Since the catastrophic bank collapses of 2008 and the government rescue of the finance industry, Wall Street has staged a dramatic comeback. Since the bailout, profits are up, capital reserves are up, stock prices are up, government direct aid has been paid back, and executive compensation is exploding. But a closer look shows bank stability is just skin-deep, and dense accounting rules hide a powder keg of bad debt and mounting funding issues. While the recent paper-thin re-regulation of finance was a major political victory, the banks’ core business is headed downhill and even worse trouble seems to lie ahead.
All of the big four U.S. megabanks—Bank of America, Citigroup, Chase, and Wells Fargo—reported either decreases or very modest increases in their massive profitability during 2010. But this surprisingly weak performance would have been even more disappointing without a pair of accounting maneuvers. One was a bookkeeping measure allowing banks to book projected profit from buying back their debt when their bonds become cheaper. But the banks rarely buy back their debt, so this is essentially a paper gain. The other penstroke that boosted profit was consumption of money set aside to protect against losses on loans—as banks have grown more outwardly confident about the economic recovery, they have lowered their stated expectations of bad loans and designated some of their capital cushions as profit.
But these shallow techniques for elevating profit weren’t enough to compensate for the decline in banks’ core business—interest income, the money collected from loans minus that paid out to depositors. That income has consistently dropped this year, mainly due to falling loan volume. Banks are making fewer loans to consumers and businesses, citing a “lack of demand,” which obscures the quite favorable credit rating now required to get a loan. The lower supply of qualified applicants as job losses persist, combined with locking out applicants with spottier credit history and a general consumer preference to reduce total debt, have all caused bank loan books to continue to shrink in the feeble recovery.
The market has not rewarded the banks for the elaborate camouflage of this core weakness, and their stock prices have lately sagged as a result. But executive compensation is another story, and traders’ pay is also rebounding into the $200,000-to-$500,000 range, while tens of millions of Americans struggle to keep food on the table. Meanwhile Obama’s much-hailed “pay czar” in charge of monitoring finance executive compensation, Kenneth Feinberg, has reported that within three months of receiving their bailouts, the megabanks had paid out $1.6 billion in bonuses—up to a quarter of their TARP rescue totals. However, the “czar” has no formal power to rescind exorbitant pay now that the majors have repaid their government capital infusions, and compensation will now be monitored by a rather unintimidating consortium of regulators. With the CEOs of the banking majors making about a million a year each in straight salary, no upward limit is in sight for financier compensation. But the banking institutions themselves may have some bumpy days ahead.
Extend and Pretend and Descend
While the banking majors were relieved of much of their bad home mortgage-based investments by government purchases in the course of the financial crisis and aftermath, large loans related to commercial real estate remained on their books. Many of these loans were to growing businesses and overoptimistic developers, and have frequently failed to perform, as the recession has rendered projects unprofitable, reducing borrowers’ ability to repay.
But the loans are often for sobering amounts, upwards of tens of millions of dollars, and rather than foreclose on such large credit lines, banks large and small are engaging in what has come to be called “extend and pretend.” The practice involves not taking legal measures on underperforming commercial real-estate loans, but rather “restructuring” loans with new, more favorable terms for the borrowers, like below-market interest rates or extended timelines for repayment. The goal of the practice is to prevent foreclosure on large loans, with the hope that extending maturities will give borrowers enough time to recover their business and repay.
There are several problems with this practice. First, it conceals the real condition of the commercial real-estate market. Second, the restructured loans are usually still foreclosed upon in the end—in first quarter of fiscal year 2010, 44% of restructured loans were still a month or more delinquent, a fact related to the startling two-thirds of commercial real-estate loans maturing by 2014 that are underwater—meaning that the property is worth less than the bank loan itself. Finally, the bad loans take up space on bank balance sheets that could go to real lending. This suggests that the banks’ current predicament may lead to a miniature version of 1990s Japan, where refusal to accept real-estate loan losses led to a decade of slow growth, in part due to banks’ inability to make fresh loans when demand recovered.
However, the “extend and pretend” policy presents one major benefit to the big banks: restructuring these loans allows banks to count them as “performing” rather than delinquent or worse, which means banks may reduce their capital reserves against losses. This enables banks to claim their capital cushions as profit; banks remain in denial about their bad loans, and this itself allows the recent profit increases. And when banks are one day obliged to confront these serious losses, they may find they no longer have the capital cushion to absorb the damage.
This ominous hidden liability is on top of the better-publicized problem of banks’ under-performing residential mortgage holdings. The mortgage delinquency rate is now hovering around 10% nationwide, and including those behind on payments and those on the verge of eviction, fully one U.S. mortgage in seven is in some kind of trouble. Importantly, the bad mortgage debt on banks’ books has ceased to be a primarily “subprime” phenomenon of low-income loan recipients; over a third of new foreclosures early this year were prime fixed-rate loans, as the layoff-intensive recovery pulls the rug out from under mortgage recipients.
Notably, the home mortgages still held by the banks are listed on bank balance sheets at inflated values since they are for homes bought at the housing bubble peak, and government has not forced the banks to account them at any reasonable value. And beside this additional hidden weakness and the space taken up on bank balance sheets by this bad mortgage debt, the banking majors are vulnerable to moves by insurers and other investors to force the banks to repurchase securitized home loans sold to them at wildly inflated prices. So far, losses on affected and expected repurchases have cost the biggest four U.S. banks nearly $10 billion, with further losses anticipated.
Meanwhile, the banks have allowed extremely few mortgage borrowers to modify their mortgages or reduce their principal—the National Bureau of Economic Research has found that just 8% of delinquent borrowers received any modification, while a pitiful 3% have received reductions in their total owed principal. However, about half of all seriously delinquent borrowers have had foreclosure proceedings brought by their bank. Of course, banks ultimately benefit more from a renegotiated loan that is paid off than from a foreclosure, but the long timeline required in the foreclosure process allows the banks to once again push back acknowledgement of the loss.
The banks’ rush to foreclose is reflected in the recent suspension of the practice by several megabanks, after discovery that foreclosure standards were not being followed, with single employees overseeing upwards of 400 foreclosures daily, far more than can be properly reviewed according to legal standards. The investigation by state attorneys general adds to the legal swamp that may slow down the flood of foreclosures, but also testifies to the large banks’ preference for foreclosure over loan modification.
Lending On Borrowed Time
Banks face other market difficulties in the near future. One involves the increased reliance of the large banks on short-term borrowing to fund their loan portfolios. While banks have issued bonds to raise loan capital for years, in recent years they have grown increasingly dependent on short-term borrowing—the average maturity of recent bank bond issues is under five years, the shortest in decades. This is in fact why the seizing up of the credit markets in 2008 was such a big deal—banks were in immediate trouble if they couldn’t borrow. Of course, the government bailout included guarantees for short-term bonds, leading the banks to become even more reliant upon them.
This means banks must “turn over” their debt more frequently—they must issue fresh bonds to raise capital to pay off the maturing older bonds—and U.S. banks must refinance over a trillion dollars through 2012. The problem is that the banks will be competing with huge bond rollovers from state and federal government, which are heavily indebted because of upper-class tax cuts, as well as expensive wars and recent rounds of stimulus at the federal level. Even the powerful megabanks may struggle in this environment—as the New York Times puts it, “The cost of borrowing is likely to rise faster than banks can pass it on to customers.” The total demand for institutional credit may significantly spike in coming years, meaning perhaps higher interest rates as states and finance houses compete for the bond market’s favor, or a further decline in lending by banks due to prohibitive funding costs.
Meanwhile, smaller banks have experienced a different post-crisis environment. Despite some TARP bailout crumbs, they have gone under in record numbers—140 failed in 2009, with 2010 on track for a yet larger figure. Most of these smaller fry succumb to losses or suffocate under bad loans following the real-estate bubble of the last decade. This sector of the industry is ironically on track to cause more taxpayer losses from non-repayment of bailout funds than the majors, which have attracted the most scorn for taking TARP funds.
Compounding these stabilized but still shaky banking positions, the industry is now subject to a significantly reshaped regulatory environment. In addition to the major finance reform bill enacted in July, banks face new international capital standards in the Basel Rules and new regulatory scope for the Federal Reserve as well. But all these reforms have been limited by massive lobbying spending by Wall Street, coming to over $700 million in the last 18 months alone, as estimated by the Center For Responsive Politics. (See sidebars.)
A crucial part of the picture is the uncertainty caused by the notorious secrecy of the financial world. Large parts of the modern finance system do not accept deposits as commercial banks do, and therefore face far less regulation, allowing them to disclose much less information about their investments and leverage. Additionally, even the commercial banks are not obliged to report changes to the terms of their commercial real-estate holdings, obscuring the full extent of “extend-and-pretend” practices. And the Federal Reserve, for its part, has fought to preserve its own institutional secrecy. The Wall Street reform bill does include provisions for limited audits of the Fed’s open-market operations and discount window, the basic monetary policy tools used to manipulate interest rates and to modulate economic activity. But this casts little light on the Fed’s expansive holdings in mortgage securities and other paper bought from the banks in the course of the 2008-9 bailout. From the banks to the regulators, secrecy—and thus uncertainty—colors the picture.
In the end, moderately higher capital requirements and the public listing and indexing of derivatives may take the financial system back to short-term stability, but banks remain stuck with significant bad loans limiting core interest income, and continue to rely on market bubbles and on their outsized political power. They also face a difficult short-term bond market in the near future in addition to some higher regulatory costs, and crucially, their core business is further limited by weak credit demand in the low-expectations recovery. Unsurprisingly, compensation has rocketed back into seven figures in spite of these circumstances.
So while ordinary Americans limp along in a jobless recovery, the banks have their execs instead of Hell to pay.
Sources: Eric Dash, “JPMorgan Chase Profit Rises as Loans Provisions Fall,” New York Times, October 13, 2010; Eric Dash, “Citigroup Reports $2.2 Billion Profit in Third Quarter,” New York Times, October 18, 2010; Bradley Keoun, “Bank Profits Are Worse Than They Look,” Bloomberg BusinessWeek, July 22, 2010; Matthias Rieker and Marshall Eckblad, “Banks Generate Profits, but Struggle to Lend,” Wall Street Journal, July 22, 2010; Eric Dash, “Federal Report Faults Banks on Huge Bonuses,” New York Times, July 22, 2010; “Bankers’ Pay,” New York Times, July 27, 2010; Carrick Mollenkamp and Lingling Wei, “To Fix Sour Property Deals, Lenders ‘Extend and Pretend,’” Wall Street Journal, July 7, 2010; David Streitfeld, “Mortage Data Leaves Bankers Uncertain of Trend,” New York Times/i>, May 19, 2010; Floyd Norris, “Banks Stuck With Bill for Bad Loans,” New York Times, August 19, 2010; Manuel Adelino et al, “Why Don’t Lenders Renegotiate More Home Mortgages? Redefaults, Self-Curse and Securitization,” NBER, July 2009; Jack Ewing, “Crisis Awaits World’s Banks as Trillions Come Due,” New York Times, July 11, 2010; AP, FDIC Closes 6 Banks, Including 3 in Florida,” New York Times, July 16, 2010; Randall Smith and Robin Sidel, “Banks Keep Failing, No End in Sight,” Wall Street Journal, September 27, 2010; Binyamin Appelbaum, “Mortgage Securities It Holds Pose Sticky Problem for Fed,” New York Times, July 22, 2010; Peter Goodman, “Policy Options Dwindle as Economic Fears Grow,” New York Times, August 28, 2010; Center For Responsive Politics, Lobbying Spending Database, FIRE 2010, opensecrets.org.
One Hand Regulates the Other
July’s Wall Street Reform and Consumer Protection Act was expected to be a return to at least moderate finance regulation, even if a far cry from the more sweeping controls of the 1930s. But the slap-on-the-wrist nature of the bill became clear when stock prices of the megabanks rose 3% on its passage. The bill delegates dozens of important decisions, from what constitutes a systemically important bank to credit ratings disclosure, to the regulatory agencies themselves. Crucially, bank regulators are expecting what the press calls a “lobbying blitz,” as former employees of the regulators are bankrolled by Wall Street to lobby for industry discretion and relaxed standards on every rule. Highlights include:
- While now stuck with limits on overdraft fees and the “interchange fees” charged to merchants for debit card processing, banks are phasing out free checking accounts and elevating fees elsewhere, since they have the market power to do so. Many depositors are unable to afford checking account fees, of course, but the New York Times expects the banks to “jettison unprofitable customers.”
- The Volcker Rule would limit banks’ “proprietary trading,” investments made with a bank’s own money rather than clients’ funds. The practice was damaging during the financial crisis, but banks have already found a work-around for the new rule. Banks are moving star proprietary traders to client desks, where they will primarily conduct derivatives trade for clients, but will also be able to engage in the barred practice on the side, further blurring the client/proprietary distinction.
- Derivatives will now be listed on established indexes and will require collateral as a cushion against losses, having previously been traded ad-hoc by individual banks. This removes significant risk from the banks themselves, reducing them to competing on service rather than generating large securitization fees. Importantly, businesses that use derivatives for legitimate purposes, such as farmers buying futures contracts to secure favorable grain prices, are exempted from the bill’s indexing and collateralizing requirements.
- The bill includes a resolution authority that gives regulators a procedure to “unwind” a bank—overseeing its bankruptcy in an orderly fashion and at its creditors’ expense. Additionally, the Kanjorski amendment to the bill gives regulators the authority to break up any financial institution considered to be a systemic threat to the financial system. But it seems unlikely that regulators, typically close to the firms they regulate, would let a titan go down regardless of their resolution authority.
- The new Consumer Financial Protection Bureau requires more information transparency from banks in their communications with customers. However, despite apocalyptic predictions from bank spokespeople, it is notable that banks with under $10 billion in assets are exempt from its rules. This excludes the small and medium-sized lenders that make up 98% of U.S. banks, but does include the large proportion of the industry run by the majors.
Sources: Congressional Oversight Panel, Small Banks In the Capital Purchase Program, July 14, 2010; Eric Dash and Nelson Schwartz, “Banks Seek to Keep Profits as New Oversight Rules Loom,” New York Times, July 15, 2010; Aaron Lucchetti and Jenny Strasburg, “What’s a ‘Prop’ Trader Now?—Banks Move Those Who Wager With Firms’ Money to Client-Focused Jobs,” Wall Street Journal, July 6, 2010; Randall Smith and Aaron Luchetti, “The Financial-Regulation Overhaul,” Wall Street Journal, June 26, 2010; Damian Paletta, “Late Change Sparks Outcry Over Finance-Overhaul Bill,” Wall Street Journal, July 2, 2010; Michael Phillips, “Finance Overhaul Casts Long Shadow on the Plains,” Wall Street Journal, July 14, 2010; “Killing Them Softly,” The Economist, August 26, 2010; “Not All On the Same Page,” The Economist, July 1, 2010; Eric Lichtblau, “Ex-Regulators Get Set to Lobby on New Financial Rules,” New York Times, July 27, 2010.
Basel Faulty
The Basel III bank guidelines are meant to be the G-20’s coordinated global response to the crisis of 2008, establishing consistent rules limiting banking risk. But like the American bill, the lightweight standards were greeted by stock jumps for the bank majors, since the process was heavily influenced by massive financial industry lobbying and other, nationalist factors.Perhaps most notably, the biggest banks’ minimum leverage ratio—how much hard capital banks must hold to cushion against sudden losses—has been set at a modest 7% of assets. However, banks need not meet this requirement until 2019, with only a 2.5% requirement by 2015. Further, the Basel Committee has caved to industry demands to count assets like deferred-tax funds, mortgage-service rights, and investments in other firms as capital. These are now allowed to make up 15% of a bank’s capital cushion, despite being illiquid and thus not very helpful in a crisis. Notably, some U.S. megabanks had reserve levels close to these on the eve of the finance crisis, and of course found them to be insufficient.
A related issue is how much long-term funding (vs. short-term bonds) the banks issue, making them less-vulnerable to sudden credit-market lockups as in 2008. The committee failed to reach agreement on this issue, and the rule has been postponed until 2015, along with many others, including “calibration,” the specific required reserve level banks must maintain based on their importance to the overall finance system.
One obstacle to progress is the distinctly nationalist approach taken by the regulators, who aim to minimize the weight of regulations that will affect the banks based in their home countries. The United States has pushed aggressively for broader definitions of capital, since U.S. banks still hold large volumes of mortgage-securitization rights. Germany wants “flexible” enforcement of the reserve requirements for its undercapitalized banks; France wants allowances for its banks to continue to own insurers, and so on. The result is banking regulators fighting tooth and nail against regulating their own banks.
In this way, the standards meant to prevent banks from reverting to their old systemically risky ways have been heavily diluted, diminishing Basel to a fig leaf. As the Wall Street Journal accurately predicted, “significant moves by the Basel Committee to back away from its initial proposals…[are] likely to provoke criticism that regulators are caving to industry pressure and missing a chance to impose restraints that could reduce the risk of future costly crises.”
Sources: Damian Paletta and David Enrich, “Banks Gain in Rules Debate,” Wall Street Journal, July 15, 2010; Damian Paletta and David Enrich, “Risks Rulebooks Is Nearly Done—Key Aspects of Banks’ New Restraints Are Agreed Upon,” Wall Street Journal, July 27, 2010; Damien Paletta, “Banks Get New Restraints,” Wall Street Journal, September 13, 2010.
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