The Back Alley Archives

Finally, I am positive that some time during either the 3rd or 4th quarter that a large number of banks—large and small—will no longer be able to hide their liquidity issues behind the debates over “mark-to-market or “mark-to-model” and the adequacy of loan loss provisions and the carrying value of OREO. The fact of the matter is that many, especially the larger institutions —and especially if one takes their off-balance sheet liabilities into account—are still highly leveraged. It just doesn’t take a very large percentage of their earning assets (loans and securities) to stop cash flowing before serious problems arise in meeting routine obligations as they come due. Overnight repos and FHLB advances, maturing time deposits, regular DDA and money market account withdrawals, payroll, vendor invoices, taxes, FDIC assessments, etc. I know I have dragged its name through the mud ad nauseam in this forum—but still not often enough for my liking—but the late great “Goin” Downey comes to mind. When the OTS seized it, 12 ½% of its loans were delinquent or in foreclosure; two-thirds of these were 90+ days delinquent or in foreclosure. Another 9% were restructured (modified), only one-third of which showed up as problem loans. So, over one-fifth of Downey’s loans by unpaid principal balance (UPB) were either not making any payments or making them at a lower-than-originally contracted rate. Meanwhile, some of its obligations were coming due every day. FHLB advances, for example. Although the FHLB-SF will roll over overnight advances, even from troubled institutions like Downey, it will only do so if they can prove they can extinguish it in its entirety first. So, to obtain another overnight advance, Downey had to repay the original, even if just momentarily, just to demonstrate it had the liquidity, the wherewithal to do so. I’m certain that it was something like this that tripped Downey up and forced the OTS to seize it. Unlike the “Crack Daddy” (a.k.a. IndyMac Bunko), there was no Chuck Schumer-inspired run on the bank. The liquidity issue here was that there was too much cash going out and way too little cash coming in.

There are dozens, if not hundreds, of regional and community banks facing this kind of issue. And a few superregionals as well. Given the concentration of their portfolios in commercial real estate and construction (both SFR and commercial) and the likely withdrawal of $100s of billions of uninsured deposits in the coming months—totaling $4.3 trillion among FDIC-insured institutions, mostly business payroll and other accounts as well as individual accounts exceeding the $250,000 limit on deposit insurance—I am positive we will finally see primary regulators forced to act. It is my understanding that the FDIC is now fully staffed and fully equipped. And the inadequacy of its reserves—now down to less than $20 billion—is irrelevant. Protecting depositors is now the explicit responsibility of the U.S. government. The only reason the FDIC has not started taking over these problem institutions more aggressively is that it can only act when appointed receiver by the primary supervisor—the OCC, the OTS, or state banking departments. As long as liquidity wasn’t an issue these primary supervisors were loath to act—mostly, I believe, out of a fear of losing face, credibility. Remember, the heads of these organizations aspire to higher office or appointment. Or a lucrative job in the industries they supervise. Very few want to appear incompetent to the general public. So, they have given essentially failed institutions a lot of rope, urging them to find buyers or capital infusions. Hasn’t happened. Buyers are not willing to buy at prices sellers think their institutions are worth. And new capital has come with too many strings. Loss of control. New management. Additional directors. So primary regulators have let these banks and thrifts sit out there in limbo. Perfect definition of “zombie” banks. If, as I foresee, liquidity becomes not just a problem, but a crisis at these institutions, their primary regulators will be compelled to step in and appoint the FDIC receiver. They cannot jeopardize the safety of the deposits—or else depositors will flee the system en masse, despite any assurances they receive that their money is insured.

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Some have argued—and apparently their arguments have fallen on deaf ears—that the resurgence in the capital markets is a government-led recovery. Supporting their theses have been data suggesting that the increases we’ve seen in total equity and debt market capitalization approximately equal the liquidity provided by fiscal and monetary stimuli. I’ve attached one such thesis. I guess that this is the mandate of equity investors in the post defined benefit era: to sop up excess liquidity. Prior to that era, institutional investors invested with a purpose, usually to meet projected benefit obligations, cover projected claims liabilities, or fund endowments or philanthropies. Now they are completely (mis)guided by naked fear, greed and ego. They invest against their better judgment because they can’t be seen on the sidelines while the market is running up 40%. They fear they will lose their investors and their jobs. They know stocks are overvalued, but by riding their momentum and merely earning a market rate of return, they can generate meaningful management and performance fees, thereby boosting their own pay without breaking a sweat. And look like geniuses in the process.

Getting back to the thought about U.S. government and Fed stimuli providing all of the increases in equity and debt market values (high yield bonds are up an astonishing 37%, nearly 3x the increase in investment-grade corporates, notwithstanding the expectation of many participants in that market that “junk” bonds will experience much higher losses than those observed over the last decade). The trouble is, no good can come from these stimuli-induced returns. The markets become addicted to them (and most equity investors are junkies). Withdraw them and the Dow is right back to 6500—or lower. Keep providing them their fix and one runs up huge deficits, resulting in higher long-term rates and borrowing costs (and the Treasury will be issuing new debt a lot faster than Ben can buy it), crushing any nascent recovery and the market value of debt and equity securities. This is the worst kind of “cold turkey”.