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Bank Failures in Slow Motion

Mises Daily: Wednesday, October 27, 2010 by

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[Speech given at The Economic Recovery: Washington's Big Lie, the Supporters Summit for the Ludwig von Mises Institute, October 8, 2010.]

Every Friday evening a few more banks are closed — seized by the various state banking regulators and handed over to the Federal Deposit Insurance Corporation (FDIC) for liquidation. This all happens rather quietly, barely making the news. We're told these bank failures are no big deal. No reason to panic. The names of the banks change over the weekend and many customers don't notice the difference.

We've only had 294 failures this cycle, but it is a big deal: adjusted to current dollars, the Depression banking crisis was $100 billion, the S&L crisis was $923 billion, and the current crisis is nearly $8 trillion.

So while FDIC chairwoman Sheila Bair said the current crisis would be "nothing compared with previous cycles, such as the savings-and-loan days," it's actually much bigger, because the financial sector had grown to be nearly half the economy by 2006 — as measured by the earnings of the S&P 500.

But the question is, Why haven't there been more bank failures? In 2008, there were 25 failures, last year there were 140, and so far this year 129 have been seized on Friday nights. The greatest real-estate bubble in history has popped — first residential and now commercial — and we only have 294 failures?

It takes easy credit to make a real-estate bubble and it was America's commercial banks that provided most of it. It's estimated that "half the community banks in America remain overleveraged to commercial real estate, and the possible losses that remain are about $1.5 trillion," according to bank-stock analyst Richard Suttmeier.

The Moody's Commercial Property Price Index (CPPI) has fallen 43.2 percent since its peak in October 2007. Raw-land and residential-lot values have fallen even further. Almost 3,000 of the 7,830 banks in the United States are loaded with real-estate loans where the collateral value has fallen over 40 percent, and yet less than 300 banks have failed?

We all know what's happened to the residential-property market, but to illustrate how bad the situation is for the commercial market, over 8 percent of commercial mortgages that have been packaged into bonds are delinquent; more than $51.5 billion of such loans are at least 60 days late on payments compared with $22 billion a year ago.

If anything the commercial property market would seem to be getting worse. Losses on loans packaged into US commercial-mortgage-backed securities totaled $501 million in August — more than double the $245 million in April, and over 10 times the $41 million in losses of a year ago.

Past-due loans and leases at the nation's banks and S&Ls increased 16.2 percent from second quarter 2009 to the second quarter of this year. Restructured loans and leases increased nearly 54 percent.

Over 7 percent (7.32 percent) of all real-estate loans were 90 days or more past due, which included construction and development loans, of which 16.87 percent were noncurrent at midyear.

"While the banks are being propped up, capital is diverted from businesses and entrepreneurs."

Even the collective real-estate-loan portfolio of the 105 largest banks is 8.64 percent noncurrent (or over 90 days past due) and the big banks' construction-and-development portfolio is nearly 19 percent noncurrent.

These delinquency numbers are bad anyway you look at it. So, they must be reflected in bank's profit numbers, right? Well, no. Second-quarter earnings by the nation's banks were the highest in 3 years — nearly $22 billion.

Based on these numbers, FDIC chair Sheila Bair claims, "The banking sector is gaining strength. Earnings have grown, and most asset quality indicators are moving in the right direction, putting banks in a stronger position to lend."

And bankers must figure the coast is clear: they are cutting their provisions for bad debts. Yes, at a time when one out of four Americans has a sub-600 FICO score, a quarter of all homeowners are underwater on their mortgages, and commercial real estate is hitting the ditch, banks are dipping into their loan-loss reserves to report profits.

To illustrate, bankers have cut their ratio of loans to reserve coverage almost in half — that is the amount reserved divided by noncurrent loans (90 days past due or more and loans on nonaccrual). This ratio has declined from 120 percent in March of 2007 to 65.1 percent at June 30 of this year.

Banks added a total of $40.3 billion in provisions to their loan-loss allowances in the second quarter: that is the smallest total since the first quarter of 2008 and is $27.1 billion less than the industry's provisions in the second quarter of 2009.

So, the banking industry made $21.6 billion in Q2 by not putting as much away for loan losses.

By the way, of the $21.6 billion in second-quarter profits, $19.9 billion was earned by the 105 largest banks in the country. The other $1.7 billion in profits was spread between the other 7,725 banks.

So the big banks are backing off on putting money in reserve and booking big profits only months after being rescued by government TARP moneys (by the way, 91 banks are behind on making their TARP payments to the government). More importantly, these banks were the primary beneficiaries of accounting-rule changes in April of 2009 — amendments to FASB rules 157, 115, and 124, allowing banks greater discretion in determining at what price to carry certain types of securities on their balance sheets and recognition of other-than-temporary impairments.

"The new rules were sought by the American Bankers Association, and not surprisingly will allow banks to increase their reported profits and strengthen their balance sheets by allowing them to increase the reported values of their toxic assets," according to James Kwak, coauthor of 13 Bankers: The Wall Street Takeover and the next Financial Meltdown.

So the banks get some accounting breaks and are aggressively reporting profits at the expense of putting money in loan-loss reserves; still, why haven't there been more failures?

Earlier this year, Elizabeth Warren and her Congressional Oversight Panel did a report that indicated 2,988 banks were in trouble because of real-estate concentration in their loan portfolios.

Ms. Warren noted that office vacancies had increased 25 percent since 2006–2007, apartment vacancy was up 35 percent, industrial was up 45 percent, and retail vacancy had increased 70 percent since 2006–2007. The report said the recovery rate for defaulted real-estate loans was 63 percent last year. Land-loan recoveries were only 50 percent. Development-loan recoveries were even worse at 46 percent.

Another banking expert who sounded a warning signal about the banking industry was bank analyst Chris Whalen, who, a year ago, estimated the number of troubled banks to be 1,900. The FDIC itself said there were 829 problem institutions on its top-secret radar by June 30, 2010 — almost exactly double the 416 announced by the FDIC a year ago at midyear. By all indications the pace of closures should be speeding up. But instead we see these numbers:

3rd Q 2009 50 closures
4th Q 2009 44 closures
1st Q 2010 41 closures
2nd Q 2010 45 closures
3rd Q 2010 41 closures

Sheila Bair has said many times that the peak in bank failures will be the third quarter of 2010. What's the holdup?

Why aren't more banks being closed?

1. Maybe there's nobody there who knows how to make a deal.

After all, the FDIC's main deal maker, Joe Jiampietro, left suddenly in August. Jiampietro came to work at the deposit insurer after working at JP Morgan Chase and UBS. He and his partner Jim Wigand sold more than $508 billion in assets including WaMu and Corus. The New York Times reported that Wigand and Jiampietro did good work for the government, "by acting like bankers, not bureaucrats."

Wigand worked at the FDIC for a couple decades. The fresh blood was Jiampietro. He was the eyes and ears in the markets and advised on the biggest and most complex deals, meeting with bank execs, hedge-fund managers and other big investors to get their feedback on deal terms and other agency policies.

These two started hatching deals with companies like Rialto (a division of homebuilder Lennar). Rialto bought a 40 percent share of $1.2 billion in loans from failed banks for 40 cents on the dollar, with the FDIC carrying a loan for $1 billion of the deal at zero interest for seven years.

They also came up with the FDIC's Securitization Pilot Program. Barron's reported that the FDIC has $37 billion of bad bank assets to sell, but that the loans would only fetch 10 to 50 cents on the dollar. But US-guaranteed FDIC senior certificates enable "the FDIC to push much of the losses off its books, thanks to the US guarantee of principal and interest." The notes are backed by loans (remember the ones worth 10 to 50 cents on the dollar) but ultimately the losses could be absorbed by Uncle Sam.

Ex–Federal Savings and Loan Insurance Corporation regulator William Black says the FDIC is selling the equivalent of Treasury bonds without congressional approval and the deposit insurer should be selling bad assets. "It hides the economic substance of what's really happening — an unlimited taxpayer bailout," Black contends. The FDIC disagrees.

2. Maybe it's politics.

Bill Bartmann, publisher of the Bartmann Bank Monitor Report, says the FDIC isn't closing banks faster because of politics.

"They (FDIC) are waiting until November to drop the other shoe," Bartmann claims. He says 500 banks will be closed in 2011 after the mid-term elections have been completed.

"'Deposit insurance' is simply a fraudulent racket."
– Murray Rothbard

Are bank failures political? Shorebank in Chicago was kept alive for months: "Senior Obama adviser Valerie Jarrett served on a Chicago civic organization with a director of the bank, and President Obama himself has singled out the bank for praise in lending to low-income communities." But the politically connected bank was finally seized on August 20th, when the FDIC finally found a single buyer for the failed bank — Urban Partnership, which includes "American Express Co., Bank of America Corp., Citigroup, Ford Foundation, GE Capital's equity investments arm, JPMorgan Chase & Co., Key Community Development Corp., Morgan Stanley, Northern Trust Corp., PNC Investment Corp., Goldman Sachs Group Inc., and Wells Fargo & Co. Former First Chicago executives who joined ShoreBank in recent months will run the bank."

3. Maybe the number of bidders for bad banks has dried up.

The juicy deals Jiampietro and Wigand were making last year are over, the Wall Street Journal reports. According to Keefe Bruyette & Woods (KBW), acquiring banks were booking 4.5 percent capital gains on deals done in 2009. That is now down to 2.5 percent.

Investors are halting efforts to bid on the failed banks, saying the economics no longer make sense. A group led by former FDIC Chairman William Isaac recently ended a push to raise $1 billion for bidding on failed banks in the U.S. Southeast, in part because of lower returns on potential deals, Mr. Isaac said. Another group, of former Wachovia Corp. executives hoping to launch Charlotte, N.C.-based Union National Bank, recently pulled its federal charter application because bank-failure bargains are becoming tougher to find, a spokesman said. …

"In the current environment our view is that FDIC-assisted transactions are not really attractive entry points," the Union National spokesman added.

But while some are paying up for failed banks,

others who were able to grab bargain deals earlier in the crisis say they are done for now. Tiny Sunwest Bank in Tustin, Calif., for example, snapped up assets from three failed institutions with discounts as high as 44%. The deals doubled the bank's assets to $658 million and increased its head count from 68 to 140. Chief Executive Glenn Gray said he doesn't expect to be a bidder anytime soon, acknowledging how the pricing has changed.

4. Or maybe the FDIC just doesn't have the money to close banks.

The FDIC Deposit Insurance Fund has already spent over $19 billion this year, which is well above the $15.33 billion prepaid assessments that it collected from banks for all of 2010.

The situation is probably worse than the FDIC is letting on, according to ex-regulator William Black. "The FDIC is sitting there knowing that it has both the residential disaster and the commercial real estate disaster [and] knowing it doesn't have remotely enough funds to pay for it."

Black is not surprised there aren't more failures, but he says that

we should be upset there are not more bank failures. The industry has used its political muscle to get Congress to extort the financial accounting standards board to gimmick the accounting rules so that banks do not have to recognize their losses.

Black claims the Prompt Corrective Action law, which mandated closure of insolvent financial institutions, is being ignored.

The FASB rule changes I mentioned earlier have allowed banks to value assets at inflated bubble values that have nothing to do with their real value. Thus, reported bank capital is greatly inflated. According to Black, even insolvent banks are reporting lots of capital.

Black, the author of The Best Way to Rob a Bank Is to Own One, contends that the FDIC is "intentionally keeping foreclosures down because it knows it does not have enough money to pay off depositors who are insured by the FDIC."

Maybe that's why suddenly the expected losses on some of the bank closures in the third quarter were considerably below historical norms. The FDIC estimated the expected losses as a percentage of assets for three banks that were seized on August 20th — Sonoma Valley bank, Los Padres Bank and Butte Community Bank — to be 3 percent, 1 percent and 3.5 percent, a fraction of the average expected percentage loss for 2009 closures, which was 22 percent, and for 2010 closures, which was 23 percent.

Black told Aaron Task of Yahoo! Finance that this delaying in liquidating insolvent banks will make ultimate losses grow. It's a "Japanese-type strategy of hiding the losses," which will result in a lost decade or two.

"Geithner and Summers were selected and promoted because they are willing to be wrong."
– William Black

While the banks are being propped up, capital is diverted from businesses and entrepreneurs.

Black says, "Well I said it from the beginning, Geithner and Summers were selected and promoted, and the same is true with Bernanke, because they are willing to be wrong and have a consistent track record of being wrong. That's useful for senior politicians but disastrous for the country."

The FDIC is required to maintain a Deposit Insurance Fund (DIF) of 1.25 percent of insured deposits. As of June 30 of this year, the DIF held negative 15.2 billion, standing behind $5.4 trillion in insured deposits. That's negative 0.28 percent. In its second-quarter banking profile, the FDIC noted the 10 basis-point improvement in the DIF from the first quarter, when the DIF was at negative 0.38 percent.Download PDF

However ValuEngine's Richard Suttmeier calculates that the DIF is currently $33.66 billion in the hole or negative 0.62 percent

But don't be afraid, Chris Dodd and Barney Frank have taken care of everything. The Dodd-Frank Wall Street Reform and Consumer Protection Act not only made the increase in deposit insurance of $250,000 permanent, but it requires the FDIC "to take steps necessary to attain a 1.35 percent reserve ratio by September 30, 2020."Download PDF

So, in a decade, the FDIC will have $1.35 standing behind every $100 you have in the bank — promise — you have Chris and Barney's word on it.

A Fraudulent Racket

But can deposit insurance really be considered insurance? Can insolvent banks hide their losses with the help of their friends in government and at the same time have an arm of the government that itself is insolvent cover their losses — and call it insurance?

Insurable risks, such as death, accidents, or health emergencies are homogeneous, replicable, random events that can therefore be grouped into homogeneous classes and predicted in large numbers. However, market events are inherently unique and heterogeneous; they are not random but influence each other; so they are not insurable and not subject to grouping into these homogeneous classes measurable in advance. It is for the entrepreneur to assume the uninsurable risks of the marketplace.

"If no business firm can be insured," Murray Rothbard writes,

then an industry consisting of hundreds of insolvent firms is surely the last institution about which anyone can mention "insurance" with a straight face. "Deposit insurance" is simply a fraudulent racket, and a cruel one at that, since it may plunder the life savings and the money stock of the entire public.

As far as the lack of bank failures, "a dearth of bank failure should rather be treated with suspicion," Murray wrote, "as witness the drop of bank failures in the United States since the advent of the FDIC. It might indeed mean that the banks are doing better, but at the expense of society and the economy faring worse."Download PDF

So are banks lending out that deposit money the FDIC is insuring? No, loan balances continue to fall, down $96 billion in the second quarter.

But they are loading up in one area — derivatives. You remember those things (essentially side bets between two parties on the value of a particular asset or the direction of interest rates). Warren Buffett called them "financial weapons of mass destruction." Société Générale's Jerome Kerviel orchestrated the largest bank fraud in world history via derivatives trading (a £3.6 billion loss). Arthur Leavitt said "derivates are something like electricity; dangerous if mishandled, but bearing the potential to do good."

Well, banks have increased their collective derivative exposure from $209 trillion a year ago to $224 trillion. Ten years ago, banks had less than $40 trillion in derivative exposure. But I'm sure bankers know how to handle these things.

The 20 years prior to 2008 were a boom for banks, morphing in size to gargantuan proportions on the ricketiest capital structure the world has ever seen. The needed correction is equally huge, and the FDIC can't stop it. The government agency might delay the cleansing for years, keeping themselves and the zombie banks they regulate in business. But, ultimately, the deposit insurer will fail along with the banks it regulates, going the way of the FSLIC, which insured savings-and-loan deposits. It was recognized as insolvent in 1986.