The Fourteenth Banker Blog

August 25, 2010

New Banks Needed #1

Filed under: Running Commentary — thefourteenthbanker @ 1:43 PM

This week news flow continues to indicate an economy that is significantly weakening from an already anemic activity level. There are wide-ranging destructive effects on every sector of the economy, households, businesses, and government. Some of these effects threaten to spiral into negative feedback loops causing further destruction and unpredictable outcomes from economic depression and attendant extreme unemployment, to deflation, to hyperinflation, to currency devaluation. All of these are possibilities. So what to do about it?

The current state of the society reflects the nature of society. I have posted before on the stratification of society into various interest groups which I have compared to the conditions before the revolution in France. We have profound ethical issues confronting us at every turn. There is a lack of trust. Cronyism here in America is alive and well.

Until we attack these underlying causes and conditions in a meaningful way, it is foolish to expect that we will have sustained economic recovery and general prosperity. The seriousness of the situation can be measured by our hopes. What we hope for is a little stimulus, a little inflation, a shift in exchange rates that will make exports more competitive, a return of the consumer to excessive spending, credit expansion. Are these the things that prosperity is made of? No!

Getting much attention in the news these days is the asset price cycle. The immediate manifestations are the recent sharp declines and possible further declines in the prices of residential and commercial property, the manic-depressive stock market, bond price bubbles and collapsing interest rates.

Amid this backdrop, one of the critical factors in an economic recovery will be the availability of credit to worthy businesses and investors. Already there are high net worth investors buying distressed property. Credit terms are tight and buying distressed property is still a risky investment. It is high risk with high potential reward. Facilitating these purchases are record low interest rates for super qualified borrowers. The opportunity for such returns, as usual, is for the rich. Those with idle cash have the opportunity to profit on the distress of others. Further stratification of wealth will be the inevitable result.

One blogger this week sought to find deeper solutions. Eric Haseltine suggests that we quit reacting to the panic of the moment and focus on building up our people in aggregate to create conditions for creative expansions.

Unless we overcome our temporal myopia, we’ll continue to put band-aids on this economy and it will continue to deteriorate: in other words, we’ll continue to treat symptoms and never go for a complete cure.

And what would such a cure look like? Let’s start by looking at disease that afflicts us. The fundamental problem with America’s economy is a decline in the capabilities and motivation of our workforce. True economic growth — not the artificial kind spurred by fiscal policy — stems from innovations such as Google’s search engine that create entirely new businesses and markets. Such innovations grow out of technological advances, which in turn emerge from earlier scientific discoveries.

Alan Greenspan, former Chairman of the Federal Reserve Bank, reinforced this idea when he said “Capitalism expands wealth primarily through creative destruction — the process by which the cash flow from obsolescent, low-return capital is invested in high-return, cutting-edge technologies.”

Ingrained in this approach is the requirement that creative destruction must be followed by investment in new technologies. That requires a functioning financial sector.

John Hussman agrees and fleshes out the arguments further in a previous market update.

If we as a nation fail to allow market discipline, to create incentives for research and development, to discourage speculative bubbles, to accumulate productive capital, and to maintain adequate educational achievement and human capital, the real wages of U.S. workers will slide toward those of developing economies. The real income of a nation is identical its real output – one cannot grow independent of the other.

Again, note that we must accumulate productive capital. This is a function of effective financial intermediation. Too much financial intermediation has been directed to speculative activity benefitting from market volatility and to the creation and sale of complex and opaque financial instruments that allow high profits from the lack of developed competitive markets and exchanges and frankly the ignorance of the buyers of these instruments. This is exploitative and is not productive capital formation.

So do we regulate such banks or do we start new ones? The first question is, can the banking sector, if it even chose to, provide for the capital needs of the economy. This point/counterpoint article addresses just that, among other topics of the day.

Mish Shedlock in citing the Jerome Levy Forecasting Center and agrees with but refines these particular points in the linked article.

There are various theoretical reasons given for the liquidity trap, but let’s just focus on what is happening now and what is likely to happen in the years ahead. Presently, excess reserves are not inducing lending for several reasons, and adding to them further will not make much difference.

  • First of all, banks are capital constrained, not reserve constrained.
  • Second, interest rates could not fall far enough during this business cycle to enable troubled debtors to refinance their way out of trouble, so now banks remain worried about the volumes of bad debt they are carrying and how future loan losses will impinge on earnings and capital.
  • Third, deflationary expectations are beginning to work their way into banks’ loan evaluation process on a micro level; in more and more areas, loan officers are looking at households with shrinking incomes and firms with deflating revenues.
  • Fourth, the private sector has too much debt, and many households and firms are trying to reduce debt, especially as more of them worry about deflation in their own incomes or revenues.

Point numbers one and two above are key factors in the financial intermediation part of this economic problem. Banks are capital constrained. Balance sheets are loaded up with problem debt. Future losses are embedded in booked exposures. The banking sector is not sufficiently healthy to support economic expansion or to reverse deflationary pressures.

So the question is how do we evolve? The government has propped up the banking sector, believing systemic impacts of bank failures would trigger a tidal wave of further liquidity contraction and trigger depression. The propping up has not worked. Yes, it has prevented a massive financial system collapse, but it has not supported economic growth. We need creative destruction in the banking sector. Let these existing banks reap the rewards of their policies. Create new banks with new fresh capital, unencumbered by toxic assets, headed by wise risk managers, but ready to lend. The FDIC may not like this because they do not want new competitors to pressure earnings of existing institutions. But the piddling cost of bank resolutions is nothing compared to the destruction of value in a squeezed economy. Fund up the FDIC and let these banks trickle towards failure. If new institutions are in place and ready to go, asset prices will reach clearing level and new investment will recycle assets into productive use. Many assets are already at or near clearing levels. As I said before, high net worth individuals are buying distressed assets. If you combine this recycling with vibrant human capital and a new sense of optimism, now there is something to work with.

The new banks could also have new business models that are supportive rather than exploitative. But that is for another post.



  1. I ran across some coverage recently that the Mc Mansion or real mansion is a dying proposition. The commentary is to the effect that they are instant slums, subject to alternate uses or , in short, not worth very much soon. Given that these edifices now form a big plurality of upper middle class income ownership and of all those aging yuppies in particular, disaster seems at hand. We are evaluating selling our smaller house in a desired retirement spot. We think our buyer may be the credit forced retiring older yuppie. Anyways, the sixty something yuppie with a big 401(k) ( up to the generous limits) for each spouse has options. They have a dead dog McMansion, hocked to the hilt that is killing them. Their bankruptcy attorney may well tell them to quit as soon as you are able to go on Social Security and be able to start taking distributions from your 401(k)s. They then file bankruptcy for everything and apply their exemptions to other assets they may retain. This is a nice clean little Chapter 7. The upshot is that after the discharge, they can buy a nice little retirement house ( like mine) with some of their 401(k) funds. Buy the little house and live off the rest in a now more fashionable and sedate manner. Fashion does seem to follow economic dictates.

    My bankruptcy lawyer friends are just now seeing this strategy move into place.
    If you quit your job, with a tiny planned interim, all the debts and the dog McMansion goes too. You keep your retirement funds up to the very generous limit and other assets. You can dump a lot of stuff anyway going into a smaller house.

    The big problem for banks is going to be bad debts and title to an unsaleable Mc Mansion property. Might this alone kill their equity to the point of seizure in the next year or two?

    This problem is staring at me two ways. I also have my late mothers property in a town of mansions/ McMansions that has been in the family since 1943 to sell or do something with. Recent comparable sales are unanimously around 60 % of the Assessor’s market value. It seems an awful lot of people in the above $500,000 level of property ownership are way, way underwater. They seem to be mostly grey hairs too !

    Comment by Jerry J — August 25, 2010 @ 9:52 PM | Reply

  2. Just how much maneuvering room is there for the current banks of the US? They obviously have latent equity problems from charging off losses related to existing loans they cannot collect in the next year or two without improvements in the desire and ability to pay of retail debtors. Somewhere in the banking system these losses wind up as a charge against equity. Bernanke marvelously reacted to the 2008 crisis on an ad hoc basis. Might his actions really be a con? Let me explain. The last weekly Fed consolidated Balance Sheet before the 2008 crisis truly set in was that of August 28, 2008. Thebank reserve deposits of member banks carried as deposit liability on the FRB’s was $19.377 bn. A tad higher than average. The banks carried these deposits as a component of Cash and Equivalents. The banks tended to take these funds down quickly through normal methods usually involving Reverse Repos and other ways to turn the deposits into live funds. Reverse Repos outstanding were $43.768 bn. More or less normal as things have gone for the preceding seventy years or so.

    OK, let’s look at last week. As of the August 19, 2010 Consolidated Weekly Report, Member ank Reserve Deposits were $1,041.795 bn. Reverse Repos were a pittance total of $60.185 bn. The member banks were carrying their deposits of $1,041.795 bn in Cash and Equivalents on their Balance Sheets. Highly dubious? These high values have been the case since the start of Bernanke’s ad hoc solution to the 2008 financial crisis. The banks together are unable to take down their Reserve Deposits to near zero as they routinely did for the entire history of the Federal Reserve System before the autumn of 2008. Bernanke’s liquidty injection was achieved by banks loaning their reserves to banks that were short of reserve deposit requirements. How much in terms of volatility since the net change is always zero?

    Bankers do not explain a simple question about the member banks choice to all draw down their reserve deposits to levels that existed in 2008 before the crisis. Outside of asking for currency, the member banks have only normal methods to reduce their reserves and these methods are highly constrained as the current Reverse Repo Liability of $60.185 bn shows. The only other mass action available to reduce the reserve deposit liability to 2008 levels would be the direct repurchase of Mortgage Backed Securities they sold to the FED in exchange for an increase in their reserve deposit liability account. Current MBS balance exceeds Reserve Deposits of member banks with a current total of $ 1,113.017 bn.

    OK , where is the next trick to come from with respect to liquidity? As 14th points out, the foregoing does not address the equity problem. In the next crisis , the equity problem may only be addressed by recapitalization decree. A mass bankruptcy proceeding. That is all debt and some part of deposits are lost to creditors in exchange for capital shares. The former creditors and reduced depositors now own and operate the bank. The old shareholders are out. The court voids derivative contracts that that the bank cannot meet or includes them too in capital in exchange for some portion of the contract values due the derivative creditor. The net of all this will be a vast stated capital and a lesser but equally vast capital deficit from operations with a very nice positive net capital. The capital deficit can be offset against stated capital to show zero accumulated capital from profits to prettify things.

    Recapitalization seems the only way to go. One aspect of the reorganization would obviously be the conversion of the FRB Reserve Account asset of the banks into an investment in the capital structure of the FRB. The banks truly own a proportionate money stake in the FRB.

    What other alternates are there under the current system considering that none of the foregoing alleviates the core problem…….. the lack of ability of debtors at the retail level to sufficiently repay their loans to guarantee a viable banking system? Repaying the loans requires a sound earnings complement for debtors. The elites cannot get around the base problem except by ending the system as endlessly commented on by thinkers like Michael Hudson. Even Paul Craig Roberts acknowledges this problem in his latest anthology where he says the only avenue left will soon be the government just giving money to debtors to repay their loans.

    The liquidty injection seems spurious in terms of the real economy. For example, why not have the banks loan the ” Cash” they have deposited at the FRB to the real economy to restart our manufacturing? Just kidding. The balances deposited at the FRB member banks is not convertible to funds for lending as I suggest because the deposits over a small minimim ( say 20 % stretching it) are not convertible except as currency in such quantities under present legal restraints.

    The liquidty for the people of the US purposes is not there. The equity of the banks is also not there looking forward to losses. The elite have destroyed their own system of generating personal wealth and their stored wealth too over time as I see it.

    Comment by Jerry J — August 26, 2010 @ 2:20 PM | Reply

    • You have triggered the memory banks. First, up until recently the Fed paid interest on reserve deposits, which they had not historically done. This was simply an earnings prop for the banks to help with equity. It was a low rate, but net net was a disincentive to lend for those banks that could have. Next, Risk Based Capital requirements are such that a bank that is capital constrained may not be able to draw down liquidity they otherwise could, because if they lent the money it would be in a higher risk based capital category. Third, good point about where the liquidity goes. Most liquidity injections go to Primary Dealers. Since the government is the biggest borrower, liquidity injected that goes into a government bond purchase by a dealer never gets out of that loop. It does however bake in another profit for the dealer in that it drives market rates down further and they make money on their book.

      Comment by thefourteenthbanker — August 26, 2010 @ 9:26 PM | Reply

      • Thanks ever so much. I have been making the point among accountants since the FED liquidated swaps in early 2009 and replaced them with Mortgage Backed Securities that the did some very monumental things for banks that flew on by almost without public notice. Essentially, the FRB’s bought outright $1 trillion worth of MBS’s on the banks books by mere journal entry. The FRB’s essentially did nothing more than credit the demand deposit with no real way for checks to be drawn against the account. This single device did some enormous things for the banks. First, the MBS’s were bought at par plus accrued interest, any associated loss reserves on the banks books were now freed for application to other loss reserving uses or to be taken into income. Secondly, the practically unusable credit to the the member bank’s Reserrve Demand Deposit Account was an increase in the Cash and Equivalents on the banks books. At the least, functionally these Cash and Equivalent holdings are sequestered and would ,outside the banking shenanigans, be at least treated as non current sequestered deposits earning near zip interest after a hurried law change in 2008. The banks swapped say 5-6 % MBS’s for deposits earning 15 basis points. There was a quid pro quo here for short term earnings purposes on the banks books. Might that be a massive release to earnings in 2009 or an offset to losses booked on other assets of the bank. Why would banks give up the CASH FLOW of Fannie and Freddie guaranteed MBS’s earning 5-6 % for 15 crummy basis points other than cosmetics and non cash bookkeeping income or lowered non cash bookkeeping losses? After all, the FRB’s are relying on the F&F guarantees in the stead of the bank they purchased them from on a real world non cash transaction basis.

        Comment by Jerry J — August 26, 2010 @ 10:37 PM

      • I pretend here that in early 2009 my bank owns $100 bn of 5 % Fannie and Freddie guaranteed Mortgage Backed Securities that I carry after reserve loss accruals at 70 on my books. I am earning $5 billion a year but took a bookkeeping loss of $30 bn writing them down to market or impaired from the conservatorship of F&F putting the guarantee in doubt. I know that my normal funds generation would allow me to buy $50 bn of these same securities. Now , what if I get the Feds to buy my holdings at par and I can buy $50 billion of MBS’s for $35 billion and push those too over to the Fed too. The catch is that I must sit on the proceeds at 15 basis points for years on end. So, I indeed sell the whole $150 bn of F&F guaranteed securities to the Fed at 100. I get an increase in my Reserve Account at the Fed that I carry as cash even though I will let it sit there for years on end. But I need the profits now. So, I buy the $ 50 bn of securities for $35bn and turn it over immediately to the Fed for a $15 bn profit. My own securities now have a loss reserve credit on the books for $30 bn which is now freed up and I use it to cover $30 bn of impairment losses on other assets to avoid a $30 bn hit that will kill the bank. I use half of the added $15 billion profits to cover even more impairment charges. The other half of the gain turns 2009 into a banner profit year where I get a killer bonus.

        Thank you Ben Bernanke for saving the system in 2009, my bank too but especially for keeping my gravy train rolling. Of course , buying up those MBS’s for the FRB killed ability to loan much in 2009 and 2010. But , the non cash journal entry bookkeeping rage ” effectively” created the crisis and the non cash journal entry bookkeeping rage will be used to get my ass out of the outhouse hole I fell into.

        But lo, the Fed will eventually sell these same $150 bn of F&F guaranteed MBS’s back to me at 100 by charging my existing Reserve Account at the Fed. These securities are legitmately laundered back to 100 on my books where I will carry them for a very slow sell off. They are and will in the future be 100 % backed by the government owned new F&F that emerges. So, I start making my 5 % again in 2012. In the meantime I booked $35 bn of profit on the transaction , cash and non cash, and that is 9 years regular earnings rolled into one year where I needed it to survive.

        Interesting scenario that some of us figured out in the summer of 2009. But , Bernanke did save the present system until the next crisis. The crisis muddled into in 2008 was otherwise likely fatal to the system.

        As the TV Maverick Brothers used to say. ” My Pappy could slither around anything and come out on top”.

        Comment by Jerry J — August 27, 2010 @ 12:48 PM

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