Europe's Problems Have Really Been Connected With Insolvency, Not Liquidity

The working definition of a liquidity crisis that has prevailed during most of my professional career has emphasized the short-term nature of such a crisis.  The financial crisis in Europe does not match this definition! 

Historically, a liquidity crisis occurs when there is a change in expectations in the financial markets that causes the buy-side of the market to re-evaluate values.  The re-evaluation is always on the down-side and buyers do not re-enter a market until they re-gain some confidence as to where prices should be set.

Until that confidence is re-gained, market prices can be in free-fall.

A classic case is that of the financial crisis that occurred in 1970 that was related to the commercial paper market.  The shock that hit the market: the credit rating of the Penn Central’s commercial paper was downgraded.  The downgrade surprised the market because the financial condition of the Penn Central had been assumed to be solid until the downgrade was announced. 

Market participants responded by questioning the ratings on other issuers of commercial paper.  If a company, like Penn Central, that was carrying a high credit rating could be downgraded what other companies might face the same fate. 

As a consequence of this downgrade, companies issuing commercial paper could not roll-over their debt and therefore had to go into their commercial banks and draw on their “backup” lines of credit to cover maturing debt.

The commercial banks were then faced with selling their “liquid” assets in order to fund the lines of credit.

The money markets faced a downward spiral of prices as participants wondered about where prices should be set in the commercial paper market and in the market for short-term Treasuries.

This, to me, is a classical example of what a liquidity crisis is all about.

How does one combat a liquidity crisis?  This is where the central bank comes in.  A central bank combats a liquidity crisis by providing sufficient liquidity to the financial markets so that selling assets, like Treasury securities, ceases and order is restored to the pricing process.

Historically, the vehicle used to accomplish this outcome has been the discount window of the Federal Reserve.  In the case of the Penn Central crisis, the Federal Reserve threw open the discount window and stated that any bank needing liquidity to cover draw-downs on their backup lines of credit could come to the discount window and borrow what they needed. 

The caveat on this opening of the discount window was that the borrowings were only to last for a short time until the crisis past.  It was generally expected that the situation would resolve itself within about four weeks. 

A liquidity crisis is a short-term phenomena!  A liquidity crisis occurs because market participants, on the buy-side, do not have sufficient information to set prices…hence, the demand-side of the market is extremely weak.

I have constantly argued over the time that I have been writing this blog (started February 2009) that government officials were wrong to consider the sovereign debt crisis in Europe and the ensuing banking crisis as a “liquidity problem” and not a “solvency problem.” 

The problem has been that the market may not know exactly where the prices of financial assets should be, but they do know that these prices are below the value at which governments and banks carry the assets.  The owners of the assets will not sell them because it would bankrupt the institution.  But, this is not a “liquidity problem” in the classical sense.  The problem is connected with the solvency of the institutions.

The officials in Europe (I will not call them leaders) have attempted to treat their problems as a liquidity problem.  Their responses to the financial markets has constantly been to provide troubled governments and financial institutions sufficient liquidity to work their problems out thereby “kicking the solution to their problems down the road.”

Now, even the “liquidity solutions” are coming back to further weaken these institutions.  Note the description in the New York Times about the liquidity provided to European banks by the ECB.

“At the root of Spain’s crisis has been a drastic flight of foreign capital from the country — one that, paradoxically, has been accentuated by the European Central Bank’s program of providing low-cost three-year loans to European banks so that they might buy their governments’ bonds.

When the central bank created that program late last year, and dispensed two rounds of loans within a few months, it was credited with having done much to ease Europe’s crisis. 

In the case of Spain, while the program bought time, it has made the country’s underlying problems worse. Spanish banks have by far been the most aggressive participants in the cheap-loan program, having borrowed more than 300 billion euros from the central bank. And much of that money was spent on Spanish government bonds. 

In the short term, those bond purchases helped the government by bringing down interest rates — by reducing Madrid’s cost of borrowing. But as a result, Spanish banks now own a larger share, about 67 percent, of their own government’s debt than the banks of any other country in the euro zone, according to research by BNP Paribas. 

Now the value of those bonds is declining — prices fall as yields rise — and further weakening Spanish banks.”

In my experience in working with failing institutions, those running the failing institutions continue to deny the reality of their problems by ignoring the reality of their insolvency and by pointing their fingers at any other possible cause of the failure in order to hang onto their illusions. 

 

We hear, “the problem is caused by greedy speculators”; “the problem is just a problem of liquidity”; “the problem is the Germans”; and so on and so forth!

Just having returned from two weeks in Rome, I can’t get the image of Nero playing the fiddle while Rome burned out of my mind.  The fiddle-playing of the European officials has allowed them to suppress the real issues that have to do with the solvency of their governments and their banking institutions and the reform and restructuring that needs to be gained in their cultures.  As long as this denial continues the issues will not be resolved.    

Can Europe Really Reform and Restructure?

Europeans, apparently, don’t want any further integration.   The Pew Research Center in eight EU countries found that “the public is more doubtful about EU membership and the single currency and is shifting decisively against handing Brussels more power over national budgets.”

I have jut returned from two weeks in Italy.  The following comments represent some of the impressions I gathered on the trip.

National divisions are just one reason, although a major one, for the continued failure of the European Union to reach some form of resolution to the ongoing financial crisis.  Whether these divisions can be overcome in the longer term is, of course, a concern of many that a unified solution can be achieved. 

But, there are many other hurdles that work against moving Europe into some greater form of common union.

So much public attention has been given to the fiscal affairs of the national governments and rightly so.  But, there is another aspect to these fiscal affairs that go beyond the ability of the governments to repay their debts.  This other aspect is the social framework that has been built up in these countries through the actual spending that has taken place.

I have often discussed some of the structural problems in the United States created by government spending aimed at keeping people employed in the jobs that they have been working in and to build up government payrolls at the local level, as well as at the national level, to keep people employed and happy.  The consequences of these kinds of policies include rising levels of under-employment, reaching maybe 20 percent of the working age population, and bloated state and local government budgets supporting excessively generous hiring practices and underfunded pensions.

Well, from what I saw and the people I talked with, when compared with Europe, the United States is a “Scrooge” when it comes to this kind of behavior!

And, if the United States has an un-employment rate a little over 8 percent and an under-employment rate of around 20 percent, what is the situation in Europe where countries face 20 to 25 percent government measured un-employment?  What is the level of under-employment in these countries?

In addition, what is the situation in the bloated government bureaucracies and the school systems in these European countries?  The university systems in these countries are, to me, frightening.

Another truly amazing thing to me is three-hour lunch hours…mandated!

What about the spread of information technology?  This, of course, is one of the major things driving modern society.  Read an interesting article that appeared in the New York Times yesterday.  “Italy remains well behind most other West European countries in the reach of the Internet….”

I was discussing the use of information technology in the financial field, especially in banking, with a very advanced thinking Italian, someone who has spent quite a few years in America.  His comment was that Italy was many years behind the United States banks in adopting modern computer technology to daily banking transactions.

And, everywhere I saw industrial zones created to support manufacturing employment with empty parking lots and houses and business buildings standing uncompleted with nothing around them to indicate that activity would return to them soon.

The one thought I took away from trip was that although Europe has a fiscal crisis to deal with in terms of getting their financial affairs in order, the much bigger problem faced by the Europeans is the need for the reform and restructuring of the way they do things.

Modern technology is being used in these European countries, but the technology is being used to maintain a lifestyle that existed in another century.  This is not unlike some radical religious groups that use modern information technology to retain a hold on their medieval social practices. 

In my reading of history, the advance of information technology always wins.  The advancement may be diverted or delayed for some period of time but the spread of information always triumphs in the end. 

The transformation is not easy and will not be easy in the case of Europe.  There will need to be much social change along the way and the existing structure of classes, intellectual as well as wealth and business, along with the current philosophies pertaining to labor unions and governments, will put up substantial barriers to the changes that are needed. 

An example of this given in the New York Times article quoted above is the efforts made by former Italian prime minister Silvio Berlusconi to protect his media business empire from intrusions of the Internet.

The whole world is going through massive changes and no one group, organization, or nation, is going to be able to avoid the changes.  I knew many of the countries in the eurozone were behind the curve in this transition.  I have argued that Europe seemed to be devoid of the leaders needed to guide their countries through this period.  But, my recent trip has made me more pessimistic about the ability of the European Union to throw off their blinders and actually carry out the reform and restructuring that is needed. 

A conclusion like this can only make one more pessimistic about investing in Europe.  I like to think of myself as a value investor that invests for the longer term.  In terms of Europe, therefore, the longer term, in my view, just got that much longer.   

Can Europe Really Reform and Restructure?

Europeans, apparently, don’t want any further integration.   The Pew Research Center in eight EU countries found that “the public is more doubtful about EU membership and the single currency and is shifting decisively against handing Brussels more power over national budgets.”

I have jut returned from two weeks in Italy.  The following comments represent some of the impressions I gathered on the trip.

National divisions are just one reason, although a major one, for the continued failure of the European Union to reach some form of resolution to the ongoing financial crisis.  Whether these divisions can be overcome in the longer term is, of course, a concern of many that a unified solution can be achieved. 

But, there are many other hurdles that work against moving Europe into some greater form of common union.

So much public attention has been given to the fiscal affairs of the national governments and rightly so.  But, there is another aspect to these fiscal affairs that go beyond the ability of the governments to repay their debts.  This other aspect is the social framework that has been built up in these countries through the actual spending that has taken place.

I have often discussed some of the structural problems in the United States created by government spending aimed at keeping people employed in the jobs that they have been working in and to build up government payrolls at the local level, as well as at the national level, to keep people employed and happy.  The consequences of these kinds of policies include rising levels of under-employment, reaching maybe 20 percent of the working age population, and bloated state and local government budgets supporting excessively generous hiring practices and underfunded pensions.

Well, from what I saw and the people I talked with, when compared with Europe, the United States is a “Scrooge” when it comes to this kind of behavior!

And, if the United States has an un-employment rate a little over 8 percent and an under-employment rate of around 20 percent, what is the situation in Europe where countries face 20 to 25 percent government measured un-employment?  What is the level of under-employment in these countries?

In addition, what is the situation in the bloated government bureaucracies and the school systems in these European countries?  The university systems in these countries are, to me, frightening.

Another truly amazing thing to me is three-hour lunch hours…mandated!

What about the spread of information technology?  This, of course, is one of the major things driving modern society.  Read an interesting article that appeared in the New York Times yesterday.  “Italy remains well behind most other West European countries in the reach of the Internet….”

I was discussing the use of information technology in the financial field, especially in banking, with a very advanced thinking Italian, someone who has spent quite a few years in America.  His comment was that Italy was many years behind the United States banks in adopting modern computer technology to daily banking transactions.

And, everywhere I saw industrial zones created to support manufacturing employment with empty parking lots and houses and business buildings standing uncompleted with nothing around them to indicate that activity would return to them soon.

The one thought I took away from trip was that although Europe has a fiscal crisis to deal with in terms of getting their financial affairs in order, the much bigger problem faced by the Europeans is the need for the reform and restructuring of the way they do things.

Modern technology is being used in these European countries, but the technology is being used to maintain a lifestyle that existed in another century.  This is not unlike some radical religious groups that use modern information technology to retain a hold on their medieval social practices. 

In my reading of history, the advance of information technology always wins.  The advancement may be diverted or delayed for some period of time but the spread of information always triumphs in the end. 

The transformation is not easy and will not be easy in the case of Europe.  There will need to be much social change along the way and the existing structure of classes, intellectual as well as wealth and business, along with the current philosophies pertaining to labor unions and governments, will put up substantial barriers to the changes that are needed. 

An example of this given in the New York Times article quoted above is the efforts made by former Italian prime minister Silvio Berlusconi to protect his media business empire from intrusions of the Internet.

The whole world is going through massive changes and no one group, organization, or nation, is going to be able to avoid the changes.  I knew many of the countries in the eurozone were behind the curve in this transition.  I have argued that Europe seemed to be devoid of the leaders needed to guide their countries through this period.  But, my recent trip has made me more pessimistic about the ability of the European Union to throw off their blinders and actually carry out the reform and restructuring that is needed. 

A conclusion like this can only make one more pessimistic about investing in Europe.  I like to think of myself as a value investor that invests for the longer term.  In terms of Europe, therefore, the longer term, in my view, just got that much longer.   

The Condition of the Banking System: March 31, 2012

 The FDIC banking statistics for March 31, 2012 were released last week.  There is room for hope in the statistics, but we are still not out-of-the-woods, yet.

The FDIC press release trumpeted the fact that the number of commercial banks on the FDIC list of problem banks fell for the fourth quarter in a row and reached a total of 772 banks, which was the lowest level this list has seen since year-end 2009. 

However, there are still 772 commercial banks on the problem list, which is more than 12 percent of the total number of commercial banks in existence. 

Only 16 commercial banks were closed in the first quarter of 2012, but there were 27 fewer banks in existence at the end of the quarter than there were at the end of 2011.

Over the last 12 months the number of commercial banks in the banking system declined by 190 and only 82 of these were closed. 

So, the banking system continues to decline with the majority of banks leaving the system due to merger or acquisition.  The vast majority of the decline (175 banks) is in the smaller banks (banks with assets of less than $100 million) where most of the problems seem to center. 

Over the past five years, the number of commercial banks in the banking system has declined by almost 1,000 banks.  The number of the smaller banks leaving the industry over this five-year period totaled 1,110!

At the end of the first quarter of 2012, there were only 6,263 FDIC-insured commercial banks in the industry. 

Even though the number of FDIC bank closures has dropped substantially in recent quarters, mergers and acquisitions continue to take place at a fairly rapid pace. 

I believe that we will continue to see results like this over the next several years.  The number of commercial banks in the banking system will continue to decline as troubled small- and medium-sized banks continue to be acquired.  If the decline in the number of banks continues in the 150 to 200 range for the next three years, the banking system will drop to between 5,700 and 5,800 banks by the end of 2015.  These numbers are above the 4,000 number that I had been predicting over the last couple of years but are still stunning given that there were 14,000 commercial banks in the banking system early in my banking career.

Regardless of the exact number, there are few reasons for new commercial banks to be formed and there are plenty of reasons why existing commercial banks will continue to consolidate.  This will mean that there will be fewer and fewer of the smaller banks in the banking system and more and more larger banks. 

Right now, according to the FDIC statistics, the largest 525 commercial banks in the United States (about 8 percent of the banks in the system) hold almost 91 percent of the assets in the banking system.  According to Federal Reserve statistics, the largest 25 domestically chartered commercial banks in the United States hold approximately two-thirds of all the assets in domestically chartered commercial banks.

In a real sense, the small- to medium-sized banks are almost irrelevant to the banking system except that their failure or clumsy exit could cause trouble to the rest of the system.   

Whether you like it or not, the number of banking units in the United States is shrinking relatively rapidly and more and more of the assets of the banking system are being found in the larger banking institutions.  And, this does not include the impact of the growing number of foreign commercial banks that are becoming players in the United States. 

Given the weakness in the commercial banking sector it is not surprising that bank loans are not showing much bounce.  Loan balances at FDIC-insured commercial banks declined in the first quarter of 2012 by slightly more than $56 billion. This decline occurred after loans had increased modestly over the previous three quarters.  Loan increases generally took place at the larger commercial banks. 

Revenues and bank profits continue to rise, but most of the increase, as expected, came in commercial banks that had more than $1.0 billion in assets.

It is still my belief that the general thrust of the monetary policy of the Federal Reserve is to keep commercial banks open and operating so that the FDIC can continue to close the weaker institutions in an orderly fashion and to allow the stronger, larger banking institutions to acquire the weaker ones, who are generally the smaller banks.  This strategy will continue to be followed until the condition of the banking industry improves sufficiently to grow stronger on its own.

Continued weakness in bank lending, particularly at the smaller institutions, will signal to us that the banking system, as a whole, has not fully recovered from the financial crisis that took place several years ago. 

This continued weakness in bank lending will also contribute to tepid growth in the economy as consumers and small- and medium-sized businesses cannot obtain the funds they need to spend and expand.  All these pieces seem to go together.       

Federal Reserve Remained Quiet in April

As reported in my last review of Federal Reserve actions, all remains quiet on the monetary front. Right now, as far as monetary policy is concerned, there is not much for the Fed to do…and, to me, this is good.

Things are quiet in the banking system…except for the complaints of top bankers about new rules and regulations that are being discussed.  The FDIC closed only one bank this week, bringing the total for the year up to 23.  But, closers are going “smoothly”.

Economic growth, year-over-year, continues to be in excess of two percent, although not by much.  And, other data being reported contain some good information…and some not-so-good information.

The European crisis continues along with more stress being placed on the creation of growth rather than continuing “austerity.”  The question is how much the elections of the weekend will change the near term future for the eurozone.

And, with the presidential election in full swing, the Fed seems to be content with the above scenario.  There is little or nothing it can do between now and the election to change the trajectory of the economy before November.  It “stands by” in case there is any “fire” that needs to be put out in the meantime.  (For more on this see my post.)

Furthermore, it seems as if we have had the last of the “education” sessions put on by Professor Bernanke for a while.

Thank goodness!

In terms of the actions of the Federal Reserve over the past month, most changes that occurred on the Fed’s balance sheet seem to be “operational”.  That is, the Fed was just responding to general “operating” factors impacting the banking system. 

The largest “operating” factor that occurred in April was connected with the yearly tax collections.  Deposits at Federal Reserve banks rose in April by almost $80 billion.  This is a seasonal swing as funds are collected at tax time in “tax and loan accounts” at commercial banks.  Then, the Treasury transfers these balances to its account at the Fed, the account the Treasury writes checks on.  This movement absorbs bank reserves at the same time the Treasury writes checks, which will then go back into the banking system as the recipients of those checks deposit them.  This procedure minimizes disruptions to the amount of reserves in the banking system.  Hence, these actions are called “operational”.

Two other factors can catch our attention.  First, over the past four weeks, the Fed has increased its holdings of mortgage-backed securities by $11 billion.  This is the first increase in mortgage-backed securities for more than a year.  In total, this account declined by almost $80 billion from May 4, 2011 to May 3, 2012.  Some support for this sector of the financial markets?

The second factor is the decline in Central Bank Liquidity Swaps.  This account increased over the past year as the European sovereign debt crisis expanded into the fall of 2011.  But, these liquidity swaps began to decline since the second Greek bailout was accomplished.  Central bank liquidity swaps declined by about $19 billion over the last four-week period, and declined by over $77 billion during the last 13-week period.  As of May 3, 2012 there were slightly more than $27 billion swaps still on the Fed’s books. 

Reserve balances with Federal Reserve banks on May 3, 2012 stood at $1,481 billion ($1.5 trillion rounded off) only $8 billion more than existed on May 4, 2011.  Excess reserves in the commercial banking system, a two-week average, were $1,458 billion, just about what was in the banking system one year ago, $1,452 billion.

This relative stability on the Fed’s balance sheet was achieved despite substantial changes taking place within the banking system itself. 

Although the total reserves in the banking system only increased by a little less than 4%, required reserves in the banking system rose by about 32%.  The reason for this difference is that demand deposits at commercial banks, deposits that have the highest reserve requirements, increased by more than 41%.  Time and savings deposits at commercial banks, which have lower reserve requirements, rose by a little more than 8%.  Thus, there was a shift in the banking system from deposits with lower reserve requirements to deposits with substantially higher reserve requirements.

This shift from time and savings deposits to demand deposits has been going on for a long time.  I have been reporting on this for more than two years now.  The shift is taking place, not only because of the low interest rates being paid by banks (and thrift institutions), but because of the weak economy.  People out of work or on the edge financially transfer the wealth they have to “transaction” type of accounts so that they can live and pay their bills.  They don’t have the resources to “manage” their wealth across a spectrum of assets.  Thus, the growth in demand deposits, to me, is a sign of weakness in the economy and not a sign that monetary policy is working.

Another piece of evidence supporting this claim is the strong demand for currency outside the banking system.  Currency in circulation is increasing at a 9%, year-over-year, rate of growth.  This is an extremely high growth rate and a sign of a weak economy and not a strong one.

As a consequence of these demands, money stock growth continues to increase at a very rapid pace.  The M1 measure of the money stock remains in the high teens, growing at an 18% rate for the past year, while the M2 measure is growing at a pace slightly under 10%.

Both of these rates of growth are high, historically, but can be explained by the shift in assets toward more liquid and more transaction-based accounts.  Only recently has loan growth started to increase and this may provide some reason for the money stock to continue to increase in the future.  If loan growth does continue to increase and if this creates a reason for the money stock to grow, this would be a healthy sign for a recovering economy. 

So, not much has changed on the monetary front from last month.  I believe that this is a good situation for the monetary authorities.  It doesn’t mean that the future will be easy.  The Fed is still going to have to deal with almost $1.5 trillion in excess bank reserves when the economy begins to expand more rapidly…the threat of rising inflation is real.  Yet, the past is past and we are where we are right now…and, to me, where we are right now is hopeful.   

The Unemployment Rate is Not the Most Important Thing

How do I say this gently?  The unemployment rate dropped to 8.1% in April, the lowest it has been since December 2008, but, it seems to me, that this is not the most important thing we should be focusing on. 

If we continue to look at the unemployment problem as a cyclical problem we will do the wrong things. 

I know, I know, there is an election coming up this fall.

Yet, this is where the Obama White House and where the apparent Republican presidential candidate are putting all the marbles.  Listen to this: "Much more remains to be done to repair the damage caused by the financial crisis and the deep recession," wrote Alan Krueger, chairman of the White House's Council of Economic Advisers, in a statement. "It is critical that we continue the economic policies that are helping us dig our way out of the deep hole that was caused by the severe recession that began at the end of 2007."

The financial crisis and the deep recession...come on!

Here is the number I think we should be focusing on: the participation rate…the share of the population of working age that are in the labor force…is at 63.6 percent, the lowest it has been since December 1981.  And, this was just when women were really starting to participant in the work force.  Within this figure the percentage of working age men in the workforce fell to 70.0 percent, the lowest it has been since the Labor Department starting collecting data in 1948.

The labor force dropped 342,000 in April.  This is not unemployment…it is something worse!

My calculations indicate that about one in five Americans of working age are under-employed.  This is a structural problem…it is not a cyclical one.

And, how did we get into this situation?  We got into this situation because we treated almost everyone that lost a job a consequence of the business cycle. 

And, the proposed solution to this problem?  Inflate the economy with Government deficits and monetary expansion.

Put everyone that lost a job back into the job he or she lost!

This was the political mantra that inhabited both sides of the political spectrum since the early 1960s. And, although the politicians pursued these policies with the intention of achieving high employment…and getting themselves re-elected…it was probably, over the longer run, the worst thing that these individuals did for the people they were trying to help.

The American…and the European…problem right now is a structural one and not a cyclical one. 

Look at the figures: since the Great Recession began in December 2007 payroll employment in construction is down by almost 26 percent; manufacturing payrolls are down by 13 percent; and retail payrolls are down by over 5 percent.  This is after almost four and one-half years of economic recovery. 

And, we know that jobs losses in the public sector are adding more and more to the overall depressing figures.  Last month, government job losses totaled 15,000 a rate that has been roughly maintained over an extended period of time.

We know that there has been a big push for productivity over the past four years of so.  This was one way to combat the recession and get businesses going again.  And, this worked for a time, although the recent increases in productivity may be coming to an end. (http://professional.wsj.com/article/SB10001424052702304746604577381713675051658.html?mod=ITP_pageone_1&mg=reno64-sec-wsj)

The 1990s into the 2000s saw labor hoarding in many manufacturing and other business jobs as the credit inflation policies of the federal government bought out the business exposure connected with the hoarding of labor. Rising property values meant that state and local governments could build their regional empires with the assurance that they would have a constant increase in revenues to cover their expansions.  Housing programs along with financial innovations like subprime loans, underwrote a massive expansion of the housing industry.  There was substantial over-hiring in so many fields during this time period.  And, this was a time when the Internet boom took off resulting in a huge re-structuring of the way almost everything gets done. 

The point is, the only real solutions to the situation we now find ourselves in are long run solutions.  Short-run stimulus will only delay the efforts to re-structure the workforce and postpone any real efforts to make things better.  And, monetary policy cannot, in the longer run, reduce the unemployment rate.    

Long run programs, like education and re-training, are what are needed. I direct your attention to a recent article that addresses this situation: “Education is the Key to a Healthy Economy” by forms Secretary of State George Shultz and Eric Hanushek. (http://professional.wsj.com/article/SB20001424052702303513404577356422025164482.html)

The problem is that politicians work only within a very short time horizon…the next election.  We can expect little help here!

That is why I say that the unemployment rate is almost irrelevant, except to those that are up for election.  People are leaving the workforce.  Many of the people that have left the workforce cannot be hired back into the labor market in positions similar in effort or pay to the jobs they lost because they don’t have the skills or experience to work in any other area than direct customer service…and this region of the jobs market is already over supplied.

We need to shift our focus to things like labor force participation rates, male labor force participation rates, and under-employment and ask the really hard questions about what is needed to turn these trends around.  Given all the blather connected with the current presidential election, one cannot be too hopeful.    

Small Banks Unlikely to be Able to Repay Bailout Funds

“Most small banks bailed out by US taxpayers during the financial crisis are unlikely to be able to repay the Treasury department, the Obama administration says.” (http://www.ft.com/intl/cms/s/0/bc09f03c-9562-11e1-8faf-00144feab49a.html#axzz1tp5ngu6K)

This came out in a blog post on the Treasury’s website yesterday. See “Winding Down TARP’s Bank Program,” by Timothy Massad, assistant Treasury secretary for financial stability. (http://www.treasury.gov/connect/blog/Pages/Winding-Down-TARPs-Bank-Programs.aspx)

 The Treasury does not expect “the majority of the nearly 350 lenders still partially owned by US taxpayers to repurchase in the next 12-18 months the preferred stock that Treasury received in exchange for bailing them out.”

The “smaller” banks are defined as those with less that $10 billion in assets. 

This is just another piece of information that keeps leaking out that the state of the health of the US banking system is still not what it should be.  We await new information from the FDIC on the number of commercial banks still on its problem list. 

On December 31, 2011 there were more than 800 institutions still on the FDIC’s problem list.  And, we know the problem list does not include all those banks that are “troubled.”  The FDIC not only oversees the closing of troubled banks, it also is active in assisting “acquisitions” of banks that are experiencing difficulties.  In 2011, for example, there were 92 banks that closed.  However, from December 31, 2010 to December 31, 2011, 240 banks dropped out of the banking system.

The point is, the banking system is still not out of the woods.  I am still standing by my prediction that the banking system will decline by more than 2,000 institutions over the next five years, dropping from 6,290 banks on December 31, 2011 to less than 4,000. 

This decline will take place as the bigger banks in the United States become even bigger and as more and more big foreign banks increase their presence in the US.  On this last note I refer you to the list of the world’s strongest banks published by Bloomberg Markets magazine.  Of the top 10 strongest banks in the world, four were from Canada, and there were two more near these, one coming in as the 18^th strongest and one as the 22^nd strongest. (http://www.bloomberg.com/news/2012-05-02/canadians-dominate-world-s-10-strongest-banks.html)  

Note: only three American banks showed up in the top twenty, JPMorgan Chase at number 13, PNC Financial Services Group at number 17, and BB&T Coro. at number 20.

Adding to this movement, let me just add two more aspects of the future of banking that work against the smaller banks.  First, there are the advancements in technology taking place in the world.  Banks are becoming more and more wired (just notice the new bond trading platform introduced yesterday by Goldman Sachs, a development that is highly dependent upon scale) and more and more mobile.  As the world, even the world of Main Street becomes more connected, the smaller banks will be less able to compete.

Second, the “shadow banking” sector continues to grow.  The “new” idea is for banks to outsource some of their “core” small business lending to a new crop of loan funds…”shadow banks.” (http://www.ft.com/intl/cms/s/0/85ce3bde-9546-11e1-8faf-00144feab49a.html#axzz1tp5ngu6K) Financial innovation continues to accelerate.

And, how important is shadow banking?  Well, take a look at the accompanying charts.  

Shadow banking is huge and is growing.  The smaller banks will not be able to compete with them. (http://www.ft.com/intl/cms/s/3/981cb220-8a47-11e1-93c9-00144feab49a.html#axzz1tp5ngu6K)

The United States banking system still has major adjustments to go through.  The structure of banking is changing.  Whereas America has always had a “small bank” culture…my banker grandfather was a staunch advocate of “unit” banking where a bank could only have one branch and must keep its business interests within that state.  Within the current environment, however, is the Canadian banking system, where there are only eight oligopoly banks, more realistic?

The United States banking system is not stable in its current position.  Huge changes are to be expected.  With the Treasury blog post we understand that there still is a solvency problem.  The Fed will continue to keep excess reserves in the banking system to preserve as much stability as possible for the health of the economy.  The economy and the financial system are heading in the right direction but it takes a long time to unwind 50 years or so of economic mis-management.  We must understand the still fragile condition of the financial system in order to understand why the government and the regulators are acting the way they are. 

The US Bond Market and the Situation in the Eurozone

In my last post, I wrote about the bond market in the United States and how the European situation is impacting the structure of yields in US financial markets.  My conclusion was that the “flight to quality” being experienced in world financial markets has led to a situation in which the supply of funds to United States financial markets has resulted is extremely low long-term interest rates and a negative yield on the US Treasuries inflation-adjusted securities (TIPS). (http://seekingalpha.com/article/551121-what-are-the-bond-markets-trying-to-tell-us) 

The question then becomes, if the extremely low long-term interest rates are a consequence of a “flight” of funds from European markets and this condition will last in some form until the European Union “gets it act in order” what will be a condition of Europe “getting its act in order”?

Over the past two years or so the efforts of the European Union to resolve the sovereign debt crisis has “kindly” been referred to as “kicking the can down the road.”  No one seemingly wants to “get their hands around the situation” and work to resolve the crisis.  Consequently, the crisis lingers on with recurrent bouts of national concern like that now being focused on Spain. 

It should be obvious by now that “kicking the can down the road” is not going to end the sovereign debt crisis in Europe. 

The current direction in which European elections are headed seems, if anything, a step backward in the process.  But, Europeans are tired of all the austerity.  They want to throw existing policymakers out of office and elect someone else…it doesn’t really seem to matter who.  And, we are seeing this played out in this weekend’s elections in France and Greece.  This following the situation in the Netherlands where the existing government was defeated, the 10^th such government to lose power since the debt crisis began.  

Tom Sargent, an economist who won the Nobel Prize last year, suggested in his Nobel Prize winning acceptance speech that the current problems being faced by the nations of the eurozone are similar to those faced by the United States as it was trying to become a unified country in the late 18^th century.  The European Union now is like the US under the Articles of Confederation at that time.  The US had to become a unified country under a Constitution and establish its fiscal credibility before it could operate as a nation among the other nations of the world.  Sargent suggests that Europe must achieve the same goal. (http://www.nobelprize.org/nobel_prizes/economics/laureates/2011/sargent-lecture.html)

While the fiscal crises of the states was going on during this period in the United States there was also a banking crisis going on in the private sector, a lot of it caused by the credit problems faced by the states.

Taking the experience of the United States as an example, one can argue that the only way the European Union is going to “get its arms around the problems” is to form a fiscal union amongst it members that will supplement the monetary union that is already in existence. Many anticipated this next step when the original monetary union was formed. (http://www.ft.com/intl/cms/s/0/50a1f9fe-9466-11e1-8e90-00144feab49a.html#axzz1tp5ngu6K)

However, the fiscal union implies more.  A federal union of countries is going to have to establish its credit standing in the world which means that it will have to be able to issue debt with the “joint and several liability” of the eurozone backing it.  Of course, this implies that the new fiscal union of eurozone countries will conduct it budget operations on a sound basis. 

Furthermore, the eurozone is going to have to move to save European banks.  The European Central Bank cannot solve the whole problem through its “liquidity” efforts.  The countries of the European Union are going to have to provide funds directly to the European banks that need them.  This will not be inexpensive in the short-run.  Hopefully, over the longer run the European Union will get a large portion of the funds back.

European banks are even in worse shape that United States banks.  Bloomberg Markets magazine has just released its list of the strongest banks in the world.  There are only four European banks in the top twenty: two from Sweden, one from the U.K. and one from Switzerland. (http://www.bloomberg.com/news/2012-05-02/canadians-dominate-world-s-10-strongest-banks.html)

Whoops!  None of those banks are in countries in the European Union.  Seems like the strongest banks in the world are not in countries that have pursued the policies of credit inflation that have created huge amounts of debt.

The problem is: who is going to lead Europe into a fiscal union?

Angela Merkel, the German Chancellor, has indicated that that is the direction in which she is headed.  Yet, it is not altogether clear that the German people will accept a fiscal union because so much of the load of the new union will be placed on Germany.  Furthermore, you have the move to new governments within the European Union that “anti-austerity” and “anti-German.”

Still, Germans have benefitted more than any country in Europe from the monetary union and from its reunification and from integration with other European countries.  Germany stands to continue to benefit from “more Europe” rather than less. 

And, this is true of the rest of Europe.  It is not an easy path to a new European future, a united Europe, but it will, in the end, produce the greatest amount of wealth and prosperity for the continent as a whole. 

This is a massive undertaking.  A movement in this direction will not resolve all of Europe’s growth problems, its unemployment problems, or, its real estate problems in the near term.  To stay separate, however, in my mind, is almost unthinkable.  We might get a taste of this soon in Greece if a new government comes to power that cannot follow up on the conditions of the recent bailout.  If the new government is unable to deliver, the European Union may ask for it to withdraw.  My sense is that this would be pretty bad.

In terms of the United States bond market, I believe that it will not take the full consolidation of the European fiscal union to reverse the flow of funds coming into US financial markets.  What is needed, however, is some credible leadership to arise in Europe that can achieve some credible gains in movement toward the union.  Given the elections coming up this weekend and in the near term, it is hard to see such leadership ascending.  So, it may be awhile before yield relationships return to more normal levels.