"Banks - Is There Another Chapter to the Story"

Sydney M. Williams

Thought of the Day

“Banks – Is There Another Chapter to the Story?”

October 6, 2010

In a report on Monday, J.P. Morgan notes that 295 banks with $600 billion in assets have failed since 2007, and that the number continues to rise. What seems remarkable to me is that more banks with even greater assets have not failed. Perhaps they will, though the rate of failure has moderated this year.

Reflecting the demise of manufacturing and the rise of the service economy, the Financial Sector’s weighting in the S&P 500 has expanded from 0.8% in 1970 to 21.3% in 2005 – from the smallest segment to the largest. (Today, Financials have shrunk to 16.3%, second to Information Technology.) Despite the beatings bank stocks endured in 2007-2009 due to a near-death experience in 2008, the twenty year stock performance for most of the larger banks – notable exceptions being Citigroup and BankAmerica – has substantially trounced that of the market. The shares of JP Morgan, US Bancorp and Wells Fargo, for example, have outperformed the market by a factor of four over the last twenty years.

The nexus of Banks’ extraordinary growth during the 1990s and the first half of the 2000s included an expansion in risk taking via an aggressive use of off-balance sheet vehicles, the creative use of derivative instruments, the elimination of many components of Glass-Steagall, the growth of proprietary trading desks and favorable treatment by the Federal Reserve which accommodated their money needs by keeping interest rates extraordinarily low in the early 2000s. But, as much as anything, it was the housing industry – the run up in prices, the use of new and innovative mortgages, and persistent low interest rates – that encouraged risk taking by individuals and led banks to the edge of the precipice.

The value of the housing stock in 2007, according to data from the Federal Reserve, was estimated to be $21.15 trillion, against which were just under $10 trillion in mortgages. The Case-Shiller Home Price Index for their 20 City Composite showed a peak to trough decline of just under 30%. While home prices peaked in late 2005-early 2006, the data suggests a decline of about $6 trillion, or 60% of the equity value of homes!

Smaller businesses would have been allowed to have failed, but the banking industry was deemed integral to global capital markets. And it was decided large banks were to big too fail. The system could not fail, and it did not, though the landscape is littered with victims.

The Treasury acquired billions in troubled loans, made equity investments in banks, and guaranteed other loans and deposits. The Federal Reserve, by December 2008, had lowered the Fed Funds rate to 25 basis points from 425 basis points a year earlier. In keeping Fed Funds close to zero, and with a steep yield curve, the Federal Reserve permitted banks to reduce risk, while allowing them to earn (essentially) risk free returns. In acting as quickly and as expeditiously as they did, the Bush/Obama Administrations saved the financial system in late 2008-early 2009; however, they also sowed the seeds of the Indian summer we are now experiencing.

The Fed is certainly aware that they have provided ideal conditions for banks. Easy and cheap credit and a steep (though now moderating) yield curve allows banks to earn (relatively) risk free returns, permitting them to rebuild their balance sheets. The Federal Reserve and HUD have been discouraging banks from foreclosing on mortgages, as the damage it does not only to the mortgagor, but to the neighborhood and the economy. The question occurs: is this a deliberate policy – allowing banks to rebuild their balance sheets, so that write-offs of troubled loans can be postponed to a more opportune time?

There have been two other times during the past eighty years when the banking industry was under severe stress. The first was in the 1930s when margin calls (stocks could be bought on 10% margin in the late 1920s) forced speculators to raise cash, which created runs on banks. By 1933, 4000 banks with $140 billion in assets had been closed. Adjusted for inflation, that $140 billion would be equivalent to $2.3 trillion today! (And, of course there was no deposit insurance at the time. The FDIC was created in 1933, in conjunction with Glass-Steagall.) The second time was the S&L crisis in the late 1980s and early 1990s. Over a ten year period, 2800 banks with assets in excess of $500 billion failed. The negative consequences of the latter period, while severe for some, never reached the levels of today, let alone the 1930s.

The fragility of the economy is obvious. Many economists have lowered expectations for GDP for the balance of this year and for 2011. Employment is anemic. The risk of a double-dip exists. The Fed is considering extending quantitative easing. Interest rates are being kept low. Countries around the world are competing for the lowest currency valuation – a race of questionable wisdom, in my opinion. What does that mean for global growth? If we are all exporters, who buys? Confidence is AWOL. Thus far the only inflation we are experiencing is in commodity prices, harming the poor, as the Wall Street Journal makes clear in an article this morning, “Middle Class Slams Brakes on Spending”. While spending for upper and middle income people is lower, driven by fear, “The lowest earners spent 15.4% more on food last year than in 2007, shelling out more on cereals, meat and processed vegetables.” It raises another question, are our fiscal and monetary policies helping or hurting?

I am not an analyst and don’t pretend to have answers. Banks may have moved beyond the worst of their write-offs, but a second half may lie ahead? I don’t know. The market does, however, look ahead and perhaps we should take comfort in its recent performance, but one thing I do know – markets never move in straight lines.