Be Cautious About Investing In Commercial Banks

by: John M. Mason

From October 31, 2012 to October 30 2013, the total asset of commercial banks in the United States grew by $1,007 billion … or $1.005 trillion. This according to the H.8 release of the Federal Reserve System.

From October 31, 2012 to October 30, 2013, the reserve balances of commercial banks at Federal Reserve banks grew by $1,001 billion … or $1.001 trillion.

For the same period of time, cash assets at commercial banks grew by $995 billion … or $0.995 trillion.

Breaking this down, cash assets at the largest 25 domestically chartered banks rose by a little more than $356 billion and cash assets at the rest of the domestically chartered banks rose by about $31 billion.

The biggest gainer? Foreign-related institutions … the cash assets on the balance sheet of these financial institutions rose by $608 billion!

One should also note at this point that at these foreign-related institutions, $381 billion in funds flowed out of the United States, connected, I believe, with the flow of funds back into Europe as financial markets became calmer on the continent. The major part of this increase came after March 2013, when long-term interest rates began to seriously rise in the United States. (See "Further Signs of Funds Flowing Back to Europe.")

But, let's move on to the real estate sector, the area that the Federal Reserve has seemed particularly intent upon stimulating.

Over the past year, residential real estate loans declined by over $35 billion at all banks! The decline was split almost equally between the 25 largest banks and the "smaller" banks. This decline occurred pretty much throughout the whole year!

Yet, sales of housing are up, year-over-year. Where is the financing coming from?

When we look at where a lot of the activity in home sales is coming from we pick a sense that maybe households are not the major purchasers of homes in the current environment. A lot of activity in home sale is being driven by hedge funds, private equity funds, and construction firms or their subsidiaries. (See "Blackstone Hits a Home Run" and "Restructuring the Housing Industry: Deals Galore.")

These acquisitions would not be done using residential mortgages. Let's sift through the data a little bit more.

Commercial mortgage lending has increased over the past year, it is up by about $55 billion.

Note, however, that almost all of the increase in this category of loans has taken place outside of the largest 25 domestically chartered banks in the country. The increase in the largest banks amounts to only a little more than one billion dollars. Over the past 13 weeks, commercial real estate loans at the largest banks actually declined by $9 billion!

Furthermore, lending to hedge funds and private equity funds would not be listed under "commercial" real estate loans. They would be listed under business (commercial and industrial) loans.

C&I loans are up strongly at the largest 25 domestically chartered banks. One other thing to note is that business loans are up strongly at the foreign-related institutions. It would seem that a lot of the lending going on at these larger institutions is not going into "productive" business loans that are connected with an increase in economic growth.

It seems as if many business loans are going toward the purchase of assets like residential properties, which the businesses that are buying them are going to rent or "flip". The business loans are going to organizations that are acquiring existing assets, typical of a period of credit inflation, rather than investing in new capital that can boost output and employment.

The largest banks in the rest of the banking system, still smaller than the largest 25, may be doing some of this type of lending as well, but it seems rather obvious that the lending is not going into stimulating the local business community.

What about the increase in commercial real estate loans at the "smaller" commercial banks in the United States?

I have written about this earlier and the commercial real estate loan situation at the "smaller" banks is one of the reasons I caution investors about investing in the commercial banking system at all. Throughout the recovery from the Great Recession I wrote about the problems in commercial real estate and one of those problems was that we really didn't know what shape the banking system was in because most commercial real estate loans were five year … or, seven year maturities … and nothing had to be paid on them until maturity.

The earlier fear was that many of these loans would not be able to be rolled over and refinanced.

Given that we are now in the fifth year of the economic recovery the "outward" appearance of the commercial real estate industry appears to be more stable. Consequently, these loans are being rolled over and refinanced. In fact, the loans are not only being rolled over, but the commercial banks are adding to the face value of the loans because of the need to provide sufficient cash to complete deals or to see them through the refinancing "bump."

I am not totally confident that these commercial real estate loans are that strong or stable. And, there is no way to look at the balance sheets of the banks and tell whether or not I am wrong. I just sense that we are not totally "out of the woods" yet when it comes to the health of the banking system.

And, the commercial real estate loan problem is primarily a "smaller" bank problem. For one thing, the commercial real estate loan portfolio of the smaller banks is 1.65 times the size of that of the largest 25 domestically chartered banks. Furthermore, commercial real estate loans make up almost 25 percent of the assets of the "smaller" banks and over one-third of the total loan portfolio of the "smaller" banks.

Bottom line: I am still not very confident about the commercial banking system in the United States. We keep thinking a bank is "OK" to invest in and then there are regulatory problems or problems connected with portfolios that bank accounting were unable to prepare us for. I just think that there is a lot of uncertainty connected with the commercial banking system that we don't, as investors, have a handle on right now.

And, note … as I stated at the beginning of this post ... the assets of the commercial banking system have not grown at all this year if one subtracts the funds that the Federal Reserve have pumped into the financial system. This, to me, is not a sign of health.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.