Tony Jackson in the Financial Times ponders whether banks are in worse trouble than we realize. “Maybe some of their grosser offences, such as huge sign-on bonuses, are in fact defensive action against the real credit crunch to come. In which case, hitting them with capital requirements now may mean we assuage our feelings at the expense of our pockets.”
The cycle of news recently has been feeding a general complacency that “the worst is over,” things are “less bad” and an economic “recovery” is upon us. In the last six months some of the largest U.S. banks have been able to raise additional capital (generally by selling additional shares of stock) and repay the Troubled Assets Relief Program (TARP) funds injected by the government last fall, economic statistics have shown increases in manufacturing, consumer spending and home sales, and the stock market has bounced approximately 60 percent. Many stock market pundits have noted that severe economic declines are almost always followed by better-than-expected robust growth, and so, the market still offers value (“stocks are cheap”) even at the current levels.
Thus, this strange cycle becomes self-fulfilling. A bank announces it is raising capital, a piece of economic data arrives showing that a part of the economy is no longer looking like the “end of days” is upon us, the stock market rises, making people feel better, so they pay their credit card bills that month and maybe buy a little more (provided they are employed), and then the banks feel better and they make sure they say so, and the stock market rises a little more, and then people get nervous that the stock market is going to up forever, and so they buy more stocks, and then banks sell more stock, sensing an opportunity to easily raise capital, and so on.
This is all well and good, certainly much preferable to the situation one year ago, but it is not the stuff of a strong economic rebound that will result in new jobs and a return to the robust growth rates we have been fortunate to live with the last 30 years or so. There are at least three problems: (1) government spending is almost entirely responsible for the stabilization in the economy; (2) the banking industry still has a lot of problems; and (3) jobs are still slipping away and are not likely to return.
This blog has beaten to death the first issue, government spending. For detail please click on the following links: (More Positive Signals in August 2009, But is Inflation Heating Up? and Bank of England Holds Rates Steady, Continues Quantitative Easing: Is There Now Moral Hazard at Work in Equity Markets?). To summarize, the federal government has spent to save the banking industry, the automobile industry, the housing industry, municipal bonds, money market funds, and the list goes on including the $787 billion stimulus package. Consumers have returned to saving and corporations are hoarding cash (not to mention that corporate insiders have been selling shares of their stock lately). It is not yet foreseeable that private sector spending will regain its pre-crisis levels. Therefore, the stock market seems to be pricing in earnings growth that will not likely come from private sector spending. The government could continue to fill the gap, and keep interest rates extremely low to encourage borrowing and spending, but we do not know what the consequences (both intended and unintended) of such strong actions may be.
The jobs situation is also pretty dire. Even though the monthly job losses seem to be ebbing, there are still monthly job losses, not gains. We should let the data play out for a few more months though to see whether the jobs market recovers.
This brings us back to the issue that started this column: the banking industry. While most media headlines tout the repayment of $75 billion in TARP funds by certain large banks or focus on the drama surrounding the Bank of America-Merrill Lynch merger during the credit crisis, a few analysts still have their eyes on the industry as a whole, and what they see is very troublesome.
The noted banking industry analyst firm, Institutional Risk Analytics (IRA), recently issued its latest report grading banks all across the country. The company takes data from the FDIC and crunches it with their own set of risk parameters. While the FDIC has a little over 400 banks on its current “watch” list, IRA gives 2,256 banks a grade of “F.” The firm projects that over 1,000 banks will either fold or be taken over during the current cycle.
To date in 2009, a total of 92 banks have failed across the country, compared with 25 for all of 2008, according to the FDIC. That leaves roughly 900 more to go.
The banks rated “F” have total insured assets of $4.46 trillion. In the current cycle to date, banks that have been taken over by the FDIC are showing losses of 25 percent.
IRA comments:
An important point in the analysis is that estimated losses for failed bank resolutions by the FDIC are running around a quarter of failed bank assets, a level much higher than between 1980 and 1995, when failures cost an average 11 percent. Our firm’s long-held view of the likely loss rate peak for the US banks in this credit cycle is 2x 1990 loss rates or, as noted by the IMF, around 4 percent of total loans. Since total loans and leases held by all FDIC-insured banks was some $7.7 trillion as of Q2 2009, the IMF estimate implies a cumulative loss of over $300 billion.
If you start with the internal assumptions used by our firm that roughly half of the banks currently rated ‘F’ or some 1,000 banks will fail and/or be merged with another institution and that the loss to the FDIC bank insurance fund will be approximately 20-25 percent of total assets, then the cost of these resolutions to the FDIC through the full credit downturn could be in excess of $400-500 billion.
Keep in mind that in making this alarming estimate we ignore other banks currently
in ratings strata above “F” and that some of these institutions may indeed fail
as well. Also, our overall “worst case” or maximum probable loss (“MPL”) for
large US banks above $10 billion in assets is $800 billion through the current
credit cycle.
[SOURCE: John Mauldin, The Hole in FDIC]
From almost $60 billion last fall, the FDIC’s reserves have been drawn down to only about $10 billion today (after set-asides), a 16-year low. A quick look at the FDIC’s own data shows us how inadequate those reserves are compared to the deposits they are now insuring. The FDIC only has about two-tenths of one cent for every dollar of assets it covers.
In conclusion, while stock market bulls and bears can trot out prior market performance statistics and argue whether the market is over- or under-priced, investors need only look to the facts of the ongoing credit crisis to know that the usual elements that spark a recovery from a deep recession are not lining up at this moment, and that serious problems lie ahead along with the uncertain outcome of such heavy government intervention. The point is not to argue whether things will continue to improve or whether they could get ugly once again or to try to time the market to take advantage of either outcome, for both have plausible arguments. Rather, one should simply note that now is not a time for the prudent investor to needlessly chase returns by taking on increased risk.
Gregg D. Killoren
victoria1014
