Bank COPs and Bank Robbers

We have been seeing and feeling the impact of the bank robbers for a couple of years now. It is time that we contemplate the reactions of the bank cops. Noah's post on the accounting shenanigans going on in the banking industry are part of the age-old back and forth of real estate cycles, financial market crises and banking system resuscitations. For those with a mind for history it is worth noting that the real estate market, which was riding a wave of speculation centered on Florida, peaked in 1926, 3 years before the stock market peaked and well before the Depression set in. Only after the Depression set in did waves of bank failures follow.

The rolling regional real estate crashes of the mid- to late 1980s, precipitated a savings and loan crisis that dragged on and on, but the true credit crunch didn't hit until the early 1990s well after the stock market crash of 1987, when recession finally took hold. It was during this period that regulators "got tough." It was actually 1989 when the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) regulation went into effect. It was following this that bank regulators began cracking the whip on financial institutions, in effect forcing the clean-up of the toxic assets that had been collecting for half a dozen years. Some would argue that they also precipitated the credit crunch. In fact, banks eventually ended up reversing billions in charge-offs they were forced to take by regulators in those days.

It is clear that bankers are anticipating a repeat of history this time around. Unfortunately I think they are likely to be wrong and I will discuss a few reasons why in a future piece. Today let's just focus on the current state of affairs in the banking system.

The cataclysmic mix of Lehman and AIG going under, interest spreads blowing out, credit default swaps imploding and money market funds busting the buck collaborated to force the government to switch from a policy of remediating bad debt through "resolution" as they did in the 1990s, to throwing a TARP over them so that banks could claim solvency and forestall a massive bank run. As noted in the recent report by the Congressional Oversight Panel (COP) on the continued risk of troubled assets:

Given such market conditions, Secretary Paulson and Chairman Bernanke recognized that Treasury needed to use the authority and flexibility granted under the EESA as aggressively as possible to help stabilize the financial system. They determined the fastest, most direct way was to increase capital in the system by buying equity in healthy banks of all sizes. Illiquid asset purchases, in contrast, require much longer to execute......

Now, ten months after its creation, TARP has not yet been used to purchase
troubled assets from banks, although the capital infusions have provided breathing space for
banks to write-down many of these assets and to build loss reserves against future writedowns
and losses.

The report goes on to comment on the undesirable effect that TARP is having on bank lending (as predicted here way back in our January 5 2009 piece entitled "Excess Reserves Go Berserk As Lending Flatlines")

The uncertainty created by the financial crisis, including the uncertainty attributable to the troubled assets on bank balance sheets, caused banks to protect themselves by building up their capital reserves, including devoting TARP assistance to that end. One byproduct of devoting capital to absorbing losses was a reduction in funds for lending and a hesitation to lend even to borrowers who were formerly regarded as credit-worthy.

The report rightfully points out the continued risks to the economy and financial system that are not being addressed as long as losses are not taken and cleared off banks' books. But why clear these loans if you are not forced to and you believe that these assets will be worth more in the future?

If the economy worsens, especially if unemployment remains elevated or if the commercial real estate market collapses, then defaults will rise and the troubled assets will continue to deteriorate in value. Banks will incur further losses on their troubled assets. The financial system will remain vulnerable to the crisis conditions that TARP was meant to fix. The problem of troubled assets is especially serious for the balance sheets of small banks. Small banks' troubled assets are generally whole loans, but Treasury's main program for removing troubled assets from banks' balance sheets, the PPIP, will at present address only troubled mortgage securities and not whole loans. The problem is compounded by the fact that banks smaller than those subjected to stress tests also hold greater concentrations of commercial real estate loans, which pose a potential threat of high defaults. Moreover, small banks have more difficulty accessing the capital markets than larger banks. Despite these difficulties, the adequacy of small banks' capital buffers has not been evaluated under the stress tests.

Why will the banks who were stupid enough to make these loans....and we all know now that it wasn't just sub prime credits or highly leveraged corporate buyout loans, but also aggressive lending across the board from credit cards to commercial real estate.....be smart enough to predict when these values will come back?

Circling back to Noah's piece on the changes to GAAP accounting for loan losses, the COP report also touches on the negative effects of letting the foxes guard the proverbial chicken coop of bank accounting:

The details of these accounting issues are less important than their impact. As a result of the crisis, asset values are uncertain. By increasing bank managements' use of discretion in valuing assets, the new rules reinforce the underlying uncertainty in valuation, especially because banks may not apply the rules in a uniform way. Thus, there is no way of knowing whether a bank's assets are of a sufficient realizable value to support the bank's liabilities, let alone to preserve the capital necessary to support lending. To lower the risk of this uncertainty, banks, especially large banks, have reduced participation in the credit markets. Whatever the merits of the new accounting rules, their application adds to the sort of uncertainty on which financial crises feed.

I will make a prediction right now. At some point the government, unhappy about further deterioration of banks' balance sheets and or their inability to lend to individuals and businesses who at some point will want to borrow again, will force the issue through the use of regulatory pressure. When this happens we will see another leg of the liquidity crisis. The tough love approach was untenable during the heat of the financial crisis of late 2008, but the Treasury was later forced to make a show of its largesse being justified, through the "stress tests" that followed the bailouts.

Until regulatory reform is accomplished, following the obligatory turf wars of course, the persecution of the banks will not begin. So we have some time before the bell tolls for the banks. In fact, we may go right through the period of inventory restocking and "renormalization" of the economy to a new equilibrium level of GDP and consumer deleveraging. Of course, bankers' optimism relative to loan values will only increase over that time, making them more recalcitrant in dealing with their likely losses.

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