Bernanke and Paulson Shocked US Legislators: Now Banking Conditions Justify The Meeting’s Sense of Urgency

In the offices of House Speaker Nancy Pelosi, FED Chairman Ben S. Bernanke and former Treasury Secretary Henry M. Paulson told a gathering of astonished US Senators and Representatives the financial system of the US, and perhaps the world, was on the cusp of tightening into a knot of illiquidity.

The nighttime emergency meeting occurred in late September, but the problems voiced there are becoming more obvious every day.

David M. Herszenhorn of the The New York Times reported the tone of the meeting:

  • Senator Christopher J. Dodd said, “Somber doesn’t begin to justify the words, we have never heard language like this”;
  • “When you listened to him describe it you gulped,” added Senator Charles E. Schumer, referring to Chairman Bernanke’s remarks;
  • Senator Christopher J. Dodd summarized the message–“We’re literally days away from a complete meltdown of our financial system, with all the implications here at home and globally.”

Chairman Bernanke and Secretary Paulson Demanded Action

The federal officials emphasized then and on days following that if Congress did not act decisively and rapidly, the wheels of America’s credit markets could come to a grinding slowdown that could spread to other countries.They explained an overextension of credit and securitization of sub-prime mortgages worldwide had set off accelerating mortgage foreclosures, personal bankruptcies, and rising nonperforming bank loans that were freezing bank credit worldwide.

In response, Congress cobbled together and President George W. Bush signed the $700 billion “Troubled Asset Relief Program” (TARP) legislation, which is being used mostly for injecting money into ailing banks and removing toxic securities from the portfolios of lending institutions. In addition, Congress passed an $838 billion economic stimulus bill, to counteract the expected contraction from shuttered capital markets.

 

Key Banking Benchmarks Show Deteriorating Banking Conditions

Skeptics abound that the federal reaction so far is overkill and will create a $3 trillion federal deficit and actually worsen the situation. They accuse the financial officials of crying “Wolf!”

However, key measures related to allowances set aside by banks for insurance against loan and lease losses show there is solid evidence the banking dysfunction the Washington officials warned of is real. Insurance against loan losses is shrinking.

From the end of 2007 until December 2008, a severe deterioration occurred in the portion of banks whose Allowance for Loan and Lease Losses exceeded their Nonperforming Loans. Yet, ominously, nonperforming loans are on the rise.

Super Bank Conditions Are Especially Troublesome

Although the condition is much more prevalent among super banks–those with assets in excess of $20 billion–this deterioration endangers the whole system and suggests more mergers will have to be arranged by banking authorities soon. By 2008 yearend, the ratio of adequate allowances for loan losses in super banks had plunged to 18.08 percent, based on banking assets in that size category. On the other hand, medium-size banks of $10-20 billion in assets and small ones with up to $300 million are in better shape. Among the former, the adequate allowance ratio is 45.44 percent, while the latter’s ratio is 50.37 percent.

For all banks, the collapse is an eye-opener. The climactic drop began at the current recession’s outset in December 2007, when only 50 percent of banks maintained adequate reserve allowances. That ratio sank to nearly 24 percent by the end of 2008.

Inadequate Allowances Put Depositors and Stakeholders at Risk

Such reserve shortfalls put deposits and equity capital of many banks at risk, for if allowances are not adequate to cover losses, some losses must be charged to income. Actually, the 50 percent mark of December 2007 was low, historically. During most of the 1995 to 2005 period, the ratio was above 90 percent.

In terms of the adequacy of allowances for loan losses by regions, a surprisingly large spread exists. Among banks with $1-10 billion in assets, New England institutions rank highest, with nearly 85 percent maintaining adequate allowances. The East North Central region, which includes the industrial Midwest, ranks lowest, with coverage by 21 percent. New York banks are in the Middle Atlantic group, with 61.41 percent. (chart 5).

Similar Results Expected in 2009 First Quarter

When conditions for the first quarter of 2009 are reported, this imbalance likely will persist. Loan charge offs for banks doubled in 2008, rising from 0.5% to 1.0% of total loans, according to the St. Louis Federal Reserve Bank. It is clear keeping up with accelerating charge offs puts a strain on bank managements’ ability to maintain allowances for nonperforming loans.

In a perfect world, 100 percent of banking assets would be in banks whose allowances adequately cover nonperforming loans and lease losses. But as Secretary Paulson and Chairman Bernanke told Congress so emphatically that chilling night in September, this is not a perfect world.