The Banker: Connecting the Dots

In two recent articles, The Banker’s Dilemma and The Banker’s Choice, I discussed the conflicted objectives of banks. The first article concluded that, torn between increasing earnings through greater lending and ensuring continued solvency through improved capital ratios (higher reserves), the banks will choose ensuring solvency. The second article pointed out that the first moves by banks to employ TARP funds have included several substantial acquisition moves. These appear to be encouraged by the Fed’s announced “quantitative easing” policy, which will make traditional assets on the balance sheet less attractive. The stated Fed objective is to encourage more lending. Instead of increasing lending, it appears that TARP fund recipients are making an end run to find assets more attractive than treasuries and other debt instruments.

Other articles published since the two previous banker articles were written are relevant.

Dr. Bill Conerly, a former bank executive and now Senior Fellow at the National Center for Policy Analysis, has reported that small banks are being pressured by their regulators to increase reserves, which, of course, would curtail lending.

Many sources have reported that small banks have done a much better job of loan placement and have much stronger balance sheets (better capital ratios) than the large banks. Ira Altman, an experienced debt analyst and trader for several major banks, has suggested a possible policy pattern that could cause the assets of small banks to be shifted to the large banks.

The observations of Bill Conerly indicate the capital ratios of the small banks may be strengthening further through regulatory pressure. Combined with Mr. Altman’s observations, we get the picture of a bank robber influencing bank customers to make deposits just before his planned robbery. Maybe I’m just being paranoid here, but some one needs to talk me down before I get this picture out of my mind.

What Mr. Altman has suggested appears to be a process of taking the assets of the virtuous to rescue the corrupt. The justification might be that it is necessary to do that in order to rescue the nation that has been corrupted. The first question is: Is this asset shift from Main St. to Wall St. necessary? The second question is: Isn’t there a better way?

Only a few dots have appeared so far on the canvas identifying all aspects of the financial crisis and the paths being attempted to right the foundering ship. But the few dots we can connect so far appear to be drawing the start of a disturbing picture. Are we, so far, simply seeing the results of lack of policy coordination, the right hand not knowing what the left hand is doing? When we have more dots to connect will the picture become more reassuring?

Comments

[Tom Armistead:]

John, we already have enough dots and you have connected them accurately.

Hopefully a combination of public outrage and a new administration can develop new and better solutions.

2008 Dec 31 07:58 AM

[Alan von Al...:]

You've done a great job of reporting a very serious and nuanced threat to community banks. Thank you.

Several points worry me. Yves Smith and others have been pushing the "Swedish model" of seizing banks (all of them), declaring force majeur on swaps and Tier 3 junk, winding up the zombies and IPO floating the survivors to new sharholders. The truly worrisome aspect is that the US won't bat an eye or lift a finger in protest. Jesse had an important post yesterday. The United States of Ennui

2008 Dec 31 08:56 AM

[Alan von Al...:]

jessescrossroadscafe.b...

2008 Dec 31 08:57 AM

[Crocodilian:]

Nothing about borrowing short & lending long makes sense during a leverage unwind. Every institution which doesn't have explicit and guaranteed access to short term Federal lending looks shaky . . . because if leverage is going down, it is.

Its very difficult, if not impossible, to distinguish between institutions in this climate. Good banking practices or bad, all banks are vulnerable to a bank run.

The "emerging picture" is that of an highly leveraged financial system, burning off that leverage through massive losses. These losses have to find a home, as the equity slice of capital isn't enough to absorb them. When the losses strike debt positions, the danger of cascading defaults becomes immense, but not readily calculable.

The reason that "only a few dots have appeared on the canvas" is that we actually have next to no idea as to the inter-connectedness of the existing financial structure. Given the aftermath of the Lehman failure, one may reasonably fear that we've a situation where we cannot permit "dots" to appear on the canvas-- we have any number of potential single point failures which could "bring down the system".

2008 Dec 31 02:49 PM

[John Lounsbury:]

Crocodillan - - -

Thanks for the comment. You have given a very good statement about some of the still unknown "dots". Doom is not inevitable, but Nelly might die before the sun shines again.

(For the puzzled, I refer to the song sung on the NYSE floor: "Wait Til the Sun Shines, Nelly.")

2008 Dec 31 03:22 PM

[Steven Hansen:]

john, when many dots are connected on this canvas, most dots appear ad hoc. when the treasury and fed try to run ahead of events, the results seem to be illogical. i guess academics studying the great depression and building computer models is not the same as the real deal.

this has been my worry - the consequences of massive intervention using an unproven script will yield unexpected results, i would feel more comfortable knowing that they know their concepts are shaky - rather than knowing they know what they are doing.

2008 Dec 31 06:19 PM

[Craig Brown:]

You commented on my article noting that an unwinding process for CDSs is a potential solution to reducing the weight for that 800 pound gorilla. I read in November that leading up to the Lehamand Countrywide price settlements for CDSs (by the ISDA) that a good bit of this was done for those entities, so it is possible. Banks sat down and tore up trillions in notional value CDSs that were offsets.

The CDS market is very similar to the reinsurance market, which I have litigated over for years. If you do a bit of research you can see that there were some rather nasty reinsurance spirals (everyone insuring everyone else) that had to be unwound. Now some of this was done through commutations but a lot of it had to be resovled through litigation. I have a six inch wide book on my shelf that is the court's decision in one of those cases in London. And, unfortunately, reinsurance spirals were much more limited in terms of players and dollars at stake than the CDS market. Nonetheless, someone with some pull needs to bring all the players and their CFOs into a room and negotiate away the off-setting CDSs. That will undoubtedly still leave tens of trillions in notional value, which is still a major hangover. These instruments also need to be regulated, put on an exchange or outright banned going forward, in my opinion.

Jan 01 02:38 PM

[Oregonrain:]

This is a very interesting article. I am not sure if what is happening is an "unintended consequence" or exactly what was/is intended by the regulators.

But the idea of fattening up the smaller banks so they can be fed to the B of A's of the world and worse is a truly disgusting thought. I see these sweat little "piggy banks" on a conveyor belt being fed into the great big ugly "meat packing plant." Wow...truly a frightening idea.

Jan 01 10:04 PM