The Mortgage Market and More Plans to Aid Homeowners

There is still no better place to observe the consequences of the credit inflation of the last fifty years than the housing market.

Politically, this is democracy at work. Every wave of political change in the post-World War II period has focused on the housing market and putting “Americans” in their own homes in order that the new majority in Congress can get re-elected.

I was in Washington, D. C. during the time period that the mortgage-backed securities were being designed. The rationale for this innovation? Almost all mortgages were made in local depository institutions at that time. But, insurance companies and pension funds had lots of money to invest in longer term securities. If an instrument could be constructed that would allow local depository institutions to sell their mortgages to these companies that wanted long term investment vehicles then the local depository institutions would still have funds available to make more mortgages and put more “Americans” into their own home. And, the incumbent politicians could show their constituents the role they played in not only helping people acquire a home, but also how this effort helped to stimulate the local economy through additional home building. This surely would help the incumbents to get re-elected.

Economically this effort seemed to be sound because it would provide for an almost continued stimulus to the economy, spurring on economic growth and raising employment. A little “inflationary bias” along with this was not bad because almost all the economic models used at this time period showed a positive relationship between inflation and higher levels of employment. Inflation was good for the country!

And, these basic efforts were supplemented by the activities at the Department of Housing and Urban Development, the Federal National Mortgage Association (Fannie Mae) along with the creation of Freddie Mac and Ginny Mae and the work of the Federal Housing Authority, the Federal Home Loan Bank System, and other initiatives forthcoming from both presidential administrations and the Congress. Who could be opposed to such a worthwhile idea?

What we see is that maybe inflation was not all it was said to be. Maybe inflation, in the longer run, can actually be harmful to many of the people it was supposed to help. Maybe one of the “lessons learned” from application of the economic philosophy that dominated Washington in the last fifty years is that you can’t artificially “force” people into situations that are not fundamentally sound on an economic basis.

The efforts of the federal government over the last fifty years or so culminated in the Greenspan/Bernanke credit inflation of the 2000s. The United States experienced a housing bubble during this time period that really capped off the government’s effort to promote homeownership. Asset prices were artificially “forced” to rise further and further. And, as we saw, in the longer run the run-up in housing prices was unsustainable. So the bubble popped!

The consequence? The New York Times reports that “About 11 million households, or a fifth of those with mortgages” are underwater (http://www.nytimes.com/2010/03/26/business/26housing.html?hp). One in five homeowners with a mortgage faces a mortgage that is larger in value than the market price of their home! In addition, many of these homeowners have lots and lots of other debts which they assumed in the Greenspan/Bernanke period of credit inflation. Thus, the default or bankruptcy problem does not exist just in the mortgage area.

Inflation, in the longer run, does not help the lower income brackets and it does not help the middle class. Most people cannot protect themselves against inflation, as can the wealthier classes in society, and the tendency is for those that are not of the wealthy classes to “stretch” their budgets, especially during periods of inflation, to acquire more than they can comfortably carry, financially. Furthermore, as we have seen, inflation tends to increase those that are underemployed in the economy as well as those that are unemployed. When the music stops, the family budget problems extend beyond just paying a mortgage.

This is the dilemma faced by the government in attempting to create a program that will prevent or slowdown defaults and foreclosures. It is not just the fact that the homeowner is underwater. The problem is that the mortgagee is over-extended in other areas and has a real cash flow problem.

The initial effort to provide relief to these troubled borrowers was to reduce interest payments that would reduce monthly mortgage payments. Over the past 12 months over 50% of all mortgages modified in this way defaulted, according to a report just released by the Comptroller of the Currency and the Office of Thrift Supervision. Mortgages that are at least 30 days late climbed to about 58% over the last twelve months. This seems to be evidence that the problem is more than just one of meeting mortgage payments. (See http://www.bloomberg.com/apps/news?pid=20601010&sid=aVYxPZ56vjys.)

The next effort, promised to be released by the White House today, will focus more on writing down the value of mortgages. It is expected that this will prove to be more beneficial to homeowners because it will result in a greater reduction in monthly payments and will reduce the psychological effect of having to pay off something that is larger than the underlying value of the asset it is financing. Another portion of the effort will be to have the F. H. A. insure mortgages that are re-written with lower loan balances, a risky effort for a tax-payer supported institution that is already facing financial difficulties.

There are several problems associated with such a program. First, if financial institutions re-write or re-finance underwater mortgages, the issue becomes one of the solvency of the underwriter. Almost one in eight banks in the United States is either on the problem list of the FDIC or near to being on this list. Can these banks afford to be forced to write off these losses in the near term?

Analysts argue that one of the things the initial effort did (the effort to reduce interest rates) is that it just “spread out” the banks having to deal with foreclosures and capital write-downs over several years. This, at least, allowed the banks to slow down the write-off process allowing them to continue to “stay alive” while they worked out their loan problems. This new program threatens these banks: the losses on these loans would have to be written-off sooner rather than later. Could this accelerate the closing of banks?

Another issue relates to whether or not these problems of “underwater” mortgages are connected to bigger issues than just the foreclosure on houses. It is the case that many of the people that purchased these houses were “stepping up” to a higher living standard and doing so created other payment obligations connected with the higher living standards. Many of the people that are underwater now re-financed in the years before the financial “collapse” and took out a lot of the equity built up in their homes to finance other purchases, perhaps a second home or an addition on the home or some other expenditure that allowed them to “step up.” Without the credit built up through the inflation in their home price they would not have been able to afford the purchases out of their cash flow, even if they continued to remain employed. In these cases the cash flow problem is more than just the difficulty in covering the monthly mortgage payment.

The point is that when a person, a business, or a society attempts to live beyond their means, events will, sooner or later, catch up with them. Inflation incents people to live beyond their means. We are observing the consequences of such behavior in the problems being experienced in the housing market.

Commercial Banks Continue to Struggle

The Federal Deposit Insurance Corp. presented us with the new list of problem banks. As of December 31, 2009, there were 702 commercial banks on the problem list of the FDIC. At the end of the third quarter of last year, the total stood at 552. If 3 to 4 banks failed every week, then roughly 39 to 52 banks failed last quarter. Thus, at least 200 new names were added to the list in the fourth quarter about 36% of the number on the list at the end of the third quarter.
The rule of thumb that I have heard used on bank failures is that approximately one-third of the banks on the problem list will fail over the next 12 to 18 months. If this holds true then about 234 banks will fail during this time period, roughly an average of 3 to 4.5 banks per week!

Right now the quarterly net loan charge-off rate and the number of loans at least 3 months past due were at the highest levels ever recorded during the 26 years that these data have been collected. As I have said many times, the important thing is that these charge offs are occurring in on orderly manner. The banks seem to be able to absorb these loses without substantial disruption to their operations. Also, the closing of so many banks by the FDIC seems to be taking place in an orderly manner without substantial disruption to the banking business.

The banking system, as a whole, continues to be risk-averse at this time as banks continue to reduce the amount of loans of their books. In this the FDIC data are consistent with the call report data released by the Federal Reserve in that the total loan balances on the books of the banking system continue to decline.

The economy may be recovering but the outlook for the banking industry remains dark. Other news released this morning point to a continued dismal future. The Gallup organization released information that suggested that 20% of all workers in the United States are underemployed.
This is a larger number than put out by the labor department and is attributed to the fact that the Gallup data are not seasonally adjusted.

However, this does not seem inconsistent to me with the information, also released this morning, that consumer confidence dropped precipitously in February from a revised 56.5 to 46.0. Furthermore, consumer expectations for economic activity over the next six months fell from a revised 77.3 to 63.8. In addition, the people that are expecting more jobs in the near future fell while the proportion of those expecting fewer jobs rose. More than 17% of the respondents expected their incomes to fall over the next six months, while 9.5% expected their incomes to increase.

This is not good information to the banks as foreclosures and bankruptcies continue to increase. Furthermore, there is more and more information about people walking away from properties after allowing their loans to go delinquent, even though they might be able to pay the loans. It seems as if more people are arguing that the decision to abandon a house is a “business decision” and not a decision about whether or not to leave a “home.” If the price of the “home” is less than the mortgage, then the “home” becomes a “house” and is abandonable.

But, banks, and others, still face several other serious shortfalls in the future. The commercial real estate situation is well known and Elizabeth Warren, head of Congressional oversight on the TARP funds has claimed that 3,000 commercial banks face a potential torrent of defaults on commercial properties.

State governments continue to teeter on the fiscal edge as state tax collections declined in the fourth quarter of 2009 for the fifth quarter in a row. State governors, meeting in Washington, D. C. this last weekend, warned Washington, as well as the nation, that the fiscal year beginning in July 2010 will be the most difficult of any met so far during this financial and economic crisis.

City and municipal governments also have their backs against the wall with many of them now considering the pursuit of Chapter 9 bankruptcy. This, too, is not a good sign for the banking community.

Both the cities and the states are soliciting Washington, D. C. for more and more stimulus money cover their needs. They obviously do not see their salvation coming from the private sector. But, what about the federal government? Is there any hope here?

One answer comes from the likes of Joe Stiglitz, Paul Krugman, and others with a similar leaning: the federal government has erred on the side of not spending enough. Washington just has to spend more and more and more until jobs stabilize, incomes begin to rise, and confidence turns upward once again.

The other side? The other side is represented by Bob Barro who has another op-ed piece in the Wall Street Journal this morning. (See http://online.wsj.com/article/SB10001424052748704751304575079260144504040.html.) Barro has contended all alone that the spending and taxing multipliers used by the Obama economics team far overstates the real effect that the government fiscal stimulus program has on the economy. To quote his results: “Viewed over five years, the fiscal stimulus package is a way to get an extra $600 billion in public spending at the cost of $900 billion in private expenditures. This is a bad deal.”

Add to this the fact that the deposit insurance fund fell by $12.6 billion in the fourth quarter of 2009 to $20.9 billion; and the only proposal on the table being to assess the banking system to replenish the fund. It looks inevitable that the federal government will have to provide some sort of assistance to help keep the fund solvent. Oh, and then there is the upcoming costs related to Fannie Mae and Freddie Mac (http://online.wsj.com/article/SB10001424052748704259304575043573979877134.html?mod=WSJ_Opinion_AboveLEFTTop). But, the addition to the deficit from these outflows relates to things that have happened in the past, there is no stimulus or job creation here but some fairly sizable price tags.

None of this is good news for the banking system. Is it possible for the list of problem banks to reach 1,000? Probably not at the end of the first quarter of 2010, but maybe in the second quarter. Remember that there are only slightly more than 8,000 commercial banks in this country. Can you imagine if one out of every eight banks were on the problem list?

Housing and Banking

One of the most disturbing statistics around these days is the status of home owners. The New York Times reported yesterday that it is estimated that one-third of homeowners with a mortgage, or 16 million people, owe more than their homes are worth. Any further drop in home prices, of course, would just enlarge that figure and exacerbate the problem.

This, to me, raises additional concern about the banking industry. My guess is that banks, and other financial institutions, haven’t taken this potential write down onto their balance sheets. For one, they don’t know which individuals in the 16 million are going to default on their mortgage and they don’t know when that is going to happen.

This is, of course, a very important reason for banks not to lend at this time. They are uncertain as to the real condition of their own balance sheets.

The forecast is for a new flood of foreclosed homes to hit the market later this winter and spring.
It has been argued that the best way to assist troubled borrowers is not through reducing the interest rate that has to be paid on the mortgage but by reducing the balance of the mortgage. But, this would mean that in reducing the balance on the mortgages of troubled borrowers, the banks would have to take the loss immediately, something they may not have reserved for, given the fact that they don’t know exactly who is going to need assistance. Many of the plans require the borrower to come in for assistance.

This, however, would reduce the capital that the bank has and threaten the existence of the bank.

And, how many banks are already on the problem bank list of the FDIC? At the end of the third quarter of 2009 the number was 552.

What might be the strategy of the banks?

Well, if banks amend the mortgage agreement to include a lower interest rate they do not have to recognize any loss on the loan at the present time.

But, analysts have said, this just postpones the problem and, in all likelihood, the borrowers will still not be able to pay back their mortgage and so this just slows down the recognition of the failure of the loan.

Right! That is the point!

Banks gain something by adjusting loan rates. They lose by granting principal reductions. By adjusting loan rates, they don’t have to take a charge-off right now. If they grant principal reductions they do have to take the charge-off right now.

Bankers are always more willing to postpone taking charge-offs in the hopes of the environment improving. At least that was my experience in doing bank turnarounds.

Furthermore, the location of the problem we are discussing is in the small- and medium-sized banks in this country.

The big banks, they are running away with huge profits gained from the excessively low interest rates (thank you Fed!) and the large trading profits made in bond and foreign exchange markets. This is not their problem, now.

Also, these small- and medium-sized banks face additional problems down the road in commercial real estate, car loans, and other extensions of credit made during the credit inflation of the 2000s.

It seems to me that Main Street is still not “out-of-the-woods” and that 2010 may be the time when the Main Street “shake-out” really occurs. I hope not, but we need to be aware of this possibility.

The total of 552 troubled banks is really disconcerting. It only seems to me that this number will rise in 2010 before it begins to fall. Best guess is, however, that there will be a lot of bank failures this year.

BERNANKE BUBBLE

I would like to recommend the article in the New York Times this morning by David Leonhardt with the title “If Fed Missed This Bubble, Will It See a New One?” (http://www.nytimes.com/2010/01/06/business/economy/06leonhardt.html?hp)

I would also suggest reading this article along with reading my post from Monday, January 4, “The Bernanke Fed in 2010.” (http://seekingalpha.com/article/180764-the-bernanke-fed-in-2010)

Leonhardt quotes the recent Bernanke speech with regards to “lax regulation”: “The solution, he (Bernanke) said, was ‘better and smarter’ regulation. He never acknowledge that the Fed simply missed the bubble.”

Going further Mr. Leonhardt argues that “This lack of self-criticism is feeding Congressional hostility toward the Fed.” It is also fueling the criticism of other interested parties.

“He (Bernanke) and his colleagues fell victim to the same weakness that bedeviled the engineers of the Challenger space shuttle, the planners of the Vietnam and Iraq Wars, and the airline pilots who have made tragic cockpit errors. They didn’t adequately question their own assumptions.
It’s an entirely human mistake.”

From which Leonhardt concludes: “Which is why it is likely to happen again.”

Need I say more?

The Supply Of and Demand For Loans at Commercial Banks

More and more stories are appearing that exhibit the reasons why the commercial banks below the behemoth size are not seeing their lending growing. And, the evidence appears to be that the slowdown in lending is being affected by the demand for loans from businesses and households as well as by the supply of loans coming from the banking sector.

Yesterday, I touched on the aggregate balance sheet figures published by the Federal Reserve. (See, http://seekingalpha.com/article/165994-commercial-real-estate-lending-problems-hitting-the-smaller-banks.) One can interpret the most current data as showing that the financial difficulties that larger commercial banks have been facing are migrating to the smaller banks and this is affecting bank lending activity.

This morning there were two articles in the New York Times on the front page of the business section that provide additional antidotes and analysis on what the “less-than-huge” commercial banks are facing. The first looks at the situation that some borrowers are facing in attempting to obtain loans from banks. This article, by Peter Goodman, “Clamps on Credit Tighten”, http://www.nytimes.com/2009/10/13/business/smallbusiness/13lending.html?_r=1&ref=business, emphasizes the difficulties small companies are having because they cannot obtain funds from the banking system at this time.

It becomes apparent within the article, however, that the shortfall of lending is not solely coming from the supply side. Raymond Davis, the chief executive of Umpqua Bank, in Portland, Oregon is quoted as saying, “Banks want to lend money. The problem is the effect that the recession is having on us. Some of these businesses are still trying to come out of it. For them to go to a bank, if they are showing weak performance, it is harder to borrow.” The Umpqua Bank is a regional lender.

In other words, businesses know that the banks have tightened their requirements when it comes to lending and they know that their balance sheets and income statements are not up to these new bank standards. Consequently, they are postponing even going to the bank until such time as they are in a position to get a favorable response on a loan application.

These business, of course, are ones that are not in such dire straits that they are desperate for funds and are trying to find any source they can for obtaining the funds that they need. Fortunately for them they can wait out the current state of affairs, at least for the near term. However, this delay means that people don’t get hired and inventories are not purchased and so economic recovery is pushed off longer into the future.

Also, these companies are restructuring in an effort to get their balance sheets in order: “Among small privately held companies, the amount of debt they carry as a portion of their equity has slipped by about 5 percent since 2007” the article reports. “The drop reflects not only how companies have cut their inventories and paid down debt, but also the tightened credit terms they face when they try to borrow.”

The intermediate term problem relates to the cumulative result that if firms can’t borrow, for whatever reason, they can’t conduct their business, they can’t hire people who then don’t have money to spend on things, and the firms can’t make profits to improve their balance sheets. The article contains several narrative stories on how this is playing out in various areas of the country.

Another article in the New York Times, deals with the “pace” of loan losses. See the article by Eric Dash, “Pace Slows on Losses for Banks”, http://www.nytimes.com/2009/10/13/business/economy/13bank.html?ref=business. The gist of the article is that although loan losses at commercial banks “are still expected to stay high through most of next year” the speed at which these losses are accumulating is lessening. Loan losses “haven’t peaked, but outside of mortgages, we are getting close,” according to Scott Hoyt. Again the evidence points to the differences in where the difficulties are coming. Larger banks are currently suffering more from delinquencies and defaults from consumers.

The “Less-than-large” banks are facing rising pressure from problems in the commercial real estate area. “Elbowed out of the credit card business and mortgage lending businesses by their larger rivals, (hundreds of small, community banks) began aggressively financing home construction projects as well as office, hotel, and retail development deals. Many of those borrowers are just starting to default, leading the banks to book giant write-offs and set aside more money to cushion future blows.”

That is, these charge offs are just starting to hit the books!

Some businesses are finding one possible source of funds that they have not tapped to any degree in the past. This is the bond market. As reported by Goodman, “As the financial crisis has largely eased in recent months, big companies have found credit increasingly abundant, with bond issues sharply higher.” This movement to bond financing seems to be occurring in companies that are smaller than big and it seems to be a worldwide phenomena. For information on this latter development see the article in the Financial Times, http://www.ft.com/cms/s/0/0abdb056-b78f-11de-9812-00144feab49a.html. These companies are using funds for the bond markets in ways that they formerly used bank lending for. Plus, they are not faced, in the bond markets, with some of the covenants and restrictions they faced with the banks.

This move by companies to obtain bond financing raises an interesting question. The question is this: What if this movement is part of the overall effort to “securitize” everything? That is, what if almost all funding occurs in “financial markets” and not in financial institutions as it mostly has been done in the past? Maybe this slowdown in bank lending will accelerate this movement to market-based financing. Then maybe the commercial banking industry will shrink as has the thrift industry (see my “Have Thrifts Outlived Their Usefulness”, http://seekingalpha.com/article/164533-have-thrifts-outlived-their-usefulness).

Certainly commercial lending is not the major part of the balance sheet of the commercial banking industry as it once was. Commercial and Industrial Loans at commercial banks, as of September 30, 2009, represent only about 12 percent of the total assets of the banking system. In January of 2000, this number was about 18 percent. In the 1980s, the number was substantially higher. The makeup of commercial banks is changing. Is the current move to greater use of the bond market just one more step along the path to the remaking of the whole financial system?

Just a thought.

Bank Failures Are Up: Way Up!

On Friday, bank failures for the year reached 77. In January or March of this year people started projecting that we may make 100 by the end of the year. I think that is as sure a bet as you can get these days. Now, we are seeing forecasts of over 200 more bank failures in the next 18 months.

The headlines over the past several days have been eye-catching. On Bloomberg.com, we saw “Toxic Loans Topping 5% May Push 150 Banks to Point of No Return.” On Reuters Blogs, we saw ”Citi’s Dirty Pool of Assets,” which reported that Citigroup had identified $39.5 billion that represented deep problems on its pool of subprime mortgages, of which it has only incurred $5.3 in looses leaving another $34 billion to go. Citi also faces problems in it CDO portfolio some of which it has hedged its exposure with credit default swaps. And, Jonathan Weil, in an article titled “Next Bubble to Burst Is Banks’ Big Loan Values” on Bloomberg.com, argues that the change in mark to market accounting early this year has covered up huge losses on the books of the biggest banks that were reported in the fourth quarter of 2008 but have since disappeared.

The good news in all this is that most of the troubled assets in banks have been identified and the regulatory bodies, particularly the FDIC, are fully aware of the most troubled banks. These individual insolvency cases are being worked out on a case-by-case basis. We got headlines in the newspapers this week because of the sell-off of Colonial BancGroup Inc. which was the largest bank to fail in 2009 and one of the most costly bank failures ever. But, this bank had been identified a long time ago and it has been systematically handled. The other four that failed this week did not claim headlines. This is good because the banking sector is staying relatively quiet. (See my post of August 10 on this http://seekingalpha.com/article/154998-banking-sector-stays-quiet.) Most bank failures over the next year or so will not get major headlines. (Our most optimistic wish is that none of the bank failures coming in the next year or so will warrant headlines.)

We are in the part of the credit or debt cycle where things are relatively calm: we are way past the phase of the cycle where liquidity was the primary issue. The problem now is not that financial institutions need to and want to get rid of assets as quickly as they can. We are in the “work out” phase of the cycle. Historically, the time it takes to “work things out” depends upon the depth of the collapse in asset values. The betting now seems to be that this time around, the “work out” phase of the cycle will be a relatively long one.

If we still have to go through 125 to 150 more bank failures in the next 18 months or so, the banking system as a whole is not going to be too aggressive in putting new loans on its books. And this will not result in a strong economic rebound going forward.

In addition, the amount of debt that is still outstanding in the economic system will remain a major drag on the banking system. The uncertainty pertaining to the future repayment of loans to the banking system, in the areas of commercial real estate loans, of credit cards, and because of another wave of residential loans that will be repricing over the next 12 months or so, is still a concern. This uncertainty will further restrain banks from being too aggressive in making new loans. (See my post of August 12, “The Debt Problem Poses a Two-Sided Threat to the Fed,” at http://maseportfolio.blogspot.com/.)

And, those who have borrowed will be reluctant to spend giving the uncertainties about the state of the economy, unemployment, foreclosures, and other economic dislocations. Even Paul Krugman has recognized the role that debt plays in spending. In a recent lecture Krugman discussed why the Great Depression did not re-start after World War II when almost all economists expected it to do so. He argued in this talk that by the end of World War II the private sector of the economy, households and businesses, had worked off most of the debt that it had taken on in the 1920s, but had not been able to eliminate in the 1930s. The private sector had deleveraged by the 1950s and was now ready to spend. Krugman contends that the private sector will not begin to spend again coming out of the current recession until it has deleveraged itself from the current buildup of debt.

The financial system and the economic system are working themselves out of their recent problems. Let us hope that things stay quiet. That means, we need to avoid any more surprises. If we don’t have surprises, there is a good chance that the recovery will start and will continue. This doesn’t mean that it won’t take a long time for the banks, households, and businesses to work through their current problems. It will. And, it doesn’t mean that other problems with respect to long term interest rates and the value of the United States dollar may not worsen because of the huge and increasing load of federal debt.

This “quiet” does give us some hope that we are moving in the right direction. There will continue to be bank failures, and foreclosures, and bankruptcies, and more. But, they can be worked through if we don’t get too impatient.

"Problem" Banks and the Economic Recovery

Sheila Bair, chairwoman of the Federal Deposit Insurance Corporation, released the latest information on “problem” banks on Wednesday. The list now includes 305 institutions, up from 252 at the end of 2008. We have had 36 bank failures this year and if no more than a quarter of the “problem” institutions fail, we will be over 110 bank failures for the year. This is nowhere near a record and the cumulative number of failures since the beginning of the recession in December 2007 is minimal compared with what happened in the 1988 to 1991 period.

This raises a question about how many more financial institutions are going to merge or close in the next two to three years. If the historical record is any indication, one could argue that a minimum of 100 banks or thrift institutions will close each year for the next two years. Bank closures are not a leading indicator of economic health and can continue for some time even after the economy begins to recover.

The basic scenario that we are looking at for the next two to three years or so is a stagnant economy for much of the time. Economic growth is supposed to be tepid for an extended period of time. Mohamed El-Erian of the bond fund PIMCO stated the other day that PIMCO was expecting the United States economy to grow by no more than 2% or less in the near term. Given that potential real GDP will only be growing at a crawl during this time, unemployment will stay around 8% or above, something similar to the period from January 1975 through to February 1977 where the unemployment rate was at 7.5% or above and the period from October 1981 through to January 1984 where the unemployment rate was above 8.0%. Thus, from January 1975 through to January 1984, unemployment averaged more than 8%.

Within such an environment, foreclosures and bankruptcies will continue to increase and more and more personal loans and mortgages will have to be charged off bank balance sheets. Furthermore, this environment will not be a good one for non-financial business and many more businesses will close their doors. The restructuring of industry will continue as businesses attempt to align themselves with the markets and technologies of the future. This will impact commercial and industrial loans and more of these will have to be charged off going forward.

There is great concern in the F. D. I. C. and beyond about the adequacy of current loan loss reserves in financial institutions. The underlying fear is that a lot of banks have not sufficiently reserved for the loan losses they will be facing in the near future. Bankers have a tendency to be slow in accepting the fact that so much of their loan portfolio is severely challenged. It is a historical fact that reserving for loan losses tends to lag behind the need to build up bank coffers for future charge offs. The present time is not an exception.

This is not a scenario that contains a lot of enthusiasm for producing loan growth. For one, the focus of the bankers should be upon cleaning up their balance sheets. Therefore, they should not be looking for new loans or new sources of loans. These bankers should be focused internally on what they already have on their books. They need to be focused on the performance of existing loans, on working out existing loans, and on charging off loans that are no longer performing.

As many analysts have stated, we still are anticipating increasing charge offs connected with credit cards, consumer loans and commercial real estate. Furthermore, we still have not reached the end of the problems connected with residential mortgages. And then there are the business loans to keep small and medium sized businesses going. The point of all this is that “we are not out of the words yet” in the banking sector.

Secondly, there is not going to be a lot of acceptable loan demand coming into the banks. Credit standards are higher now than they have been for a long time. Bankers are getting back to the idea that you don’t deserve a loan from them unless you are so well off that you don’t really need a loan from them. This has recently been referred to as “boring” banking. Boring, yes, but also prudent.

Some analysts are arguing that the trouble in the smaller banks is not as big a problem as that for the larger banks. Stuart Plesser, a banking analyst at Standard & Poor’s in New York has been quoted as saying that smaller banks were more vulnerable to a souring economy than larger institutions because they were more specialized or focused on a particular region. “But,” he continued, “the repercussions of the failures among the smaller institutions were not as severe for the overall economy as they would be if a larger bank stumbled because the big banks are more important to the economy. It’s not as big a hit if the small fail.”

This may be true in terms of the “systemic” risk in the banking system, but it is not true in terms of the impact of bank failures on “Main Street.” Because the small and medium sized banks are “more specialized or focused on a particular region,” their failure can contribute to the weakness in the local or regional areas they serve and, hence, can slow down any turnaround or recovery that might take place there.

For the past year or so, we have been focusing on big banks and the problem of systemic risk. Now we need to turn our attention to the rest of the banking sector for there is still much work to be done there. Bank failures are going to rise and remain at a relatively high level for an extended period of time. This is an adjustment process that the economic and financial system must go through. It will be a painful process, but there is little that the government could or should do to accelerate the restructuring.

One comment on recent discussions of the government’s P-PIP. Enthusiasm for this program is waning. As I have written, the problem with the toxic bank assets the government has been worrying about is not a “liquidity” problem. The problem is not that certain “legacy” loans or securities cannot be sold within a reasonable period of time. The problem has been that the value of the loans and securities has been in question because of the quality of the assets. The government has been trying to “force” a sale of these assets. But, this is not the problem. The problem is one of working out the value of the assets and the solvency of the banks themselves. An effort to “force” the sale of bank assets is only a program to “socialize” bank losses so that the government can transfer the losses from the banks to the tax payer and does not resolve the ultimate problem. As the banks are attempting to re-capitalize the solvency issue becomes less pressing and so the interest in the program drops off. Except in the case where the government allows the banking system to make a risk-free re-purchase of their own assets at a profit!