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What Is The Banking System Up To?

Last time we had a really bad real estate crisis was in the mid-1980s, when changes to the rules regarding the deductibility of passive losses triggered a sell off in commercial real estate that led to the S&L crisis.  In order to get things back on track, the Fed created the Resolution Trust Corporation into which banks poured all their toxic debts.  The RTC was charged with selling off all these toxic loans (and their underlying collateral) to willing investors for cents on the dollar.  Thus the system was purged, losses recognized, and banking capital freed up to make new loans.  As real estate recovered, people who owed money to these investors soon were compelled to restructure or lose their collateral.  Either that or the underlying assets were seized and sold at a profit.  RTC bottom feeders became billionaires virtually overnight.

In the 2008 crisis, the management of the banks (who through the miracle of stock options were also shareholders), felt certain that the trajectory of the crisis would follow along a timeline similar to the 1980s crisis.  They reasoned that if a recovery could be achieved, why sell off loans that might recover?  Why create an RTC at all?  Why not just expand the central bank balance sheet for a time - long enough to create a recovery - at which time the banks would redeem the once toxic loans and move on down the road.  Why give away profits to RTC bottom feeders when all you need is a little time and a growing, more affluent population?

Surely, there is a finite amount of toxic loans on our books, the US banking system reasoned.  Maybe a trillion of student loans and credit card debts combined?  Maybe 2-3 trillion of real estate debt?  Maybe a trillion of commercial debt?  OK, so the fly in the ointment is that US sovereign debt is big and getting bigger, but surely we can chew through the rest without too much pain and suffering?  A little growth here, a little inflation there, a tightening of credit standards so we don't add new toxic debt while we're clearing out the old, and voila!  A deal is struck.  The Fed will not only buy the crap off our books and sell it back to us if and when it isn't crap any more, they will pay a huge premium for it and create an interest rate environment that virtually assures a combined annual growth plus inflation rate of 10% per annum.  And as things get better the stock market will recover, people will feel wealthier and that will stimulate the economy, too.  A perfect solution to a temporary problem.

Five years in and virtually no growth later, we now know that there has been no meaningful deleveraging.  The recovery in the value of real estate has been something that equates to a dead cat bounce.  A few corporations have fortress balance sheets and massive cash hoards, while most are as leveraged as they have ever been.  Consumer savings is supposedly up, but consumer debt is trending upwards, too. 

One of the biggest problems with the government is that it aggregates numbers to generate statistics.  Yes, there is wealth, but it's CONCENTRATED.  Yes, there is savings, but it's CONCENTRATED.  Yes, average home prices are rising in New York, but it isn't all prices that are rising, it's the high end real estate that is skewing the figures.  A single $100 million home sale offsets the losses on 1,000 $100,000 homes.

What happens if instead of a V shaped recovery we slow slog along in what Bill Gross of PIMCO calls "the new normal"?  What if ZIRP is not only helping the banks, but also slowly syphoning off the savings of an entire generation of middle class retirees whose pension funds are modeled on an 8% annualized return?  What if, over time, the poor become homeless, the middle class becomes poor and a whole new pool of once-serviceable debts become toxic?  It is, to quote Howard Hughes, "the way of the future".

In that case, the banks, the Fed and the government can only run ahead of new defaults as long as there is still savings left to confiscate, either through ZIRP, high-frequency prop trading or inflation.  If there is no growth there can be no recovery - only an infamous Japan-style slide into neo-feudalism.  

What does that world look like?  Interestingly, I have recently been working on helping several people either get or refinance debt.  Here are some of the take aways:

1)  You can no longer get a meaningfully sized loan if you don't have BOTH income and assets.  The loan must be collateralized by an asset and also serviceable by the borrower's income stream.  Credit cards for all but the very wealthy are limited at $500-$1000 per issuer and credit reports are regularly checked and borrowers rejected when aggregates exceed standards.

2)  Banks no longer take personal property or precious metals as collateral.  Where once banks allowed a borrower to place in the bank's vault their coins, jewels, furs, art, etc.  against a loan, this is no longer allowed.  Nor IRAs nor any asset that cannot be seized and sold without due process of law.  If you have publicly traded stocks and bonds you can get a margin loan of 50-60%, otherwise forget it.

3)  Banks won't give mortgages without an individual borrower named as a party to the loan.  No more piercing the corporate or trust veil required.  No more shell games.  No more compartmentalization that hinders a bank's ability to access collateral.

4)  Many banks are now refusing to make fixed rate loans.  Many banks also refuse to make residential real estate loans where the underlying real estate qualifies as a homestead.  Banks are incredibly leery of both the possibility of an inverted yield curve (where they lend at rates cheaper than they can themselves borrow) and the process of default.  It's simple - if a market-rate loan is backed by rents that exceed the monthly debt service the bank lessens its exposure to zero. 

5)  Few banks service the loans themselves.  We are still very much playing the game of hot potato where banks only originate loans but don't keep them.  So where do these loans end up?  Usually on the books of a pension fund, that's where.

Even so, as hard as banks are working to raise fees, generate trading and investment income, lessen their exposure to default, etc. the truth is that while the Fed and banks are busily strengthening the health of the financial sector, there is a whole other world out there that is not in recovery.   The FOMC is so down in its own weeds that it thinks it can stop purchasing treasuries in a year or two.  It thinks the banks will soon be healthy enough to reclaim and deal with all their old toxic MBS. 

Yes, the banking system believes it is in recovery.  Meanwhile, 50,000 new people go on food stamps every month, shadow unemployment is rising, pensions are going bankrupt, health care costs, food costs, and energy costs are going up.  Off balance sheet debts and the unfunded cost of administering the government is increasing at a rate of $5-6 trillion a year.  Promises that were made to baby boomers, wounded warriors, and students in debt are slowly but surely being broken.  The huge number of people who are less than 1-2 paychecks away from default increases each and every day.  The path to social unrest is clear.

Yes, I'll agree that there is a finite percentage of existing debt that can go bad.  In that the banks and the Fed are correct.  The only question that remains is what that percentage is.  Is is the 10% that the banks and the Fed are currently clearing?  Or is it more?  Perhaps much, much more? 

There is a cloud in the silver lining of the Dow reaching new nominal highs.  The cloud is the fact that companies have achieved their new highs by cannibalizing their mom and pop competitors.  In the last six months my local small pharmacy, liquor (2), hardware, shoe, and pack and ship stores have all cried uncle.  It seems every day more and more small business go belly up.  First they cut staff and stop restocking inventory and then, suddenly, they are no longer there.

The next stop on the cannibalization trail is for publicly traded companies to begin cannibalizing each other.  Sears and JC Penney are already deeply in trouble.  Many companies are reducing the number of locations they operate and are trying to make up for it with online sales.  How long before the banks start experiencing weakness in commercial real estate, working capital lines of credit and shrinking inventory and accounts receivable loans?  In the shade of the umbrella of our successful stock market and the corresponding increase in margin debt, nothing much is growing.  Nothing much at all. 

 

 

 

 

   

 

  

   

 

 

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