Friday, November 27, 2009

The Coming FDIC Crisis

(Editor's Note: Paul Schatz, President of Heritage Capital, LLC, in Woodbridge, will be contributing to Fi$callyFit every Friday. Read his biography here)

I am often asked how I can be positive on the stock market, yet so negative on the economy. As I’ve discussed before, the stock market’s rally is based on liquidity, meaning a tsunami of money flooding the financial system needing to find a home. I absolutely do not believe it’s based on sound and well thought out fundamental policy and systemic changes. This was my main theme in two CNBC interviews. (Click Here to Listen) They are the first two listed on the page.

My ongoing concerns are the same ones I’ve had all along. The global financial system cannot stand on its own two feet without government support, intervention and manipulation. At some point, the free money ride will end without private investment being able to take its place. That’s when the house of cards crumbles again. The Federal Reserve and Treasury used the vast majority of their immense arsenal to stem the tide in 2008 and 2009. I doubt they will be able to have the same affect next time.

One area I want to spend some time on today is the FDIC, the agency that insures member bank deposits, now up to $250,000. Along with Ben Bernanke, I believe Sheila Bair, the FDIC chairman, deserves very high marks for her handling of the financial crisis. When so many “experts” were running around with their heads cut off, she remained firmly in control, offering multiple plans on how to stem the tide and attack the crisis head on. As things began to stabilize her agency also offered some quality suggestions on proposed regulatory reform.

On Nov. 24, the FDIC (Federal Deposit Insurance Corp.) released its Third Quarter Report on member banks. It’s no secret that we are seeing more FDIC-led bank takeovers than at any time since the Resolution Trust Corp (RTC) was created to help solve the S&L Crisis in the early 1990s. So far in 2009, there are 95 insured institutions that have failed in the third quarter alone. Any time the FDIC comes in for a “rescue”, it usually means that its own capital must be employed to shore up the bank’s reserves. With its coffers already stretched to the dangerous level, another major financial problem is brewing.

If I really believed the economy and financial system were healing correctly, I wouldn’t worry so much about the FDIC. But since I don’t, and the number of “problem” banks is up to 552 ($345B) from 416 in June, some drastic measures will likely be taken. First, the FDIC can tap an emergency line of credit with U.S. Treasury, something that Sheila Bair doesn’t seem too keen on doing. Second, the FDIC can issue fixed income instruments, like bonds and notes and borrow from investors.

Currently, the FDIC is requiring banks to prepay the next three years of fees to help shore up the agency’s own capital base without having to resort to more draconian measures. While I applaud Sheila Bair’s efforts at trying to fix this with minimalist intervention, the problem is that the FDIC will take capital from the banks when they can least afford to give it up. The process of recapitalizing banks will likely take a good decade or so, but we’ll continue to see more banks fail along the way. Prepaying fees with so many institutions still capital starved will only make credit harder to come by, which is the perfect segue to the next problem.

Perhaps the most troubling thing about our banking system is that credit continues to shrink at an historic rate. In the very first sentence of the FDIC’s report, they start with the good news that member banks are making a lot of money. How could they not? If you own a bank and can borrow at essentially 0% to either loan out or invest in something paying 2, 3 or 4%, how can you lose? Add leverage into that equation and the banks essentially have a license to print profits in this environment, exactly what the Fed, Treasury and FDIC need them to do.

At the end of the first sentence, they give us the really bad news, “but loan balances declined by the largest percentage since quarterly reporting began in 1984.” According to Casey Research, bank credit has fallen by $500 billion over the past year. Think about it. That’s half a trillion dollars no longer available for lending and growth. It is nearly impossible for the economy to achieve a sustainable recovery without credit flowing freely. Almost every small business I visit or speak to share their frustration in trying to obtain a loan or line of credit. Since small business is the backbone of our economy, this doesn’t speak well for future organic growth.

The FDIC is in a very tough position, but they’re only one of the problems we face. Until we get the financial system stable and entice private capital back in, whatever growth we are currently seeing is only temporary. With state and local tax receipts falling off a cliff, the various governments need to get their own financial houses in order immediately. That means cutting unnecessary spending and keeping taxes as is or cutting them. Raising taxes without real economic growth will have disastrous implications. Tax incentives must be given to small businesses and entrepreneurs to hire workers and encourage growth. With all of our problems, there is one positive thing I am certain about. This country, economy and financial system has successfully emerged from every single crisis in our history. And this one, too, shall pass with time.

I wish you and your family a very happy, bountiful and peaceful Thanksgiving!

Until next time…

Paul Schatz

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