Bernanke and Paulson Shocked US Legislators
Now Banking Conditions Justify The Meeting's Sense of Urgency
May 4, 2009
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.
On September 19, 2008, David M. Herszenhorn of the The New York Times reported on the substance and tone of the meeting. According to his article:
- 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, on October 3, 2008. Those funds are being used mostly for injecting money into ailing banks and removing toxic securities from the portfolios of lending institutions.
Key Banking Benchmarks Show Deteriorating Banking Conditions
As though illustrating the underlying problems, 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. The Federal Reserve Bank of St. Louis reports in its "Condition of Banks" report, updated February 26, 2009, that allowances for bad debts are 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. (Chart 1.)
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 year-end, the ratio of adequate allowances for loan losses in super banks had plunged to 18.08 percent. (chart 2.)
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. (charts 3 & 4.)
For all banks, the collapse is an eye-opener. The slide began at the current recession's outset in December 2007, when 50 percent of banks maintained adequate reserve allowances. That ratio sank to nearly 24 percent by the end of 2008. (chart 1.)
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, those 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).
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.
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Chart Legend: ALLL=Allowance for Loan & Lease Losses; LLRNPT=Loan & Lease Reserve for Nonperforming Loans. Chart 5 by HBB.
The writer is a Chartred Financial Analyst.
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