The Federal Deposit Insurance Corporation (FDIC) released its Quarterly Banking Profile (QBP) for year-end 2009. Things have never been worse for the banking system: bad loans (loans that are 90 days or more past due) account for 5.37% of all loans and leases, an all-time record; net charge-offs (NCOs) – losses taken on bad loans – totaled $53.0 billion, or 2.89% (annualized), in the fourth quarter which is also the highest rate ever recorded in the QBP’s 26 year history. Banks did not increase loss reserves fast enough to compensate for the growth in charge-offs and nonperforming loans. As a result, ratio of reserves to bad loans fell to 58.1%, the lowest level since mid-1991 and almost certainly too low to absorb all of the expected losses. The FDIC labeled 702 insured depository institutions as “troubled” up 68% from 416 at-risk banks in June 30, 2009. The rate of deterioration may have slowed, but things have not stopped getting worse.
The QBP also provides insight into the credit crunch facing small business. In 2009, bank balance sheets shrunk by 5.3%, the largest amount on record. However, all asset classes did not fare equally: loans to businesses fell by 18.3% and accounted for 37% of the decline in total assets. By contrast, banks’ securities holdings actually grew by a whopping 23% during 2009. As a result of these shifts, securities accounted for 19% of total bank assets at the end of 2009 – up from 15% in 2008; business loans shrunk from 11% of bank assets in 2008 to only 9% at the end of 2009.
Bank assets allocation
The reason for the shift was the steep yield curve: banks can borrow at next to nothing, thanks to a fed fund rate that is less than 0.25% and buy Treasury securities that yield 3.65%. The average net interest margin for banks in the fourth quarter was 3.49%, which also happens to be the average difference between the 10 year Treasury yield and the fed funds rate. Banks have no incentive to extend loans to business borrowers when the credit risk-free spread is that attractive. Moreover, banks’ poor health also boosts demand for credit risk-free U.S. Treasury securities because banks need to marshal the capital they have to absorb expected losses on the nonperforming loans already on their balance sheet.
The Administration has responded to the decline in business lending with an expansion of SBA and a plan to buy $15 billion in securities collateralized by small business loans. Given the reported shift in balance sheets, effectively the plan was for Treasury to issue $15 billion in new debt, purchased largely by banks, to buy small business loans from banks so that they could purchase more Treasury securities. While this seems ridiculous (because it is), the Treasury has little choice in the matter given its enormous funding needs. Treasury can’t ask banks to shift their portfolios back towards loans without potentially causing its own borrowing costs to go up.
Morgan Stanley released a report the same day as the FDIC’s QBP that wondered whether the government would seek to avoid a debt crisis by taking things a step further and requiring banks to accumulate more Treasury securities. Mandating large Treasury holdings would provide a supportive bid that would hold funding costs down. It would also provide an outlet to place new debt issuance if rumors about China’s declining appetite for dollars turn out to be true.
Solving the U.S. debt crisis through bank regulation was also hinted at by the head of the Bank for International Settlements – the association of central banks – in a recent speech. He argued than banks should hold “a sufficient stock of high-quality liquid assets to be able to survive a month-long loss of access to funding markets.” Depending on how this rule is structured, it could have virtually the same effect as the regulation suggested by Morgan Stanley given the unrivaled liquidity of Treasuries.
U.S. banks are in very bad financial condition. So too is the federal government. Don’t be surprised if the two issues are linked in the coming year through a strategy to use new “liquidity regulation” on banks as a pretext for regulation really aimed at preventing a U.S. debt crisis.