The Smaller Banks Continue to Lose Ground

First, we need to define what the Federal Reserve calls “Small” banks.  The Federal Reserve defines small banks as domestically chartered banks that are not counted among the largest 25 domestically chartered banks in the United States.  Hence, “Large” domestically chartered banks are the largest 25 domestically chartered banks in the United States. 

As of September 7, 2011, the largest 25 domestically chartered commercial banks in the United States account for 56 percent of all the banking assets in the United States.  The smaller banks represent about 28 percent.  Foreign related financial institutions control about 16 percent.    

From August 2010 to August 2011, the total assets held by the small banks in the United States grew by one-half the rate at which the total assets in the largest 25 banks.  The “large” banks grew at a 1.4 percent annual rate while the “small” banks grew by 0.7 percent.

Over the last calendar quarter from the banking week ending June 1 through the banking week ending September 7, the smaller banks actually shrank by almost $20 billion while the larger banks grew by about $165 billion. 

Over this last quarter, “Loans and Leases” at the smaller institutions dropped by almost $70 billion.  At the largest 25 banks, “Loans and Leases” rose by over $130 billion.  At the smaller banks, loans fell in ALL categories. 

From the banking week ending August 3 through the banking week ending September 7, “Loans and Leases” at the smaller banks rose by only $1.5 billion while they rose by more than $30 billion at the 25 largest banks. 

One could say that lending activity is increasing on Wall Street but not on Mail Street.   One could ask questions, however, about the type of loans that the larger banks are initiating.  See my posts from last week: http://seekingalpha.com/article/293657-bankers-expect-weak-profit-performance-in-the-future and http://seekingalpha.com/article/293893-some-banks-are-stretching-for-risk.   

But, business loans are not suffering the most at the smaller banks.  Over the past year, residential real estate loans (home mortgages) at these smaller banks have declined by more than 6 percent, year-over-year.  Over the past quarter these loans have fallen by $12 billion. 

And the smaller banks still are suffering through the commercial real estate decline as these loans declined by almost 7 percent, year-over-year through August.  Commercial real estate loans at these banks declined by more than $40 billion over the last quarter alone. 

The FDIC reports that there were 6,413 commercial banks in the banking system as of June 30, 2011.  Of this number, 865 banks were included on the FDIC’s list of problem banks for this date, more than 13 percent of the banks in insured at that time.  Troubled banks total even more than this, some estimate that more than twice this number are very fragile institutions. 

From these data one can argue that bank lending activity may be picking up, but it is not picking up among many of the smaller banking institutions that still face serious balance sheet troubles.  These organizations are not going to participate in any economic recovery and, in fact, are going to have to be closed or absorbed into the banking system that will remain.  As mentioned above, even though loans may be picking up in the largest 25 banks in the country, the loans may not be going into the physical investment that would cause the economy to grow faster than it is. 

FOREIGN RELATED INSTITUTIONS, QE2, AND THE EUROPEAN BANKING CRISIS

Dollar deposits continue to flow out of the United States into foreign banking offices through domestically located foreign related institutions.  From August 2010 through August 2011, cash assets at these domestically located foreign related institutions rose by about $470 billion!  This increase in cash assets tracks closely the Federal Reserve’s implementation of QE2 and represents about 75 percent of the roughly $630 billion rise in cash assets of the whole United States banking system. 

The interesting thing for our purposes is that the item on the other side of the balance sheet that most closely tracks this increase in the cash assets of foreign related banking institutions is “Net Due to Foreign Offices.”  That is, this money is going off shore. 

From August 2010 through August 2011, this account, “Net Due to Foreign Offices”, rose by almost $540 billion.  In the last quarter it rose by over $160 billion.  In the last month it rose by $112 billion. 

Can the rise in this this account be associated with the sovereign debt crisis in Europe and the recent problems faced by many of the large European banks?

I believe one can make a pretty strong case for this conclusion.  The Fed’s QE2 preceded the agreements that the central banks made last week to provide more US dollars to European banks. 

Of course, this provision of US dollars to the world is not spurring on economic growth although it may be helpful to preventing another Lehman Brothers meltdown.  

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.

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.

The Troubled Smaller Banks and Elizabeth Warren

For over nine months I have been expressing my view about the problems being faced by many of the small domestically chartered banks in the United States. Very little has been forthcoming from public officials about the problems of these smaller financial institutions. Well, yesterday, Elizabeth Warren, the Chair of the Congressional Oversight Panel, in testimony given to the U. S. Senate Committee on Finance, provided us with a little insight into what government officials are working with.

Here are some of her written comments: “The Panel’s most recent report analyzed the participation of small banks in the CPP (the Capital Purchase Program of the Troubles Asset Relief Program--TARP). Under the program, Treasury put money into 707 banks. The Panel found the experience of small banks differed substantially from that of the nation’s largest financial institutions. Seventeen of the 19 U.S. banks and bank holding companies, with assets totaling more than $100 billion, received the majority of funds (81 percent), most getting their money within weeks of the announcement of the program. Now 76 percent have repaid their TARP funds and returned to profitability. On the other hand, small banks entered the program more slowly, and ultimately most—about 90 percent—stayed out of TARP altogether. Notwithstanding the fact that those small banks that received TARP funds were required to prove their financial health, fewer than 10 percent have managed to repay their TARP obligations, and 15 percent have failed to pay at least one of their outstanding dividends. Their problems are substantial. Small banks face serious difficulties with the coming wave of commercial real estate loans resets. Moreover, small banks do not have the same access to the capital that larger banks have, and investors know that these regional and local banks are not too big to fail. Worse yet, if they cannot exit from TARP in the next few years, they face a TARP dividend that will increase sharply from 5 to 9 percent.

TARP gets its name from the so-called “troubled assets” that were weighing down the balance sheets of the nation’s financial institutions. The meltdown in the subprime mortgage market—and the eventual spillover effects into the prime and alt-A mortgage markets—saddled banks with assets composed of or derived from residential mortgages. These securities became difficult to price and hard to sell. Nearly one year after the passage of TARP, the Panel reported that these same assets continued to impair bank balance sheets. Today, some of these same assets continue to encumber the balance sheets of many banks—especially smaller banks that are also heavily exposed to commercial real estate assets, as the Panel identified in our most recent report. So long as the residential housing market remains weak and homeowners continue to default on their mortgages and fall into foreclosure, these troubled assets will continue to pose challenges for financial institutions.”

In verbal testimony, Ms. Warren provided a number: the number was 3000. She stated that 3,000 small banks faced serious problems in the future related to the residential housing market and the “wave of commercial real estate loan resets” forthcoming in the future.

I presume that this does not include the almost 800 commercial banks that were on the FDIC’s list of problem banks as of March 31, 2010 since these banks are already “problems”.

If her number is added to the number of banks on the FDIC’s list then we have close to one-half of the domestically chartered banks in the United States facing the substantial “challenges for financial institutions.”

One-half of the banks in the United States are facing “serious difficulties” and that ”investors know that these regional and local banks are not too big to fail.”

No wonder that the Federal Reserve is keeping its target interest rate close to zero and expects to keep the rate at this level for an “extended time.” Again, expectations are for this target rate to stay near zero into the third quarter of 2010, a period that goes beyond when most of these large commercial loans are supposed to reset.

The real estate bubble of the 2000s will not go away. It is the gift that just keeps on giving!