What the Banks Aren’t Telling Us

by John Mason

I am still worried about what banks aren’t telling us.

Why?

Total Reserves in the banking system have increased by $857.8 billion over the
twelve month period ending in May 2009. Excess reserves in the banking system
have increased by $842.1 billion in the same time period.

The Federal Reserve System has overseen a 1,900% increase in total reserve in
the banking system, year-over-year, for the year ending May 2009, and banks
have chosen to sit on the injection almost dollar-for-dollar!

These figures come from the Federal Reserve statistical release H.3 “Aggregate
Reserves of Depository Institutions and the Monetary Base.” I have used the “not seasonally adjusted” data.

This is unheard of! In May 2008, excess reserves were $2.0 billion and stood at 4.5% of the total reserves
in the banking system. In May 2009, excess reserves totaled 93.7% of the total reserves in the banking
system.

Unless someone can convince me otherwise there are, in my mind, only three reasons for this behavior.
The first is the volume of bad assets currently on the balance sheets of banks that have not been
recognized. The second is the volume of bad assets that banks anticipate will be forthcoming over the next
year or so. The third has to do with how the banks have funded themselves in the past several years.

If these assumptions are correct, the recession cannot be called over yet and any economic recovery that
might be forthcoming is going to be relatively tepid or postponed for some time. I obviously hope that I am
wrong but something just does not “foot” with the data that I have reported above.

In the first category, current bad assets on the balance sheet, one would think that we know a fair amount
about them. Their volume was sufficiently large so that the government put into place the TARP program
and then followed that up with the idea of the P-PIP. Several banks feel sufficiently strong that they are
returning their TARP money and it appears as if the P-PIP will never be actually implemented.

Financial markets have responded favorably to these events. Yet, we know that there still remain a large
number of bad assets in the banking system. The current confidence has allowed some banks to return
the TARP funds wanting to get the “Feds” out of their buildings and out of their compensation committees.
In addition, with the relative calm in both financial and economic markets, confidence has risen within the
banking system that maybe they can ride out the rest of the way to recovery, hoping that many of the
remaining bad assets will turnaround or be refinanced or be worked with.

In my experience working in the banking sector, “hope seems to spring eternal” when it comes to believing
that bad assets will eventually become good assets. The attitude is that “with time” the borrowers will come
through.

But, what kind of confidence is it that sits on $844.1 billion in excess reserves, funds that are earning no
return to the banks? Required reserves in the banking system in May only totaled $58.8 billion. What am I
missing?

Let’s look at the second category, that about debt coming due or repricing in the future. We have seen
more and more reports in recent weeks about the Option Mortgages that are coming due over the next 18
months or so; we read about all the commercial mortgage debt that is on the edge and this was
accentuated this week with the bankruptcy filing of Six Flags; and we know that credit card delinquencies
are still rising. What we don’t know is the extent of the fallout from the bankruptcies in the auto industry
and how this will impact those industries and regions that have depended upon a healthy car business. In
addition, personal bankruptcies and small business bankruptcies continue to rise and there is really no
firm information about when the increase in these will moderate and what the effect on the banking system
will be.

Finally, there is the problem of financing the banking system itself. I recommend that you take a look at the
article by Gretchen Morgenson in the June 14 New York Times, “Debts Coming Due at Just the Wrong
Time.” Morgenson writes about the debt of the banking system and the need for bank balance sheets to
shrink. The banking system, itself, needs to de-leverage and may have to do so unwillingly.

In this article, Morgenson refers to a study by Barclays Capital that discusses the amount of debt of
financial companies coming due over the next year or two. The figures, roughly $172 billion of debt will
mature in the rest of 2009 and $245 billion will mature in 2010. This means that financial institutions will
have to refinance about $25 billion a month for the next 18 months or so. Part of the problem in
refinancing this debt is that “many of the entities that bought this debt when it was issued aren’t around
any more.” Furthermore, in general, “few buyers of short-term bank debt are around now.”

Raising equity capital is fine, but, over then next few years, the banks may have a larger hole to finance in
terms of the debt that it must try to roll over. This, of course, will put more pressure on the policy makers.
The policy makers have gone out on a limb in attempting to protect the need to write down bad assets.
The policy makers have provided capital for some of the banks that were in the worst financial shape. The
next issue has to do with the need for the purchase of bank liabilities. This may be a very tough balancing
act to complete successfully.

But, maybe the government has already provided the funds to meet these emergencies. Maybe that is why
banks are holding such large amounts of excess reserves. They know that over the next 18 months that
they are going to have a severe funding problem. Excess reserves are the perfect answer to paying off the
debt as it runs off, leaving the banks with a lot of funds that still can buy them time to “work out” the bad
assets that remain on their balance sheets.

Original Article

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