More Bad News Bears / Banks

Includes: SKF, SLF, SPY
by: John Lounsbury

Two articles at the American Banker detail more bad news for the troubled banking sector. In one article, entitled "Problem Bank List Hits 15-Year High", Joe Adler reports that the FDIC troubled bank list has been increased by 36% to 416. Assets in these banks total nearly $300 billion. This number (416) is four times the number of banks already failed in the current crisis, and $300 billion is more than double the assets of the banks already failed. The reasons for this growing crisis were reviewed recently here.

In a related article, "DIF Reserve Thins; List Of Problems Expanding", the same author (Adler) describes the depletion of reserves used by the FDIC to handle the excess liabilities of failed banks when they go into receivership.

Both articles are posted at the American Banker website, which is for subscribers only. A longer abstract of the first article is available at the Financial Planning Daily website, here. In an attempt to attract more investment capital into banks, the FDIC is backing looser requirements for capital investors in banks and is lowering Tier 1 reserve requirements from 15% to 10% (raising leverage from 6.67/1 to 10/1). Read that story here.

This is a case of taking a number of steps to extend the banking problem rather than resolve it. The only logical argument for taking this course of action is to start with the assumption that the economy will improve sufficiently that:

  1. Some residential and commercial mortgages and loans which are delinquent will be 'cured' rather than default.
  2. Operations for the troubled banks will improve with the economy sufficiently to allow them to earn their way out of the hole.
  3. The weaker capital position of investors allowed to buy banks under relaxed 'source of strength' requirements will be improved with the economy.

If there is weakness in the economy over the next 2-3 years, these steps have little chance of success. A lot is being bet on one outcome. If the economy is weaker than expected, the future costs are increased over what current costs would be. Current actions would simply delay failures that could have been gotten out of the way now. If failure is accepted now, bad assets are isolated and healthier assets are transferred to stronger banks. The weakest banks are gone and the stronger banks are strengthened. The financial system is healthier immediately rather than several years from now.

The other negative aspect of extending lives of the weakest banks would be opportunity cost. If we wait 2-4 years to work out a financial system health profile that could be obtained now, we are simply removing the opportunity of the system to contribute to the economy (as much as it could otherwise) over that intervening time. This lost opportunity cost exists (but is less) even if the economy improves.

The zombies should be locked away in a mausoleum. If it takes more capital than contained in the DIF reserve, use some TARP money to shore up FDIC reserves. That is a better use of government money (using it to get rid of bad banks and strengthen stronger banks) than putting money into bad banks.

When you kick a can down the road enough times, you can end up with a can that is full of holes and no longer holds water. Let's not go there.

Disclosure: The author, family members and clients own shares of SKF.