Tuesday, June 8, 2010

Bank Failure Observations Worth Noting ...

In case you didn't see it, the last few days have seen some interesting things happen over in FDIC land.

Last week, the FDIC took down two micro banks. These small institutions basically imploded in one quarter, a pattern that has not been the norm in terms of bank closures. Most are allowed to struggle along for as many as 5 to 8 quarters before facing the inevitable. These are different. Disaster strikes quickly. The pattern first appeared with the demise of La Jolla Bank in San Diego when a large fraction of their commercial R.E. loans went sour en masse. The question I asked at the time was "how many other banks on the edge are looking at 'walk away obligor' risk?"

Last week tiny Arcola Homestead Savings Bank in Illinois and First National Bank of Rosedale, MS also did dramatics power dives to oblivion. Also last week the FDIC shut down long struggling Tier One Bank in Lincoln, Nebraska.

You can look at them on IRA's Casualty List Forensics page if you like.


Friday, May 14, 2010

2009 Commercial and Industrial Lending Trends at Large and Mid/Small Banks

I decided this blog would be a good place to take on answering more questions. This week a compare and contrast request about what's been going on in commercial and industrial lending and how reactions to market pressures in 2009 affected the large and small strata of the banking industry.

Here’s my take on it:

During 2009, C&I loans outstanding by large institutions declined from $1,200B to $953B between 12/2008 and 12/2009 confirming the Federal Reserve’s observation of a 20% contraction in lending. Of note, this shrinkage is equal in magnitude to the lending of the entire mid and small bank lending base. During the same period, the under $10B asset banks went from $310.8B to $281B in C&I loans outstanding, an estimated contraction of only 9.5% based on an IRA examination of the universe of FDIC CALL/TFR Reports from the period. On the surface that would seem to single out the big banks as being the sole culprits of diminishing credit availability in the U.S. That’s not quite true and here’s why.

Another important part of the credit availability story for U.S. business in 2009 reveals itself more clearly if one looks at unused commitments for C&I Lines of Credit (LOC). During 2009, large bank C&I LOC commitments went from $46.7B up to $49.8B for the year even as their annualized gross experience factors tripled from 113.1bp at the beginning of the year up to 294.9bp by December. Granted the terms demanded by these big banks became more onerous. However on the mid/small bank side of the industry, credit availability completely collapsed in 2009. LOC commitments for these banks plummeted from $17.3B at the beginning of the year to $8.8B by year end. For them, gross defaults only doubled going from 98.9bp to 218bp for the year but it still resulted in a more severe commitments contraction.

The real question then is what’s behind the disparity in reaction patterns to what I personally believe are actually two parallel sub-groups within a larger complex industry?

Smaller banks don’t have the reserves depth of their larger counterparts so their reaction to systemic stress is to pull back from risk taking. They embark on a flight to quality and that ultimately results in fewer, but not that much fewer, loans and tighter limits on commitments to lines of credit. Borrowers are faced with the task of overcoming much higher acceptance standards.

Big banks, who had been far more liberal in their lending when winning market share was the mission at all costs, begin to cull their lower quality loans under the pressure of improving operating risk management. They can then draw on government subsidies and use them to issue new loans on more onerous terms because portfolio theory dictates they need these higher terms to recoup the loan quality mistakes now manifesting as higher default rates. To attract customers, they grant somewhat more liberal lines of credit that are of course shrouded in covenants designed to make actually trying to use these lines an obstacle course. That’s what’s meant by “loss management” strategy.

The net result from these independent parallel responses to the common systemic shock? U.S. commercial industry is more difficult and costly to conduct.

Here are the reference data links:

Large Bank C&I

Mid/Small Bank C&I

Tuesday, April 27, 2010

Bank Crisis Casualty List

Here's the link again for the failed banks casualty list with the IRA forensics reports.


After Bastille Day: Is There a Future for Big Banking?

As bank reform continues to grind through Congress something sorely lacking so far is concentration on safely managing down "points of risk" from Too Big Too Fail business models. We are awash in anger but remain devoid of constructive action. Perhaps it's because finding better basis for the role that big banks play in the U.S. economy is so important that we are paralyzed? And in this I'm including both the government and industrial side of the fencing. We all know this is the next step in the evolving theater so why aren't we infusing this latest round of legislation with constructive guidance and authorization to put the U.S. on a path to a solution? Possibly because we need someone to define a better mousetrap. Here's my stab at thinking about what that might be.

I've been observing with great interest the Johnson and Kwak hypothesis about limiting maximum bank size as a function of risk to U.S. Gross Domestic Product (GDP). The thesis is that we need to somehow cap TBTF exposure so that it's no more than 4% per business entity. It's an intriguing thought that causes me to wonder - as many other people are - about how one might go about slicing up the population of TBTF's to achieve this in a way that does not trigger unwanted side effects to the remainder of the economy in the process.

Over the years IRA has piled up mountains of data on banks and I've designed tools to support all manner of what-if modeling for acquisitions and divestitures. Some of these tools were used to confirm that the objectives of the Move Your Money initiative would indeed be positive contributors to the economy before we committed to donating our support to this cause. The tenets of building solutions strategies that are stable and achievable are central to my own comfort zone going all the way back to my Cold War days as a strategic military analyst. These cautions apply even more so when it comes to turning screws on the nuclear devices of finance, the TBTFs.

So the thought hit me that it might be interesting to ponder the stoichiometry - the math behind the chemistry - of the TBTF rebalancing issue. Butchering mastodon into chewable portions along logical lines turns out to be a rather complex process of avoiding unintended consequences. It's clear that doing careful impact analysis on things like regional competitiveness and market share up and down the national to local strata of the economy is critical. We do not want "machete-scale" TBTF action at the high end to cause undue damage to other parts of the banking and finance system.

For instance, parametrically slicing any one of the big banks is probably a combination of separating lines of business, dividing operating geographies and in some cases further dividing share within over dominated specific markets. The appropriate sizes and lines of business combinations are in turn driven by the landscape of incumbent competitors, large and small as well as healthy and stressed, within the affected sub-markets. Because we still do want to improve economic system efficiency not degrade it, there remains an overarching need to preserve whatever economies of scale and technology leverage have been gained from these big banks' combined corporate learning curves.

While the populist thinking is to send these banks to the gallows, that's not necessarily the safest or even achievable approach to furthering long run U.S. economic stability. Note that one does not necessarily need to legally slice up the institution to accomplish many of these risk management objectives. In fact, in some cases, it might be strategically counter-productive, causing a disastrous series of "knee jerk" responses further destabilizing the system. What's important to consider here is what's in the best "national interest".

As the nation ponders bank reform, I suggest that opening a line of discussion about a series of stringent rules imposed on banks that are either over a certain size or if they engage in certain combinations of lines of business. Such a discussion would say that they must set up set up certain new "walls" between segments of their business and run them as silos might be enough to bring some aspects of net risk to GDP per institution into better alignment. In other aspects of the process, forcing the creation of true arms length separations might be more appropriate.

I also believe that both government and banking need to be exploring this, if not together, then certainly in parallel. TBTF banks can make it proactive corporate policy to set up internal controls so that no single silo within their business can generate a "bail out" triggering risk. Banks within a certain exposure class can do the right thing and elect to disclose more transparent data so their combined systemic risk exposures can be tracked by both regulators and markets to emphasize promoting - as opposed to hiding - earlier warning and avoidance of future broad crisis conditions. Just like we did with things like Sarbanes-Oxley give them a fixed number of years to change, instruct the regulators to track the changes and adjust the regulations during that period to take advantage of what's learned during the process, then make the resulting more stable rules mandatory. Anyone who resists the tide? That's what liquidation is for. Now you've got a true carrot and stick enforcement strategy with a specific and actionable set of objectives. Better mouse trap.

Only in this way can government once again begin to operate as a guiding hand instead of a slapping one. If we don't do this we're going to break something. This is industrial engineering on a grand scale no less far reaching other great things in America's history. It cannot be done by the seat of one's pants or the smell of one's nose. But it can be done.

Investment Banking and California's Municipal Bonds

California State Treasurer Bill Lockyer is a man with a lot of questions. On March 29, 2010 his office sent letters to Bank of America Merrill Lynch, Barclays, Citigroup, Goldman Sachs, JP Morgan and Morgan Stanley asking about their Credit Default Swap practices. In his letter, he expressed worries that these firms - who are hired to market California's General Obligation (GO) bonds and also sell many other municipal debt issuances across the United States -- also participate in the credit default swap (CDS) business of betting against these bonds.

Mr. Lockyer notes that the State of California has never defaulted on its' obligations, he asked each bank to explain why they both sell for the State on one hand and bet against the State with the other. Responses were due back by April 12, 2010 and the State of California posted all of the responses on the Treasurer's website at this URL http://www.treasurer.ca.gov/cds/index.asp.

Why is there a market in California defaults? Basically an opportunity for arbitrage - what I like to call a mathematical gap between reality and financial modeling - exists. In an article published by Bloomberg News on April 19 on L.A. Unified's latest bond issuance, they note that California has "the lowest-rated U.S. state, is ranked Baa1 by Moody's, three steps above non-investment grade, and A- by S&P, four levels above." Bookies call this the "spread" and so does Wall Street.

The language of the banks responses to California are steeped in the murky language of finance but translated into English the banks say the answer is because there's money to be made playing both sides of the street. In the finance business it's acceptable for institutions to happily take fees and commissions both on the "sell side" as they market California's debt to primary buyers and on the "buy side" making markets - that means promoting business - for people betting against that debt using, among other things, CDS. Of the banks asked, the response by Goldman Sachs was the most direct.

They explained that working both sides is fine and dandy because a "Chinese Wall" separates the two sides of their activities. The message is that California - or any municipality - is a client only of the sell-side. California is not a client of the buy-side on the other side of the "Chinese Wall. That's some other "client" in need of insurance because the rating agencies say your State isn't a risk free investment. In effect, they take the business position that the job of a Wall Street middleman is to make as much for the house from both business channels. The other banks admit they do this too though the demeanor of their letters seem somewhat less ebullient probably remembering that there's money to be made on the sell side.

The letters tell California State Treasurer Lockyer that CDS is actually a good thing because someone buying insurance on the predicted mathematical default probability somehow means they are creating a bigger market to buy more of it. Huh? That's what the letters say. The common theme says because someone buying California GO bonds can also buys CDS protection they can lever up and buy more GO bonds. They've hedged their position against California defaulting on its' debts even though it never has. Remembering that their sell-side services business is also lucrative, they also say that California's bonds are among the most desirable on the planet. This brings up two questions. One, are you sure that Chinese Wall is sound proof? And two, why do you need default insurance on bonds that don't default again?

Citigroup, one of California's staunchest sellers of tax-exempt municipal issuances, did note with what I felt was a hint of sympathetic frustration in their response that they thought the buy-side hype about California's so called modeled default spreads has been overblown and at times out of control. Insurance is about selling perceived risk even if that perception is purely mathematical. So maybe we need to ask if, just as people wonder if some ratings were pushed up to help sell certain types of now toxic securities, might there also be a need to see if we need to weed out systemic pressures to push risk spreads on CDS arbitrage?

If your head isn't hurting too badly yet read on. It gets weirder.

On February 17, 2009, President Barack Obama signed the American Recovery and Reinvestment (ARR) Act. Part of this stimulus package created something called the Build America Bonds program known in finance circles as BAB's. Most municipal bonds are tax-exempt financial instruments. BAB's aren't. They are federally subsidized taxable bonds sharing some of the characteristics of corporate bonds.

BAB's opened a door for taxable bond investors, who had previously not been as active in this area, to become active speculating on municipals. In case you haven't figured it out by now the finance universe consists of micro-communities that get along about as well as the bi-polar opposites of the U.S. middle-class, Progressives and Tea Partiers. Taxable bond investors are used to working with corporate bonds. Unlike sovereign debt, corporations carry tangible default risks and corporate bond investors live by the motto that it's prudent to take on insurance to hedge their positions. So what happens when these people come to play in the municipal bonds sector?

Their deeply ingrained habits about the "investment tripod" of position, hedge and financing will begin to alter the market for municipal bonds. Corporate bond CDS spreads are based on the perceived problems of the company. Anything and everything imaginable is fair game for arguing what the spread should be. And these folks can be a mite jittery. Can Municipal BAB's be any less risky than a heavily government subsidized entity like General Motors? And so California's legendary polar politics, budget woes and legislative gridlock become the shrapnel far outweighing the payment history tapes.

Reading their letters, all of the respondents noted that they weren't quite sure what this means. Alignments of unsteadiness like that are significant in finance. BAB's are new, a very recent invention on the Obama Administration's watch. All of them were careful to assure California that this won't affect demand for the State's General Obligation bonds. But the letters also said the CDS desks of these institutions fully intend to continue to make markets from this new source of transaction clients interested in purchasing CDS insurance on things like BAB's. They also indicated the possibility that the CDS' written on these BAB's may result in an uptick in both rational and irrational analysis of municipal issuer default quality. That could make all municipal bonds harder to sell. Given that the credo of charge what the market will bear is almost irresistible to Wall Street, one needs to ask if the law of unintended consequences just manufactured another future systemic challenge to deal with.

One additional note, the statutory issuance window for BAB's ends in January, 2011. However, other federally subsidized taxable bond programs such as the Qualified School Construction Bond (QSCB) program authorized under the very recent Hiring Incentives to Restore Employment Act also exist. So it's not like these things are going to disappear. Per the Bloomberg article mentioned earlier, QSCB's trade more thinly than BAB's so the pressure to help them liquefy is even stronger.

My point is that finance is never quite as simple as calling for solutions one can make with a machete. Bill Lockyer's stack of letters deserves a broader reading. They are a canvas to learn a little more about the perturbations we make to the very complex system that is the U.S. economy.

Thanks to Tom Petruno from the L.A. Times for pointing me at the letters.

Off Balance Sheet Derivatives: Show Me the Money!

It's always good to have something to ruminate on over the weekend. With bank reform being the "trill thrill" of the week, what's this derivative thing? And more important, who's got how much in play at the casinos? So print this out and ponder it with your buddies while watching that ball game.

Remember, this is all about life inside the Matrix. "It'll feel ... a little weird." Derivatives are made up transactions. Two people, each of whom thinks he or she has the brass to out model the other, agree to bet on what will happen to an arbitrary amount of money. The winner of the bet gets the difference in the outcome. The winnings or losses are leverage that helps the bank participate in more betting both on-balance sheet real investments - they call that improving liquidity - or, if they like the trader/analyst team that did it, authorization from the risk and compliance officers to do more innovating.

They call the imaginary bet the "notional balance". Because it's not real money auditors won't let you book it on a balance sheet and that's why it's tracked as an off-balance sheet line item. For you aficionados, please see form RC-L of the Call Reports. To get the bigger picture, IRA sums these amounts across the individual FDIC Certificate (CERT) units of a bank holding company (BHC) and runs a variety of calculations on these numbers. One of my personal favorite measures is the ratio of the OBS notional balance versus the balance sheet assets of just the operating bank portion of the BHC. This figure gives you an idea of how much leverage derivative activity within the bank contributes to ongoing business operations.

There's one final thing to note before flashing the stash. These families of instruments were originally meant to be back office activities that served primarily to offset market risks against things like interest rate or currency exchange rate fluctuations. In many cases they still are. This aspect of derivatives is what people mean when they say they serve a financially useful function. Many of the banks listed below can and do use derivatives for these purposes. It's the appropriateness of innovating leverage for leverage sake that accelerates systemic speculation we need to assess as we reform.

Ok here goes. What ya'll make of these?

Top 50 Banks Reporting Off Balance Sheet Derivatives Notional Balances to the FDIC as of 4Q2009(amounts in $ millions)Source: IRA Bank Monitor/FDIC
Off Balance Sheet Derivatives Notional Balance, per CALL/TFR"Bank-Only" Assets, per CALL/TFRRatio of OBSDIR to CALL/TFR Assets
JPMORGAN CHASE & CO.$78,608,811$1,729,22945.5
BANK OF AMERICA CORPORATION$44,470,772$1,674,09926.6
GOLDMAN SACHS GROUP, INC., THE$41,597,107$91,050456.9
CITIGROUP INC.$37,982,426$1,278,88229.7
WELLS FARGO & COMPANY$4,193,794$1,187,3153.5
HSBC HOLDINGS PLC$2,934,372$169,14217.3
SUNTRUST BANKS, INC.$237,963$164,3411.4
U.S. BANCORP$93,875$282,1690.3
TORONTO-DOMINION BANK, THE$86,133$150,1020.6
BB&T CORPORATION$68,275$162,0610.4
FIFTH THIRD BANCORP$65,733$112,7360.6
MORGAN STANLEY$41,467$66,1590.6
GMAC INC.$25,915$55,3030.5
BANK OF MONTREAL$18,347$44,6610.4
ALLIED IRISH BANKS, P.L.C.$17,609$68,7680.3
METLIFE, INC.$15,907$14,1071.1
BNP PARIBAS$11,472$73,7060.2
BARCLAYS PLC$10,182$12,6140.8
PRIVATEBANCORP, INC.$5,863$12,1010.5
UBS AG$5,188$30,1740.2
CIT GROUP INC.$5,017$9,1460.5
BANCO SANTANDER, S.A.$3,562$80,4310.0
ASSOCIATED BANC-CORP$3,352$22,5820.1
ROYAL BANK OF CANADA$3,074$27,6670.1
POPULAR, INC.$2,769$34,1360.1
CULLEN/FROST BANKERS, INC.$2,499$16,3440.2

Wednesday, January 13, 2010

First Bank Closure of 2010

On January 8, 2010 the FDIC failed Horizon Bank in Bellingham, Washington. Here is the forensic page for this bank.

Horizon Bank

Note from the data that the first indications this bank was in trouble was in early 2008. At the end of 2007, the bank's Federal Home Loan Bank (FHLB) advances exceeded the 15% maximum and crossed into territory the FDIC considers to be a Moral Hazard. One quarter later(in March 2008), the lending default rate went from 1.6 basis points to 26.1 basis points. A basis point is 1/100th of 1 percent.

The track record of the next two years shows things worsening progressively finally resulting in the first FDIC closure of 2010.