European Bankers Balk at Big Write Downs

In my experience there are three ways for bankers with “bad” assets to move on.  First, the bank can “work out” the bad assets, but this takes time and in some cases a lot of luck.  The “lot of luck” component of this solution often refers to a recovery of the economy, local or national, that lifts up all asset values and brings the value of the “bad” assets more in line with the accounting values that exist on a banks’ balance sheet.

The second way is to get someone else to take over the “bad” assets.  Can the bankers find a “sucker” to acquire the “bad assets” at a price near book value and relieve the bank of the need to write down the value of the asset?  There are “suckers” out there, but the “suckers” then have the problem of having an overvalued asset on their balance sheet.  Of course, in some cases, the “sucker” turns out to be the government…or, should we say the “sucker” turns out to be the taxpayer. 

Third, the bank can write down the assets to a realistic value and get on with business. 

The first way is what bankers generally try to do.  Bankers are notorious for their optimism concerning the value of the assets on their balance sheets.  “We just need a little more time and everything will be fine.”  “The borrower just had some bad luck, but is getting things back in order.”  “The economy is improving and we just have to hold on until things get better.”  Of course, in the case of bonds on the balance sheet: “We plan to hold on to them until maturity.” 

In many cases, the old line applies: “People told to smile because things could be worse, so I smiled and sure enough things got worse.”

When the hole gets deeper the problem becomes more severe. 

I have successfully completed three bank turnarounds in my professional career and my general impression is that bankers tend to “look the other way” and postpone dealing with their problems, particularly when the problems pile up.  In many cases, the time runs out and the bank either has to be sold or taken over or has to be closed.

In terms of the second avenue, “suckers” are all around.  However, in the case of one bank “selling” a “bad asset” to another investor, the bank escapes the problem of dealing with an overvalued asset, but the “system” does not get rid of the overvalued asset.  It still has to be dealt with.  In the case of the government (Fannie Mae or Freddie Mac) buying the asset, or, as in the case of the FDIC closing a bank, or, in the case where the government “bails out” a company or an industry and sets up a company with the “bad assets, the government must absorb the difference between the accounting value of the asset and the market value of the asset.  The losses incurred in this way must be paid by the taxpayer over time. 

Admitting one made a mistake and writing down the value of assets is the only way for a bank to really get on with business.  This is a hard thing to do, but to recognize the problem early on and deal with the problem as soon as possible is the only way to allow the bank to get back to the business as usual.  If bankers take the first or second route mentioned above, they lose focus and their performance suffers. 

This is why I am such an advocate of banks marking their assets to market on a regular basis.  It forces them to address their problems as early as possible and after facing their problems head on, they can then turn their focus back to what they should be doing, making loans and building their customer base. 

Even in the case of the bankers buying long-term securities with short-term funds: bankers are doing this to increase the interest rate spread they earn.  They are intentionally taking on interest rate risk in order to improve their performance.  To me it is disingenuous for these bankers to act surprised and perplexed when interest rates rise and the market value of their long-term securities drop relative to their accounting value.

The problems bankers face related to overvalued assets can never really go away until the bankers fully embrace the situation and write down the value of their assets to realistic values.  The asset values must be written down to a level that, at least, eliminates the uncertainty about whether or not the bankers are fully recognizing the problem.

This is one of the freedoms of coming into a troubled situation to “turnaround” a bank.  The “turnaround” specialist can assume a “worst case” scenario and write down assets sufficiently to eliminate the uncertainty surrounding the value of the assets.  If the “turnaround” specialist does not do this, he or she is only creating further problems for themselves sometime down the road.  It is the only way to move on!

European banks still appear to be somewhere in the middle of these three paths to the future.  See, for example, the piece “Bankers Balk at EU push for Bigger Greek Losses” in Bloomberg this morning. (http://www.bloomberg.com/news/2011-10-16/bankers-balk-at-eu-push-for-bigger-greek-losses-higher-capital.html)

The problems faced by the European banks are huge.  The problems faced by European governments are huge.  The lack of fiscal discipline on the part of European governments for the past fifty years or so has caught up with both the governments and the banks that supported this deficiency.  Now, the governments and the banks find that they cannot continue to ignore the problem and hope for things to get better.  Furthermore, the governments and the banks cannot just push the problems off on the taxpayers.

Still they continue to hold out!

The only way the Europeans can resolve their current difficulties is to “bite the bullet” and accept the fact that several of the governments in Europe are insolvent and that the value of the sovereign debt issued by these governments must be written down to values that will eliminate the uncertainty pertaining to whether or not the governments are really accepting the severity of the problem. 

A difficulty inherent in this solution, however, is that the European Union may have to become more politically unified.  Letting the EU dissolve at this time is almost unthinkable and would end up, I believe, in an unconscionable banking catastrophe for the continent.  This may be the “unforeseen consequence” of the formation of the EU…that the crisis resulting from the way the union was initially set up may result in the nations of the EU forming a more unified political structure.  Imagine…

But, the financial problems will not go away as long as those running the governments of Europe continue to face up to the real issues and then deal with them.  The real issues relate to the fiscal irresponsibility of several of the European nations and the consequent insolvency that has resulted.  This insolvency is threatening the insolvency of the European banking system.

Unless this reality is accepted and acted upon, the crisis will just continue to play itself out. 

The Solution to the European Problem?

“The bare minimum the eurozone needs to cope with its crisis is an effective mechanism for writing down the debts of evidently insolvent private and sovereign borrowers, such as Greece; funds large enough to manage the illiquid bonds markets of potentially solvent governments; and ways to make the financial system credibly solvent immediately.”

‘

This is the prognosis of Mr. Martin Wolf, the economics editor of the Financial Times, in today’s edition of the paper. (http://www.ft.com/intl/cms/s/0/3ba2f7c4-ee76-11e0-a2ed-00144feab49a.html#axzz1ZuI4wzxo)

“Yet, alas, the eurozone requires more still: it needs a credible path of adjustment, at whose end we see weaker economies restored to health.”

The word is getting out…the European banks are going to have to take bigger write downs of their holdings of sovereign debt than ever imagined. 

Can the eurozone governments cover the hole in the balance sheets of these banks?

The United States stock market seems to think that they can.  This is the reason given for the rapid recovery of stock prices in the market yesterday. 

But, let’s look more closely at what Mr. Wolf is saying.  In the first condition, he writes about how the amount of the write down will be determined along with how the write down will be administered.  This is a daunting task in, and of, itself. 

Note further, however, that he is including ‘private’ debt along with the debt of sovereign borrowers.  The need to write down the ‘private’ debt is something new, something that has not gotten a lot of attention in the press in all the noise relating to the sovereign debt issue.  

The second point Mr. Wolf makes is about contagion.  How is any write down of the debt of the peripheral nations going to be kept to just the peripheral nations bonds, themselves?  The concern is that once write downs take place in bonds of the fiscally weaker nations that some spread is bound to occur to the nations that are in a stronger position, fiscally.

Then, Mr. Wolf addresses the issue of credibility.  Given all the “messing around” for the better part of almost three years, how can financial markets come to believe that solvency has been restored to the impacted nations?  If anything has increased over the past three years or so, it is the lack of trust in the eurozone governments when it comes to how the politicians carry out their responsibilities.  There is little or no trust in the people heading up most of the governments in Europe.  Can this “trust” be regained…and in time?

The add-on to this analysis is that the eurozone countries also need an immediate return to a robust economic recovery.

The happy conclusion to the analysis: “If such a path is not found, the eurozone, as it is now, will fracture. The question is not if, but when. The challenge is simply as big as that.”

Two comments on this analysis: first, I am glad to see that some people are finally seeing the problem as one of solvency and not one of liquidity.  It has taken a long time for the analysis to get to this point.  Now, it is time for the policy makers to accept this fact.

Second, Mr. Wolf pretty well lays out the dislocation that is going to have to take place in order to restructure and restore the eurozone to some sense of order and balance. 

“How, then, did the eurozone fall into its plight? The easy credit conditions and low interest rates of the first decade (of the European Union) delivered property bubbles and explosions of private borrowing in Ireland and Spain, incontinent public borrowing in Greece, declines in external competitiveness in Greece, Italy and Spain and huge external deficits in Greece, Portugal and Spain.”

The European condition is the result of credit inflation!  Quite an admission for a dyed-in-the-wool Keynesian!

The point is, however, that a long period of excesses must be matched by a painful and uncomfortable period of restructuring. 

In conclusion, however, one cannot ignore the social situation in Europe.  The “social contract” of the post-World War II era appears, to many, to be broken, and there is protesting and rioting in the streets.  Strong economic growth and low levels of unemployment, something that seems more and more unlikely to happen in the near future, of course, can resolve this situation.  Writing a new “social contract”, as history shows us, is not an easy thing to do.

Are there any lessons here for others?

The Banking Mess: It's Not Over Until It's Over

Credit inflation impacts asset values.  In a credit inflation, the expansion of credit takes place at a faster rate of growth than does the rate of increase in the production of the underlying assets.  Credit inflation can create bubbles. This occurred, as we know, in the dot.com bubble of the 1990s and the housing bubble of the 2000s.

The Federal Reserve is desperate to get credit inflation going again. This was the whole point behind the Fed’s QE2 operations.  Now, we have a version of “Operation Twist” an effort to lower longer-term interest rates relative to shorter-term interest rates.   

At present, the only bubbles the Federal Reserve has created have been in foreign assets like commodities and the stocks in emerging markets.

So far, the policy of the Federal Reserve has not been very successful in the way of domestic assets.  Credit expansion in the United States remains moribund.  And, as a consequence, asset prices seem to be remaining level.

Housing prices continue to fall, or, at best, stay relatively constant.  The stock market has gone nowhere.  Year-over-year, the Dow-Jones Average is up just 0.8 percent.  Since the same time in 2007, around the start of the recent recession, the Dow-Jones Average is still down 21.6 percent.

The only major borrowers of any consequence seem to be the largest companies and they seem to be either holding onto the cash or using the cash to repurchase their own stock.  Where once it was felt that these funds would be used for the acquisition of other companies, so far the number of acquisitions taking place have fallen below expectations as the future remains listless and uncertain.

We still have to look at the banking system for any sign of a recovery in credit and the credit inflation cycle.  And, in looking at the banking system, the signs of expansion still are absent.

A start up of bank lending is going to depend upon the status of the banks themselves…and this picture is mixed, at best.

The good news is that the FDIC is closing two of its three temporary offices.  Due to a decline in the amount of bank problems and the severity of those problems, the FDIC has decided that it can handle problem banks primarily out of its permanent offices.  The period of the ramping up of staff and the sending of staff all over the country, seven days of week, seems to be over.

Also, only 74 commercial banks have been closed this year through Friday, September 30.  In 2010 the total number of banks that failed were 157 with 30 closings coming in the fourth quarter of the year.  In 2009 a total of 140 banks failed.   Bank failures are on the wane.

Note that the number of bank failures does not include the decline in the number of banks in business.  For example, since December 31, 2007, 396 commercial banks have failed.  Yet, the number of banks in the banking system declined by 871.  This left the commercial banking system with 6,41 banks in existence. 

Likewise, about 1,000 banks and savings institutions have disappeared since the end of 2007, leaving only 7,513 FDIC insured institutions in existence on June 30, 2011.

And, still there are 865 banks on the FDIC’s list of problem banks at the end of June, down only slightly from a total of 884 at the end of March 2011.

“Camden Fine, president of the Independent Community Bankers of America, a trade group, predicted another 1,000 to 1,500 banks will vanish between now and the end of 2015.” (http://professional.wsj.com/article/SB10001424052970204138204576603130578559172.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj)

My prediction has been more in the range of a further decline of 2,000 to 2,500 banks.  This will put the total number of commercial banks in the United States below 4,000.  And, I believe that the total number of FDIC insured institutions will drop below 5,000. 

The way that credit inflation works is through the rate of increase in asset prices.  In essence, if asset prices are increasing rapidly, the “real” value of the credit goes down making it much easier for the debtor to handle the increased leverage on his/her balance sheet.  This is, of course, what happened over the last fifty-year period of credit inflation. 

But, credit inflation is a cumulative process.  As people begin to borrow more, asset prices begin to rise.  And, as asset prices rise, borrowing, in real terms, becomes cheaper and so more borrowing takes place.  But, this causes asset prices to rise further, and so on and so forth.

Right now, people and businesses are not borrowing.  They are trying to reduce their debt loads because asset prices are remaining relatively constant or are declining.  The Fed is trying to get to the first stage of the cumulative process…to get people to begin borrowing again.  The commercial banks, especially the small- to medium-sized ones are not contributing to this cycle, either because the people aren’t borrowing or because the banks, because they are in trouble, are not lending. 

And, on top of this the commercial banks face two other problems.

First, the banks are facing a tougher regulatory environment that is resulting in increased costs of doing business.  Either they have to absorb the increased costs…or they have to pass them along to customers.  The debit card fees announced by Bank of America and others are just one result of this.  There is more, a lot more, coming.

Second, the banks are facing further interest margin squeezes due to the Fed’s “Operation Twist.”  Balance sheet arbitrage is dependent upon the ability of the banks to “borrow short” and “lend long.”  If these margins are narrowed because of what the Fed is doing, more pressure will be put on the banks to raise fees in order to survive.  The small- and medium-sized banks will suffer more because of this.

I believe that we need to keep a close eye on the banking system to determine whether or not the economy is going to pick up.  The banking system is still in a troubled state.  If either Camden Fine, of the Independent Community Bankers of America, or myself is correct about the continued decline in the number of banks in the United States, the commercial banking sector has a lot of adjustment to go through over the next four years or so and the focus of the industry will not be on lending. 

On the other side, the Federal Reserve is acting relentless in its efforts to start up credit inflation once again.  And, given the political climate in Washington, D. C. I don’t see any change in this attitude.

The question then becomes, when do we reach the tipping point?  When does the unwillingness of the banks to lend and the unwillingness of families and businesses to borrow lose out to the efforts of the Fed to create the credit inflation it so badly wants?  The problem is that once a tipping point is reached, the cumulative credit cycle buildup begins and I don’t really see how the Fed can prevent this from happening. However, there is no indication that another bout of credit inflation will produce more robust economic growth and job creation.   Still, keep your eye on the banks.

Wanna Chance to Double Your Money in 30 Days?

Why do large investors…hedge funds and others…like governments to get involved in financial affairs?

Because these investors can make lots of money from the actions of these governments. 

Ask George Soros about the behavior of the British government in the 1990s.

Now we have another possible piggy-bank on the horizon…thanks to the Greek government and the Eurozone.

“Under the deal Greece struck in July with its banks as part of Europe’s rescue plan, a substantial portion of its existing bonds are scheduled to be swapped into new longer-term securities that could be valued at more than 70 cents on the euro.” (http://www.nytimes.com/2011/09/29/business/global/hedge-funds-betting-on-lowly-greek-bonds.html?_r=1&scp=1&sq=greek%20bonds%20lure%20some,%20despite%20risk&st=Search)

Why is this “deal” important?

Many Greek government bonds “are changing hands for as little as 36 cents for each euro of face value.” 

Making money on this deal requires that the latest Greek bailout system is ratified by the parliaments of the 17 European Union countries that use the euro by late October. 

If the EU deal closes, “those who bought the bonds recently at distressed prices might in some cases come close to doubling their money.”  And, in only one or two months time!

Again, investors benefit…taxpayers suck it in…

“According to a person with direct knowledge of the debt swap, about 30 percent of the investors who are expected to participate in the (deal) bought their bonds after July 21.  They are not the original debt holders…”

What governmental “leaders” don’t seem to understand is that once they take a position, many other people in the world will change their positions to take advantage of the new position of the government.  Things just don’t stay the same.  And, if these “leaders” follow the same strategy over and over again…others will take advantage of the repeat strategy and use it against the “leaders”.

In the case of the European Union, the “leaders” of the EU have tried repeatedly to “kick the can” down the road.  By failing to take action in the past, these “leaders” have postponed the actions that must take place.  But, by postponing and postponing the day when the actions will take place, the “leaders” have just limited their options and created situations in which large investors can take advantage of the dislocations that have developed in financial markets. 

If the “leaders” had been leaders and had moved earlier when the dislocations in the financial markets were smaller, such possible large returns would not have been available.  By postponing action, these “leaders” allowed the situation to get further “out-of-line” and this results in the possibility of well-placed investors making lots and lots of money. 

Of course, the bailout must go through…and this is the risk that these investors face. 

And, the fate of the taxpayers?

“Defenders of the (deal) say that while it may not be ideal, it was the best deal that could be reached at the time.  If hedge funds make some money along the way, they say, that is a small price to pay for securing a contribution from the private sector.” 

An investment tip…look for dislocations created by government actions. 

Another place where lots of money was made recently was on French banks.  Why?  Well, because French banks…and other European banks…have been given special treatment in the past and the problems relating to European sovereign debt have been handled, well, inconsistently…at best.  And, then there were the “stress tests” given the European banks which proved to be a joke. 

The stock prices of French banks had to decline and with this decline the rating agencies lowered the ratings that were given to the banks exacerbating the decline in their stock prices.  The article cited above begins its discussion of hedge fund purchases of Greek bonds by stating, “After a number of investors struck gold by betting against French banks…”

Lots of money will be made from the European financial crisis.  Lots of money will also be lost.  The money made will tend to go to the better off who can “bet” against the governments.  Postponing actions to protect the “less well off” only seems to lead to situations where the benefactors of the ultimate actions of the government are not the ones the “leaders” of the government are trying to help.

As I have stated many times, Europe has gotten into the current situation by assuming that its sovereign debt problems were problems of liquidity and not solvency.  People tend to avoid as much as possible questions relating to solvency.  This is especially true of bankers and the assets that reside on their balance sheets. 

Solvency problems, however, cannot be postponed forever…they must eventually be dealt with.  But, this is where real leaders must step up.  Identifying solvency problems earlier rather than later is always a benefit.  Identifying solvency problems earlier let you deal with the issues surrounding the asset sooner when the problems are not so severe.  Dealing with solvency problems earlier rather than later allow one to make smaller, incremental adjustments that the institution…or country…can more easily absorb. 

People…especially politicians…don’t like to admit mistakes and so we declare that the problems we face are liquidity problems and not solvency problems and we postpone the day of dealing with them. 

Such postponements can only result in opportunities for others.  Wanna chance to double your money?        

An Economic View from the Supply Side

As I have written before, the United States economy is recovering.  It may not be recovering as fast as some would like, but economic growth is positive.  Economic growth is not as rapid as some would like because there is still a massive debt overhang that must be eliminated, one way or another.

Furthermore, unemployment and under-employment are not dropping as fast as some would like.  The labor market is not improving with any speed because the economic policies of the last fifty years has resulted in a large amount of the United States manufacturing capacity being unused.  As physical capital is unused so is human capital.

Both of these situations took a long time to get to their present state and will take a long time to regain higher levels of economic growth, capacity utilization, and employment. 

The background for this situation can be examined from the following chart.

  This chart contains a graph of real Gross Domestic Product beginning in 1960 and ending in 2010.  I start with the year 1960 because that is the year before the United States government, both Democratic and Republican, introduced a “new” economic philosophy into its policy considerations, one that emphasized the inflation of credit throughout the economy. 

To me, the important thing about this chart is that real GDP is almost continuously rising.  Yes, there is a sizeable bump at the far right-hand side of the chart, and this is associated with the Great Recession, an apt title.  Otherwise, there are other little deviations from the upward trend, but these are relatively minor movements along the way.

This is where I take my stand with the economic growth proponents.  In the United States economy, growth is almost always positive.  The annual compound rate of growth for the period covered in the chart is 3.1 percent.  The annual compound growth rate of the United States economy, ending the calculation in 2007 (the Great Recession began in December 2007) the rate of growth rises to something around 3.25 percent.  But, growth is dependent upon the private sector, not directly on the government.    

I define credit inflation as a period in which the rate of growth of debt in the economy exceeds the rate of growth of the economy.  Over the past fifty years, the debt of the United States government has increased by more that a 7.0 percent annual compound rate of growth.  The debt of the private economy has risen in the range of 11.0 to 12.0 percent every year.  This meets my definition of credit inflation because these growth rates are far in excess of the rate of growth of the economy. During this period, the purchasing power of the dollar declined by about 85 percent.  In other words, a 1960s dollar could only buy 15 cents worth of goods and services today versus a dollar’s worth in 1960.

Side note on credit bubbles: when the annual compound rate of growth of the debt being created in a subsector of the economy exceeds the annual compound rate of growth of the economic growth of the subsector, a credit bubble can be said to exist.  The housing market bubble of the early 2000s fits this definition.

Credit inflation can have a detrimental impact on economic growth.  Credit inflation creates incentives that cause manufacturers to move away from the producing of goods and to move into the creation of finance.  Two examples of this are GE and GM: for example a couple of years ago GE was earning more than two-thirds of its profits from its finance wing.  In terms of the whole economy, there has been a huge swing over the past fifty years from the manufacturing sectors of the economy to the financial services sector of the economy.

Some of the consequences of this re-allocation of capital is that the employment of capital declined: capacity utilization is around 77 percent now relative to more than 90 percent in the 1960s.  Under-employment is over 20 percent now and was under 10 percent in the 1960s.  And, the income/wealth distribution is more skewed toward the wealthy than it was 50 years ago.

This has impacted economic growth.  For example, the annual compound rate of growth of real GDP has only been 2.5 percent over the past twenty years, down substantially from the rate of growth for the whole period.  Credit inflation, as an economic policy of the government, seems to have exactly the opposite impact on the economy that is desired by policy makers.

But the other important thing to notice in the chart is the “bumps in the road”.  In my opinion, all of these “bumps” resulted in some way from dislocations in the growth of credit instruments as a result of the monetary or fiscal policies of the United States government.  In most cases, the dislocations were relatively minor. However, as the debt load expanded and the private sector devoted more and more resources to financial services, the ability to carry the load grew greater and greater.

The debt burden cannot keep growing: it has to collapse sometime and along with it the economy.  In most cases the “bumps” were relatively minor.  I know it is never fun for anybody to be un-employed or under-employed, but in the aggregate sense, the “bumps” were not large. 

During the Great Recession and following, the “bumps” were much larger because the build-up of the debt dislocations were greater than ever.  However, since the debt burden must be worked off, it will take more time for the economy to achieve the longer run rates of growth that were achieved earlier in this fifty years of economy prosperity.  But, it will come. 

We must be aware of these dislocations and the things that must be done to re-structure the economy and get back to the economic growth performance we are looking for.  For example, we cannot ignore the state of the banking industry in this recovery. (See my post from last Friday: http://seekingalpha.com/article/295630-why-banks-aren-t-lending.)  Resolving the “bumps” just means that the previously created dislocations in finance and economics must be resolved.    

Why Banks Aren't Lending

Remember the old story about commercial banks?  Commercial banks only lend to people who don’t need to borrow.

Well, that seems to be the “truth” about bank lending now.  The story going around is that the larger banks have increased their business lending, but the lending is really only going to those institutions that have a lot of cash on hand.  Otherwise, the commercial banks will sit on their excess reserves.

This also seems to be the story in Europe: commercial banks are just not lending anywhere. (http://www.nytimes.com/2011/09/23/business/global/financing-drought-for-european-banks-heightens-fears.html?ref=todayspaper)

And, the relevant question is not “Why aren’t commercial banks lending?”  The relevant question is “Why should commercial banks be lending at this time?”

The first reason why many banks shouldn’t be lending right now is that there is still a large number of banks who may be severely undercapitalized or insolvent.  Many commercial banks have assets on their balance sheets whose economic value is substantially below the value the asset is accounted for on that balance sheet.

The most notorious case of this is the sovereign debt issues carried on the balance sheets of many European banks.  The values that many of these banks have on their balance sheets for these assets have the credibility that the recent “stress tests” administered to more than 90 banks by European banking authorities. (Note that the European Union moved today to recapitalize 16 banks, http://www.ft.com/intl/cms/s/0/49d6240e-e527-11e0-bdb8-00144feabdc0.html#axzz1Yj4RAJ9F.)    

But, the problem is not limited to Europe.  How many assets on the books of American banks have values that need to be written down to more realistic market values.  For example, small- and medium-sized commercial banks in the United States have a large portion of their loan portfolios in commercial real estate loans.  The commercial real estate market is still experiencing a depression and market values continue to decline in many areas.  The write off of these loans can take large chunks out of the capital these banks are still reporting. 

The bottom line here is that commercial banks that still have problems are not willing to take on any more risk than they have to while they still have to “work out” these depreciated assets, or, at least, wait until the markets recover and asset values rise once again to former levels.  If you don’t make another loan…it will not go bad on you…so why take the risk of making a new loan.

And there are 865 commercial banks on the FDIC’s list of problem banks and many more surrounding that total that have not met the specific criteria of the FDIC to be considered a problem bank. 

The second reason why many banks shouldn’t be lending right now it that the net interest margin they can earn on loans is hardly sufficient to cover expense costs.  I have talked with many bankers now that say the only way to make any money through bank operations is to charge for transactions.  That is, to generate fee income. 

A general figure that represents the expense ratio of a bank is by taking expenses and dividing them by total assets.  Recent data indicate that this expense ratio is in excess of 3 percent, being around 3.15 percent to be more exact.  This means that on basic lending operations a commercial bank must earn a net interest margin of 3.15 percent in order to “break even”. 

Is there a problem here?  You betcha’!

Adding to this dilemma is the fact that the Federal Reserve has added on a new “operation twist” to the mix.  All these banks need is a flatter yield curve. (See my post http://seekingalpha.com/article/292286-will-bernanke-policy-destroy-credit-creation-bill-gross-is-worried-it-will.) 

There are two ways to respond to a flatter yield curve.  First, one can take on more risk in their lending. (See http://seekingalpha.com/article/293893-some-banks-are-stretching-for-risk.) Or, commercial banks can attempt to earn more money through additional fees, or principal investments (private equity or venture capital), or through the assumption of systematic risk taking. (See http://seekingalpha.com/article/292446-will-bernanke-policy-destroy-credit-creation.) 

Is this what the Fed wants?  The Fed seems to be caught in the bind that it must be seen as doing something, even though that something may not be very productive (QE2) or even counter productive (leading to bubbles and other speculative activity). 

The take on Fed behavior during the Great Depression has been that the central bank did not do enough.  Hence, Mr. Bernanke and crew are taking the position that history will not brand them with the same interpretation.  For the past three years they have operated so as to avoid the claim that they did not do everything in their power to counteract the forces causing a great recession, slow economic growth, or economic stagnation.

And, here they face the possibility of “unintended consequences”.  If the flattening of the yield curve results in even less bank lending than would have occurred otherwise, the Fed could actually be exacerbating the situation.  The stock market declined upon hearing the Fed’s policy.

The third reason why banks may not be lending now is the absence of loan demand.  Fifty years of government created credit inflation has resulted in excessive debt loads being carried by individuals, families, businesses, governments (at all levels) and not-for-profit institutions.  People, faced with under-employment, declining asset values, and income/wealth inequities, are attempting to de-leverage.  This de-leveraging will continue until people feel more comfortable with their debt loads, or, the Fed creates sufficient inflation so that people will start to take on more debt again. 

If the Fed achieves the latter, then we have returned to the credit inflation situation that has existed for the past fifty years.  This period of credit inflation has resulted in an 85 percent decline in the purchasing power of the dollar, more and more under-employment of labor, and greater income/wealth discrepancies within the society. 

The fourth reason is the uncertainty created in “the rules of the game.”  The Dodd-Frank financial reform act has created a great deal of uncertainty within the financial community.  For one, only about 25 percent of the regulations have actually been written and only a portion of these have passed.  As a consequence, commercial banks don’t know what rules they will have to follow…or, even more important, what rules they will have to find ways to circumvent.  Another new set of rules, these on taxation, were introduced by President Obama this week.  George Shultz, former Secretary of the Treasury, has argued that new, complex tax proposals not only lead to short-term uncertainty about what must be dealt with, but that over time “the wealthy and GE” will find ways to manipulate the tax laws in their favor. (See my posts of September 20 and 22:  http://maseportfolio.blogspot.com/.)  But, unfortunately, people, families and businesses, will devote time and resources to dealing with these “rules of the game” and not allocate this time and resources to more productive activities.

Again, I raise the question “Why should banks be lending?”, not the question “Why  aren’t banks lending?”   

Something is Missing...

The Dow-Jones Stock Index dropped almost 400 points today. European stocks also dropped substantially…the FTSE 100 dropped by over 4 and one-half percent. 

European sovereign debt continues to grab headlines a the interest spreads on ten year bonds of troubled countries versus the yield on ten year German bonds remained near peaks. 

Today, the Economic Union moved to speed up the recapitalization of banks that did not show well in the recent stress tests administered to more than 90 banks.  “The move would affect mostly mid-tier banks. Seven are Spanish, two are from Germany, Greece and Portugal, and one each from Italy, Cyprus and Slovenia.” (http://www.ft.com/intl/cms/s/0/49d6240e-e527-11e0-bdb8-00144feabdc0.html#axzz1Yj4RAJ9F)  But, there is little confidence that this move will resolve things because the stress tests were such a joke!

Moody’s downgraded Bank of America, Wells Fargo, and Citigroup…and a couple of days ago a few European banks…that passed the stress tests. 

And, the top officials in the European Union continue to argue over this issue and they continue to argue over that issue and resolve little…but still hope to kick the can down the street a little further.  No one seems to be facing the real issues because their solutions appear to be so painful.   

In the United States, Ben Bernanke and the Federal Reserve attempt to grasp another straw in the wind as they continue to throw “stuff” against the wall, hoping that some of it sticks.  For three years now the Fed has thrown “stuff” against the wall but it must be too wet…for very little is sticking to the wall.  The Fed’s current monetary policy is to make sure that they throw all the “stuff” they have against the wall so that no one writing future history books can accuse them of not leaving any unused “stuff’ in the …

And, President Obama has come up with his new economic re-election platform disguised in the form of a jobs program, which includes new proposals to finance the program with various tax increases.  Since this combination is a part of the re-election campaign it must contain a little of this and a little of that to appeal to different parts of his voter base.  The problem with something like this is that it just makes the tax code more complex and provides incentives for the more heavily taxed…in the words of George Shultz, the former Secretary of the Treasury, ”the wealthy and General Electric”...to find ways to avoid bearing the burden of the tax. (See my post from Tuesday, September 20, “The Case Against the Obama Taxes”, http://maseportfolio.blogspot.com/.)   

Something is missing!

My answer has been and continues to be, that the something that is missing is leadership!

The problem is that there are no easy answers…no painless answers. 

People in Europe and the United States have been living high for fifty years.  The goals of high levels of employment and income re-distribution through the spread of home ownership have produced their consequences…excessive amounts of debt in households, businesses, national, state, and local governments. 

The economic policy of almost consistent application of credit inflation for the past fifty years has produced, in the United States, an 85 percent reduction in the purchasing power of the dollar, an under-employment rate of at least 20 percent, and the widest skewing of the income/wealth distribution in recent history.  If this is what credit inflation achieves…I don’t want it. 

Continuing to apply the policies of the past fifty years to the current situation will only exacerbate things.  We are facing an extended period of economic stagnation, at best, and a double-dip recession, at the worst.  Little or no growth in this situation will be accompanied with continued increases in the under-employment rate.  And, of course, continuing with all this stimulation with little of no economic growth will result in even more decline in the purchasing power of the dollar.

And,  as a consequence of the uncertainty related to the attempt to solve these problems, volatility continues to plague the financial markets.  Experts predict that the volatility of these markets will not subside until things settle down on the policy side and some true leadership is shown amongst our governmental officials and regulators.  That is, the volatility will continue until someone steps up to the plate and initiates a real solution to the existing situation.

The problem is that the main job of politicians is to get re-elected.  It is very clear to most politicians that resolving the debt-situation is going to be painful and many are already hearing the discontent of their constituents.  Riots in the streets of Greece and Spain are just a small indication of the disruptions that the politicians fear.  But, there is the fear that if they do too much they will not get re-elected.  The are caught in the trap of having to do something…but not too much.   

The financial markets…the economy…are getting no clear vision of what the future may look like.  They don’t know what their taxes are going to be.  They don’t know what the rate of inflation will be. 

All the financial markets…and the economy…can do is go up…and go down…

Something is missing and the problem with this is that no one in the financial markets…or the economy…can identify where the leadership is going to come from. 

Can you?