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Many articles have been written lately regarding the precarious state of our banks, and I am sure many more will be written. This has become especially true since the announcement by our government of its $196 billion lawsuit against the largest banks.

Remember that it was not too long ago that these same banks were hailed as great buying opportunities.

In fact, it was just two weeks ago that an article came out in Forbes that some of the “top” bank analysts were pushing the values of buying bank stocks.

The main reason why these analysts were pointing their renewed interest in banks was that their stocks were selling at discounts compared to the “value” of their assets.

But do we really know what the balance sheets of these banks really represent, especially when we are on the precipice of another economic downturn?

Will the ultimate failure of these large banks, a la Lehman, have a serious effect upon our overall equity and credit markets?

A Little History

In 2007-2009, the world experienced a financial meltdown, the likes of which had not been felt since the Great Depression. The public quickly lost confidence in our banking system, and a panic ensued, which trimmed over 50% of value off of our equity markets.

Hank Paulson, the Secretary of the U.S. Treasury, and Ben Bernanke, Chairman of the Federal Reserve, both recognized that there was a true lack of liquidity within the U.S. banking system. Although they would never admit this publicly, they understood that banks were truly undercapitalized in terms of actual depositors’ money on hand to meet any serious liquidity issues within our markets. Paulson recognized that if this led to a run on our banks, the average citizen would not realize that they had lost everything until it was too late for them to do anything about it.

What most of us did not understand was that there was only approximately $65 billion in actual cash greenbacks in the U.S. vaults and at the Fed, compared to the estimated $40 trillion worth of dollar-denominated credit outstanding. What was, therefore, abundantly clear to Paulson, et al, was that the actual cash on hand was seriously insufficient backing for the total denominated credit outstanding. With less than 2% of all depositors’ assets on hand in their vaults, have you ever wondered why so many banks have been closing during the past two years?

Did We Learn Our Lesson?

In hindsight, the powers-that-be finally recognized – only behind closed doors -- that the signing into law by Bill Clinton of the Gramm/Leach/Bliley Act, which effectively repealed the Glass-Steagall Act, directly contributed to the severity of the financial crisis we experienced during 2007-08. During this financial crisis, we were told by these same people that the largest banks in America were “too big to fail,” even though they recognized that this caused significant risk to our banking system in the first place. Once the real estate market began to tumble, the feeble house of cards upon which these banks had been built began to tumble as well.

In 2002, the top 10 banks owned 55% of the total US banking assets. However, over the last several years, the regulators and others who are charged with the oversight of our banking system have not reduced the risk in our banking system, but have actually significantly increased the risk by 40%. In fact, now 10 banks own 77% of all US banking assets. Therefore, not only have the inherent dangers that caused the major problems of the 2008 financial crisis not been fixed, but the fact that it is even further centralized now makes our system much more vulnerable than it was prior to the 2008 crisis.

Further consider that the major equity markets had retraced approximately 75% of their losses over the last couple of years by May 2011, whereas the overall financial index had only retraced approximately 35% of its losses. The traditional leaders of our economy are truly in a precarious state, despite the fact that the lion’s share of the benefits of unprecedented government bailouts and quantitative easing inured to the banking industry. What is worse is that, last year, they handed out record bonuses -- yes, bonuses that even exceeded those granted prior to the 2008 financial crisis.

And when the traditional leaders of our economy are in a precarious state, it then causes our entire equity and debt structure to fall into a precarious state as well, as we clearly saw in 2007-2009.

So, have we learned our lesson? I think not.

What Does the Future Hold?

While no one can ever be certain of the future, we can at least take notice that there are serious headwinds facing our financial system, and the largest banks that represent 77% of US banking assets.

First, as was recently announced, the Federal Housing Finance Agency arm of our government, after sitting on its hands for years, is now purportedly acting to protect us, and has filed a $196 billion dollar lawsuit against our largest banks. Although these lawsuits will most probably be settled in short order, it will still cause a financial drain upon an industry that cannot afford much more financial drain.

Furthermore, I truly believe that this is simply the tip of the iceberg, as the public mood towards these banks has been quite negative, and has only been getting more and more negative as time goes by. Otherwise, I highly doubt that such a lawsuit would have been filed to begin with.

Second, does anyone see the bottom to the real estate market yet? When we take into account that even the smaller banks (which are usually more risk averse than the larger banks) are still struggling to survive due to the fact that housing prices have still not found a bottom, coupled with expected continual loan defaults due to the fact that a resolution to unemployment has still not been found, the near term horizon for our banking industry does not look promising. Furthermore, due to increasing loan losses on commercial real estate, we can surely see further significant bank failures in the years to come.

Third, when you consider how truly illiquid our major banks were in 2008, the fact that they are now some minor multiple of that level is really a farce.

Conclusion

As the social mood continues to decline, with credit contraction abound, and lack of trust pervasive through the system, margins and availability of credit will be reduced further and further. Furthermore, it is clear that the public does not want to accept upon itself further debt, nor does it want our government to do so either.

Ultimately, this growing public perspective, along with our inability to solve the unemployment issue, will put even more downside pressure on asset prices. As our bank’s asset values continue to decline, it is only a matter of time before this snowball gets too large for anyone to stop.

Too big to fail? Ultimately, I believe we are headed to ”too big to save.” And, clearly, all of this will have a disastrous effect upon our equity and debt markets, which can make 2007-2009 look like a walk in the park.

Source: Too Big To Fail May Now Be Too Big To Save - Setting Up Market For Disaster