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The Crisis of Confidence and the Banks
September 16, 2008

The Crisis of Confidence

"In the autumn of 1929 the mightiest of Americans were, for a brief time, revealed as human beings. Like most humans, most of the time, they did some very foolish things. On the whole, the greater the earlier reputation for omniscience, the more serene the previous idiocy, the greater the foolishness now exposed. Things that in other times were concealed by a heavy façade of dignity now stood exposed, for the panic suddenly, almost obscenely, snatched this façade away. We are seldom vouchsafed a glance behind this barrier; in our society the counterpart of the Kremlin walls is the thickly stuffed shirt… I have never adhered to the view that Wall Street is uniquely evil, just as I have never found it possible to accept with complete confidence the view, rather more palatable in sound financial circles, that it is uniquely wise."

John Kenneth Galbraith
The Great Crash
Houghton Mifflin (1954)

The IRA is on the road this week, visiting Wichita, KS, to participate in the annual conference sponsored by LendingTools.com, "New Visions in Correspondent Banking."

One of the nice things about visiting the American heartland is that you realize that Middle America has largely missed the ill-effects of the real estate bubble and the wonders of complex structured finance. Real estate markets outside of the two coasts did not rise nearly as much as the overheated markets on the nation's periphery and thus have less distance to fall in order to adjust.

For reading on our trip, we chose Galbraith's commentary on the Great Crash of 1929 quoted above.  Reading this book again after nearly 25 years is a rather chilling experience. Change the names of people and securities, and the dates, and the account of Galbraith could be published in a newspaper today describing the fall of Bear, Stearns, Lehman Brothers or Merrill Lynch (NYSE:MER).

And our favorite chapter: "In Goldman Sachs We Trust," a scathing comment by Galbraith on how the masters of the universe at Goldman Sachs (NYSE:GS) sponsored trusts such as Blue Ridge and Shenandoah, speculative Ponzi schemes that made the market collapse of October 1929 far worse than it would otherwise have been.

There has been a huge amount of commentary on the fall of Lehman, the fire sale of MER and the impending demise of AIG (NYSE:AIG).   In each case, we see firms that are arguably still solvent, but increasingly illiquid. Driven into panic by a noxious combination of leverage, fair value accounting, hedge fund bear raids and incompetence in Washington, all manner of financial institutions are now on the defensive.

Some observations:

First, the demise of the GSEs and now the monoline investment banks, those dealers not affiliated with a commercial bank, may be considered the appetizer and soup courses of this dismal meal. The main event now approaches, namely how Washington will deal with the impending illiquidity of some of the nation's largest depositories. Led by wounded soldiers like Washington Mutual (NYSE:WM),  there are many US banking institutions that are under stress but still solvent, and require only additional capital to see themselves through the next 2-4 quarters of loss. Once the private markets are able to estimate the likely peak loss rates of such institutions, then a flow of new capital can and should enter the system to recapitalize these banks.

The question is, how to get from here to there without forcing some of the largest, most visible banking industry names into an open and very messy liquidation that can only further erode the public trust in our banks and the governmental agencies charges with their safety and soundness. Does anybody really believe that the market for Treasury and agency debt would survive the collapse of a major bank or another primary dealer?

Second, we as a nation need to distinguish between our free market rhetoric and the financial reality forged over more than three quarters of a century since the Great Depression. Commercial banks are GSEs, as our friend Alex Pollock at AEI likes to remind us. Just look at the liabilities of commercial banks and count the federal guarantees and subsidies that make banks appear profitable and liquid. 

Watching our friend Larry Kudlow and other American conservatives beat their chest and profess undying loyalty to the goddess of free market discipline is all fine and well, but the fact remains that we live in a largely socialized economy.  Since the 1930s, when we substituted government regulation for personal responsibility when it comes to ensuring bank safety and soundness, Americans have lived in a system where financial institutions are already supported by government guarantees and liquidity facilities.  The public/private business model of US commercial banks is the best example of that Depression-era compromise which was struck between the traditional American ideal of free market discipline and the outright communism advocated by many of the New Dealers who surrounded FDR.

Third, by telling Americans that their deposits were insured by the federal government, Washington desensitized generations of Americans to risk from bank failures. Now that risk is apparent and menacing to many Americans with deposits above the $100,000 FDIC insurance cap, as reflected by the user traffic on the IRA web site.  Not only have we seen the search requests on our site over the past six months shift from large, publicly traded banks to smaller private banks, but the volume of search requests on our demonstration tools has risen five-fold and continues to rise.  We interpret the changes in traffic patterns on the IRA web site as growing evidence of a slowly but steadily building retail bank panic. Older Americans particularly are running scared, pulling funds out of still solvent and safe institutions for fear of losing their retirement nest eggs.  Consider this email we received yesterday from a reader of The IRA who lives in NC:

"The run on the banks that you mentioned as a concern later in that article is closer than I think anyone realizes. And I wasn't surprised at all to hear you talk about this. I am a 44 year old woman with four and half years of college and a private school education. I have a job for the moment making $11.00 an hour, $8.00 an hour less than I did just five years ago. I took it out of desperation after looking for work for six months last year. I have been living hand to mouth for the first time since I was 20-something. That job is ending in a couple of weeks - I took it in February; it ends in October. My fiancé is out of work right now as well, and having zero luck finding work. I have already bought two homes in my life, but I don't have a mortgage now because I couldn't possibly afford a house on what I make, so I guess I'm lucky there. Sarcasm tinged with reality. Take my situation, mix well with job loss and skyrocketing gas prices (over $1.00 per gallon in Asheville, NC since last Friday) and I just may have to walk to my new home under the bridge. So, yes, I'm considering pulling what tiny bit of money I have out of the bank, as are far more people than I think anyone realizes. Of course, I understand this would cause the entire country to fall down around our ears, but in these times choices are grim and few. Do I leave my money in there day after day hoping each morning it will be there so I and millions of others don't cause the very collapse we're afraid of? How am I supposed to manufacture that kind of faith? Will the collapse happen anyway and then my money will just be gone? What are we to do?"

This is just one of dozens of emails, telephone calls and letters we receive each week, a cry for help from an American who has lost faith in the US economy, our political leaders and our financial system. Keep in mind that IRA has no advertising other than our comments and media appearances, yet we are selling dozens of our IRA Bank Reports every day. Two months ago, we did not have any retail customers. Today we have several thousand retail users of The IRA Bank Report.

Fourth, with the volatility of bank deposits and debt rising, financial institutions all over the world are being forced to change their business models. Banks from Oslo to Manila are increasing cash and equivalents, and decreasing lending and assets, all in the name of maintaining liquidity. Whether under attack by hedge funds or fleeing retail depositors, no depository, solvent or not, can survive a sustained bank run, whether by retail depositors or institutional clients.  This contraction in credit by comercial banks is affecting the entire global economy and threatens to turn the US recession into a prolonged period of no growth or outright reduction of economic activity.

So what is to be done? Recalling the advice years ago of Federal Reserve Board Chairman Arthur Burns to a fellow we know named Richard Whalen, we'll number our points:

1. The Fed, Treasury and Congress need to immediately devise and announce publicly a plan to backstop the FDIC with up to $500 billion in borrowing authority to meet the agency's cash needs required to close and/or sell insolvent banks.  While the FDIC already has a credit line in place and this figure may seem excessive - and hopefully it is - the idea here is to overshoot the actual number to reinforce public confidence. Simply having Treasury Secretary Hank Paulson or Ben Bernanke making hopeful statements is inadequate. Like it says in the movies: "Show us the Money."

2. The Treasury needs to immediate seek authority from Congress to inject capital into solvent banks that are temporarily unable to raise new capital. While the capital adequacy screens available to users of The IRA Bank Monitor do, we believe, closely track the FDIC's problem bank list of 120 or so institutions below one of the three capital thresholds, there are 10x that number of banks currently under stress that could easily survive. The calculus that must be weighed is how much damage will be done to all banks, solvent or not, should the government refuse to act due to some illusory belief that we are a pure free-market economy. Again, commercial banks are GSEs.

3. The Fed and OCC should publish ASAP new guidelines for investors seeking to take significant positions in US banks and bank holding companies. These rules, as we discussed in an interview with Ernie Patrikis ("A Change in Bank Control: Interview With Ernest Patrikis," July 9, 2008),  should allow investors to take control positions with board representation without the excessively restrictive rules imposed by the Fed on bank investors in the past. As a practical matter, does the Fed staff really believe that investors will invest billions into wounded commercial banks without board representation?

The good news is that there are a growing number of funds of various descriptions that are waiting to move new capital into the banking system.  But until loss rates stabilize and visible capital losses slow, determining the valuation for a bank recap is difficult to impossible. But if Paulson & Co at the Treasury are smart and subtle, it may be possible to provide a bridge between the current illiquidity facing a growing number of otherwise solvent banks and an infusion of private capital that can reverse the industry's present rate of balance sheet contraction.

Unless the US authorities move quickly to stem the tide of fear and worry that we see manifest in the growing number or retail users of The IRA Bank Reports system, we believe that the US could be facing a full-blown banking crisis before the end of the year - indeed before Election Day.

So far, we believe that Paulson and Bernanke deserve credit for moving quickly to deal with the problems of the GSEs and the annihilation of the monoline broker-dealers - a process that may well consume GS and Morgan Stanley (NYSE:MS).  But if they wish to avoid the mistakes committed by their predecessors in the 1920s, mistakes that were comprised largely of doing too little too late, then further decisive action may be required.

As President Herbert Hoover wrote in his memoir regarding speculation: "There are crimes worse than murder for which men should be reviled and punished."  Among them are inaction when our entire nation desperately needs a sign that Washington understands the true dimension of the problem. 

Questions? Comments? info@institutionalriskanalytics.com

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