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.      

Economic Growth Will Continue: Entering the Next Stage

I continue to be more optimistic about the path of economic growth that is occurring in the United States.  There are still potential “bumps-in-the-road” like the recession in Europe (http://seekingalpha.com/article/317268-issue-number-1-for-2012-recession-in-europe) and the slowdown in the economic growth of China.  Still, the economic recovery in America goes on.

On the positive side, I am encouraged by the fact that bank lending is getting stronger. (http://seekingalpha.com/article/499921-loan-growth-continues-to-pick-up-at-commercial-banks) The important signal, to me, coming from the banking data, is that the health of the banking system is improving.  Although many commercial banks still have major problems, the system, as a whole, is getting stronger and this is allowing for greater loan growth.  In the first quarter of 2012, the annualized rate of growth in loans and leases at commercial banks was almost 6.5 percent.  This is good.

Today, we got some encouragement from the housing industry: “Building permits in March 2012 were at a seasonally adjusted annual rate of 747,000, up 4.5 percent from the revised February rate and up 30.1 percent from March 2011. Housing starts in March 2012 were at a seasonally adjusted annual rate of 654,000, down 5.8 percent from February’s revised estimate but up 10.3 percent from March 2011.”  The decline from February to March was due to unseasonal strength in the housing area because of the very mild winter weather experienced this year.  The year-over-year rate for March is much more indicative of the pick up in this construction.

The economic recovery is continuing. 

On the negative side, I still believe that economic growth will continue to be anemic compared with historical trends.  As I have argued before (http://seekingalpha.com/article/469671-gdp-growth-the-road-ahead-and-the-investment-climate), I am expecting economic growth to be in the 2 percent to 3 percent range, but I believe growth will be closer to the former figure than the latter.

There are several reasons for this.  One reason is that under-employment will still remain high.  I don’t care that much about un-employment in the current case because under-employment has remained in the 20 percent range and as long as this condition exists in the United States, consumer spending will remain relatively weak.  Furthermore, this condition just adds to the pressure for families to deleverage and get out from under the debt loads they have been carrying.  This helps to account for the very weak consumer loan data at commercial banks.

There are also other reasons for only moderate economic growth.  State and local governments still have a ways to go before they become a positive force in the economy again.  With declining property values and huge problems in the pension area, these governmental bodies will continue to slash payrolls and other budget items in an effort to return to some form of fiscal prudence. 

And, there is one other area that I believe will continue to weigh on the economy over the near future.  I have written from time-to-time about the impact the last fifty years of credit inflation has had on the productive capacity of the United States manufacturing base.  Credit inflation is not good for producing improvements in the productivity of capital.  And, if the productivity of capital is not increasing then economic growth is going to suffer.

The effects of this credit inflation are picked up in the utilization of our productive capacity.  In the 1960s, capacity utilization in the United States was well in excess of 90 percent.  There has been a secular decline in capacity utilization in America as the peak of every business cycle over the past fifty years has been at a lower utilization of our capital base. At the last cyclical peak we were using slightly more than 80 percent of our capacity.  At the present time capacity utilization is increasing as the economy has expanded since June 2009, but we remain around 78 percent. (The March figure of capacity utilization of 78.6 percent was released this morning.)

I believe that the economic growth rate of the United States will remain below the post-World War II level of about 3.2 percent as the rate of capacity utilization continues to lag.

The problem with this is that this growth rate will not accelerate as potential inflation problems arise. 

This inflation problem is raised by Francesco Guerrera in the Wall Street Journal: “Sowing Seeds of the Next Major Crisis.” (http://professional.wsj.com/article/SB10001424052702304818404577347641050572260.html?mod=ITP_moneyandinvesting_0&mg=reno64-sec-wsj)  For one, the Federal Reserve has pumped massive amounts of reserves into the banking system.  This was done to protect against a greater financial crisis than was experienced and to prevent the banking system from collapsing.  The post-crisis problem is about the ability of the Fed to remove these reserves from the banking system without jump-starting another crisis. But the question is, if the commercial banks have all these excess reserves (about $1.5 trillion of them) and if the banks are beginning to lend again, where is all this money going to go?   

If the economy will not grow much faster, the answer is that the money will force up prices.  These are not “normal” times.  As Guerrera states, “Unfortunately, there is little ‘business as usual’ around. Not at a time when Europe is in recession, the U.S. in the throes of an anemic recovery and even China is slowing down. And not when bank balance sheets are saddled with decaying leftovers of the crisis—asset-backed securities, bad loans and litigation—and vital parts of the system, such as derivatives trading, are gummed up by fears of new regulations.”

This scenario has “stagflation” written all over it.   The economy will continue to grow, but maybe we should start to prepare for our next series of problems.

The Credit Markets: Two Apparent Contradictions

The yield on the 10-year US Treasury bond closed at 2.301 percent on Friday.  The dramatic rise in this yield at the end of last week has many analysts worried that the bull market in bonds is over. 

The yield on the 10-year Treasury was 2.384 percent at the close on last October 27 and at the end of July 2011, the yield was around 3.00 percent, where it had been for some time.

Note that a large portion of the time that the yield on the 10-year Treasury had been at these higher levels, the Federal Reserve had been operating under a policy of quantitative easing.

What set off the decline in yields in August and September was a series of things that lead to a rush into gold and a flight to quality in the financial markets. 

The price of gold had remained relatively stable in the May and June period, but began steadily increasing in July and August.  By August 2, the price of gold reached $1660 per ounce and then flew through $1700 on October 8, the day of the S&P downgrade of US debt.  By August 18, the price closed at $1828 and almost closed at $1900 on August 22.

Even more startling, the yield on the 10-year TIPS turned negative in early August.  On August 10, this yield was -0.155 percent!  In late July it had been trading to yield above 0.500 percent. 

The 10-year Treasury yield plummeted from about 3.00 percent on July 29 to 2.40 percent on August 4 and about 2.00 percent on August 10.

The stock market was also highly volatile during this July/August period. 

And, Treasury yields remained low through the whole Greek debt restructuring that took place throughout the fall into the new year of 2012.

My view: over the past month or so, financial markets have calmed somewhat, primarily due to the Greek situation, and this has been leading to a movement of funds out of US Treasury issues and into riskier “stuff”. 

Then we got the news last week from Mr. Bernanke that the Fed was not going to do much in the way of bond purchases in the near future and, in particular, there was no inclination on the part of the Open Market Committee to engage in a new phase of Quantitative Easing. 

These two factors, I believe, are leading to a reversal from the previous “flight to quality” in the financial markets. 

Since January the ratio of the yields on government bonds relative to Aaa-rated corporate securities has been rising, indicating funds were flowing more freely into other sectors of the financial markets.  Furthermore, the ratio of yields on Aaa-rated corporate securities to Baa-rated corporate securities was rising indicating a relative move to less highly rated credit. 

Therefore, I am less concerned about an end to the “bull market” in Treasury securities than I am about a market adjustment that has followed the “flight to quality” that took place last summer. The economy continues to expand (http://seekingalpha.com/article/437481-economic-recovery-the-good-and-the-bad) and monetary policy will continue to be supportive of a still fragile banking system. 

I am looking more for a relative rise in the yield on US Treasury securities as an indication that funds are flowing back into other areas of the financial markets rather than for a cyclical increase in yields due to a strengthening of the economy. 

There is a second issue I would like to clear up that was brought to my attention by someone commenting on the above mentioned blogpost. (http://seekingalpha.com/article/437481-economic-recovery-the-good-and-the-bad)

In this blogpost I discussed the continued deleveraging taking place in the American economy and the rise in bank lending, which I took as a positive sign that the economy would continue to grow.  One person who commented on this post stated that the idea that deleveraging was to continue but bank lending was increasing seemed to be contradictory. 

As such, the two pieces of information does sound contradictory.  In arguing that “both” of these conditions can exist within the economy I draw on a point I have made continually over the past several years.  My argument has been that over the past fifty years or so the United States government has conducted a policy of credit inflation.  This credit inflation has helped to bifurcate the society as those with more wealth and better access to advice and consulting have been able to protect themselves from the inflation or even take advantage of the inflation to improve their position in the economy.  The less-well off have not been able to even keep up with what is going on.  As a consequence, the income/wealth distribution in the United States has become even more skewed to those possessing wealth. 

As I have described in other places, the current economic policies of the United States government just exacerbate this movement.  That is, the economic policies of the United States government are making things even worse.  Deleveraging continues, but generally amongst those that are less well off, those who are heavily in debt, those who often find themselves underwater with respect to the ownership of their own home, and those who have little or no savings. 

Lending is picking up to others, businesses as well as households, that are not is such a situation.

Thus, you can have bank loans increasing in the economy while many in the economy still have to reduce their financial leverage to even keep going.  I believe we are in such a situation.    

Finally, Some Real Loan Growth at the Banks

It finally looks as if the commercial banking system is starting to do some serious lending.  My last review of the banking statistics focused on the continued flow of funds in the United States banking system to foreign banks and then to deposits in the foreign offices of these banks. (http://seekingalpha.com/article/344571-developments-in-the-banking-sector-still-flowing-to-foreign-institutions) 

At the time, this flow of funds dominated everything else going on in the banking system…especially the lending activity. 

There had been a little pick up in commercial and industrial (business) loans at the largest 25 domestically chartered banks in the last quarter of 2011, but the increase was not too exciting.

Over the last two months or so, business loans at commercial banks have picked up more steam and a good portion of the increase has come at the other (approximately) 6,265 “smaller” commercial banks in the banking system. 

Also, commercial real estate loans and residential loans (home mortgages) showed some strength over the past two or three months at these “smaller” commercial banks.

For the last two years or so I have been looking for some life in the lending portfolios of commercial banks.

I believed that the economy was growing but very modestly.  My concern was that there was so much debt in the economy, household as well as commercial (both in terms of business loans and commercial real estate) that the economy would continue to drag along without much oomph. 

My concern was that households and businesses still needed to do additional de-leveraging before the commercial banks would start lending again and commercial banks needed to start lending again before there would be much life in the economy in terms of economic growth.

Now, I believe, that we are really starting to see some life in bank lending.

Over the past three months, loans and leases on the books of commercial banks in the United States increased by just about $80 billion.  Of this total, $54 billion came in the past month. 

And, to me the surprise in these numbers was the fact that over 85 percent of the increase in these loans came at the (approximately) 6,265 “smaller” banks in the United States.  The totals for these smaller banks were $69 billion and $46 billion, respectively.

Loans and leases on the books of the largest 25 domestically chartered banks in the United States continued to increase over the past three months, but not at the pace experienced by the other banks. 

Not only did commercial and industrial (business) loans increase at the “smaller” banks but there was a pick up in real estate area as well, something that had been sorely missing in earlier.

Whereas commercial and industrial loans at the largest 25 domestically chartered banks rose by almost $26 billion over the last three months, these loans rose by over $20 billion at the “smaller” domestically chartered banks.  In the last month the increase was less that $8 billion at the largest banks and over $10 billion at the “smaller” ones.

The surprise was that commercial real estate loans rose by $17 billion at the “smaller” banks over the last three months while they continued to decline at the largest banks. 

Furthermore, residential real estate loans rose by more than $23 billion at the “smaller” banks in the last three months with $16 billion of this increase coming in February 2012.

To me, this loan growth is GOOD!  It is good for the banks and it is good for the economy.   Let’s just hope it continues!

As far as the foreign-related banking institutions are concerned, cash assets at these banks rose by just about $260 billion over the past twelve months which was 75 percent of the increase in the cash assets of ALL commercial banks in the United States.  This was the concern mentioned in the first paragraph of the post.

The thing about this that we have been watching so closely is that at these banks, Net Deposits to Foreign Offices rose by almost $480 billion during the same time.  The timing of these increases coincided with the sovereign debt problems occurring in Europe and this seemed to indicate that monies being put into the American banking system were being channeled to Europe to help the banks and financial system over there. 

The Federal Reserve System also moved to offset the pressure being felt by the European Central Bank (ECB) and other central banks closely connected to the eurozone by opening up its liquidity swap line with these other central banks. 

Furthermore, the ECB also began to lend on a three-year basis to European banks.   European banks took out more than $1 trillion of these loans by March 1, 2012.

All these actions have resulted in a decline in the cash assets of the foreign-related financial institutions in the United States and basically no change in the net deposits due to the foreign offices of these institutions.  Over the past three months the cash assets of this banks have declined by more than $82 billion, about $52 billion of the decrease coming in the past month. 

So, for the time being, the liquidity problems arising from the sovereign debt crisis in Europe seem to have receded.  However, we will need to keep our eyes on this situation as some pressure is released from the Greek situation and is transferred to other European nations like Portugal and Spain.

So, I am a little encouraged.  But, I don’t want to go overboard in my enthusiasm.  It is good news that commercial bank lending has increased some over the past several months, especially at the “smaller banks”.  It is good news that foreign-related financial institutions seem to have slowed their demand for funds from the United States.  It will be more good news if economic growth accelerates a little bit.