Q3 FDIC Stats - Messy but Improving

The FDIC's quarterly compendium of statistics for Q3 (ended September 30) 2009 is out. Overall the numbers are messy but improving. Here are some highlights and lowlights with my comments:

FDIC insured institutions earned $2.8B vs. a loss of $4.3B in Q2 and an $879 million profit in Q3 2008.

Improvements in securities markets/changes in accounting rules (technically, declines in realized losses on securities), increases in non-interest income (fees) and very large spreads (net Interest income/margins) drove the better results. The first factor is ephemeral, the second unsustainable and the third will likely be the one most relevant to the health of banks and the economy going forward.

Only 43% of all institutions reported higher quarterly earnings versus the prior year. Fully 26.5% of all FDIC insured banks were unprofitable in Q3 09.

Many banks experienced deterioration in their loan portfolios that overwhelmed the positive forces cited above.

Net interest margins (the spread banks are garnering between their own borrowing costs and what they are being paid to lend money out) hit a high not seen since Q3 2005.

The Federal Reserve has been able to engineer an environment where banks borrow dollars from them for nothing, hold those dollars in interest paying reserve accounts at the Fed and lend out funds they don't need to the U.S. government by buying Treasuries or mortgage backed securities. These markets are being supported by Fed buying and now explicit government guarantees. The yield curve continues to steepen (spread between long and short rates widen) as bond holders grow increasingly anxious that economic growth and deficit spending will cause inflation. (Inflation would eat up bond holders returns and hence buyers are demanding higher long-term interest rates). The bottom line is that banks are re-liquified to the point that they appear to be able to afford to take the losses on their debt. This liquidation of bank debt, on the one hand, will take place while on the other hand the federal debt grows. The federal debt is in part being monetized (Fed printing money to buy the debt and support prices) and inflation expectations are being pushed up. WE ARE INFLATING OUR WAY OUT OF THE BAD DEBT PROBLEM BY MAKING MONEY OUT OF THIN AIR THROUGH THE MECHANISM OF SYNTHETICALLY PROPPED UP BANK SPREADS.

Loan loss provisions appeared to peak this quarter, declining 7.1% from Q2 2009 to $62.5B, marking the fourth consecutive quarter above $60B. Despite registering the smallest year-to-year increase in provisions in 2 years, almost 2/3 of institutions increased their loss provisions year-to-year.

Because a well run bank, should be increasing provisions at a faster rate than loan delinquencies are piling up (in order not to fall behind), the potential peak in provisioning activity does not necessarily signal the peaking of delinquencies.

Loan Losses as measured by charge-offs (final tally of the loss from a loan that has gone bad, once it is disposed of by sale, foreclosure, etc.) increased for the 11th consecutive quarter to $50.8B, up 80.5% year-to-year. Charge-offs as a percentage of all loans hit 2.71%, a record since measurements began in 1984.

The biggest increase in charge-offs came from C&I (commercial and industrial loans) which were the last to start going bad (C&I Starts to Unravel), reflecting the downturn in the economy more so than purely shoddy lending practices. Overall the record in charge-offs implies that this credit crisis is worse than the early 1990s experience.

Loan loss reserves grew at the smallest rate in eight quarters but the ratio of reserves to noncurrent loans declining for a 14th consecutive quarter from 63.6% to 60.1%.

While loan reserve growth moderation appears to be signaling that banks believe that they may have reserved enough for the bad debt they see coming, the numbers so far do not bear this out, as reflected by the continuing decline in the ratio of reserves to noncurrent loans.
Banks continue to display a rather cavalier and deceptive attitude towards the bad-debt situation....the earnings improvement on display in these figures, would have been significantly lower had banks reserved enough of their profits to boost their ratio of reserves to noncurrent loans. This is a tack that would seem prudent given the continued growth in noncurrent loan balances.

Noncurrent (90 days past due) loans continued to rise, increasing by 10.5% year-to-year to $366.6B, or 4.94% of all loans. This is also a record. the rate of growth in non-current loans slowed for the second consecutive quarter, and was the slowest in four quarters.

This is the most important figure in this data as far as I am concerned. We are still plumbing the depths of the bad debt. It appears that with the recent slowdown in debt going delinquent and a recovering economy, that we could be nearing the peak of the bad debt problem. Although, there is still much uncertainty with regard to further residential mortgage deterioration and commercial real estate loss recognition.

Overall, I think it would be difficult to argue against the supposition that the banking system continues to be in terrible shape. There are glimmers of light in the darkness of the debt abyss, however. The chief factor that have contributed to the stabilization of the banking system and snap back in financial markets is the massive spread widening engineered by the Fed, and the consequent improvement in net margin driven earnings power of banks. This has tempted investors to bid bank shares up and allowed for a momentous amount of capital raising, yet still the banks are not rich and would appear in even worse shape were it not for accounting shenanigans including reporting as profits dollars that should be being shunted into reserves for bad loans.

I hope this crystallizes for Urban Digs readers why many aver that the Fed will remain on hold for a while yet (they need to keep bank funding costs down and preserve the wide spread) and why I still have worries about "repurfusion injury". That is possible unforseen issues resulting from the massive spread widening campaign (be it inflation, asset bubbles or more bad lending e.g. the FHA) and negative consequences that may be catalyzed by an economy that actually starts to accelerate. Case in point is the situation with C&I loans. Commercial and industrial companies, if well run, produce more cash flow during the onset of an economic slowdown than during an expansion. During slowdowns, these firms run down inventories and collect receivables from business booked previously thereby wringing cash out of their working capital accounts. At some point however if business doesn't rebound cash flow will stagnate at a low level, potentially resulting in an inability to support debt that was sustainable before the downturn and even for a while during the deceleration phase. When demand does return those businesses that can still support their current debt loads often need more money to start to grow their inventories and support receivables growth from their customers. This is often when the businesses are choked by a lack of financing availability. Here is the chart of bank lending included in the FDIC report. As you can see, lending continues to decline, with C&I loans being hard hit. Is it any wonder that the President is cajoling lenders with regard to lending to small businesses. If you are a banker, still sitting on piles of bad debt, making huge spreads while taking no risk lending to the government, why would you want to make loans to commercial and industrial companies, which while high yielding are among the most risky loans you can make? In a strong enough non-inflationary rebound spreads flatten and banks eventually begin to move out on the risk curve (while the risk of making loans to business actually comes down due to the more durable nature of the expansion).

Any way you slice it the banking system is slowly coming out of it's coma. There will be unforseen complications from this near-death experience, which may not currently be factored into buoyant financial markets (which is why I am cautious on stocks right now). Thankfully, we do not all live and die by the stock market and any correction should not be nearly as bad as the prior crash, as long as taxation and spending policies are reasonably supportive of the expansion and sustainable.....a tough balance to be sure but one I wouldn't bet against right now. The slowly improving environment should be supportive of real estate overall. New York City's dependence on Wall Street makes it a special case. I would not worry about the market here running away to the upside while the best of the market and financing activity snap backs may be behind us for now.