"The System should always be engaged in a ruthless examination of its past record."

William McChesney Martin
Federal Open Market Committee Minutes
November 26, 1968

"Federal Deposit Insurance Corp. Chairman Sheila Bair told lawmakers that 500 more banks are at risk of failure "unless something dramatic'' happens, Senator Jim Bunning said. Bunning, a Kentucky Republican, said at a Senate Banking Committee hearing today that he had "just'' left a meeting with Bair in which she made the statement. An FDIC spokesman, Andrew Gray, disputed Bunning's recollection of the meeting. "In both public and private settings, the chairman and the FDIC is always careful to not make predictions on the number of upcoming bank failures,'' Gray said in an e-mail. "No estimate" was given during the meeting, which took place last week, Gray said. "We would regret any miscommunication, but she did not say that," Gray added."

Dawn Kopecki
Bloomberg News
July 16, 2009

The quotation from Federal Reserve Board Chairman William McChesney Martin above comes from a paper by Bob Hetzel, "Monetary Policy in the 2008-2009 Recession," that is featured in the August 2009 edition of FRB Richmond's Economic Quarterly. He argues that contractionary monetary policy, not the propagation of shocks through dysfunction in credit markets, accelerated the economic downturn.

And our colleague Dawn Kopecki of Bloomberg News continues her relentless reporting on the financial agency beat as per the excerpt above. The official troubled bank list is still well below 500, but our Stress Index ratings survey suggests that the troubled institutions are closer to 1,000. Click here to see the IRA press release showing the aggregate distribution of the IRA Bank Stress Index scores as of Q1 2009. But in whichever camp you may be, over or under the 500 troubled banks suggested in the Bloomberg story, we look for more banks to be resolved in 2H 2009 than in the first half of the year as we try to find the bottom of the recession.

Kopecki also reports today on something called the "The New Democrat Coalition," a group of 69 democratic lawmakers that describes itself as moderate and pro-growth, and is pushing alternative legislation for regulating OTC derivatives. Looks like we've found yet another data point on the relevance of entropy as a descriptive model for human action, this time in the fragmentation of the two major political parties.

And was that our very own Senator Nancy Pelosi (D-CA) choking on the idea of taxing "the rich" to pay for socialized health care? In terms of political risk to Barack Obama's agenda, this party ain't even started yet.

Yesterday the IRA Advisory Service added Marshall & Ilsley Corp (NYSE:MI) to our coverage with a "neutral" outlook. We are ever looking to be constructive, but we just don't get the feeling that MI management have any more visibility on peak loss rates than does Bank of America (NYSE:BAC) CEO Ken Lewis. The BAC chief gave a good overview of the credit markets and future loss rates in his remarks last week and, in fact, kind of reminds us of something we read a year or so ago in The IRA.

Back in December of last year we talked about MI in The Institutional Risk Analyst ("On the Prime Solution: Interview with Eric Hovde', December 11, 2008). Banker and ibanker Eric Hovde called MI a survivor among the regionals because of their willingness to take foreclosed properties "to the curb" in toxic housing zones such as AZ. That state ranked second only to Nevada in home foreclosures for the first half of 2009, according to the foreclosure listing service RealtyTrac Inc.

This week we tell subscribers to the IRA Advisory Service why we can't get that excited yet about MI and other smaller lenders - much less the crippled zombie money centers. Fact is, the reaction from the Washington political class has been to borrow and spend more on building political legacies (aka "stimulus") rather than to remake the largest and most problematic commercial banks. Thus the forward outlook on the top four names remains doubtful, in our view, especially excluding official subsidies and accounting effects.

Reflecting the simulated view of the top financials, Joe Kernan of Squawk Box on CNBC said to us the other day that "We would own all the big banks if we'd listened to you." We didn't have the heart to tell him the truth on air. "We do own them Joe," is what we should have said. Look at the growth of interest income vs. interest expense in the top four money center banks and you see your tax and monetary dollars hard at work.

The go slow approach to dealing with the zombies is not much help for the real economy, which is represented by real assets on the books of real banks, many of which have stopped lending. The policy of extend and pretend followed by elected officials "trickles down" from Barack Obama to your governor and mayor, delaying the necessary adjustment to the US financial system and increasing the financial and social cost of the cleanup. This cost is especially acute as it effects small business because contracted credit markets discriminate based on size above all.

Most of our readers know that Main Street has been feeling the credit squeeze for over a year. The remarkable thing about CIT's financial crisis was that it took until July of 2009 to actually emerge as national news. We've been watching a steady stream of sales talent leaving CIT for months in the CA finance community, a sure sign that no new business was being written. But now, at least, we are talking about the creditors/owners picking up the ball and recapitalizing the company. Debt for equity swaps will work as well for Citigroup (NYSE:C) as CIT.

As we get ready to head for Leen's Lodge for the Shadow Jackson Hole fishing trip and economics conclave, the question of the number of failed banks comes to mind. Our wager was 250 banks resolved in the year ended July 2009 and $800 billion in failed assets. We are clearly low on the number of institutions resolved, but pretty close on the $800 billion in assets resolved if we include Wachovia Bank and Washington Mutual. In both cases, the FDIC was driving the sales process and had open bank assistance in place with the former. We'll have to await the ruling from David Kotok.

Speculating on the fate of any depository is no joking matter and one with profound political consequences. One reason that the body count is not higher is that local politicians and regulators are resisting calls to restructure dead banks. They rightly fear that jobs and financing will never return to local communities once these charters and branches are lost. As we discussed with Ed Kane in a recent interview, there is always a complex web of political and human relationships around the operation of financial institutions.

Citigroup: Restructuring, Resolution and Rebirth

The "too big to fail" banks are so in part because their disruption affects so many employees as well as customers and regulators at the state and federal level. The most prominent example of extend and pretend is Citi, an institution that is one of the biggest employers in the NY/NJ/CT area. You can bet that NY Mayor Mike Bloomberg, Senator Charles Schumer (D-NY) and other NY officials are not clamoring for prompt corrective action at C - this on top of the severe job and spending cuts already taken by the Citi organization.

On a bank level basis, the efficiency ratio of C fell into the 40% range in Q1 2009 from the 60% range at year-end 2008 and historically, a huge reduction in operating cost that suggests a very troubled institution preparing for further stress. The Q2 2009 earnings release confirms that C has delivered a 21% decrease in operating expenses YOY.

Net Credit Losses or NCLs at C were 588bp, are already well-above early 1990s peak levels and likely to climb further during 2009. Compare NCLs at C to the Q2 2009 charge-offs at Wells Fargo (NYSE:WFC) of 211bp and you see why we've long reminded all who will listen that each money center business model is different. We'll be opining on the WFC results as well as US Bancorp (NYSE:USB) in the IRA Advisory Service.

To our earlier comments about risks from securitizations, note that C wrote down revenue over $3 billion due to losses from securitization activities, double the year before. BAC also wrote down significant amounts from top-line revenue due to losses from maturing securitizations. No similar line item on securitization expense from WFC. WFC officials told The IRA today that they were not aware of any such expenses.

Bottom line on C is that we expect to see more management changes and less chatter from the CSUITE about the cosmic positioning of various regulatory agencies. When Ned Kelly starting yowling about the FDIC a while back, we cringed for this fellow ibanker who probably did not understand (or even know) about the term "open bank assistance."

When your bank has a loss sharing agreement, FDIC debt guarantees and other "open bank" assistance in place, anybody with an FDIC logo on their card is either "Sir" or "Mam." Comments to the media about the agency's relevance are discouraged.

We have confidence that chief accountant John Gerspach, who became the bank's fifth finance chief in five years by replacing Kelly, will be sufficiently adept at presenting the bank's financials. Kudos to CEO Vikram Pandit for accepting a problem existed with Kelly and fixing it by promoting him, but Kelly never should have been put into the CFO slot to start with. Again, governance seems to be the weak point at C.

More impressive was the fact that C also hired banking veteran Eugene McQuade to become chief executive of Citibank NA and head the North American retail-banking unit. Should McQuade eventually succeed Pandit as CEO, that would mark the first time in almost two decades that the C was headed by someone with strong bank operating credentials. And just in time for the corporate coming out (again) party.

As we told David Faber on CNBC last Friday, the future of C is "restructuring, resolution and rebirth." Pandit and his team are already changing the risk profile of the company significantly. But we continue to believe that the interest rate and other subsidies will be insufficient to prevent C from needing future cash capital injections, not the window dressing underway by converting preferred stock to common. As charge-offs for C and other money centers grow, extend and pretend will give way to restructuring for financials, corporate obligors and a growing number of municipalities and even states.

The good news is that we expect to see the "Three Rs" operate at C sooner rather than later, if only so that federal regulators may restore the credibility of resolution with respect to large banks. Once the toxic assets have been sold and the company has been restructured via a debt equity swap, C will be the most competitive large bank in the US and will provide an example to other institutions as to the way out of the economic swamp called "buying time."

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