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Tuesday, January 05, 2010

US Banking

Haha. This is going to be ugly, so let's grit our teeth and get right down to it. There are three main Federal Reserve statistical publications that give an overall picture of US banking health. They are:

H.3 Aggregate Reserves of Depository Institutions and the Monetary Base.
From November 2008, total bank reserves increased from 609.7 billion to 1,123.0 billion in December 2009. This rise has caused many to claim that banks are just "hoarding" cash, whereas (snort choke) the truth is that banks still don't have enough reserves.

Lest you doubt me, we'll look at an historical comparison of ratios of loan loss reserves as a percent of total loans versus net loan losses as a percent of total average loans:

Regressing to our childhood, we curl up into a fetal ball singing "One of these graphs is not like the other, one of these graphs we don't like at all." Miss Piggy the Central Banker has struck again.

H.8 Assets and Liabilities of Commercial Banks in the United States.
It is true that bank lending to consumers and businesses (although not to the Fed in the form of Treasuries) has declined. "Assets" in banking terminology are money-earning items such as loans or bonds. "Liabilities" are your paycheck and savings; these represent a cost to the bank. In effect, you loan your money to them when you deposit it.

In November 2008, total bank credit was 9,406.2 billion. As of December 23rd, it is 9,034 billion. Loans and leases (excludes securities and so forth) fell from 7,239.4 billion to 6,695.8 billion over the same period. Over that period, deposits increased from 7,119.6 billion to 7,706.8 billion. Borrowings dropped from 2,597.2 billion to 1,887.7 billion. A lot of that is TARP repayments; some is money borrowed from the discount window, and some of it was borrowed from other banks, even foreign banks. So banks have been repaying a lot of their loans as the deposit money flows in. This should surprise no one, because one doesn't have to pay very much at all to borrow money through deposits right now.

FRB: Charge-Off and Delinquency Rates.
The real number to watch here is charge-off rates, although delinquency rates do give one an idea of where chargeoffs are heading. Last year I watched some of the more optimistic business-type blogs cheerfully posting delinquency rates. It is true that total delinquencies were not then that bad compared to historical peaks. But when a bubble bursts, chargeoffs rise disproportionately in relationship to delinquencies, because the loss per default rises sharply as the bubble portion of asset valuations abruptly drops out of the system.

Interest rates charged to borrowers are composed of several elements:
  1. The cost of funds, plus
  2. The risk cost (expected credit losses), plus
  3. The cost of servicing
The thing to remember about chargeoffs is that these numbers are annualized and are directly convertible into interest. In theory, if you have a pool of credit prospects that will produce losses at 2% higher than another pool of credit prospects, you can convert them into similar financial assets simply by charging the first group of credit prospects 2% more to cover the additional losses. In practice, it is not that simple. Higher interest rates = higher payments = higher defaults. There are limitations. The cost of servicing goes up for higher-risk accounts as well.

Building on that basic observation (that higher payments increased credit losses), the Fed had spawned a theory that if the higher risks just didn't show up in the payments but instead came out later in the form of equity, the higher risk pool would be the same quality credit asset. Hence, innovative mortgages. Well, let's see how that worked out....

I made you some hockey stick graphs. These are not the fakey type of hockey sticks, but plain, unadorned actual data produced from a system in which everyone (and over a trillion dollars) is trying to minimize these figures:

Credit cards are the standout, but you'll not that they haven't risen anywhere near as disproportionally to 2001 as total loans or RE loans. Notice that they always rise during recessions, but the peaks come well after the official end of the recession.

These are some honkin' high numbers through Q3 09, with the peaks still to come.

What's truly extraordinary are residential mortgages, WHICH JUST DO NOT DO THIS. EVER. Unless, that is, you create an residential real estate bubble through funky lending....

But hey, who'd ever be crazy enough to do that? Oh, that's right, the Fed.

Check out that light blue ribbon of household wealth destruction.
Wholesome fun for the whole family! (I'm channeling Mark here.)

It's also fun and games for the lenders. There are few better ways to destroy your capital than by lending at 6% and taking credit losses over 2%. This rate will go on rising for a while, too.

Come to think of it, maybe Greenspan's plan to boost the economy by lowering initial payments below the long-term cost of actually carrying the loan (he also loved adjustables, because he figured that adjustable mortgages gave the Fed an easy way to pump the economy in low spots) suffered from inadequate risk evaluation.

But hey, it's not just mortgages. At one point various professorial economic pundits (including even Bernanke) were expressing astonishment that consumers weren't getting the benefit of lower cost of funds on their credit card payments. Ummmm, let's discuss that. Just about a year ago I was pointing out the errors in their theories. Now let's see how this developed.

These two graphs are the same thing in different format. I don't know which one will be easier to read, so I included both.

The red line is CC chargeoffs - the amount of defaulted loans that are being written down and withdrawn from reserves.

The green line is calculated from G.19, and it is the rate of growth in the revolving credit portfolio. That rate has turned negative due to contracting balances.

The black line is the result of adding the green and the red lines. You will note that the black line is much steadier than either component, which is just a numerical representation of the fact that there is a consistently inverse relationship between declines in credit quality and growth in lending.

All of you who are not Federal Reserve Governors and professors of economics probably find that logical. You're just not educated enough to believe that the solution to bad lending is more bad loans.

But, sad as it seems, that was the theory upon which the Fed has basically been acting. Here we must draw a distinction. It is worthy to inject cash into a system so that credit is not withdrawn from creditworthy borrowers with functional businesses or regular incomes when you have created a financial implosion. One wishes to save what one can from the wreckage, and to the extent that TARP was aimed at this limited goal, TARP was a valid expenditure of money and had a good chance of success.

It is not worthy to write more bad loans in the theory that throwing enough good money after bad will change the bad money to good. That's impossible. Here we must pause and visit the Onion's Money Hole video once again.

Another Look at Reserves:

The whole idea behind charging higher interest rates for higher credit risks is not that the creditor will take the extra money and spend it, but that the creditor will take the extra funds and put them into reserves. At the time the credit losses occur, those losses will be covered by money withdrawn from reserves. That's the theory.

The catch is accurately projecting loss rates. This is done from historical loss rates for similar credit. Since our mortgage system has been shifted toward a deflationary cycle for valuations, it is obvious that historical precedents don't mean much. When you have not forecast your current credit losses, it goes without saying that you will be pulling from current and future earnings instead of reserves to cover those losses. And that cuts into Net Interest Margin, which is interest payments - credit losses - servicing costs - cost of funds. From the ever-useful St. Louis Fed:

According to the data reported, Net Interest Margin rose although it was still appallingly low, and that is an odd result when chargeoffs rose from 2.61% in Q2 to 2.88% in Q3.

There are several factors. The first is that the drive is on at a number of banks to repay TARP loans so they have to report earnings in order to get the regulators to let them do it. To accomplish this goal (which has to do with the top-level managers' paychecks) they are under-allocating reserves. The second is that higher reserves are taking some of the pressure off, and the third is that cutting portfolios of lending to businesses and consumers allows banks to reallocate reserves. For example, if I am claiming that my loss ratio on my internal CCs is 9%, and I cut the size of my portfolio by 10%, that allows me to cut the size of my reserve on that portfolio.

See Angry Saver's two rants in the comments on the post below. Of course this is deflationary. We are reducing the money circulating in the economy. Wages and salaries are still falling and banks are cutting total lending. We are also a long way from the end of the debt-unloading cycle.

The situation becomes even clearer when we look at chargeoffs for the 100 largest banks vs for all other banks. In Q3, total chargeoffs on loans and leases for the 100 largest banks was 3.20% versus 1.84% for all other banks. Net Interest Margin is rising much faster at larger banks than it is at smaller banks, though. We bailed out the Great American Money Hole!

This is what happened to Japan, which has had two decades of stagnation - literally no job growth. We won't be Japan because we have different attitudes toward debt and far more businesses and consumers will go BK, but it is going to take a while.

Next up, public banking (aka the Fannie/FHA portion of the Money Hole).

Would you do me a favor and wait a day or two to do the Fannie Mae post? I don't think I can take any more good news just yet.
"One of these graphs is not like the other, one of these graphs we don't like at all." Miss Piggy the Central Banker has struck again.

Perhaps you should call Mel Brooks. I hear he needs help with his next movie. LMAO

Question: I've long since shifted my business from the money-center banks to regional banks and a credit union. This is partly because they have better customer service, partly because I figured they were safer. Now I'm not so sure about the "safe" part, and I'm not sure how much faith to put in the FDIC. What do you think?

I suppose I should check what portion of my banks' loan portfolios are commercial RE.
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