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Is ‘Too Big to Fail’ Our Worst, Best, and Only Option?

Posted by Larry Doyle on August 12, 2009 4:53 PM |

High five to Always Learning for pointing out that not unlike the disparity in the housing and mortgage markets, the banking industry is truly a tale of two systems. Those systems being institutions deemed ‘too big to fail’ and everybody else. I am increasingly concerned about this very prospect. Why?

The largest institutions are now married to Uncle Sam, whether either partner likes it or not. Certain of these marriages (Citi and BofA) are more formal while the balance are more ‘friends with benefits.’

What about the small fry banks struggling with loan books that continue to bleed money but without the capital market activities to generate the gift-like earnings supported by the totally accomodative Federal Reserve? What does the future hold for these institutions?

First and foremost, a significant number of these banks are burdened by rising delinquencies and defaults in their commercial, construction, corporate, and residential loan books. As Bloomberg highlights in writing, TARP Panel Says Smaller Banks May Need Fresh Capital:

Regional and some smaller U.S. banks may need $12 billion to $14 billion in additional capital to cope with troubled loans still on their books, the Congressional Oversight Panel said today in a monthly report.

The panel, which reports to lawmakers and was created to monitor the $700 billion Troubled Asset Relief Program, said the biggest U.S. banks appear prepared to handle more loan losses, particularly the 19 banks that regulators put through stress tests earlier this year. Banks with assets of $600 million to $100 billion may face bigger challenges, the panel said.

My gut instinct tells me that the $12-14 billion figure for banks beyond the top 19 is likely low. That said, where may these institutions raise this capital? One of three places:

1. Private equity, which recently is being severely constrained by restrictive covenants and capital commitments made by the FDIC.

2. New issuance of equity, which depending on the institution’s health may be doable or not.

3. Acquistions or asset sales. Who are the likely buyers?  The banks which are currently TOO BIG TO FAIL. What does this mean? These institutions are only getting bigger and riskier.

What may drive these situations? The fact that the PPIP (Public-Private Investment Program) and TALF (Term Asset-Backed Loan Facility) are having very little true positive impact in helping banks liquidate troubled assets. Why? Banks do not want to take the immediate hit to capital required to find clearing prices.

Bloomberg weighs in on this topic by reporting:

Banks of that size “will need to raise significantly more capital, as the estimated losses will outstrip the projected revenue and reserves,” the report said, citing its own loan analysis. The panel is led by Elizabeth Warren, a law professor at Harvard University.

“We haven’t really resolved this problem” of illiquid assets on bank balance sheets and “it’s more acute for the small banks,” she said in an interview on Bloomberg Television today. The panel “has repeatedly called for more stress tests” that apply more rigorous reviews of capital levels under adverse economic scenarios, she said.

The report said the Treasury and other regulators should do more to help smaller banks deal with whole loans on their books. The Treasury and the Federal Deposit Insurance Corp. program have shelved the Legacy Loans Program, intended to use a combination of public and private funds to buy loans from banks.

As time goes by, the larger banks are gaining the upper hand within the industry and with Uncle Sam. The risks are growing in the process.

If our regulators were not capable of managing these institutions in the past, how will they manage them in the future?

LD

  • lizzy

    Great article LD. The Bloomberg report gave some great information. There is an interview with Elizabeth Warren posted at Zero Hedge. She mentions the impact of the mark to market rule change and the expected increases in defaults from commercial loans.

  • kbdabear

    Link for video of Elizabeth Warren’s interview on MSNBC

    http://www.zerohedge.com/article/elizabeth-warren-we-have-real-problem-coming






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