

The good news is that the economic recovery is just about a quarter short of being two years old
and the recovery seems to be robust enough to continue to meander along in an upward direction.

It would be nice to have more bank lending to spur the recovery along, but it will be even better if the financial system can continue to function without a disruption to the steady pace of the FDIC closing the banks it needs to close.

The World Debt Crisis Lingers

The Federal Reserve, the European Central Bank, the Bank of England, and others, are all desperate to keep interest rates from rising. The debt overhang in the developed world is humongous and any substantial rise in interest rates would just exacerbate the financial crisis that hangs over Europe and America.

We observe the debt crisis all around us. Gretchen Morgenson writes in the Sunday New York Times about the need of commercial banks to write off billions of dollars of mortgage loans sold to Fannie Mae and Freddie Mac. The article is “$2.6 Billion to Cover Bad Loans: It’s a Start,” (http://www.nytimes.com/2011/01/09/business/09gret.html?_r=1&ref=fairgame). She writes, “Analysts in JPMorgan Chase’s own research unit published a report last fall stating that possible mortgage repurchase liabilities for the overall banking industry ranged from a best case of $20 bill to a worst case of $90 billion.”

The Financial Times reports that “US Regional Banks Set for Consolidation,” (http://www.ft.com/cms/s/0/2388dd24-1c27-11e0-9b56-00144feab49a.html#axzz1AjUYZy6X). The gist of this article is that commercial banks have about $1,500 billion in commercial real estate loans coming due over the next four years. People have been watching these loans for about 18 months now, but they have been kept “evergreen” as bank lenders have continually renewed these loans to keep them on the books till “something good happens.” The article list 15 regional banks that have loan portfolios consisting of, at least 38% of their loans in commercial real estate loans. Seven of these banks have more than 50% of their loans in commercial real estate. The smallest of these banks is $4.2 billion in asset size.

Many corporations in the United States and Europe still have massive debt loads that continue to increase. Several times a week there is more news about corporations facing bankruptcy. Yesterday, Sbarro announced that it was hiring bankruptcy lawyers (http://professional.wsj.com/article/SB10001424052748704458204576074214100579944.html?mod=ITP_marketplace_0&mg=reno-wsj). Last week, the Philadelphia company Tastykake indicated that it was looking for someone to buy it because of the debt problems it was having.

Another article in the New York Times on Sunday reported on “The Crisis That Isn’t Going Away,” (http://www.nytimes.com/2011/01/08/business/global/08euro.html?scp=1&sq=the%20crisis%20that%20isn't%20going%20away&st=cse). This article was about a report produced by Willem Buiter, Chief Economist at Citigroup, who claims that debt restructuring in Greece, Ireland, and Spain is inevitable: “All bank and sovereign debt is now at risk…” European debt levels, he argues, are unsustainable.

This argument is re-enforced by the information contained in another article in the Financial Times, “Europe’s Woes Put Debt Restructuring Back on the Agenda,” (http://www.ft.com/cms/s/0/c25cc3e6-1cec-11e0-8c86-00144feab49a.html#axzz1AjUYZy6X).

Not only is the sovereign debt of Portugal currently under attack but Belgian bonds came under attack yesterday.

The debt estimates for 2013 are downright scary: Greece is expected to have its debt at 144% of GDP in 2013; Italy at 120%; Belgium at 106%; Ireland at 105%; Portugal at 92%; France at 90%; the UK at 86%; and Spain at 79%.

And, what about European banks? Check out the article “Fears Mount Over European Debt, Banks,” (http://www.ft.com/cms/s/0/c25cc3e6-1cec-11e0-8c86-00144feab49a.html#axzz1AjUYZy6X). European banks are expected to go through a new “stress” test this year, one that will be much tougher than the “joke” that was administered last year. There is great concern about how these European banks will fare in the new test.

And what about government debt in America? New governors are taking a tough stance on the budgets for the upcoming year. Jerry Brown is seeking $12.5 billion in spending cuts for the upcoming California budget. And, Andrew Cuomo in New York is asking for salary cuts of 10% and is seeking even more cuts elsewhere. The governor of Illinois is (seriously) hoping that the lame-duck legislature will pass a substantial tax increase on corporations before they leave. Still many states are in dire straits, hoping to avoid bankruptcy. And, there are dozens of municipal governments on the edge of declaring bankruptcy.

Oh, and what about the federal government: Have you seen the projections for interest expense going forward given the deficits that are expected in the future?

Now, what if long term interest rates were to rise by another 100 basis points? 150% basis points?

Just how much longer can the central bankers of the world keep long term interest rates below where the market believe they should be?

Research indicates that central bank actions can keep long term interest rates lower than market conditions warrant for a short period of time. However, to maintain the rates at below market levels, central banks must inject increasing amounts of money.

QE2 was announced as a policy decision to get the economy growing faster so that the unemployment rate would be brought down.

Yet, now we see what a farce the Fed has been playing on us. Chairman Bernanke, himself, just told Congress that the unemployment rate was not going to improve much at all, even if the economy picks up speed, and that it would take five to six years for the unemployment rate to even show much of a decline.

So, one can conclude from this that QE2 is not really aimed at getting the unemployment rate down.

I have argued for a long time that the reason the Fed was providing the financial markets with so much liquidity was because of all the insolvent banks “out there”. The Fed was helping to keep banks “open” so that the FDIC could close all the banks that needed closing in an orderly fashion.

I believe that investors are coming to realize that the Fed is not trying to keep rates down in order to spur on the economy. To me, this realization contributed to the fact that the yield on 10-year Treasury securities rose by about 100 basis points after the Fed laid out its plans for QE2. The financial markets just rebounded to levels that more closely approximated where the market should be if the Fed were not “messing” with it.

Bottom line: the debt problem is still real. There is a lot of debt “out there” and the value of this debt is not really the economic value of the debt. The central banks of the world are just trying to keep long term interest rates low in order to push off the day when the debt will have to be written down to a more realistic value. The problem is that more and more attention is being paid to the fact that this debt needs to be written down. And, until this write-down takes place, we cannot really recover, economically.

Little or No Life in the Banking Sector

If the economy needs the banking sector to get healthy before it begins to grow we are still waiting for the banks to show some signs of life.

In the past few months, loans and leases in the commercial banking system continued to decline.
Credit extension over the past six months was down about 2 percent and for the last three months it was down by 1 percent. Loans and leases on the books of commercial banks also declined by $18 billion over the past month.

The category of loans taking the biggest hit has been commercial real estate loans. For over a year now, concern has been expressed about the weaknesses that were expected in this sector and, to date; this forecast has been proven to be correct. The expectation is that the commercial real estate sector will continue to remain week in 2011.

Commercial real estate loans have declined by more than 9 percent over the past year, the largest declines coming in the largest banks in the country. These loans have declined by more than 11 percent at the biggest 25 banks in the country, while they have declined by almost 8 percent at the smaller institutions.

This trend also existed over the past six months, three months, and one month with declines for the whole industry of about 5 percent, 3 percent and 1 percent, respectively. Note these are not annualized rates.

It has been the case that the rate of decline in these loans has been greater in the largest banks.

Every classification of loan continued to decline over the last six months, with all real estate loans taking the lead.

Cash assets at all commercial banks registered declines over the past year as the Federal Reserve has been less generous in pumping out funds…until recently, of course.

Over the year, cash assets at commercial banks fell by 12 percent. However, there is another
story embedded in these figures! Cash assets at the largest 25 commercial banks fell by almost 30 percent over the past year, declining by 22 percent over the last six months and by 10 percent over the last quarter. Thus, one could say that the bigger banks were becoming less conservative in that they were relying less and less on balance sheet liquidity to see them through the upcoming months.

The story is entirely different for the smaller banks. Over the past twelve months, cash assets at domestically chartered commercial banks that were smaller than the largest 25 banks ROSE by more than 15 percent! Over the past six months, these smaller banks increased their holdings of cash assets by more than 5 percent. Only in the last month have cash balances declined at these banks, but the decrease was modest, at best.

My concern over the past twelve to eighteen months has been the health and solvency of the smaller banks in the banking system. Not only are loans at these institutions down significantly over this time period, their cash holdings have increased dramatically. The implication of this movement is that the smaller banks are being very, very conservative in their management in order to weather as well as possible the removal or write-down of bad assets from their balance sheets.

Over the past twelve months, the Federal Deposit Insurance Corporation (FDIC) has been closing approximately 3.5 banks per week. As of the end of September 2010, the FDIC had 860 banks on its problem bank list, up from 829 at the end of the second quarter. (Remember also that the FDIC closed about 45 banks during the third quarter.) The number of banks on the Problem Bank List now represents 11% of all FDIC insured institutions, a little over 7,800 banks in total. Furthermore, in judging this picture we need to recall that earlier this year Elizabeth Warren, in Congressional testimony, stated that there were about 3,000 banks facing severe problems in their commercial real estate loan portfolio.

One can interpret these data as indicating that the commercial banking system, especially the banks not included in the largest 25 banks in the country, is still facing serious difficulties. Not only are we getting this picture from the banking regulators themselves, we are seeing these banks acting very, very conservatively in the face of the massive injection of funds into the banking system.

It is this picture that leads me to believe that one of the major reasons the Federal Reserve has constructed QE2 is that the banking system continues to need support as the FDIC closes as many banks as it has to as smoothly as possible.

Furthermore, what could do more damage to asset values in the portfolios of commercial banks than to have interest rates rise?

The Fed says it is trying to keep interest rates from rising in order to help encourage economic growth, but maybe there is one step missing in this explanation.

The Federal Reserve needs the commercial banking system to start lending again so that businesses can begin investing again and the economic recovery can get on track.

However, the Federal Reserve needs to keep interest rates from rising so that financial assets in the commercial banking system don’t decline further and force even more banks to close their doors.

A substantial rise in interest rates would be disastrous for the banking system.

Also, if interest rates rise even modestly, it is highly likely that commercial banks, given the condition they are in, will act even more conservatively and be even more reluctant to pick up their lending to businesses and consumers.

The Federal Reserve needs a vibrant and active commercial banking sector in order to generate sustainable economic growth.

The Federal Reserve is not there yet.

It's A Solvency Problem, Not A Liquidity Problem!

Discussion is swirling around the Fed’s new quantitative easing program, QE2.

The wisest comment I have heard up to this point about the QE2 exercise is the quote attributed to the economist Allan Meltzer at a recent celebration on Jekyll Island, Georgia commemorating the clandestine meetings that resulted in the creation of the Federal Reserve System 100 years ago.

Mr. Meltzer is quoted as saying, “There isn’t a liquidity problem.” (http://www.nytimes.com/2010/11/08/business/economy/08fed.html?ref=business)

But, one of the problems of this whole exercise is that almost the whole effort to reverse the financial meltdown and the economic slowdown has been attributed to the fact that many of our governmental leaders, Mr. Geithner and Mr. Bernanke, have seen the crisis as a “liquidity” problem. That is, to the problem that financial institutions can’t sell their assets.

And, these leaders continue to assess the situation as a “liquidity” problem. Some of us, however, see the continuing problem as a “solvency” issue. There is a world of difference between the two.

The original response of the government to the financial crisis was to create a program, the Troubled Asset Relief Program (TARP), which would allow the Treasury “to purchase illiquid, difficult-to-value assets from banks and other financial institutions.” This was enacted by Congress on October 3, 2008.

On October 14, 2008, Secretary of the Treasury Paulson and President Bush announced the first revisions to the program. Without going into the revisions more deeply, the Treasury announced their intention to buy senior preferred stock and warrants in the nine largest American banks. For there on, the effort “to purchase illiquid, difficult-to-value assets” all but completely disappeared.

Yet, the leadership in Washington, D. C. continued to speak as if the whole financial crisis was just a “liquidity crisis”.

I have addressed this issue many times before in my writings. But, let me use the words of Richard Bookstaber in his book “Demon of Our Own Design”: “A liquidity crisis is generally related to financial institutions and not to nonfinancial institutions. This is because financial institutions have assets on their balance sheets that have ‘liquidity’. The very ability to liquidate is at the root of the liquidity crisis.”

In a liquidity crisis there is the problem of “asymmetric information”. This problem occurs where one party to a potential transaction has all or most of the information about the value of an asset and other parties do not have the same information.

A liquidity event is most often set off with a shock to the market. In the case of Long Term Capital Management, an arbitrage situation was interrupted by a default by Russia on outstanding bonds. In the case of the Penn Central Crisis, the Penn Central railroad company declared bankruptcy when it had been thought to be a going concern. The buy-side of the market goes away because investors have little or no information.

Exacerbating this situation, Bookstaber states, is the fact that, very often, market participants can identify the seller that MUST sell its assets and this means that the buy side can be even more selective as to when buyers want to enter the market or not. In the recent problem experienced by the French bank, Society General, the market knew who was having problems and that they had to sell a substantial amount of assets to unwind certain transactions on their books.

In many cases associated with a liquidity crisis, without the intervention of the central bank, there is no reason for buyers to re-enter the market until more information becomes available to them. The bottom line to this analysis is that a “liquidity crisis” is a short term affair that requires immediate central bank action. Funds must be made available to the financial markets so that market participants can feel and believe that a “bottom” is reached in terms of the decline in asset values. This is where the Federal Reserves’ “Lender of Last Resort” function comes into play.

The “solvency crisis” is not usually such an immediate problem. Solvency issues can play a part in the liquidity crisis (note the longer term outcomes relating to Long Term Capital Management, Bear Stearns, and Lehman Brothers) but the real solvency crisis relates to a longer period of time and has to do with cleaning up balance sheets and raising new capital. It is not just an issue of “liquidating” an asset in the market place. The value of assets can deteriorate either due to changes in market valuations or due to the financial condition of borrowers. It is a question as to the ability of someone to fully repay another.

A solvency crisis is longer term than a liquidity crisis because the financial institutions need to proceed in an orderly way to work out the situation they face with respect to the value of the assets on their balance sheets. But, this “working out” process may take six months or a year to resolve. The working out of assets requires a substantial amount of time and attention from the managements of financial institutions. Thus, to get back to business as usual requires that a management get the problems behind them so that they can concentrate on what they really should be doing…running a business, not “working out” loans.

If a recession is not to broad or deep then some kind of governmental stimulus can “buy the banks” out of their solvency problems by means of inflation. If the problems have existed for some period of time and are also connected with too much risk taking and excessive amounts of financial leverage, the problems may not be so easily overcome. And, in these latter cases, fiscal and monetary stimulus may not be able to accomplish much in helping financial institutions “get back to business.” Inflation doesn’t help a lot.

How, then, should we interpret the current “crisis”? Well, do you believe that our main problem is still “liquidity” or is our main problem “solvency”?

For those that read this blog regularly, they know that I believe that the “liquidity crisis” occurred a long time ago, in the fall of 2008. I believe that we have been dealing with a “solvency” crisis since then. And, I believe that we are still going through this “solvency” crisis.

If you look at my post of November 8, 2010 you can see that I believe that the “solvency” crisis still has a ways to run. (http://seekingalpha.com/article/235487-the-banking-system-seems-to-be-dividing-large-vs-small-commercial-banks) If you believe as I do that we are still in the midst of a solvency crisis then you also should believe that further additional fiscal or monetary stimulus will have little or no effect on the banking system or the economy. Financial institutions are still “working out” their bad assets and they will not really want to return to “business-as-usual” until they can devote their full attention to making loans.

It is a hard thing to do to run a financial institution. I have been involved in the running of three of them. In order to be successful you need to give your complete attention to running the business and not to “working out loans” which is very demanding and very time consuming. A “liquidity crisis” does not draw this kind of long-time attention.

The Banking System Seems to be Dividing: Large Versus Small

The last three months have seen more and more weakness in the smaller commercial banks in the United States. Last month I ask the question, “Is A Crunch Coming for the Smaller Banks?” (http://seekingalpha.com/article/229385-is-a-crunch-coming-for-smaller-banks)

This month things continued to decline amongst the smaller banks while the largest 25 banks in the country really seemed to expand.

Over the past four weeks ending Wednesday October 27, the biggest 25 banks in the country saw their assets increase by almost $94 billion while the assets at the smaller banks rose by only about $8 billion; but the cash assets at the smaller banks rose by almost $19 billion.

Over the past quarter, the total assets at the larger domestically chartered banks increased by a little less than $20 billion while the assets at the smaller banks actually declined by about $9 billion. Cash assets at the smaller commercial banks rose by over $33 billion during this time.

Loans and leases at the smaller commercial banks have fallen by $14 billion over the last four weeks and by almost $32 billion over the last 13-week period. And, where has most of this decline come from? Commercial real estate loans!

This is, of course, is where many analysts, including Elizabeth Warren, have predicted the trouble would come from until the end of 2011 or so. Warren even stated in congressional testimony that there were some 3,000 commercial banks that were going to face severe problems in the commercial real estate area as these loans either matured and had to be re-financed or went into a delinquent status.

Over the past four-week period, commercial real estate loans at the smaller banks fell by almost $10 billion. Over the past 13-week period, these loans dropped by over $23 billion.

Looking back over the past year ending in September, commercial real estate loans at the smaller commercial banks declined by $74 billion, with half of the decline coming in the last six months.

The decline in assets at the smaller commercial banks is coming exactly where Warren and others warned they would come. But these banks also moved more and more into cash assets during this time indicating a very risk averse position. Over the past thirteen weeks the smaller banks did exactly the opposite of what their larger competitors did: the smaller banks added $33 billion to their cash asset portfolios while the bigger institutions reduced their cash by $30 billion.

The largest 25 banks are still not aggressively pursuing loans. But, their securities portfolios continue to increase. Over the last four weeks, securities held by the largest banks in the country increased by almost $32 billion while they rose by almost $60 billion over the past 13-week period.

This behavior is also exhibited over the last twelve months, ending in September 2010. During this period, large commercial banks increased their securities portfolio by almost $125 billion while their portfolio of Commercial and Industrial loans fell by almost $80 billion and their portfolio of real estate loans dropped by $41 billion.

Some of the financing of these securities came from the cash assets of these large banks which declined by almost $70 billion during this time period. The largest supplier of new funds to these institutions came from something called “Borrowings from Others”. In essence, the larger banks seem to be playing an arbitrage game. They are borrowing short and buying long term securities. The risk to them seems minimal since the Federal Reserve is keeping short term interest rates exceedingly low for “an extended time.” An “extended time” seems to go well into next year.

The largest commercial banks are going to do just fine. They will continue to get stronger and bigger in the future.

The smaller banks continue to struggle. The problem here is that we, the public, really don’t have a handle on how serious the situation is with respect to the solvency of the smaller commercial banks in the banking system.

The “surprise” sale of Wilmington Trust last week took most people by surprise, even the very astute analysts. (See http://seekingalpha.com/article/234027-wilmington-trust-sold-at-45-discount.) Here is a bank known for its conservatism and, in addition, it was solidly producing earnings through its trust department. Yet, the bank had failed to really report the truth about its loan portfolio. Here is a bank, roughly around $10 billion in asset size with bad assets totaling around one billion dollars. How could this happen without someone knowing about it?

How many more commercial banks like Wilmington Trust are out there?

Bankers…lenders…do not like to admit that they have bad loans. In general, they postpone reporting bad loans until it is too late for them…and their shareholders.

Elizabeth Warren said that there were about 3,000 commercial banks in the banking system that were going to face serious strains over their commercial real estate loan portfolio and their construction loan portfolio.

Recent data indicate that large dollar amounts of commercial real estate loans are leaving the balance sheets of the smaller commercial banks in the United States. It would appear as if more and more of these bad assets are being recognized and removed from the banks’ balance sheets.

More and more people are calling for commercial banks to recognize their bad assets so that the United States can start to grow again. I believe that more and more people are realizing that a strong economic recovery is not possible until something is done about these bad assets…until they are written off the balance sheets of the commercial banks.

One of the problems that the Obama team is really going to have to deal with soon is to appoint some people to provide economic and regulatory advice and administration. On the economic side, only Tim Geithner at Treasury and Austan Goolesbee at the President’s Council of Economic Advisors are in place. On the regulatory side connected to depository institutions, only “Bubble” Ben will be in place by the middle of next year. The Office of the Comptroller of the Currency has an acting head. I was at a banking conference last week and there was talk that Sheila Bair, Chair of the FDIC is expected to leave next year and does not want to be re-appointed. The Office of Thrift Supervision is merging into the OCC and the top people are looking elsewhere for leadership. Many leadership positions are empty.

One could almost say there is little or no leadership at the top in Washington, D. C. when it comes to economics and banking.

And yet, 2011 could be a crucial year in American history for determining the future of the structure of the financial system.

Coming Crunch for Smaller Banks?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Drag Caused by American Household Debt

Today I would like to reference an article by William Galston on the website of the New Republic (http://www.tnr.com/blog/77215/getting-out-the-recession-stimulus-spending-debt-banks).

Galston’s point is this: the value of assets on the balance sheets of households in the United States has declined relative to the amount of money owed by these same households.

To quote Galston: “As the value of assets used as collateral collapses, so does borrowing. This depresses consumption (because the real net worth of households has declined), and the real economy dips, making it much harder for businesses and households to service the debts incurred during boom times. Household consumption remains sluggish until debt is reduced to a level that can comfortably be serviced out of current income, a process that cannot proceed without an increase in the household savings rate. The larger the debt overhang, the longer it will take to work off the excess.”

The figures Galston quotes: in late 2007, household debt was $12.5 trillion which was 133 percent of disposable income. In the first quarter of 2010, total household debt had declined to $11.7 trillion around 122 percent of disposable income.

The Federal Reserve Bank of San Francisco has suggested, in a May 2009 analysis, that this ratio will need to fall to around 100 percent for households to feel more comfortable and begin to loosen up their pocketbooks a little bit more.

For this ratio to decline to 100 percent, the study argues, it would take up to a decade, even if the household savings rate were to rise to 10 percent. The household savings rate is now a little above 6 percent.

Government stimulus programs are not going to counteract this de-leveraging unless they were to create sufficient new inflation to get the value of assets rising rapidly once again!

It is not surprising that small- and medium-sized businesses are in a similar situation. Many of the smaller businesses in the United States used debt much as households did during the buildup of financial leverage because…they were the same people!

And, small- to medium-sized banks are having solvency problems (http://seekingalpha.com/article/222005-where-is-banking-headed-not-up).

Foreclosures, bankruptcies, and bank failures are a common part of such an environment (http://seekingalpha.com/article/222238-why-52-is-not-a-pretty-number).

Regulators and the courts are trying to work out the difficulties connected with such problems as efficiently and smoothly as possible. Galston is just pointing up the fact that correcting such a situation is not going to be accomplished over night. Even the program Galston suggests as a way out of this malaise, a “national infrastructure bank”, would not shorten the time span needed to once again achieve a robust economy with substantially lower unemployment.

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.