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TARP Watchdog: Don’t Be Fooled By The Calm, Banks Will Be Rocked By 2011’s $300 Billion Commercial Real Estate Time Bomb

Vincent Fernando

Here is an interesting email from “JL” about the architecture industry.

“JL” writes:

Hi Mish-

A while ago, you published a stat from the American Institute of Architects (AIA) regarding architecture businesses and billing increases and decreases. I thought that was a good indication of future construction growth and I checked it out. It looks like it ticked up marginally for December but it’s still terrible according to the Wall Street Journal article Architecture Billings Tick Up, but Still Show Decline.

The Architecture Billings Index moved slightly higher last month, although the index remained below 50 for the 23rd consecutive month. The score in December was 43.4 compared with 42.8 in November. The December reading indicates a continued decline in demand for design services.

To give you some information just from my small circle of friends and family in Architecture:

• All architects I spoke to said business was terrible and some in coma mode.
• My wife, an architect, has almost no business.
• Leads typically fade off when the bids come in and inquiries stop or get outright canceled.
• Construction sites around Berkeley post signs on the mobile offices saying “NO-WE ARE NOT HIRING!”
• Survey and discussion among architects and contractors revolve around how many carpentry shops have laid everyone off or shut down.

It hasn’t been this bad since the 70’s. Moreover, in the 70’s and 80’s there were some lucky firms would make a name for themselves with big government projects such as museums, embassies, government offices and such. We just don’t see that work anymore.

Moreover, the BLS employment numbers last week had a big drop in construction employment, yet again.

I expect that AIA number will fall off horribly in the near future.

As a personal anecdote, a neighbor who is an architect for his own business tells me much the same thing. He had full a time employee helper that became part-time, that became zero-time (laid off), and now he has nowhere near enough architecture work to keep himself busy.

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

What Isn’t Happening with the $3 Trillion Commercial Real Estate Market: Loans Falling and Vacancy Rates at Record Heights at 10 Percent.

With commercial real estate, you can learn a lot from what isn’t happening.  We all know that the $3 trillion commercial real estate market is already taking a drubbing in terms of pricing.  CRE prices are down over 40 percent from their peak elevated levels.  Yet with commercial real estate you don’t have the typical headline grabbing stories of individuals being forced out of their homes in foreclosures.  With CRE it is seen as a more calculated business move and those losing their shirts are those who should have known better.  Now this is how things should be but the U.S. Treasury and Federal Reserve have already back stopped the entire banking system so implicitly, the failing of any real estate is now a direct burden to all taxpayers.

What is not happening is a natural stable demand from the market.  Why?  Just like the residential market, commercial properties were over built.  We have years of excess to work off.  That is why I simply don’t buy the notion that we will somehow be back on the run by tweaking a few balance sheet numbers.  The problem is many structures are now built and are sitting vacant yet the loans still need servicing.  Who is going to pay for it?  The U.S. Treasury has already had low key talks about a preemptive bailout for this industry labeled Plan C.

While banks tell the public all is well, their actions speak louder:

If things were improving in the overall economy it is likely you would see a natural demand for CRE loans.  People want to build something or start a new business and loans are easily available so long as you can fill the building.  The chart above shows a very clear pattern.  Less and less loans are being made in this sector.  Do banks know something the public doesn’t?

Larger housing complexes fall in the commercial category.  Typically these are places with more than 4 units at least on the residential front.  Assuming a market demand, you would expect to see permits rise:

The above chart clearly shows anything but this.  This is an important indicator because those who sense the economy is turning are more likely to build additional housing units.  This is a large part of our economy since banking heavily relies on real estate for profits.  That is largely a reason for the gigantic banking bailout while the vast majority of Americans wonder what they got for the $14 trillion in financial backstops.  The chart clearly shows one thing and that is there is virtually no demand for large unit housing complexes.  We are at record keeping demand lows even after all the bailouts.  Why?  Well most of these larger complexes are rental units and the market seems to be flush with these units:

The market is saturated with rentals.  Anyone that is both a landlord and renter will know this.  Many places are offering free HDTVs with a one year contract or even better, a few months of free rent.  Rentals always have a higher vacancy than regular homes because that is the nature of the property.  Renters are more mobile and vacancies are just part of the game.  But the current vacancy rate at nearly 10 percent is putting downward pressure on rent prices.  In fact, the BLS uses an owner’s equivalent of rent and this has been falling:

The interesting thing about the BLS data is that it understated the housing bubble because most people during the bubble shifted to buying overpriced homes while the data series was still focused on rental equivalents.  Now, with such a high rate in rental vacancies and large numbers of foreclosures the BLS is adjusting quickly to the downside and making it look like we are having massive deflation since housing makes up over 30 percent of the BLS CPI measure.  Why is this important?  This factors into many things including the cost of living adjustments many receive.

So all this adds into the fact that commercial real estate has very little pricing power in today’s market.  So what are the too big to fail banks doing?  They are laying the problem off on the public.  This was seen when Morgan Stanley simply walked away from the debt obligation in a San Francisco CRE deal:

“(WSJ) So we’ve discussed the ethics of individual borrowers walking away from their mortgages. (Some say we’ve over-discussed it.) If it’s immoral, as some would say, for a borrower to walk away their mortgage, is it any different for a bank?

Morgan Stanley is doing just that. News reports on Thursday said the bank plans to give back five San Francisco office buildings to its lender-just two years after buying them at the top of the market.

“This isn’t a default or foreclosure situation,” spokeswoman Alyson Barnes told Bloomberg News. “We are going to give them the properties to get out of the loan obligation.”

Sound familiar?

Morgan Stanley bought the buildings, along with five others, in San Francisco’s financial district as part of a $2.5 billion purchase from Blackstone Group in May 2007. The buildings were formerly owned by billionaire investor Sam Zell’s Equity Office Properties and acquired by Blackstone in its $39 billion buyout of the real estate firm earlier that year, Bloomberg reports. One analyst estimates that the buildings are now worth half of what Morgan Stanley paid.”

Now this is fascinating coming from an industry leader who has had its champion in the U.S. government moralizing that people shouldn’t walk away from their debt obligations.  The CRE market is in for a long and troubled road ahead.  Right now much of the data on retail sales is being championed as great but we are comparing it to data that was down in the abyss:

When you hear of those wonderful year over year gains we are going back to early 2009 when the economy was flying off a cliff.  So sure, things are up but what are we comparing it to?

The Federal Reserve has over $2 trillion in questionable assets that they are fighting to keep from an audit.  It is likely many loans in their portfolio are now commercial loans.  The fact that vacancy rates are so high and the employment situation is still dismal, where will the demand come from?  If anything, the best we can hope for is that current spaces get leased out and we start reaching more equilibrium levels of vacancies.  But we are so far away from even that.

What isn’t happening in the CRE market is very telling.  2010 is expected to bring much pain in this market and so far, we have had very little evidence pointing to any upsurge in this market.   And with $3 trillion at stake, any small movements mean big bucks.

Treasury Department Releases Text of Letter from Secretary Geithner
to Hill Leadership on Administration’s Exit Strategy for TARP

WASHINGTON – The U.S. Department of the Treasury released the
text of identical letters sent today from Secretary Tim Geithner to
Speaker Nancy Pelosi and Senator Harry Reid outlining the
Administration’s exit strategy for the Troubled Asset Relief Program
(TARP) established by the Emergency Economic Stabilization Act of 2008
(EESA). The text of the letter to Speaker Pelosi follows.

December 9, 2009

The Honorable Nancy Pelosi
Speaker          
U.S. House of Representatives
Washington, DC 20515

Dear Madam Speaker:

I am writing to update you on the status of the Obama
Administration’s financial policies, including programs initiated under
the Troubled Asset Relief Program (TARP) established by the Emergency
Economic Stabilization Act of 2008 (EESA), the results they have
achieved, the challenges ahead, and our plan for exiting TARP.

These policies are working.  When the Obama Administration took
office, the financial system was extremely fragile and the economy was
contracting sharply.  The Administration’s financial and economic
policies have helped to shore up confidence in our financial system. 
Credit is starting to flow again to consumers and businesses, and the
economy is growing.  Further, private capital is replacing public
capital in our major institutions.

As a result of improved financial conditions and careful stewardship
of the program, losses on TARP investments are likely to be
significantly lower than previously expected.  We now expect a positive
return from the government’s investments in banks.  These banks will
soon have repaid nearly half of the TARP funds they received.  We also
expect to recover all but $42 billion of the $364 billion in TARP funds
disbursed in FY2009.  Further, we plan to use significantly less than
the full $700 billion in EESA authority.  As a result, we expect that
TARP will cost taxpayers at least $200 billion less than was projected
in the August Mid-Session Review of the President’s Budget.

But significant challenges remain.  Too many American families,
homeowners, and small businesses still face severe financial pressure. 
Although the economy is recovering, foreclosures are increasing, and
unemployment is unacceptably high.  Businesses are still cautious in
the face of uncertainty about the strength of the recovery, and many
small businesses face very difficult credit conditions.  Although bank
lending standards are starting to ease, many categories of bank lending
continue to contract.  This contraction has hit small businesses very
hard because they rely heavily on such lending, and do not have the
ability to substitute credit from securities issuance.  Commercial real
estate losses also weigh heavily on many small banks, impairing their
ability to extend new loans.

Further, the recovery of our financial system remains incomplete. 
And near-term shocks to that system could undermine the economic
recovery we have seen to date.

Exit Strategy for TARP

Our exit strategy for TARP balances the mandate of EESA to address
these challenges with the need to exercise fiscal discipline and reduce
the burden on current and future taxpayers.  There are four broad
elements to our strategy.

First, we will continue terminating and winding down many of the
government programs put in place last fall.  In September, Treasury
ended its Money Market Fund Guarantee Program, which guaranteed at its
peak over $3 trillion of assets.  The program incurred no losses, and
generated $1.2 billion in fees.  The Capital Purchase Program, through
which the majority of TARP investments in banks have been made, is
effectively closed.  Before this Administration took office, nearly
$240 billion in TARP funds had been committed to banks.  Since January
20, we have committed about $7 billion to banks, much of which went to
small institutions.  Major U.S. banks subject to the “stress test”
conducted last spring have raised over $110 billion in high-quality
capital from the private sector.  And banks will soon have repaid $116
billion of TARP funds

Second, we will limit new commitments in 2010 to three areas.

• We will continue to mitigate foreclosure for responsible American
  homeowners as we take the steps necessary to stabilize our housing
  market.
• We recently launched initiatives to provide capital to small
  and community banks, which are important sources of credit for small
  businesses.  We are also reserving funds for additional efforts to
  facilitate small business lending.
• Finally, we may increase our commitment to the Term
  Asset-Backed Securities Loan Facility (TALF), which is improving
  securitization markets that facilitate consumer and small business
  loans, as well as commercial mortgage loans.  We expect that increasing
  our commitment to TALF would not result in additional cost to taxpayers.

Beyond these limited new commitments, we will not use remaining EESA
funds unless necessary to respond to an immediate and substantial
threat to the economy stemming from financial instability.  As a nation
we must maintain capacity to respond to such a threat.  Banks are still
experiencing significant new credit losses, and the pace of bank
failures, which tend to lag economic cycles, remains elevated.  At the
same time, many of the Federal Reserve and FDIC programs that have
complemented TARP investments are ending.  This creates a financial
environment in which new shocks could have an outsized effect –
especially if an adequate financial stability reserve is not
maintained.  As we wind down many of the government programs launched
initially to address the crisis, it is imperative that we maintain this
capacity to respond if financial conditions worsen and threaten our
economy.  However, before using EESA funds to respond to new financial
threats, I would consult with the President and Chairman of the Federal
Reserve Board and submit written notification to the Congress.  This
capacity will bolster confidence and improve financial stability,
thereby decreasing the probability that it will need to be used.  This
is the third element of our exit strategy.

In order to accomplish these goals, pursuant to Section 120(b) of
EESA, I certify that I am hereby extending the authority provided under
the Act to October 3, 2010.  This extension is necessary to assist
American families and stabilize financial markets because it will,
among other things, enable us to continue to implement programs that
address housing markets and the needs of small businesses, and to
maintain the capacity to respond to unforeseen threats, as described
above.

While we are extending the $700 billion program, we do not expect to
deploy more than $550 billion.  We also expect up to $175 billion in
repayments by the end of next year, and substantial additional
repayments thereafter.  The combination of the reduced scale of TARP
commitments and substantial repayments should allow us to commit
significant resources to pay down the federal debt over time and slow
its growth rate.

Even with this extension, we expect that TARP will cost taxpayers at
least $200 billion less than was projected in the August Mid-Session
Review of the President’s Budget, including $25 billion in potential
costs from new TARP commitments in 2010.  We expect that the vast
majority of these potential costs would come from mitigating
foreclosure for responsible American homeowners as we take the steps
necessary to stabilize our housing market.

The final element to our exit strategy is how we manage equity
investments acquired through EESA while protecting taxpayers.  We will
continue to manage those investments in a commercial manner and seek to
dispose of them as soon as practicable.  We will exercise our voting
rights only on core issues such as election of directors, and we will
not interfere in the day-to-day management of individual companies.  In
addition, as the steward of taxpayers’ funds, Treasury will continue to
manage investments in a manner that ensures accountability,
transparency and oversight.  And we will work with recipients of EESA
funds and their supervisors to accelerate repayment where appropriate. 
We want to see the capital base of our financial system return to
private hands as quickly as possible, while preserving financial
stability and promoting economic recovery.

History suggests that exiting prematurely from policies designed to
contain a financial crisis can significantly prolong an economic
downturn.  We must not waver in our resolve to ensure the stability of
the financial system and to support the nascent recovery that the
Administration and the Congress have worked so hard to achieve. 
Improvements in the financial performance of EESA programs put us in a
better position to address the economic and financial challenges many
Americans still face.  I look forward to continuing to work with you to
achieve these
goals.                                                               

Sincerely,

Timothy F. Geithner

Identical copy of this letter sent to:
            The Honorable Harry Reid

cc:       The Honorable Barney Frank
           The Honorable Spencer Bachus
           The Honorable David Obey
           The Honorable Jerry Lewis

By Economic Forecasts & Opinions

Stock markets around the world cracked on Friday with the Dow Jones industrial average down more than 150 points (Fig. 1), and commodities plunging as Dubai debt woes unnerved investors, and sent tremors of uncertainty throughout all markets.

The crisis flared after Dubai, a part of the United Arab Emirates (UAE) federation, asked to delay interest payment for six months on $60 billion of debt issued by the state-run conglomerate Dubai World and its main property unit Nakheel.

Concerns that a government-backed investment company risked default ripped through world markets. Investors read it as a sign of yet another sovereign implosion after Iceland and Ireland, and recoiled from risk and piled into dollars.

Las Vegas on Steroids

Dubai World has served as Dubai’s main driver of growth, operating ports, transportation groups, spearheading real-estate & infrastructure projects both at home and abroad. Its real-estate subsidiary Nakheel built Dubai’s iconic palm-tree-shaped island, packed with luxury villas and hotels, many still under construction. Real estate and construction accounts for about 23% of Dubai’s GDP.

With little oil, Dubai financed much of this rapid real estate development with debt. After incurring its estimated $80-$90 billion of debt in a four-year construction boom to transform its economy into a regional financial and tourism hub, Dubai suffered the world’s steepest property slump in the first global recession since World War II.

Deutsche Bank estimates that Dubai’s property prices, both commercial and residential, have halved since August last year, and could fall a further 15-20% this year.

U.S. Banks Less Exposed

Most analysts believe U.S. banks are probably less exposed than European rivals to a potential debt default by Dubai World, but a lack of transparency and the interconnection of the modern financial system make it difficult to know which institutions are ultimately exposed.

Dubai World’s largest creditors are reportedly domestic banks in Dubai and Abu Dhabi. MarketWatch noted data from the Bank for International Settlements which put cross-border banking exposure for the UAE as a whole at $123 billion at the end of June. Of that total, European banks hold 72%, with the United States and Japan only holding 9% and 7% of the exposure, respectively. The United Kingdom is by far the biggest creditor with a share of 41%.

Reminder of Other Risks

On a global scale, Dubai World’s debt problem seems relatively minor, but it illustrates the impact from one tiny country in an increasingly interconnected world. The Dubai news also cast doubt over the strength of the U.S. economic recovery, and the prospects for a bottoming of property prices.

Commercial Real Estate

As pointed out in my previous article that the commercial real estate sector posed a much greater threat than the over-hyped “mother of all carry trades.”  The Dubai debt crisis further reinforces this viewpoint.

The potential for contagion from Dubai’s debt woes could further unhinge an already fragile U.S. commercial real estate sector, whose values have already fallen 42.9% from their 2007 peak, close to the lowest since 2002, according to Moody’s. (Fig. 2) The latest Moody’s projection is for prices to bottom at 45-55% below their peak, but could drop as much as 65% from their peak in a “stress case”.

As commercial property values fall, debt defaults rise. The $3.4 trillion outstanding in debt backed by commercial real estate poses a real threat to the recovery. Trepp LLC reported that last month, delinquencies on U.S. commercial real estate loans that were packaged into commercial mortgage-backed securities reached 4.8%, more than six times the year earlier level. Hotel loans, at 8.7% distressed, have begun falling into delinquency faster than any other kind of commercial real estate debt.

Write-downs and losses at banks around the world have risen to more than $1.7 trillion since 2007 as the credit crisis undermined the value of assets owned by financial institutions, according to data compiled by Bloomberg. Any further deleveraging and the resulting credit tightening from commercial real estate would impede the financial sector and probably derail the U.S. economy sending it into another recession. 

Housing Market Mortgage Crisis

So far, the appearance of recovery in the housing sector is being driven primarily by reduced prices combined with federal programs to lower mortgage rates with the goal of bringing more buyers into the market.

Based on a study released by Zillow.com, the foreclosure crisis has moved beyond subprime mortgages and into the prime mortgage market. (Fig. 3) While subprime borrowers are still a factor in the current foreclosure epidemic, it’s becoming increasingly apparent that the weak labor market is the driving force behind the mortgage crisis we face today.

According to the Mortgage Bankers Association, one in seven U.S. home loans was past due or in foreclosure as of Sept. 30, putting that quarterly delinquency measure at its highest level since the report’s inception, 1972, and up from one in ten at the beginning of the year.

The continued surge in delinquencies suggests that a recovery in the housing market could be hindered by the weak job market as well as by further fallout from the easy money and loose lending practices of the past. The foreclosures and delinquencies are expected to keep rising well into 2010, not leveling off until the unemployment rate starts to moderate.

In a study by First American CoreLogic found that one in four of all U.S. mortgage-borrowers owe more than the value of their properties in the 3rd quarter. And many experts didn’t expect U.S. home prices to hit bottom until early 2011, perhaps falling another 5-10%, as more foreclosures get pushed onto the market.

Negative equity is another outstanding risk hanging over the mortgage market.

Dubai Is No Lehman

The circumstances behind Dubai’s moves are murky, making it hard to gauge the exact risk to the pertaining bonds and Dubai’s own general creditworthiness. UBS cautioned that Dubai’s overall debt “might be higher than the generally assumed $80 billion to $90 billion, due to potential off-balance sheet liabilities. These could include unlimited and unquantifiable amount of credit default swaps (CDS) and other derivatives against the underlying assets, and once unraveled, could potentially erupt into a subprime-like crisis.

The current expectation; however, is that there’s a good chance that Dubai’s problems will probably prove a local issue. Most likely, Dubai, or its neighboring emirate, Abu Dhabi, won’t risk tarnishing their images and reputation further, and will come up with a reasonable resolution.

Even if Dubai goes into sovereign default, the amount is probably not enough on its own to threaten the financial system since any actual losses would be a fraction of the total. So, the problems in Dubai are unlikely to be as serious as last year’s Lehman Brothers collapse, nor is it a reflection on the ability of emerging markets to lead a global economic recovery.

Rational Expectations?

But Dubai could well spur a broader crisis of investor confidence in overly leveraged economies as market confidence world-wide is still fragile from the severity of the financial crisis.  The debts of many emerging markets have risen even further as the countries governments have fought the ravages of the global recession by issuing more stimulus debt to fill the gap voided by private investment.

The spread of credit-default swaps on developing-nation’s bonds jumped 14 basis points after the Dubai news broke, the most in a month, to 3.24 percentage points, according to JPMorgan Chase & Co.’s EMBI+ Index. There is also a clear sign of potential contagion effects of global risk aversion on basically all risky assets, with the dollar and yen being the prime beneficiaries.

Rational expectations or not, for now, the Dubai crisis is simply a reminder that the severe global recession has relegated much debt to near junk status, and there still remains a high degree of uncertainty as to the percentage recoverable on all outstanding debt which is going to be coming due over the next 5 years.

Despite some seminal signs of green shoots in the news headlines during this 9 month liquidity driven rally in many asset classes around the globe, we should be reminded that all that glitters is not gold, and that the global economic recovery is still on shaky ground.

#  “I know the odds are against me, but if there’s a win I’m gonna find it!”  ~Goku  #

Economic Forecasts & Opinions

? Washington’s Blog.

Why isn’t the government breaking up the giant, insolvent banks?

We Need Them To Help the Economy Recover?

Do we need the Too Big to Fails to help the economy recover?

No.

The
following top economists and financial experts believe that the economy
cannot recover unless the big, insolvent banks are broken up in an
orderly fashion:

• Nobel prize-winning economist, Joseph Stiglitz

• Nobel prize-winning economist, Ed Prescott

• Dean
  and professor of finance and economics at Columbia Business School, and
  chairman of the Council of Economic Advisers under President George W.
  Bush, R. Glenn Hubbard

• MIT economics professor and former IMF chief economist, Simon Johnson (and see this)

• President of the Federal Reserve Bank of Kansas City, Thomas Hoenig (and see this)

• Deputy Treasury Secretary, Neal S. Wolin

• The President of the Independent Community Bankers of America, a Washington-based trade group with about 5,000 members, Camden R. Fine

• The Congressional panel overseeing the bailout

• The head of the FDIC, Sheila Bair

• The leading monetary economist and co-author with Milton Friedman of the leading treatise on the Great Depression, Anna Schwartz

• Economics professor and senior regulator during the S & L crisis, William K. Black

• Economics professor, Nouriel Roubini

• Economist, Marc Faber

• Professor of entrepreneurship and finance at the Chicago Booth School of Business, Luigi Zingales

• Economics professor, Thomas F. Cooley

• Former investment banker, Philip Augar

• Chairman of the Commons Treasury, John McFall

Others, like Nobel prize-winning economist Paul Krugman, think that the giant insolvent banks may need to be temporarily nationalized.

In addition, many top economists and financial experts, including Bank of Israel Governor Stanley Fischer – who was Ben Bernanke’s thesis adviser at MIT – say that – at the very least – the size of the financial giants should be limited.

Even the Bank of International Settlements – the “Central Banks’ Central Bank” – has slammed too big to fail. As summarized by the Financial Times:

The
report was particularly scathing in its assessment of governments’
attempts to clean up their banks. “The reluctance of officials to
quickly clean up the banks, many of which are now owned in large part
by governments, may well delay recovery,” it said, adding that
government interventions had ingrained the belief that some banks were
too big or too interconnected to fail.

 

This was dangerous because it reinforced the risks of moral hazard
which might lead to an even bigger financial crisis in future.

If We Break ‘Em Up, No One Will Lend?

Do we need to keep the TBTFs to make sure that loans are made?

Nope.

Fortune pointed out
in February that smaller banks are stepping in to fill the lending void
left by the giant banks’ current hesitancy to make loans. Indeed, the
article points out that the only reason that smaller banks haven’t been
able to expand and thrive is that the too-big-to-fails have decreased
competition:

Growth for the nation’s smaller banks
represents a reversal of trends from the last twenty years, when the
biggest banks got much bigger and many of the smallest players were
gobbled up or driven under…

 

As big banks struggle to find a way forward and rising loan losses
threaten to punish poorly run banks of all sizes, smaller but well
capitalized institutions have a long-awaited chance to expand.

BusinessWeek noted in January:

As big banks struggle, community banks are stepping in to offer loans and lines of credit to small business owners…

At a congressional hearing on small business and the economic
recovery earlier this month, economist Paul Merski, of the Independent
Community Bankers of America, a Washington (D.C.) trade group, told
lawmakers that community banks make 20% of all small-business loans,
even though they represent only about 12% of all bank assets.
Furthermore, he said that about 50% of all small-business loans under
$100,000 are made by community banks…

Indeed, for the past two years, small-business lending among community
banks has grown at a faster rate than from larger institutions,
according to Aite Group, a Boston banking consultancy. “Community banks
are quickly taking on more market share not only from the top five
banks but from some of the regional banks,” says Christine Barry,
Aite’s research director. “They are focusing more attention on small
businesses than before. They are seeing revenue opportunities and
deploying the right solutions in place to serve these customers.”

And Fed Governor Daniel K. Tarullo said in June:

The
importance of traditional financial intermediation services, and hence
of the smaller banks that typically specialize in providing those
services, tends to increase during times of financial stress. Indeed,
the crisis has highlighted the important continuing role of community
banks…

For example, while the number of credit unions has declined by 42
percent since 1989, credit union deposits have more than quadrupled,
and credit unions have increased their share of national deposits from
4.7 percent to 8.5 percent. In addition, some credit unions have
shifted from the traditional membership based on a common interest to
membership that encompasses anyone who lives or works within one or
more local banking markets. In the last few years, some credit unions
have also moved beyond their traditional focus on consumer services to
provide services to small businesses, increasing the extent to which
they compete with community banks.

Indeed, some very smart people say that the big banks aren’t really focusing as much on the lending business as smaller banks.

Specifically
since Glass-Steagall was repealed in 1999, the giant banks have made
much of their money in trading assets, securities, derivatives and
other speculative bets, the banks’ own paper and securities, and in
other money-making activities which have nothing to do with traditional
depository functions.

Now that the economy has crashed, the big banks are making very few loans to consumers or small businesses because they still
have trillions in bad derivatives gambling debts to pay off, and so
they are only loaning to the biggest players and those who don’t really
need credit in the first place. See this and this.

So we don’t really need these giant gamblers. We don’t really need JP Morgan, Citi, Bank of America, Goldman Sachs or Morgan Stanley. What we need are dedicated lenders.

The Fortune article discussed above points out that the banking giants are not necessarily more efficient than smaller banks:

The
largest banks often don’t show the greatest efficiency. This now seems
unsurprising given the deep problems that the biggest institutions have
faced over the past year.

 

“They actually experience diseconomies of scale,” Narter wrote of
the biggest banks. “There are so many large autonomous divisions of the
bank that the complexity of connecting them overwhelms the advantage of
size.”

And Governor Tarullo points out some of the benefits of small community banks over the giant banks:

Many
community banks have thrived, in large part because their local
presence and personal interactions give them an advantage in meeting
the financial needs of many households, small businesses, and
agricultural firms. Their business model is based on an important
economic explanation of the role of financial intermediaries–to
develop and apply expertise that allows a lender to make better
judgments about the creditworthiness of potential borrowers than could
be made by a potential lender with less information about the
borrowers.

A small, but growing, body of research suggests that the financial
services provided by large banks are less-than-perfect substitutes for
those provided by community banks.

It is simply not true
that we need the mega-banks. In fact, as many top economists and
financial analysts have said, the “too big to fails” are actually
stifling competition from smaller lenders and credit unions, and
dragging the entire economy down into a black hole.

The Giant Banks Have Recovered, And Are No Longer Insolvent?

Have the TBTFs recovered, so that they are no longer insolvent?

Negatory.

The giant banks have still not put the toxic assets hidden in their SIVs back on their books.

The tsunamis of commercial real estate, Alt-A, option arm and other loan defaults have not yet hit.

The
overhang of derivatives is still looming out there, and still dwarfs
the size of the rest of the global economy. Credit default swaps have arguably still not been tamed (see this).

Indeed, Nobel prize winning economist Joseph Stiglitz said recently:

The
U.S. has failed to fix the underlying problems of its banking system
after the credit crunch and the collapse of Lehman Brothers Holdings
Inc.

 

“In the U.S. and many other countries, the too-big-to-fail banks
have become even bigger,” Stiglitz said in an interview today in Paris.
“The problems are worse than they were in 2007 before the crisis.”

 

Stiglitz’s views echo those of former Federal Reserve Chairman
Paul Volcker, who has advised President Barack Obama’s administration
to curtail the size of banks, and Bank of Israel Governor Stanley
Fischer, who suggested last month that governments may want to
discourage financial institutions from growing “excessively.”

While the big boys have certainly reported some impressive profits in the last couple of months, some or all of those profits may have been due to “creative accounting”, such as Goldman “skipping” December 2008, suspension of mark-to-market (which may or may not be a good thing), and assistance from the government.

Some
very smart people say that the big banks – even after many billions in
bailouts and other government help – have still not repaired their
balance sheets. Tyler Durden, Reggie Middleton, Mish and others have looked at the balance sheets of the big boys much more recently than I have, and have more details than I do.

But the bottom line is this: If the banks are no longer insolvent, they should prove it. If they can’t prove they are solvent, they should be broken up.

The Government Lacks the Power to Break Them Up?

Does the government lack the power to break up the TBTFs?

Wrong.

One of the world’s leading economic historians – Niall Ferguson – argues in a current article in Newsweek:

[Geithner is proposing that] there should be a new “resolution
authority” for the swift closing down of big banks that fail. But such
an authority already exists and was used when Continental Illinois failed in 1984.

Indeed, even the FDIC mentions Continental Illinois in the same breadth as “too big to fail” banks.

And William K. Black (remember, he was the senior regulator during the S&L crisis, and is a Professor of both Economics and
Law) – says that the Prompt Corrective
Action Law (PCA), 12 U.S.C. § 1831o, not only authorizes the government
to seize insolvent banks, it mandates it, and that the Bush and Obama administrations broke the law by refusing to close insolvent banks.

Whether or not the banks’ holding companies can be broken up using the PCA, the banks themselves could be. See this

And no one can doubt that the government could find a way to break up even the holdign companies if it wanted.

FDR seized gold during the Great Depression under the Trading With The Enemies Act.

Geithner
and Bernanke have been using one loophole and “creative” legal
interpretation after another to rationalize their various
multi-trillion dollar programs in the face of opposition from the
public and Congress (see this, for example).

And the government could use 100-year old antitrust laws to break them up.

So
don’t give me any of this “our hands are tied” malarkey. The Obama
administration could break the “too bigs” up in a heartbeat if it
wanted to, and then justify it after the fact using PCA or another
legal argument.

Is Temporarily Nationalizing the Giant Banks Socialism?

Many argue that it would be wrong for the government to break up the banks, because we would have to take over the banks in order to break them up.

That
may be true. But government regulators in the U.S., Sweden and other
countries which have broken up insolvent banks say that the government
only has to take over banks for around 6 months before breaking them up.

In
contrast, the Bush and Obama administrations’ actions mean that the
government is becoming the majority shareholder in the financial giants
more or less permanently. That is – truly – socialism.

Breaking
them up and selling off the parts to the highest bidder efficiently and
in an orderly fashion would get us back to a semblance of free market
capitalism much quicker.

The Real Reason the Giant Banks Aren’t Being Broken Up

So what is the real reason that the TBTFs aren’t being broken up?

Certainly, there is regulatory capture, cowardice and corruption:

• Joseph Stiglitz
  (the Nobel prize winning economist) said recently that the U.S. government is wary of challenging the
  financial industry because it is politically difficult, and that he
  hopes the Group of 20 leaders will cajole the U.S. into tougher action

• Economic historian Niall Ferguson asks:
  

  Guess
  which institutions are among the biggest lobbyists and campaign-finance
  contributors? Surprise! None other than the TBTFs [too big to fails].

• Manhattan Institute senior fellow Nicole Gelinas agrees:
  

  The
  too-big-to-fail financial industry has been good to elected officials
  and former elected officials of both parties over its 25-year life span

• Investment analyst and financial writer Yves Smith says:
  

  Major financial players [have gained] control over the all-important over-the-counter debt markets…It is pretty hard to regulate someone who has a knife at your throat.

• William K. Black says:
  

  There has been no honest examination of the crisis because it would embarrass C.E.O.s and politicians . . .

  Instead, the Treasury and the Fed are urging us not to
  examine the crisis and to believe that all will soon be well. There
  have been no prosecutions of the chief executives of the large nonprime
  lenders that would expose the “epidemic” of fraudulent mortgage lending
  that drove the crisis. There has been no accountability…

  The Obama administration and Fed Chairman Ben Bernanke have
  refused to investigate the nature and causes of the crisis. And the
  administration selected Timothy Geithner, who with then Treasury
  Secretary Paulson bungled the bailout of A.I.G. and other favored “too
  big to fail” institutions, to head up Treasury.

  Now Lawrence Summers, head of the White House National Economic
  Council, and Mr. Geithner argue that no fundamental change in finance
  is needed. They want to recreate a secondary market in the subprime
  mortgages that caused trillions of dollars of losses.

  Traditional
  neo-classical economic theory, particularly “modern finance theory,”
  has been proven false but economists have failed to replace it. No
  fundamental reform can be passed when the proponents are pretending
  that there really is no crisis or need for change.

• Harvard professor of government Jeffry A. Frieden says:
  

  Regulatory
  agencies are often sympathetic to the industries they regulate. This
  pattern is so well known among scholars that it has a name: “regulatory
  capture.” This effect can be due to the political influence of the
  industry on its regulators; or to the fact that the regulators spend so
  much time with their charges that they come to accept their world view;
  or to the prospect of lucrative private-sector jobs when regulators
  retire or resign.

• Economic consultant Edward Harrison agrees:Regulating Wall Street has become difficult in large part because of regulatory capture.

But there is an even more interesting reason . . .

The number one reason the TBTF’s aren’t being broken up is [drumroll] . . . the ‘ole 80’s playbook is being used.

As the New York Times wrote in February:

In
the 1980s, during the height of the Latin American debt crisis, the
total risk to the nine money-center banks in New York was estimated at
more than three times the capital of those banks. The regulators,
analysts say, did not force the banks to value those loans at the
fire-sale prices of the moment, helping to avert a disaster in the
banking system.

In other words, the nine biggest banks were all insolvent in the 1980s.

And the Times is not alone in stating this fact. For example, Felix Salmon wrote in January:

In
the early 1980s, when a slew of overindebted Latin governments
defaulted to their bank creditors, a lot of big global banks, Citicorp
foremost among them, became insolvent.

So the
government’s failure to break up the insolvent giants – even though
virtually all independent experts say that is the only way to save the
economy, and even though there is no good reason not to break them up – is nothing new.

William K. Black’s statement that the government’s entire strategy now – as in the S&L crisis – is to cover up how bad things are (“the entire strategy is to keep people from getting the facts”) makes a lot more sense.