Issue 57 - November 4, 2009

Banks - Back to the Future

As financial markets have regained their footing in 2009, there has been much discussion as to the appropriate regulatory responses to ensure that “it does not happen again”. Clearly, simply layering more rules upon those that were not well followed will not be sufficient.

Let us consider history. The Glass–Steagall Act was passed in 1933. For 66 years, this legislation laid the ground work for commercial and investment banking operations and established strict rules aimed at stopping specific widespread abuses prevalent during the 1920’s. In addition to the creation of the FDIC, the Act required the separation of banking activities from the business of underwriting securities and forbid the practice of using customer deposits to purchase securities for the bank’s own account. With the passage of time, some of the provisions of the law became fairly outdated and in a world of global banking, ineffective. The law was effectively repealed for good in 1999 with the passage of the Gramm-Leach-Bliley Act which allowed for the combination of commercial and investment banks along with insurance companies. While it is hard to imagine today a bank using customer funds to purchase speculative securities, that is essentially what happened in the heart of the current crisis. As a case in point, Citibank invested their own capital including customer’s deposits into toxic mortgage products of their own underwriting! The two primary abuses of the 1920’s came full circle cloaked in the structures and accounting of modern finance. It is simply remarkable.

The path from 1933 to 2008 was by no means straight forward. Financial markets and instruments were never static and their evolution was simply not matched by the evolution of a regulatory framework which traces its roots to the 1930’s. Consider that in 1956, The Bank Holding Company Act was passed which enacted even further restrictions on banking activity including the prohibition on interstate banking, while in 1971 the first money market fund was established as an alternative to bank deposits. During this same period, The New York Stock Exchange relaxed rules which had previously prohibited the listing of Investment Banking Partnerships or other closely held private corporations. The markets and the regulators where moving in different directions at very different speeds.

By the mid 1980’s, over the protests of then Federal Reserve Chairman Paul Volker, commercial banks were once again allowed to dip their toe back into the underwriting business through permitted offerings of Municipal Bonds, Commercial Paper, and Mortgage Backed Securities. Volker at that time made this prophetic remark – “lenders will recklessly lower loan standards in pursuit of lucrative securities offerings and market bad loans to the public.”

The final steps in this historical round trip took place in 1997 when the Federal Reserve eliminated many of the remaining ownership restrictions and Bankers Trust was the first to enter the brave new world with their purchase of Alex Brown, a privately held Investment Banking Partnership. By 1999, with the public listing of Goldman Sachs, virtually every private investment banking partnership was now either a public company or a subsidiary of a commercial bank.

This was a critical juncture. Investment Banking is a high risk/high reward proposition. When conducted within the confines of the partners own capital, the business is run with an exceeding sharp eye on risk/reward calculus. However, when the risk is largely borne by anonymous shareholders and the rewards disproportionally favor those running the business you have precisely what you had in the 1920’s. Just as Volker had suggested, the scales would tip further and further in the direction of risk until such time as the system failed.

FDIC - Navigating the Tsunami

There are currently over 8000 FDIC insured banks in the US. Since the beginning of this crisis, we have seen 115 of these institutions closed or merged into other healthier banks. It is estimated that as many as 1000 banks in total will need to be eventually shuttered by the FDIC and the losses associated with this process are conservatively projected to be in the neighborhood of $500 billion (give or take a $100 billion). For sake of comparison, the crisis of the early 1990’s cost us over 500 institutions and approximately $150 billion.

The scope of what lies in front of the FDIC is all the more daunting when you consider the following realities:

• Just as we saw in 1990, the reserve fund for handling failed institutions has largely been depleted by the closures handled to date. Plans are in the works to charge remaining members 3 years worth of premium upfront to replenish the fund with approximately $45 billion.

• The Hydra of Commercial Real Estate, where we have declining revenues and property values coupled with the monstrous, looming refinancing needs of maturing loans and securitizations.

• Calls for increased levels of capital for surviving institutions.

It is certainly an understatement to say that it is going to take some time to chew through the enormity of what lies ahead. Even without an invoice for three years worth of premiums and the calls for additional capital, banks will be forced to use much of their operating earnings to retire bad debts just as we see consumers forced to confront their own deleveraging plans. However, unlike consumers, Banks can effectively borrow from the Federal Reserve at 0% and can then turn around and purchase higher yielding securities such as two year US Treasuries at 1% with 12.5X allowable leverage. This was the successful recipe that the Federal Reserve employed in 1992-1993 to allow the banks to “earn” their way back into solvency. The downside of this treatment however is that once you allocate these subsidized earnings to loan losses and capital replenishment – there really is not much left for traditional banking purposes – like lending. It will be hard for the banks to return to robust lending until they are deemed to be healthy and are earning on their own again. For all the reasons we stated above – this will take many years.

TARP 3.0

Meanwhile, even a replenished $45 billion FDIC reserve fund is no match for a wave of $500 billion in potential losses associated with necessary bank closures. There must be another road forward and in early October, the FDIC entered into a transaction which will likely act as the prototype.

Many Private Equity funds and Real Estate partnerships had expressed interest in purchasing several impaired banking institutions directly. While their resources were welcome – allowing additional high risk enterprises to engage in lending was a non starter. The FDIC made the decision to split the problem banks into the sum of their parts and sell them separately. Traditional bank branches, deposits and operating loans would be sold to local, healthy banks, and the problem loan portfolio would be sold into a partnership between the FDIC and the investment funds. In October, Starwood Capital Group purchased a 40% interest in the $4.5 billion pool of loans from Corus Bank. The FDIC is retaining a 60% interest and providing zero cost, 5 year financing to Starwood. In this way, the investment funds are able to own and manage the troubled assets and have a 5 year window in which to work them off. They have access to loans on essentially the same terms that the banks do (0%, without the necessity or perhaps the unintended consequences of extending to these firms the ability to initiate new loans). This is a significant development and should help to break the log jam surrounding the disposition of some of the larger, insolvent institutions.

Implications

The coming catharsis in banking is going to have a number of implications for financial markets and the economy.

First, banks are going to be less profitable than they have been in the past. Loan losses that have been carried at cost will finally be realized. Asset quality will continue to deteriorate as the commercial real estate refinancing wave washes over the market further depressing valuations. REO properties – those foreclosed homes that have not yet been offered to the market – can not remain on their shelves indefinitely and this supply will weigh on the residential market. The FDIC will demand some upfront payment of future reserve account premiums which will also eat into retained earnings. Finally, there is the matter of capital. Treasury officials would like to see higher capital standards put into place which on the face of things would seem to be reasonable. But consider that sufficient capital was never at the heart of what beset the markets. Traditional banking is not in and of itself a hugely risky endeavor. Small and mid size commercial banks in the US will argue that applying a higher capital standard to them is an unfair and disproportionate burden when in fact it was the larger institutions which created the systemic risk. The larger institutions will argue that they simply do not have the earnings power, even in a 0% Fed Funds environment, to meet substantially higher requirements. Practically speaking there is never going to be enough capital in the system if leverage within our largest financial institutions is once again allowed to rise to dangerous levels. This was the major failing of the regulators. It was not their capital. It was their leverage in conjunction with their activities that brought the system down.

In terms of the economy, the healing process for the banks will continue to leave very little room for new lending activity. With securitization running at a small fraction of traditional issuance – we should fully expect to see credit continuing to contract. As we note regularly – small business is the engine of job growth and the lack of credit will flow directly through, impacting current business operations, potential expansions, and of course, hiring plans.

The recovery and stability that has been the hallmark of markets in 2009 has been a welcome development. However, some amount of the stability has been cosmetic. Not requiring the banks to mark to market their loan portfolios may have provided some needed relief from the daily volatility to the beleaguered institutions. But as we all know – problems grow at compound interest – and just because we don’t write down the losses doesn’t mean that they aren’t there. 2010 will mark a departure from this strategy. The economy may not be robust but the time has come to begin the heavy lifting of recognizing losses and transferring assets into the stronger hands of those with sufficient capital to see them through. This process will not immediately provide a boost to the overall economy, but is most definitely the necessary next step in our recovery.

Patsy and Jen

• Banks - Back to the Future
• Navigating the Tsunami
• TARP 3.0
• Implications