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Chairman Ben Bernanke gave testimony this past week on the Fed’s semiannual report on monetary policy to the United States Congress. I believe that Mr. Bernanke’s report can be summarized in two sentences. First, the United States economy is recovering, but the recovery will be quite slow. Second, the Federal Reserve will continue to keep its interest rate target at current levels.

This testimony came during a time in which the Federal Reserve has been attempting to reveal and explain how it plans to exit from its current position, a position that includes a banking system with almost $1.2 trillion in excess reserves. Fundamentally, the Fed is ready to begin to “undo” what it has done over the last year and a half. (See, for example, my posts here and here.)

The implicit contradiction in all of this is that the Fed’s “undoing” is to take place as the economy recovers, but, the Chairman in not willing to give a hint as to when the economy will be strong enough to allow the Federal Reserve to start raising its current target level of the Federal Funds rate.

To me, the message that is being conveyed between the lines is that there are still some things so wrong with the economy (that the Federal Reserve is aware of) that the Fed cannot take a chance, even give a hint of a chance, that the target Fed Funds rate will be raised.

And, what is the basis of this fear?

Well, we can start with the state of the banking system. The Federal Deposit Insurance Corporation (FDIC) produced its quarterly report last week and indicated that 702 commercial banks were now on the list of problem banks at the end of 2009. This is up from a total of 552 banks that were on the problem list at the end of September 2009. And, the FDIC closed 2 to 3 banks per week during the fourth quarter of the year.

Given the current list, the expectation is that about 235 banks, one-third of the current total on the problem list, will close over the next 12 to 18 months, a rate of 3 to 4.5 banks per week for this time period.

Remember that there are about 8,000 commercial banks in the United States, with the top 25 accounting for well over one-half the assets in the banking system. Thus, the banks that are failing tend to be small and they tend to be “local” in nature and a failure can cause quite a disruption on “Main Street.”

The problems in the banking system go deep. The insured banks charged off 2.9% of outstanding loans in the fourth quarter of 2009. This is the largest charge off rate in the 75-year history of the FDIC.

At the end of the fourth quarter, 5.4% of all loans were at least 90 days past due, a near-term high. Specific areas of the loan portfolios are showing a large amount of stress. For example, data on construction loans to build single-family loans indicate that about 40% of the loans are either delinquent or have totally been written off. Mortgage loans still remain a problem where about 12.5% of the loans outstanding are past due.

Commercial real estate loans are the looming giant in terms of providing dark clouds for future bank loan performance. Elizabeth Warren, head of the Congressional team that oversees the TARP funds has stated that about 3,000 commercial banks face the possibility of a “tidal wave” of commercial real estate loan problems. At the end of the fourth quarter of 2009, over 6% of these loans were classified as a problem in some way.

Before these problem loan areas can be resolved, the economy must begin to get stronger, people must return to good paying jobs, and real estate values must cease falling. Discouraged workers must return to the workforce and manufacturing firms must increase the utilization of their resources. There is little evidence to indicate that these factors are, in fact, improving to the extent needed to strengthen the loan portfolios of commercial banks.

The Fed, obviously, has a good seat to observe all of these facts. And, I believe, they are very, very concerned. And, I also believe, that bankers are very, very concerned.

Why?

Because the bankers are sitting on their hands and holding onto any type of asset that will not deteriorate in value…cash or deposits at Federal Reserve banks and short term government securities.

Yes, we can say that businesses and homeowners with very good credit are not borrowing. And, we can say that consumers are not borrowing.

I don’t think this is the answer.

I believe that this situation is more like the one that was experienced in the period around 1937. Commercial banks were holding a lot of excess reserves at that time too. Also, there was no lending to speak of during that period. And, the Federal Reserve raised reserve requirements to “sop up” those excess reserves.

And, what did the banks do at that time? They withdrew even further. The banks wanted those excess reserves. They did not want to lend them out. They just wanted the protection and security of having those reserves in their hands. By taking the reserves away, the Fed caused the banks to restrict credit even further in order to return excess reserves to a level more consistent with the safety the banks wanted on their balance sheets.

Ben Bernanke, the student of the 1930s, knows what happened back then. He is, therefore, fighting on two fronts in the current climate. First, there are those that are afraid that the excess reserves the Fed has injected into the banking system will eventually be lent out and this will cause the money stock to expand and this, given the size of the $1.2 trillion level of excess reserves, will result in a higher than desired level of inflation in the United States economy.

Bernanke and the Fed must do enough talking and maneuvering to satisfy this crowd. Hence the exit strategy and the efforts to get Federal Reserve’s operations back into a more normal environment.

Second, however, is the fear that the excess reserves in the banking system are “desired” by the banking system and any effort to substantially reduce them in the near future could lead to a further contraction in the banking system that would ensure a “double-dip” Great Recession.

My guess is that Bernanke is not willing to take a risk on generating a further contraction in the banking system by removing bank reserves at this time. This, to me, is the message between the lines of the Chairman’s testimony in front of Congress this past week.

The Fed is ready for the great “undoing” of its balance sheet, but is not going to begin this “undoing” until it is sure that the commercial banks are willing to let go of the $1.2 trillion in excess reserves.

Source: Reading Between the Lines on Bernanke's Testimony