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 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.       

Commercial Banks: How Safe is the Banking System?

The commercial banking system in the United States does not seem to be “out-of-the-woods” yet, in spite of the fact that 15 out of the 19 largest banks in the country recently passed the stress test administered by the Federal Reserve. 

For one, many executives of the commercial banks involved don’t seem to understand how the Fed got many of its results. 

In conference calls held after the results of the stress tests were released the banks raised major questions over how calculations of capital were made.

“Healthy institutions want to understand why there were some large gaps between their own capital estimates and the Fed’s, according to people close to those banks.  Some of the five lenders that didn’t pass the test say questions about the Fed’s scoring complicate reapplying for approval to raise dividends or buy back stock…” (http://online.wsj.com/article/SB10001424052702303812904577299611815199568.html?mod=ITP_moneyandinvesting_0)

Problems in interpretation were bound to occur, but, to my mind, the commercial banks have created their own nightmare.

The real problem:  mark-to-market accounting, or, the lack of it.

Executives in commercial banks don’t like mark-to-market accounting.  The basic reason is that they don’t like to admit that they have made mistakes or that they have taken on too much risk or that they just don’t want to deal with messy issues. 

When the value of bank assets decline, either because loans have gone sour or because interest rates have risen and the market value of securities have dropped, analysts argue that the banks should mark their assets to market so that they can get a real picture of how the bank is performing…whether or not the bank is solvent.

Bankers argue back that they shouldn’t be made to mark their assets to market “after-the-fact” because that forces them to change their balance sheets that were not expected of them before.  And, they also plan to hold their securities to maturity, when they would get their full value repaid, and they also need time to “work-out” their troubled loans as the economy improves.  They argue that analysts, by asking for them to go to mark to market accounting, are changing the “rules of the game” after the economic and financial environment has changed. 

So, the bankers can put on riskier loans, buy securitized bonds, mismatch maturities, place SIVs off-balance-sheet, and so forth, and when the economy turns south, they do not have to reveal to the public…and the regulators…what their decisions have done to the health of the bank!

They ask, “I have mismatched maturities to earn a few more basis points on my return of assets to try and keep up with the competitors, and now, since interest rates have gone up I have to mark the longer term assets to market?”

Well, you took the risk, you must own up to the consequences.  Arguing that you intend to hold the assets to maturity doesn’t “hold water” because as short-term interest rates continue to increase you will either have to sell your assets or work with a negative interest rate spread.

Also, Mr. Banker, when you made riskier loans…like subprime loans…you were stretching for yield.  You made the choice.  As the market moves, so does the value of your assets.  Own it.

  

Since the commercial banks have fought the development of an adequate mark-to-market accounting process, the Federal Reserve…and others…have tried to create a substitute for this accounting treatment of assets.  This substitute is called the “stress test.”

The “stress test” works with assumptions.  “Last November (the Fed) published test assumptions, such as a 13% unemployment rate in a U. S. recession.

But the Fed is resisting full disclosure of its methodology, hoping to retain the flexibility to make future changes and prevent the banks from gaming the numbers…”

The commercial banks “game” their own accounting numbers by not marking their assets to market.  The fear with stress tests is that the commercial banks will “game” the tests if they know what the Fed’s assumptions are.  The commercial banks want it both (all) ways.

And, how well off are the commercial banks?

Jesse Eisinger writes in the New York Times about the annual report of the Federal Reserve Bank of Dallas.  Although the article concentrates on the issue of “too big to fail”, Eisinger does print a quote from an essay in the annual report written by Harvey Rosenblum, the head of the research department at the Dallas Fed.

Rosenblum wrote: “Monetary policy cannot be effective when a major portion of the banking system is undercapitalized.  Many of the biggest banks have sputtered, their balance sheets still clogged with toxic assets accumulated in the boom years.” (http://dealbook.nytimes.com/2012/03/28/banking-regulator-calls-for-end-of-too-big-to-fail/?ref=business)

This from the head of a research department within the Federal Reserve System!

And, what about the other banks in the system?

As last reported by the FDIC there were 814 commercial banks on the list of problem banks.  There are many more on the edge of becoming problem banks.  The number of commercial banks in the United States dropped by 240 last year and only 92 of these were bank closures.  In both cases, the numbers included no banks that could be called “the biggest banks.”

You wonder why the Federal Reserve has pumped almost $1.6 trillion in excess reserves into the banking system?

I have argued for more than two years now that the Fed’s ease is not just about getting the economy going again.  In my opinion the Fed has been as generous as it has been in order to allow the FDIC to close or to approve the acquisitions of troubled banks in an orderly manor so as to allow the banking system to adjust to its “insolvency” problems as smoothly as possible.

I agree with Mr. Rosenblum, I think that there are still too many “toxic assets” on the balance sheets of commercial banks…large, medium-sized, and small.

Without some kind of adequate mark-to-market accounting process in the commercial banking system, we will continue to be “in the dark” with respect to the health of banking institutions and banks will be able to continue to “game” us.

Having an adequate mark-to-market system in place will cause bank managements to conduct their businesses in a less risky fashion.  And, only by having an adequate mark-to-market system in place will bank managements move to address the problems they face in real time, something they currently are loathe to do.