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The Next Banking Crash

9/11/2013

1 Comment

 
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Life is good for banks. They get to play by their own rules. Not necessarily your friendly community bank, which must succeed or fail on its own merit.

I'm talking about the big boys—the "Too Big to Fail" (TBTF) darlings that were bailed out during the
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financial crisis, and will undoubtedly be bailed
out again in the next crisis.

JPMorgan was too big to fail before the financial crisis. Then it gobbled up Bear Stearns and Washington Mutual. I'm not sure what that
makes it now. WAY Too Big to Fail (WTBTF)?

We seem to be moving in the wrong direction. Instead of shrinking these behemoths down to a manageable size, they continue to grow.


That need not happen. As much as the powers that be would like you to believe otherwise, the existence of WTBTF banks is not an unfixable problem.

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Doug French, today's guest contributor, is here to explain some others. Doug is an economic heavyweight; as former president of the Ludwig von Mises Institute, he oversaw the most prolific Austrian economics website in the world. He also studied under economic and libertarian legend Murray Rothbard and has written several economics books of his own.

Perhaps most importantly, Doug is a former banker himself, so he understands exactly how banks operate. Doug is convinced that rising interest rates will spur the next financial crisis, and that it will come sooner than most expect. Read on for his analysis and recommendations on how to manage your own portfolio to protect yourself from the inevitable next financial crash.

By Doug French

Expecting an improving economy, investors have piled into bank stocks the last two years. The PowerShares KBW Regional Banking ETF (KBWR) is up over 40 percent from the end of 2011.

Watching bank stocks surge, it's easy to forget the entire banking industry nearly went down the drain in 2008 and 2009. The Federal Reserve ponied up a total of $13 trillion in loans and guarantees to keep the bank business afloat. The Treasury Department also ladled out equity capital via TARP to preserve the industry.

"It was probably the most successful rescue of private enterprise ever conducted," writes Time magazine's Roger Altman.

But while regulators have patted themselves on the back for saving the industry and in turn the economy, the TARP program has been rife with fraud. Criminal charges have been filed against 144 individuals, mostly bank executives, for using the bailout funds for oceanside homes and private jets. The government has convicted 107 bankers, while 37 still await trial.

To the less than skeptical eye, bankers not caught up in the government's dragnet are achieving record profits. The industry earned $42.2 billion in the second quarter. Reportedly banks' balance sheets are clean, and US banks are the healthiest in the world.

Maybe so, but only because of favorable accounting rules.

Big Banks Hide Losses and Embellish Profits… Since the financial meltdown, banks haven't been lending much. The collective loan-to-deposit ratio for the nation's banks now hovers around 70 percent. Back in 2000, that ratio was 97 percent.

Instead of lending, banks are investing in long-term Treasuries. These government bonds are safer from a credit standpoint than loans to local businesses. However, investing short-term deposits in long-term assets is still risky.

Individual investors know that when interest rates rise, the value of the bonds they own declines, because the cash flow from the bond stays the same while purchasing the same stream of payments becomes cheaper. Indeed, during the second quarter, just a hundred-basis-point move in interest rates created a $51 billion decline in the banking industry's long-term assets.

But banks don't play by the same rules as you and I. "Under an accounting quirk, the $51 billion loss does not affect bank earnings but can reduce the book value of a bank," explains banking expert Bill Zielinski. "Unrealized losses on long-term bonds classified as 'available-for-sale' can be deferred and do not affect current earnings unless the securities are sold."

James Chessen, chief economist at the American Bankers Association, told American Banker, "When you have rates jumping by a hundred basis points, you have to expect the value of the portfolio to change and reverse those unrealized gains that you had, and it happened all at once. The magnitude and how quickly it changed I think was a surprise."

Interest rates have fallen for more than 30 years, so any increase in rates came as a surprise. However, a hundred-basis-point move in six months is far from unprecedented.

Bankers have also been padding their income by assuming all credit losses are behind them. Loan loss reserves fell by $6.4 billion to $149 billion in the second quarter. And that's nothing new—banks have been robbing their reserves to boost earnings since the aftermath of the financial crisis. At the end of the first quarter of 2010, the industry had $263 billion in loan loss reserves. Simple math tells us this accounting trick has added $114 billion to banks' bottom lines since 2010.

Big banks are also ramping up their exposure to derivatives, which were a catalyst for the financial meltdown. Investor Warren Buffett once called derivatives "financial weapons of mass destruction." As of June 30, the banking industry's derivatives exposure was $236.5 trillion. Ten short years ago that number was just $66.5 trillion. For the most part, this massive derivatives exposure does not appear on bank balance sheets. And while derivatives can diversify risk, they can also magnify risk in the same way leverage does.

While Everyone Else Is Left Holding the Bag

Small banks don't play much in the derivatives market. It's interest rates and regulations that worry them. When asked what his biggest challenge was, Douglas Manditch, chairman and CEO of the $455 million asset Empire National Bank told American Banker, "I'm concerned about interest rates climbing in an unmanageable way. If things get out of control with inflation and increasing rates, it could be very difficult on a lot of community banks because there's no way we can hide from that."

Manditch went on to say the regulatory burden is "becoming impossible," and is "never-ending." Empire spends 16 percent of revenues just on compliance. A lot is now expected of bank board members, according to Manditch. "It's to the point where you almost have to be a full-time banker to understand everything. It will be harder to get board members."

Despite the prospect of higher rates decimating bank balance sheets and sparking another financial meltdown, the Federal Reserve Board has raised its 2014 real growth forecast for GDP to 3-to-3.5%. Time's Altman agrees, writing, "the country will likely see two to three more years of good growth, which would produce millions of new jobs and begin to raise incomes."

The simple fact is interest rates are still near rock bottom, with nowhere to go but up. And while Wall Street and Washington are doing fine, the only thing growing on Main Street is dependence on government, with food stamp participation at an all-time high and unemployment still high.

The reckoning day for banks will come sooner than later. Higher rates will batter bank bond holdings and capital levels. The massive losses will set off another financial contagion that will cause government to ask taxpayers for a new round of bailouts.

The last Fed chairman, Alan Greenspan, left the Fed just in time in 2006. Ben Bernanke will do the same and be comfortably back at Princeton molding young minds when his crash unfolds. He's not worried one whit about individual investors.

How to Invest

Investors desperately seeking income have rushed into bond funds and ETFs in recent years. Total assets in junk bond funds soared from $100 billion in 2003 to $250 billion ten years later. In early May, the yield on Barclays US Corporate High Yield Index fell to a record low of less than 5%.

Since then, that rate has rocketed upward to 6.45%. That sounds much better than what your local bank is paying. Resist the siren's call. Stay out of bonds and especially bond funds. These rates will not compensate you for the beating higher rates will inflict on bond values.

Stay away from financial stocks, too. Like bonds, they've had a great run. But now it's time to walk away and watch from the sidelines.

Finally, the lesson from the '08 crash is that all assets declined together. The next crash will likely bring the same pain, and losses will be unavoidable. But remember: it was gold that dropped the least and bounced back the fastest in 2008/'09.

1 Comment
James Farley
4/30/2016 02:32:05 pm


Important Banking Laws

The most important laws that have affected the banking industry in the United States are listed below along with short descriptions highlighting major provisions or significant impacts on the FDIC.

Digital versions of most of these laws are available on the Government Printing Office's Federal Digital System (FDsys), and links are provided below. Some older legislation and legislative history may be found on the St. Louis Fed's archive, FRASER. For other legislation, paper copies may be available from a well-stocked law library, and pdf versions are available through commercial services, like HeinOnline.
National Bank Act of 1864 (Chapter 106, 13 STAT. 99).
Established a national banking system and the chartering of national banks.

Federal Reserve Act of 1913 (P.L. 63-43, 38 STAT. 251, 12 USC 221).
Established the Federal Reserve System as the central banking system of the U.S.

An Act to Amend the National Banking Laws and the Federal Reserve Act (P.L. 69-639, 44 STAT. 1224).
Also known as The McFadden Act of 1927. Prohibited interstate banking.

Banking Act of 1933 (P.L. 73-66, 48 STAT. 162).
Also known as the Glass-Steagall Act. Established the FDIC as a temporary agency. Separated commercial banking from investment banking, establishing them as separate lines of commerce.

Banking Act of 1935 (P.L. 74-305, 49 STAT. 684).
Established the FDIC as a permanent agency of the government.

Federal Deposit Insurance Act of 1950 (P.L. 81-797, 64 STAT. 873).
Revised and consolidated earlier FDIC legislation into one Act. Embodied the basic authority for the operation of the FDIC.

Bank Holding Company Act of 1956 (P.L. 84-511, 70 STAT. 133).
Required Federal Reserve Board approval for the establishment of a bank holding company. Prohibited bank holding companies headquartered in one state from acquiring a bank in another state.


GPO's compilation of legislative history and bill text for the Federal Reserve Act, the McFadden Act, the Glass-Steagall Act, the Banking Act of 1935, and the Bank Holding Company Act of 1956 is available at FRASER.
Financial Institutions Supervisory Act of 1966 (P.L. 89-695, 80 STAT. 1028).
Expanded bank enforcement powers of the Federal banking agencies, permitting regulators to bring cease and desist orders against banks engaged in unsafe and unsound banking practices or other violations of law. Granted the Federal banking agencies authority to remove bank officers and directors for breach of fiduciary duty.

International Banking Act of 1978 (P.L. 95-369, 92 STAT. 607).
Brought foreign banks within the federal regulatory framework. Required deposit insurance for branches of foreign banks engaged in retail deposit taking in the U.S.

Financial Institutions Regulatory and Interest Rate Control Act of 1978 (P.L. 95-630, 92 STAT. 3641).
Created the Federal Financial Institutions Examination Council. Established limits and reporting requirements for bank insider transactions.

Depository Institutions Deregulation and Monetary Control Act of 1980 (P.L. 96-221, 94 STAT. 132).
Established "NOW Accounts." Began the phase-out of interest rate ceilings on deposits. Established the Depository Institutions Deregulation Committee. Granted new powers to thrift institutions. Raised the deposit insurance ceiling to $100,000.

Garn-St Germain Depository Institutions Act of 1982 (P.L. 97-320, 96 STAT. 1469).
Expanded the powers of thrift institutions. Expanded FDIC powers to assist troubled banks. through such measures as the Net Worth Certificate (NWC) program, which provided for recapitalization of banks and thrifts that suffered from interest rate shock after deregulation of interest rates on deposits. NWCs were a temporary form of capital that the institution gradually replaced as it became profitable.

Competitive Equality Banking Act of 1987 (P.L. 100-86, 101 STAT. 552).
Also known as CEBA. Established new standards for expedited funds availability. Recapitalized the Federal Savings & Loan Insurance Company (FSLIC). Expanded FDIC authority for open bank assistance transactions, including bridge banks.

Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (P.L. 101-73, 103 STAT. 183).
Also known as FIRREA. FIRREA's purpose was to restore the public's confidence in the savings and loan industry. FIRREA abolished the Federal Savings & Loan Insurance Corporation (FSLIC), and the FDIC was given the responsibility of insuring the deposits of thrift institutions in its place.

The FDIC insurance fund created to cover thrifts was named the Savings Association Insurance Fund (SAIF), while the fund covering banks was called the Bank Insurance Fund (BIF).

FIRREA also abolished the Federal Home Loan Bank Board. Two new agencies, the Federal Housing Finance Board (FHFB) and the Office of Thrift Supervision (OTS), were created to replace it.

Finally, FIRREA created the Resolution Trust Corporation (RTC) as a temporary agency of the government. The RTC

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