More Banks Downgraded

Today’s news: 28 Spanish Banks were downgraded by Moody’s Investors Service.  Included in this list were Banco Santander SA (SAN) and Banco Bilbao Vizcaya Argentaria SA (BBVA).

Moody’s’ cut the ratings of 16 Spanish banks on May 17. 

Again, the argument can be made that this move was "too little, too late."

Yet, perhaps the most important thing to realize is that especially if the move by Moody’s is “too little, too late,” the situation in the banking system has not improved even though a substantial amount of time has passed since the banks entered into this “dark” region.

That is, maybe the banks should have been downgraded six months ago…or, nine months ago…or twelve months ago.  What we should reflect upon is that the banks have not improved their financial condition over this six months…or, nine months…or, twelve months…so that the ratings would not have had to be dropped!

The banks did not respond to the conditions because everyone in Europe seemed to believe that the problems faced by the banks were “liquidity” problems and not “solvency” problems, and that eurozone governments also did not face “solvency” problems.

The conditions cited by Moody’s for the downgrade included the weakness of Spain’s sovereign debt and the increasingly larger losses being recognized by the banks on commercial real estate loans.

Today, Spain requested funds for a banking bailout from members of the eurozone.  The lingering question still remains about when Spain, itself, is going to ask for a formal bailout.  Spain’s bonds are now trading near peak level spreads over German bonds of the same maturity.  The concern here is that these high yields cannot lead to a sustainable financing of the national government.

The situation of Italy is not unlike that of Spain, so there is concern over when the financial markets are going to turn more strongly on the government of Italy.

But, no one seems to have the will to act.  Still no leaders have arisen.  The general belief that the solution must ultimately rest with Germany receives cries of strong protest from German officials.  Short-term plugging of the dike is about all anyone can do. 

It is becoming more and more obvious that the only way the European situation will be corrected will be when the European governments “bite-the-bullet” and actually accept the fact that there is a massive need for structural reforms in most countries.  However, these government officials, in the past, postponed actions over and over again arguing that the problems were just ones of “liquidity.”  Now they have moved to claiming short-run cash injections will solve the “solvency” problems. 

The possibility that European government officials will really consider structural reforms for their societies still seems a distant fantasy. 

There has been talk of a banking union with the eurozone.  Yet, no one really seems serious about giving up their national interests when it comes to forming a banking union.  And, no one seems to want to create a system of deposit insurance like we have in the United States. And, no one seems to want to bear the burden of forming some central regulation agency.  Without some give, somewhere along the line…nothing will happen!

The deeper problem is that banks are not seemingly resolving their balance sheet problems with the time given them by their respective central banks.  Liquidity has been pumped into both the United States financial system and the European financial system.  Yet, few banks seem to be lending indicating they are in a “holding pattern” until things get better.

Still, things have not gotten appreciably better.  If they had, Moody’s would not have had to downgrade all the banks they have downgraded…at this late date.

And, this applies equally to the United States banking system, where commercial real estate loans also plague many banks.

Furthermore, in Europe and in the United States, economic recovery is not going to take place as long as their banking institutions are not lending. 

To me, moving to a QE3 will do no more to right the banking system in the United States nor will a QE3 do anything more to help the economy start growing faster.  Just as in 1937, having more excess reserves in the banking system does not mean that the banks are solvent or that will start lending.  Other things must happen for the banks to start lending and one of these things is to honestly recognize the serious weaknesses that exist within the banking system and continue to re-structure the banking system as smoothly as possible so as to bring solvency back to the industry.

And, this is true of Europe.  Further provision of liquidity to European banks is not going to help them.  European officials, as well as the banks themselves, must accept the reality of the situation and move on.  The banking system needs bailing out.  Several governments in Europe need bailing out.  Solvency is the issue.  Recognizing this and re-structuring their societies is necessary to move forward into the future. 

Any bright future for Europe will only face further delay by postponing the re-structuring that ultimately needs to take place.      

The U. S. Banking System: Weak Yet Still Supplying Europe

Downgrading large, internationally significant financial institutions did little to change market attitudes about the financial condition of these institutions.  The general market response was “too little, too late.”

As is too well known, rating agencies tend to be followers not leaders.  The question always is…well how far behind are the rating agencies this time?

In this respect, the rating agencies are in the same boat as are the regulators…they are always behind the curve.

As far as the banking system itself…the banking system is not doing all that well…but, we knew that…but the U. S. banking system is doing better than the banking system in the eurozone…if that is any consolation. 

The U. S. banking system is still holding almost $1.5 trillion in excess reserves. 

To me, this means that the banking system, in general, is still is such bad shape that it does not want to make many loans and is perfectly content to be sitting on all the excess reserves that the Federal Reserve has supplied it.  

This situation is not unlike the one that existed during the Great Depression.  In general, commercial banks are not in good shape. 

This general condition also existed at the time of the Great Depression.  Too much debt had been created and individuals and businesses could not pay off the debt that they owed.  Many banks were technically insolvent.   Commercial banks continued to be closed and many of the banks that still had their doors open were just waiting for the regulators to visit them and pull down the shades on their windows.

As we have seen this year, the FDIC continues to close smaller banks, more than one per week, while many other weak banks are acquired and so go out of independent existence.

While lending in the banking system has increased in aggregate over the past year there still are disturbing signs.  For one, cash assets at the smaller, domestically chartered banks increased over the past year by about $33 billion while cash assets in the whole banking system declined.  That is, it looks like the demand for excess reserves in the small banks has actually increased, a sign of management concern.

Secondly, the commercial real estate sector continues to cause the domestically chartered banks problems.  These loans continue to decline at the largest 25 domestically chartered banks in the United States as well as in the rest of the domestically chartered banks over the past year.

Whereas there is some signs that the residential real estate market may be leveling off, problems continue to exist within the commercial real estate area.  It is here that we find why many of the smaller banks are under such stress. 

During the “glory days” of the recent expansion, many of these smaller banks strained to put commercial real estate loans on their books to generate bank expansion.  In order to support this expansion the smaller banks became “liability managers” something small banks hardly ever did in the past.  So these managements made two mistakes…they got into commercial real estate loans, which they did not have the expertise to do…and they got into the purchase of funds, again something they had never done before.

Now, these smaller banks are paying the price for their lack of discipline.  But, it was the thing to do in another time period.

The smaller banks will continue to face balance sheet problems for some time and the number of commercial banks in the banking system will continue to decline.

Another thing to watch, however, is what is happening between banks.  Nearly 40 percent of the increase in bank loans over the past year came in a category titled “Other Loans and Leases” and this category includes Federal Funds and reverse repos with nonbanks and “All Other Loans and Leases.”  This latter group is defined by the Federal Reserve as Including “loans for purchasing or carrying securities, loans to finance agricultural production, loans to foreign governments and foreign banks, obligations of states and political subdivisions, loans to nonbank depository institutions, loans to nonbank financial institutions, unplanned overdrafts, loans not elsewhere classified, and lease financing receivables.”

Foreign-related commercial banks increased loans in the first category by over $66 billion.

Large domestically chartered banks increased loans in the second category by more than $34 billion.  In order to explain this I would like to concentrate on the subset “loans to foreign governments and foreign banks.”   Indications are that these large banks committed a lot of money to “foreign governments and foreign banks” over the past year.  This is where some of it shows up.

And, what was the biggest item to increase on bank balance sheets in the United States?

Net deposits due to foreign related offices of foreign-related financial institutions in the United States.  The total increase over the past year was almost $290 billion!

It looks to me like a lot of the lending activity that took place in the United States and particularly in the largest 25 domestically chartered banks were to “off shore” entities.  In other words, a substantial portion of the funds the Federal Reserve injected into the United States banking system has migrated into foreign hands.

Thus, the Federal Reserve System is not only supporting a weak United States banking system it is also going to help support a weak world banking system. 

One final point of the current situation in banking: fundamental Keynesian economists have argued that the current dilemma facing the monetary authorities today is a “liquidity trap” much as the one they claim the central bank faced during the Great Depression.

In my mind, these Keynesian fundamentalists are as wrong about the current situation as they are about their interpretation of the Great Depression. 

Interest rates are low and yet the economy is not expanding because the banking system is still so weak that the banks are not lending, not because the economy is in a “liquidity trap.”  The problem is a supply of loans problem not a demand for money problem!

And, this applies to Europe as well as to the United States. 

A stronger recovery in the United States will not occur until the U. S. banking system becomes solvent once again, debt balances in the economy are reduced, and governments realize that they are not the solution to every problem.