“Any thoughts that participants in the financial community might have had that conditions were returning to normal should by now be shattered…We are left with some very large questions: questions of understanding what happened, questions of what to do about it, and ultimately questions of political possibilities.”

 Former Federal Reserve Chairman Paul Volcker, May 19 (Bloomberg)

 Never one to mince words, the revered ex-Fed Chairman is calling attention to what many of us have been saying for some time – the economy is in worse shape that we have been led to believe; significant problems remain; and it is not all clear that the fixes that have been applied so far are doing, or will do the job.  In short Mr Volcker was saying that the usual “re-flate and wait” strategy is not working (and quite possibly may not work this time around!).

 Following Mr Volcker’s speech at Stanford University last week,  Pinehurst Bank of St. Paul, Minnesota, was shuttered by the Minnesota Department of Commerce, which appointed the Federal Deposit Insurance Corporation (FDIC) as receiver. According to the press release issued by the FDIC. the cost to the taxpayer is expected to be a relatively modest $6.0 million. The failure of Pinehurst makes that bank the 77^th bank to go down in 2010 and the 241^st bank to fail since the onset of the Global Financial Crisis (GFC) in late 2007. 

 At Recovery Partners we have examined the failure data published on the FDIC’s website and have compared recent activity to the failure experience extending back to 1990. What this research reveals is that losses to the deposit insurance funds are far higher than at any time in the last twenty years – including the S&L debacle. The table below shows that at around $73 billion not only have  losses for 2008 to date vastly exceeded the losses experienced by the Fund in the prior period, on a “per bank” basis, the current debacle shows that at 26%, losses are about 2 ½ times larger as a percentage of recorded assets at the time of failure than in the previous period. And, at around a cost of $300 MM per failed institution, the actual dollar amounts involved are around six and half times higher per institution than in the period between 1990 and 2007.

What doesn’t add up here is the fact that we are being told that the failure rate is only a third of what it was in the previous bank failure cycle, when all of the information we have, including the fact that loss severity as a percentage of recorded assets is vastly higher, suggest that the failure rate should be much higher.

 The risk of financial institution failure is high when the following conditions are present:

• Rapid growth in assets is occurring;
• Marginal loans are being made without adequate spreads built in to compensate for the underlying risk
• Balance sheet leverage is high and possibly increasing
• Loss Reserves are not maintained at levels reflecting the risk of loss in the underlying portfolio

 All of these conditions were in place in the run-up to the GFC.

During the run up to the crash, Consumer and Corporate credit growth was booming, growing far faster than nominal GDP. Now credit growth in the US is negative. This will hamper the efforts of banks to restore balance sheet strength and rebuild earnings.

Skyrocketing loan losses in the recent cycle are far higher in aggregate than at any time since this data started to become available. This is because much of the business being written towards the end of the last cycle was mis-priced and did  not reflect the risk of the borrower. This is why….

…..Bank profits are at record lows. As David Rosenberg reports the current recovery in the US is one of the weakest on record and many risks remain, suggesting growth will remain muted, likely accompanied by deflation in prices. This is not good news for bankers or the Federal Government, both of whom are hoping for a recovery in secondary market asset prices

In previous cycles the Fed eased, the yield curve steepened and banks were able to replenish capital resources by capturing the spread between the short end of the curve and term dates. Today Net Interest Margins are only about where they were when the latest Fed easing cycle started. Note also that the present spreads are far below the levels recorded in the previous bank failure cycle.

 Some commentators suggest that because the FDIC has already gone to the Government for a top-up on its Deposit Insurance Fund and jacked up the levy in order to accumulate reserves more quickly, that there should be concerns that the Fund could go bankrupt.

 The issue is not whether the insurance fund can go broke. Not only is this not possible under the existing set of arrangements, it is beside the point. Part of the issue is that from the beginning the US authorities have minimized and downplayed the significance and impacts of the crisis.

 Note that in the late summer of 2008 the FDIC reported that number of banks on its watchlist stood at 117. A year later, the FDIC reported that it had 416 banks on its watchlist. More recently, the Federal agency announced that its watchlist had grown to include 775 banks. Adjusting for changes in the number of banks since the early 1990’s our view is that the failure rate should be at least 2 ½ to 3 times higher than what is being reported; meaning that the number of zombie banks in the US is on the order of 1800-2000 at-risk institutions. Multiplying the average loss figure of $300 MM per bank by that total yields a contingent liability of around $500-700 billion for the FDIC – in short, a pretty scary number.

 The real  issue is thus whether the weakness of the banking system represents another multi-hundred billion dollar black hole that the Feds would need to fill relatively quickly if the true scale of the zombie bank problem were to be revealed to the markets. The reluctance to come clean might be because the authorities themselves realize that markets are currently fragile and the disclosure of another large fiscal requirement might cause a loss of confidence and renewed risk of meltdown; it may be that the US financial managers have been told by key creditor nations that their willingness to underwrite vast new US deficit spending programs for whatever reason is near a breaking point; it might be that yet another “bankers’ bailout”  is deemed politically unpalatable; or it may be a combination of the three issues.

The zombies are out there, problems are not being dealt with expeditiously, the banks know it and this is influencing their behaviour; and these weak financial underpinnings vastly increase the chances of a “double-dip or worse” type of scenario unfolding in the US in the not too distant future. What adds to the worry is that not only is the US  the bellweather economy for the developed world,  but that this same general set of  issues (zombie institutions, authorities in denial, severe fiscal pressure) prevails in a number of other countries - with the obvious potential for ill-timed strains to affect sovereign credit profiles and economic renewal prospects in those places as well…….

Paramedic #1 : You have no pulse, your blood pressure’s zero-over-zero, you have no pupillary response, no reflexes and your temperature is 70 degrees.

Freddy : Well, what does that mean?

Paramedic #1 : Well, it’s a puzzle because, technically, you’re not alive. Except you’re conscious, so we don’t know what it means.

Freddy : Are you saying we’re dead?

Paramedic #1 : Obviously I didn’t mean you were really dead. Dead people don’t move around and talk.

 Return of the Living Dead 1985

This entry was posted on Tuesday, May 25th, 2010 at 12:27 pm and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.