(1) stockholders

(2) customers who (a) place deposits in the bank—these are liabilities to the bank, and (b) borrow money from the bank—these are the assets

(3) the employees.

Keep this in mind: a bank’s assets consist of the loans that it owns and whatever physical assets it may own (real estate, for example.) A bank’s liabilities consist of shareholder equity and its deposit liabilities. There are rules which regulate the relative size of the two classes of liabilities. A bank can only take in deposit liabilities which are a certain multiple of its shareholder equity. These rules are international and are set by the Bank for International Settlements.

On September 15, 2008 Lehman Brothers filed for Chapter 11 bankruptcy protection. Lehman had made large investments in mortgage backed securities. Worse yet, there were highly leveraged. Lehman was not a bank but an investment bank and was allowed by SEC to leverage itself almost 31:1. A 3.5% loss in the value of its mortgage assets could wipe out all of the equity in the company.

The Lehman BK let out of the bag the fact that all the large investment banks and many large commercial banks were holding a ton of mortgage debt which was going to see a much higher default rate than anticipated. The mortgage mess/liquidity crisis was launched. Potential retail buyers of these mortgage backed securities made up of crappy loans stopped buying them and the folks who held them—the investment banks and large commercial banks—were stuck. This created a massive liquidity problem on top of the capital problem created by the losses.

Let’s go back to the statement “A bank liabilities consist of shareholder equity and its deposit liabilities.”

Deposit liabilities consist of the deposits of the regular customers (individuals and businesses) and also interbank lending. Interbank lending is short term (one day to one week) lending from one bank to another. The need for this can arise at the end of any bank’s business day. It may find that it has insufficient cash to cover its reserves. Banks with excess cash lend it to banks which are cash short every day. In general, banks face the task of funding long term loans with short term deposits. Some of these loans are things such as HELOC’s, commercial lines of credit and credit cards where the borrowers have control over the balances.

Post-Lehman what happened is that no one trusted anyone else and interbank lending dried up. Since interbank lending was the normal solution to any bank’s liquidity problem, business as usual was not an option. Banks were not concerned about making money. They were concerned about not suffering contagion from another bank’s ills.

At that point there were two serious problems with banks: (1) because the real value of their mortgage assets was a lot less that they thought they suffered a capital shortfall problem, and (2) the mutual distrust created a liquidity problem.

The risk at this point was enormous. Two thing were done to help. One was TARP which address bank capital and the other was the liquidity programs put together by the Federal Reserve. TARP (Troubled Assets Relief Program) was passed by Congress and signed by Bush II. It authorized the expense of up to $700 billion of which $432 billion was ever disbursed. This was originally intended to shore up bank capital but banks rather quickly got their own capital and paid back TARP loans. Then TARP morphed into a bailout for AIG, FNMA, FHLMC, Chrysler and GM – none of which were banks.

Treasury has collected about $13.7 billion in interest or dividend on TARP and the eventual loss is estimated to be less than $20 billion.

Banks were bailed out but quickly repaid Treasury. But the populist myth misses the point.

Bank stockholders were massive losers. Some such as Washington Mutual were totally wiped out while others were merely heavy losers. The bailout benefited the public in general. Absent a bailout, if banks had become insolvent then either depositors would have lost money or the FDIC (the public) would have made up the difference.

The most significant support when the liquidity crisis occurred came from the Federal Reserve in the form of a number of programs which provided a gigantic amount of money to a massive array of entities. These were broker dealers, banks, credit unions, and corporations.

This is a detailed blog piece I wrote explaining the various Fed liquidity programs.

The liquidity providing provisions of the Federal Reserve saved the economy from much larger disaster. They costs the taxpayers nothing and, in fact, earned a profit 95% of which went to Treasury. The bailout was more to everyone who had a bank account and lost zero than it was to banks per se. Some bank shareholders lost all the value of their equity. Other merely took large hits.

Preservation of the banking system benefited everyone. Letting almost the entire banking system fail was not an option. If these interventions had not occurred the losses to Treasury (the taxpayers) would have been much more massive and many businesses and jobs would have been destroyed.

The message that somehow only banks were bailed out and the public was ignored misses the point as to what the functions of a bank are. It is the taxpayers and the depositors who were bailed out. The bank equity owners took large losses.

“These investors likely helped push prices up during 2004-06; but when prices turned down in early 2006 they defaulted in large numbers and thereby contributed importantly to the intensity of the housing cycle’s downward leg.”

I’m just the messenger, here’s the Fed’s Flip This House report. It certainly shows why many servicers are wary of extending several loans to one borrower, in spite of proponents saying those borrowers are “professional investors and know what they’re doing.”

“Ongoing distress in real estate markets and slow growth in jobs and incomes continue to pose risks to credit quality,” Acting Chairman Gruenberg said. “The U.S. economic outlook is also clouded by uncertainties in the global economy and by volatility in financial markets. So even as the banking industry recovers, the FDIC remains vigilant for new economic challenges that could lie ahead.” As was the case in each of the last eight quarters, lower provisions for loan losses were responsible for most of the year-over-year improvement in earnings.

For the geographically challenged, Basel, Switzerland is in Europe. The Basel Committee on Banking Supervision is a committee of banking supervisory authorities that was established by the central bank governors of several large countries in 1975. It provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. The Committee also frames guidelines and standards in different areas. As the FT says:

Under the global Basel III rules, which will be phased in between now and 2019, banks have to hold top quality capital equal to 7% of their assets, adjusted for risk. The biggest banks will also be hit with an additional surcharge of up to 2.5%. Banks in the European Union will also have to hit a temporary 9% ratio next year after discounting their risky sovereign debt holdings.

But US banks are asking for weakened Basel III rules (FT excerpts and link below).

Basel III’s capital requirements, of course, is one of the reasons servicers (like GMAC) are either shifting servicing values, selling servicing, or deciding they don’t want it anymore period.

US lenders are urging financial regulators to ease new international bank liquidity rules as the industry faces a collective shortfall of $1.4 trillion for complying with the new regulations.

…American banks are at a disadvantage to their foreign peers because the regulatory response to the financial crisis limits the kind of assets US companies can use to show they could withstand a 30-day bank run … The package of reforms, known as Basel III, includes a provision that requires banks to hold enough cash-like assets to survive a month-long crisis. Lenders in the US and in Europe have argued that the “liquidity coverage ratio” is too stringent and would limit lending.

…The Clearing House urged US regulators to relax implementation of the Basel standards because they unfavorably treat debt and mortgage securities issued by Fannie & Freddie.

…While cash and sovereign debt can be used to meet the entire liquidity requirement, Fannie and Freddie securities, covered bonds and high-quality non-financial corporate bonds can only count towards 40 per cent of it.

…Fannie and Freddie securities are generally regarded as more liquid instruments than covered bonds. We have a little time: the liquidity rule will not go into effect until 2015. In response to complaints from lenders, financial regulators agreed to fine-tune the liquidity standards, where needed, by 2013.

Bill R. wrote to me, “When Basel III took over it rigged/leaned the banking systems rules and regulations toward the larger banks awash in global CDS and CDO’s. Left swinging in the wind were smaller banks forced to stand on their own feet, their own balance/income statements without the support of Government bailouts. This is what the unknowing useful idiots on WS are jumping up and down about.”

Across the Pacific, Australia’s major banks are preparing to issue covered bonds to enhance liquidity-risk positions as Basel III rules loom. “The two major benefits for Australian banks issuing covered bonds are access to lower costs of funding and a move to a more stable longer-term source of funding,” said William Mak, credit-desk analyst at Nomura. “Covered bonds will also have implications for the net stable funding ratio as banks shift to longer-term stable funding required under Basel III liquidity reforms.”
___
Reference:
-FT: Fed Sets US Banks Toughest Stress Tests
-FT: US Banks Ask For Weakened Basel III Rules
-TheBasisPoint: Time To Dump Basel Bank Capital Rules?

-The Only 2 Ways To Save Italy (Robert Sinn)
-Why Italy Is Dominating Markets (CNBC’s Patti Domm)
-Europe’s Solution Is More Integration, Not Less (CreditWritedowns)
-The Italy Factor Gets Ugly (CapitalSpectator)

-INTERACTIVE GRAPHICS: Eurozone Bank Exposures By Country (Reuters)
-Debt Contagion In Italy Now, France Next (Bespoke)
-This Is The Way The Euro Ends (Krugman)
-Chinese Inflation Slows To 5.5% (FundMyMutualFund)
-It’s Official: Flash Mobile Player Is Dead (Mashable)
-Bernanke Says Small Business Matters (WSJ)

-In Defense of ZeroHedge (TheReformedBroker)
-The Big Lie of The Financial Crisis (Ritholtz/WashingonPost)
-What’s Really Killing Jobs Growth (Fiscal Times)
-Will Greece Derail Bailout Again? (NakedCapitalism)
-Can You Really Make Money Staring At Charts? (AllStarCharts)
-Jim Grant’s Best On Money, Banking, Fed (TheTrader)

That’s Former Federal Home Loan Bank of Chicago president Alex Pollock’s Law Of Finance, which he outlines in this month’s Mortgage Banking Magazine. Not some term paper. Short and sweet. There’s lots of chatter out there, but this is one of those pieces that hits home.

It’s a must-read but the endgame is just as stark as the Law itself: “economic reality is never lasting stability, but constant adjustment and transition.” Here’s the piece:

Trying But Failing To Escape Pollock’s Law
The dominant problem with being in the wake of the bubble is that we cannot escape Pollock’s Law Of Finance, which states: Loans that cannot be paid will not be paid. Because they will not be paid, the loans will default and impose losses.

In the wake of a bubble, the losses are unavoidably massive. This applies both to the American housing and commercial real estate bubble, and to the European sovereign debt bubble.

Because this iron law and its implications are highly unpleasant, financial actors and politicians strive mightily to escape them in spite of the fact that they cannot, with scheme after scheme. All to no avail, of course. The massive losses must ultimately be taken.

So the questions are not: Will the loans default? They will. Or: Will the losses be huge? They will be. The only real questions are: What form will the defaults take? Who will take the losses? And when will the losses be recognized by those who are going to take them? These real questions provide plenty of room for lawyers, accountants and politicians to operate.

Guided by these insights, we can make more sense of financial crises and their accompanying rhetoric. [ continue reading... ]
___
Author: Alex Pollock