Banking Industry Sinking Faster Than Government Can Bail?

A useful piece at the Wall Street Journal discusses the poor prospects for the US banking industry, which will in aggregate post a fourth quarter loss despite heroic interventions by the Fed and Treasury.

The article makes much of recent and almost-certain-to-get-worse bank credit losses as the economy continues to deteriorate. Commercial real estate vacancies, particularly of retail space, are starting to mount. Construction loans were an important business for local and regional banks; a high proportion almost assuredly no longer look viable. And we of course have the grim outlook for credit cards and ongoing weakness in housing.

But the credit losses are masking a second problem: banks’ earnings engine in broken. As many have noted, as long as they are taking losses, they are not terribly keen to extend new credit.

But more serious is the fact that banks had shifted their business model to be more depended on fee income, and much of that was related to the securitization of real estate. Pending changes in credit card rules will dampen down some of the non-interest charges banks could formerly extract. Similarly, a world where the Federal government has become the 800 pound gorilla provider of mortgage credit offers far fewer fee opportunities to banks (and that’s even before considering that transaction volumes are down too).

And as we (and others) have complained, “Where’s my bailout?” maybe it’s time we also start on the less catchy but no less important, “Where’s the good bank/bad bank?” Until the dud assets are recognized, sold off, and banks recapitalized or liquidated, the industry will have a heavy millstone around its neck.

From the Wall Street Journal:

Banks and savings institutions in the U.S. appear headed for their first overall quarterly loss since 1990, as troubled loans pile up faster than the federal government’s unprecedented efforts to aid the battered industry….

“The earnings power for this industry has absolutely collapsed,” says Eric Hovde, chief executive of Hovde Capital Advisors LLC, a money-management firm in Washington that specializes in financial services.

Nearly a quarter of U.S. financial institutions reported a net loss for the quarter ended Sept. 30. The percentage is likely to climb when fourth-quarter results are announced in January, with some analysts predicting that even stalwarts like J.P. Morgan Chase & Co. could tumble into the red….

The glum fourth quarter is an ominous sign for 2009. The U.S. government so far has poured $169 billion into more than 130 financial institutions through its Troubled Asset Relief Program, according to Keefe, Bruyette & Woods Inc. But some banks already are looking for more money or hoarding their existing capital in expectation of another awful year.

Yves here. Repeat after me: you need recapitalization AND price discovery. The near pathological avoidance of the latter by the officialdom would seem to support widespread suspicions that marking assets to market, or even a realistic notion of longer-term value, would confirm that the industry is insolvent.

Back to the article:

In the past few weeks, some analysts have cut 2009 earnings forecasts and stock-price targets for a slew of big and small banks. These analysts expect rising unemployment to trigger deeper losses on credit cards, mortgages and home-equity loans as more consumers fall behind on their bills. Combined with newer problems rippling through commercial real-estate and other types of loans, many banks will need to bolster loan-loss provisions, eroding profits further.

“We believe that deteriorating economic conditions will cause asset quality to get worse in 2009, revealing the inadequacy of loan-loss reserves and impairing profitability,” Jonathan Glionna, an analyst at Barclays Capital, said in a report earlier this month. Nonperforming assets among the 27 financial institutions he covers will rise to $125 billion in the fourth quarter from $43 billion a year earlier, he estimates.

By the end of next year, the figure could top $200 billion, he said…..

As conditions worsen, struggling banks are expected to turn to private-equity firms and other outside investors for capital. Even some of those getting a government infusion may need more capital, analysts warn. Interest in shoring up financial institutions is rebounding as regulators warm up to granting bank charters to nonbank investors.

Ahem, PE firms like to buy assets they can leverage. The reason everyone wants to PE firms to inject capital into banks is to help increase their equity bases, which would lead to a reduction in leverage. That would seem to be an out-trade.

Plus the example of TPG’s $7 billion investment in WaMu blowing up so quickly and completely has no doubt had a considerable deterrent effect on other PE firms who might otherwise have considered taking a flier.

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  1. artichoke

    “Interest in shoring up financial institutions is rebounding as regulators warm up to granting bank charters to nonbank investors.”

    Not to this taxpayer. I’m sure not warming up to the idea of bailing out any more banks. I think the second half of TARP should be rejected by Congress.

    I don’t mind bailing out GMAC, only because it’s a part of GM. Car companies we need ultimately. Banks can all go to h e double hockey sticks.

  2. David

    If people want to see what the US banking system will look like in a year or two, I suggest they look at Puerto Rico. PR banks are part of the US financial system and regulated by the FDIC and Fed. However PR has been in recession for several years now. Most of these banks have non-performing loan ratios between 10% and 20%. Yes that is not a typo. The situation seems much like the US mainland but rolled ahead by about two years. Residential mortgages and consumer loans were the first wave of trouble and are now recovering. But commercial loans starting blowing up last year and finally construction loans are blowing up now. If the US mainland follows the same path, they have several years of pain ahead of them.

  3. wintermute

    Yves you are 100% right (as usual!). Governments the world over a bailing out banks – but they are loathe to unravel their liabilities and enable price discovery.
    This recession will last as many years as it takes to unravel the complex products built up over this decade. Governments must be looking for the easy way out – which is for QE to re-inflate underlying asset prices to a “reasonable” (2007?) level.
    They are ignoring human nature. Now that lenders and consumers have been burnt by the events of 2008 they will be gun-shy for years now. Frugality is reborn.
    This means that price discovery has to happen. The Japanese are only just coming to this conclusion – 15 years late.

  4. bg

    “Yves here. Repeat after me: you need recapitalization AND price discovery. The near pathological avoidance of the latter by the officialdom would seem to support widespread suspicions that making asset to market, or even a realistic notion of longer-term value, would confirm that the industry is insolvent.”

    ahem, Yves. The industry is insolvent, and the goverment knows it. I cannot say why they feel delaying the pain is better, but they obviously prefer purgatory to the lapping waves of fire in the pits of hell.

  5. Anonymous


    CORPORATIONS want to delay the pain as long as possible so their EXECUTIVES can continue collecting perks and bonuses, and their SHAREHOLDERS collecting dividends, as long as possible.

    As soon as you recognize this simple fact – that the CORPORATION is merely a legal document and an account balance but the EXECUTIVES and SHAREHOLDERS are the predators who loot it – you will begin to understand why a growing chorus of voices is saying, “Let them fail, consequences be damned!”

    Better a quick crash than grinding down the economy for a decade or longer before an even bigger crash.

  6. Anonymous


    Thanks for your comments re: Puerto Rico. I’d like to research further. What sources do you use for this information?


  7. Anonymous


    Excellent post once again! Yes, the banks appear to be insolvent. In consequence, the U.S. looks to be heading towards a long slow grind downward.

    I for one actually hope this is the case. At least a long slow grind to S&P500 at 400 is predictable. One can plan for this. A catastrophic collapse would create a level of cognitive dissonance in the general population such that this country would probably become a living hell!

    Keep up the great work!

  8. tbrown

    I think one aspect of the recapitalization/price discovery/insolvency debate that is missed out is that of time. Assuming that a bank can actually make money this year from the existing loans they have outstanding, then the retained earnings will repair its equity base, potentially taking it back to a solvent position.

    Obviously there’s the bold assumption that banks will make money in ’09, but please forgive me that one for now.

    Suppose a bank has equity of 10, deposits/debt/wholesale funding of 90, and extended loans of 100, which are now worth 90, but have not been written down because someone’s classified them as level 3 assets. Equity equals zero and the bank is insolvent, let alone within minimum solvency requirements.

    Anyway, suppose the bank generates a ROE of 10% and earns 1 on Net income, which goes to equity…

    the bank now has equity of 11, debt of 90 (probably not much of it wholesale any more, but let’s ignore the details for the sake of this illustration) and the assets still worth 90, but priced at 100…

    Anyway, it gets to the point where the bank has enough retained earnings that it can take the deserved writedown and still have enough equity to satisfy regulatory requirements. The bank is no longer insolvent and has saved itself.

    So, given that it seems banks aren’t going to go through the writedown to levels that the market believes realistic/recapitalization process, the questions I’d like answered are:
    – can banks make positive interest spreads on the business they’ve already got on their books based on their new funding regimes? (Like Yves said, they’re not extending much in the way of new credit)
    – what are the ROE’s going to look like, and how fast will this repair the capital base?

    If the Fed, BoE etc are all guaranteeing bank debt for 3 years, then when the banks come to refunding themselves, they’ll have 3 years of accumulated Net Income. That might fill a few holes, and we might get away with it.


  9. fresno dan

    “The near pathological avoidance of the latter by the officialdom would seem to support widespread suspicions that making asset to market, or even a realistic notion of longer-term value, would confirm that the industry is insolvent.”
    So much for all that advice given to the Japanese. We will pull the bandaid off even slower.

  10. River

    Yves, great post. Great work as usual!

    If we connect a couple of dots…the Brad Setzer post and this one, we might come to a conclusion, right or wrong, that we know the reason that the Fed dreads the banks admitting insolvency.

    I doubt TPTB in China will go down in flames while propping up the US economy. I suspect that China will take the path of least resistance and that might be first through the treasury sales door. The ice is becoming thinner.

  11. Glen

    Like a circle in a spiral
    Like a wheel within a wheel
    Never ending or beginning
    On an ever-spinning reel
    Like the circles that you find
    In the windmills of your mind.

    As you said Yves; “you need recapitalization AND price discovery”. With cheap cash, ever rising asset prices were adjusted up, recapitalised accordingly and borrowed against so must be the reverse. Even though we have cheap credit, we now have a downward spiral.

    Until all the players can lay their cards on table in an open and honest manner only then can the debts be realised and price discovery can begin. Postponing debts until the next quarter only smooths out the balance sheet while the market assumes that there is worse to come. In the meantime the banking system will be rightly treated with suspicion it deserves and only pushes price discovery all that further away.

  12. Anonymous

    There may be more than one issue here. Firstly the business models used by some banks over the last few years will need to be changed and revenue streams from those new models may be considerably lower. Admitting that to shareholders may be difficult.

    Secondly the business model where you securitised and relied on bond insurance and ratings agencies assessments is broken. Banks have taken to hiding a lot of this securitised debt in their tier 3 assets, knowing the market values of these assets are lower than they claim. Some banks appear to be taking the step of deconstructing the securitised bonds into separate components. Other banks appear to be resisting this as the costs involved in properly assessing risks at the individual loan level would completely break their business model. Proper assessment of individual loans, costs money and any bank going down this business model route has to compete with the US Treasury who are not looking at costs or proper assessment, but just undercutting current prices.

    The follow on question must be how much on the banks books is susceptible to revaluation during a significant downturn. Internally within banks and within the banking community this ought to be a known factor and banks have had ample opportunity to shift their riskiest portfolio on to the treasury. The treasury has its own stake in the game with the exact extent and liabilities it has accumulated being hidden, in a way that suggests the taxpayer is on the hook for far more than anyone realises.

    Banks are playing hide the truth from shareholders, and stall changing there business models in the hope some aspects of the old model can be resurrected and the party for banks and their share holders will continue. The treasury hides the truth from the tax payer and stalls revealing liabilities in the hope that some aspects of the old model can be resurrected. If shareholders and taxpayers are unwilling to perform due diligence in their responsibilities then they deserve what they get. Treasury actions are preventing banking business model adjustments which need to be made and it seems inevitable to me that all US banks will eventually fail as a result. European and Japanese banks will be waiting in the wings to pick up some of the pieces.

  13. donebenson

    It seems that no one in the Fed or the Treasury bothers to read Ken Rogoff’s conclusions that the Swedish model of rehabilitating insolvent banks works the best. Sweden nationalized them, wrote off all the bad loans, and then re-privatized the banks when they were strong enough to stand on their own.

    Without doing this, we are going down the path of the Japanese, with our own version of a ‘lost decade.’

  14. Anonymous

    Bank balance sheets are like whipped cream on s**t:
    The Fed supplies the whipped cream which is sold to pay bonuses out of “profits”.
    The stench has become overwhelming, however, so the Fed has begun shoveling the s**t onto its own balance sheet.
    U.S. taxpayers will be told to eat the s**t.

  15. Gloppie

    “The near pathological avoidance of the latter by the officialdom would seem to support widespread suspicions that making asset to market, or even a realistic notion of longer-term value, would confirm that the industry is insolvent.”

    Banks have been leaching on Society’s body for decades, what do you expect?
    Those bastards do not produce any-thing-. Paper profits, numbers on an excell spreadsheet. Bits in cyberspace….
    Mao Zedong said of the US that we are a Paper Tiger, in 1946. I guess he called our bluff earlier than anybody else.

  16. Anonymous

    If I started a community bank today I could make a very attractive NIM and ignore fee income entirely.

  17. Anonymous

    This is a key issue in the financial crisis and it’s interesting and disturbing that no one has a really clear idea of the size of the decrease in financial services industry equity capitalization because so many capital markets participants play a role in supplying financing for the US. In a recent report, Citibank claimed that the equity capitalization of the US banking sector was around $5 trillion. That number appears to include US financial services company capital allocated to overseas operations and does not include:

    1) Capitalization of US subsidiaries of foreign financial services companies (eg, Deutsche Bank’s US operating companies);
    2) Equity capitalization of asset managers who can supply personal, corporate and public financing, ranging from life insurers to hedge funds to mutual funds.

    Note that the Fed reports commercial bank assets of around $12tr with an equity capitalization of just over $1tr. Obviously, that is just one segment of capital providers in the US.

    Meanwhile, the US is laboring under a debt load that can be estimated at somewhere between $50-55tr (3.5x GDP).

    So the issue is shrouded in uncertainty at even the most basic levels. I have no idea what financial services equity available to fund US debt really looks like and I am concerned that regulators don’t know either.

    Yves – Your blog is excellent and I read it every day. One thing I would like to see more of is actual quantitative discussion of the US (and int’l situation). The Fed quantitative easing approach seems logical on a conceptual level. What makes me think that it has no chance of working is that, based on admittedly incomplete information, the numbers don’t add up. The US govt can simply not add $10-15tr in debt to make up for the deleveraging process. It’s simply not feasible. And that $10-15tr number is conservative.

  18. dearieme

    “If I started a community bank today ..”: my plans include its name (Dour and Daughter) and its slogan (The bank that likes to say “no”.)

  19. Seer

    hi Yves,

    perhaps it is the desired outcome to break the model which banks use to make money, that will leave only the state and the fed standing(private bank) meaning that whoever own the fed and rule the government just have it all.

    seeing that it is the fed and gov who caused this problem together and that it is them together presenting the “solution”, it doesn’t seem improbable, does it?

  20. wintermute

    There is one problem with the Swedish model which means it can;t work now.
    When their banks went bankrupt -they had “conventional” loans – not securitised loans. That level of indirection means that not only are banks insolvent -but the systemic ramifications of the general insolvency is unmeasurable. There are hundreds of non-banking “shadow-bank” institutions which need to come clean and participate in the price discovery. This is too painful for governments within an electoral sycle – they choose QE, currency weakness and inflation instead.

  21. joebhed

    deyawl coodanode.
    and, dey did.

    And, like many said here, dey are just squirming and cajoling to keep the whole thing floating – long enough, hopefully, to sock enough away to send the kids to college.
    you know, business school.
    Where they teach this business model.
    And nothing else.
    So we can all get ready to do it again.
    Soon as regulation becalms, and deregulation emerges.
    Ahhh, today’s capitalism business model.
    We forget at our peril Congressmen Wright Patman and Louis McFadden’s warnings, both gentlemen long-term Chairs of the House Banking Committee, about the Federal Reserve System and private debt-money creation.
    Let’s pretend that private fractional reserve banking is not the problem.
    And move on to next week’s surge of failures.
    Lots to chat about.

  22. Anonymous

    Price discovery?

    The theme song of central banks is “Don’t Stop Believin'”. Price discovery would mean the jig is up.

  23. Anonymous Monetarist

    The multi-trillion dollar question is … how insolvent are they?

    Doubt that we will know the truth nor the composition of the 2 trillion the Federales have in ‘good collateral’ until the demand restoration project concludes.

    Methinks eventually this will come down to a HUGE collateral injection.

  24. mmckinl

    “Yves here. Repeat after me: you need recapitalization AND price discovery. The near pathological avoidance of the latter by the officialdom would seem to support widespread suspicions that making asset to market, or even a realistic notion of longer-term value, would confirm that the industry is insolvent.”

    Exactly … and why we need a nationalization with FDR’s Bank Holiday. We cannot move forward with zombie banks that could implode at any time should their derivatives tank. As the economy cascades into negative growth, derivatives imploding becomes a more and more likely event.

  25. Anonymous

    About price discovery – whether to do it all now (shock and awe) or go slow (downward grind) – which one will result in a more accurate perception in the investing and consumer public’s mind? True, a shock probably will lead to over-reaction and mis-calculation. But a long-term grind will lead to years and years of doubt and continuing mis-calculation. I vote for a quick exit to price-discovery.

  26. Econophile

    Fine article. This highlights the struggle between the Basel II mark-to-marketers vs. the No-we-can’t-do-that folks. While it seems “logical” that if you don’t m-t-m, lenders would have a larger capital base, could repair their balance sheets, and go forward. Who would do business with a bank whose assets are plumped up on the books? Certainly not other banks. So until we know who is solvent and who isn’t credit will remain stuck.

    Thanks again.

  27. Mario Sanchez

    "banks had shifted their business model to be more depended on fee income"

    That's the infamous Japanese zombie model, and it's extending out to other industries, starting with automobile financing & manufacturing.

  28. GloomBoom

    Our banks are zombies, our auto companies are union-run, and our hedgies are limiting redemptions. Think Obama is having second thoughts?

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