Why Small Banks Are The Key To Recovery-Part 1 of 2

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From The Daily Capitalist

Part 1 of 2

The critical factor in our economy right now is a declining money supply which has been the result of the "credit crunch" or what Keynesians call a "liquidity trap." We have discussed this frequently on this blog. I believe deleveraging is the key to an economic recovery and measures of business. The result of deleveraging is deflation, but instead of seeing deflation as a negative, it is a necessary step for growth.

I look at these issues quite differently from Keynesian and Neo-classical economists. As we have seen the Fed has been unable to stimulate money growth through zero interest rate policy (ZIRP) or through quantitative easing (QE). This is something that their theories not been able to adequately explain, and the outcomes of their policies have led to continued high unemployment, declining growth, declining money supply, and deflation. The policy makers at the Fed and Treasury have run into the same problems that mired Japan's economy for almost 20 years: sluggish growth amidst deflation.

The reason we are seeing money supply decline is twofold. Banks have (1) tightened lending standards which makes credit less easy to obtain, and (2) banks are finding it difficult to find credit worthy borrowers. While the Money Base has increased dramatically, these funds sit in the Fed as "excess reserves" where banks earn interest on it from the Fed. I will explore this issue in a moment.

But first ...

There are two sides to this credit issue: consumers and businesses. Consumers are cutting back spending, paying down debt, increasing savings, and are cutting back borrowing (even if they could get a loan).

Here is the story of consumer credit:

While the consumer is important to the economy, it is not the consumer that I wish to focus on in this article. Consumers are doing all the right things now to help the economy recover. Their deleveraging and savings will help fuel new growth.

What is more important at this stage of our economy's lack of recovery are business loans. In this article I wish to specifically focus on smaller businesses, which comprise one-half of the economy and one-half of the jobs in America, and their banks.

There are two banking systems in the U.S. now: a few very large money center banks which have recovered or are more or less on their way to recovery, thanks to TARP, and all the other banks. Many of the regional and local banks are still suffering, mainly as a result of commercial real estate (CRE) loans they made during the boom. As you recall, they sold off their residential loans, but kept the CRE loans.

The Fed would like all banks to start lending. Increased lending activity would indicate a growing economy. Through the fractional reserve banking system, banks can lend about 10:1 which multiplies the effect of the Fed's money policy. You can see this effect in the M1 Multiplier charts. This is the Fed's main inflation generator. If banks aren't making loans and are holding all the cash that the Fed has tried to pump into the economy as reserves, then not only does the money supply not grow, it can shrink, which is what is happening now. This is deflation.

Courtesy Michael Pollaro TrueSlant

The process by which banks would start lending and create real, organic economic growth requires two things to happen:

  1. Banks need to get rid of bad debt on their books, which is mainly CRE debt, and raise capital and return to sound banking practices.
  2. Businesses need to see "regime certainty" and steady economic recovery before they borrow and expand their businesses.

As to No. 1, the government has been doing everything they can to prevent banks from liquidating bad investments. And as to No.2, the government's barrage of new legislation is creating uncertainty for businesses ("regime uncertainty"). That, plus the stimulus seesaw and new banking policies (No. 1) are inhibiting economic growth which makes businesses reluctant to borrow. It is obviously much more complex than this, but these are the brightline issues.

There are several things to watch in trying to assess whether or not banks are lending. The first is business loans:

As we can see, the level of business loan activity seems to be picking up, but it is still very depressed. Most lending is coming from the big banks and they are lending mostly to medium and large size firms.  A new Fed survey reported that 7 out of 57 banks surveyed reported easing credit for these companies. This is the second quarter of easing credit conditions. But 6 of 28 big banks (14.5%) said they had eased credit standards for small companies; this is the first such easing since 2006.

But there is a reason they are easing credit for small borrowers that doesn't have anything to do with lending standards. Rather, it is because the big banks now realize that the Dodd-Frank Act took away some of their big profit centers and they understand that they will now be more like banking utilities providing garden variety services to borrowers and savers. Consequently the big banks are now aggressively going after as much business as they can get and this includes small business borrowers. As a result of this competition, credit has eased.

But, credit demand has not significantly increased. Credit is still significantly tighter than it was before the crash and banks are reporting that business customers are still reluctant to borrow. The Fed report confirmed that loan demand is still weak after falling during the first quarter.

The latest survey by the National Federation of Independent Business, a separate trade group, last month found 91% of small-business owners reporting that their credit needs were met or they did not want to borrow, while only 4% cited financing as their top business problem. Uncertainty about the economy held back far more firms from investing: The percentage of business owners planning to make capital expenditures in the next few months fell one point to 18%, two percentage points above the 35-year record low. Only 5% said right now is a good time to expand facilities.

This lack of borrowing has hit the earnings of large banks such as BofA, JP Morgan, and Citi.

"The results from the larger banks are confirming our view that the U.S. economy is continuing to deflate," said Christopher Whalen, managing director at Lord, Whalen LLC's Institutional Risk Analytics.

According to the Fed report, small banks are still reluctant to lend. This is where CRE debt comes into play.

Almost all of the failed banks taken over by the FDIC have failed because of CRE debt. Of the five banks closed on July 31, according to Treppwire:

For the group, commercial real estate accounted for 71% of nonperforming loans. Construction and land loans were 42% of the total, while commercial mortgages comprised 29% of the total. Real estate (including residential) constituted 90% of the problem loans among these banks.

CRE debt is clogging the balance sheets of these small and regional banks. These banks are worried about their capital base if the CRE market doesn't improve, which presently is unlikely. If too many of these loans go into default, the banks will have to reserve more of their capital which means they will have less capital to lend. U.S. banks’ allowances for loan losses stood at $221 billion as of March 31, 2010, which is equal to 4.1 percent of total loans. Banks are more concerned about their survival than they are about lending. That is why "excess reserves" are so high.

On the other hand, there appears to be some improvement in small banks.

First, earnings are uneven, but, according to American Bankermaybe improving:

These small banks continued to get hit with nonperforming loans and chargeoffs, but they did not take as bad of a beating as they did the previous quarter [Q1] and a year earlier. Median net income rose by 4%-9.6% from the previous quarter depending on the region, according to a report from Sandler O'Neill & Partners LP and SNL Financial LC. At the same time, regional declines in nonperforming loans ranged from 2.3% to 9.5%. Lower expenses, higher net interest income, and the strides in credit quality fueled earnings growth.

I believe the more typical scenario is shown in earnings reports from banks like Zion Bancorp and M&I: they were hit with wider loan losses and declining loans.

Zions reported a loss of $135 million after the market closed Monday. The Salt Lake City-based lender's $1.96 billion in nonperforming loans—loans at high risk of becoming uncollectable—fell modestly over the first quarter, but still remain higher than three quarters ago. The bank's core revenue also shrunk as total loans fell for the fourth straight quarter.

 

M&I, based in Milwaukee, reported a net loss of $174 million and said its troubled loans continued to improved, a key issue for a bank that made big bets on construction loans and has now reported a loss in eight of the nine last quarters. ... Commercial loans and leases were $12.2 million in the quarter, down 17 percent, and lending to customers for construction plunged 35 percent. Total loans fell 14 percent.

I tend to believe in the more pessimistic outlook for regional and local banks.


Tomorrow: The problem with 'extend and pretend" and a glimmer of hope.