Archive for the ‘panic of 2008’ Category

Bad Ideas Result in Bad Outcomes

October 7, 2009

As regular readers know, I’ve been away from blogging for a bit while I’ve been in the middle of a job transition. In my month-long hiatus, it seems like little has changed: the health care debate continues, the deflation/inflation and economic outlook remains uncertain, and the stock market continues to “climb a wall of worry.”

As the immediacy of the financial crisis recedes, the question of what has brought us to our present state remains largely unanswered. Or rather, there are dozens of answers, not THE ANSWER.  Among the myriad causes that are put forth: the Fed, Wall Street greed, deregulation, excessive regulation, Chinese savings rates, the Democrats and the Republicans. In past posts, I’ve added my 2 cents by pointing to the culture of “overspeculation.”

Fundamentally, bad outcomes are generally the result of either bad luck, bad ideas, or some combination of the two.  It may well be that the “bad idea” from which our financial upheaval arose is the belief that homeownership is an unequivocably good thing.  I came across a prescient 2004 article in BusinessWeek that outlined some of the reasons why home ownership is not as advantageous to the poor:

  • a house is often a poor family’s sole investment: concentrating their assets in an a vehicle that combines the historically lackluster long term returns of housing with the high risks of leverage
  • the poor have a higher “cost of carry” in home ownership than the wealthy, because they often pay higher interest rates and their lower tax rate reduces the effective subsidy of a mortgage deduction
  • while a mortgage was once considered a means of “forced savings,” the growth of easy-to-obtain home equity lines, interest-only and negative amortization mortgages all have negated the (already dubious) savings argument

British economist Andrew Oswald has noted the correlation between high unemployment and high home ownership.  Although more recent work has created a more nuanced interpretation of that relationship (good overview in a Slate article here), this “Oswald Hypothesis” clearly has at least a grain of truth.  The theory argues that home ownership makes people “sticky” geographically, and therefore less likely to move to find a job or better employment.  This may be particularly true for the poor given that “borderline” housing is typically already less liquid than homes in upscale neighborhoods, further reducing labor mobility.  This lack of salability in poorer neighborhoods is particularly acute in economic downturns, just the time when geogrpahic flexibility for workers is most important.  

Those who defend policies that promote broader home ownership often point to social benefits — homeowners have a sense of “skin in the game” of American society.  These arguments are no doubt true and important.  But the advantages of reinforcing such a sense of inclusion should be weighed against the costs.   Moreover, there other ways to promote engagement with community without the consequences attached to distorting housing market incentives.

This is not necessarily to argue against such incentives for home owners.  Certainly, I and many others personally benefit from many of these.  But every policy that distorts market mechanisms has consequences, many of which are unintended and adverse.  We may not yet be through thoroughly testing the “Oswald Hypothesis.”  If that theory is correct, current real estate conditions, whereby many homeowners have negative equity, will make labor mobility particularly poor this cycle.  This, in turn, would suggest particularly intractible rates of unemployment and consequent sluggish economic growth.  If blind faith in the “goodness” of high home ownership rates is indeed a bad idea at heart, we may not yet have seen all the corresponding bad outcomes.

Fundamental Misconceptions in the Speculation Debate

July 29, 2009

Today’s Wall Street Journal features a misguided editorial blasting the CFTC for considering constraints on oil speculation.  The piece serves as a good reminder of how often those schooled only in the stock and bond world misunderstand the function of the futures market and the role of speculators within that arena.  The Journal’s editors and others are trying to apply the rules of those capital markets to contract markets like commodity futures.  This makes no more sense than trying to play a game of baseball by the rules of football.  In real life, as in the sports analogy, playing by the wrong rules leads to chaotic consequences.

Misconception #1: who should determine price?  In the capital markets, speculators and investors determine the price of securities.   This is not the way the commodity futures markets are supposed to operate.  Commodities are consumables, not investment vehicles.  Economic efficiency demands that the price  be determined by those that produce or  use these resources.  The role of the speculator in price discovery should only be on the margin, testing the limits to see when commercial demand or supply enters the market.  Speculators in these markets should not be the primary determinants of price. 

“Overspeculation” or “excessive speculation” exists when speculators become primary drivers of price.  When this happens, commodities are no longer efficiently allocated —  if prices are driven below the point where commercial supply and demand meet, shortages result.  When prices are driven to excessively high levels, economically wasteful inventory buildup is created; Nobel laureate Paul Krugman recently reversed his opinion on the impact of speculation,  pointing to huge oil stores as evidence that oil prices have been artificially inflated.  More dire consequences also can be the result of these price distortions, including unnecessary and economically damaging price volatility and even the potential for a systemic crisis in the oil industry and it financiers.

Misconception #2:  We need all this speculation for liquidity.  The commodity futures markets absolutely need a healthy amount of speculation to bridge the gap between commercial interests who may not be in the market at the identical time.  But just like any powerful medicine, an overdose causes more harm than good.  Speculation is good only up to the point where speculation becomes the main determinant of price. 

There has been a great amount of confusion between volume, open-interest and liquidity.  Traditional speculators are short-term traders who are indifferent to being long or short the market — such volume indeed creates liquidity.  Much of the problem has been created by the new breed of non-commercial participant, particularly the commodity indexed funds which are long term holders and are overwhelmingly oriented to the long side of the market.  They represent not liquidity, but a big fat bid, which actually drains liquidity from the markets by crowding out long commercial interests.

Misconception #3:  Investors need unconstrained access to the commodity markets to protect against inflation.  The idea that commodities are the only inflation hedge available to investors has been heavily promoted by those that profit from selling commodity-linked products.  This is simply a myth promulgated by Wall Street marketing departments.  As I’ve written about before, investors have very real, and possibly superior, alternatives, from TIPS to commodity linked equities. 

Misconception #4:  Position limits are an abridgement of free market rights.  The confusion of capital markets with contract markets comes into play here.  The imposition of constraints on non-commercial participation is not about heavy-handed regulation, but about appropriate market governance.  In the capital markets, I know of nobody who complains about rules against front-running, touting or insider trading.  Those are rules designed to protect the integrity of capital markets.  Contract markets like futures exchanges need rules to protect their integrity as well.  It’s just that different markets require different types of rules.  In the futures markets, integrity implies that commercial interests determine price, and this requires governance that restrains non-commercial participants.  Speculative position limits are one of the time-tested ways to ensure this critical integrity.

Informed people of good will can argue whether the markets are indeed “overspeculated” at this point.  We can reasonably debate whether position limits are the appropriate response, or whether whole different types of governance are needed.  One can perhaps even argue whether the risks of overspeculation to the economy should be balanced against the risks to Wall Street profits from curtailing their activities.  However, those that argue that the futures markets should play by the rules of the capital markets merely reveal their ignorance.

Zombie Nation

June 26, 2009

In a post a little over a month ago, “Watch the Zombie Bank Lifeline,” I suggested that market observers needed to keep an eye on the expiration date of the transaction account guarantee program within the FDIC’s Temporary Liquidity Guarantee Program.   The transaction account guarantee program offers unlimited protection to certain low interest bank accounts — this prevented a mass exodus of bank deposits during the height of the financial crisis.  But this guarantee also represents a crutch by which deposits remain in institutions which may be too financially compromised to grow their loan portfolios — in other words, deposits in these institutions have a velocity of zero.  The program is supposed to be temporary and is due to expire on December 31, 2009. 

Now comes word from Reuters that regulators are considering extending the program for another six months.   While a worthy temporary measure, such support of unworthy institutions could lead to the creation of Zombie Banks, the living dead of the financial world, competing on equal footing for deposits with healthy firms, but unable to lend the money back into the economy.   The decision on extension will be worth watching — the longer this program is extended, the greater the risk of this becoming the new status quo; the real dangers is that yesterday’s temporary program becomes today’s extended program becomes tomorrow’s permanent program.  A permanent guarantee program, while not on the table now, would almost certainly doom us to stunted economic growth as it sustains otherwise unsustainable banks.  Stay tuned…


Derivatives are the weapon of choice…

June 5, 2009

Washington is starting to get serious about the regulation of Credit Default Swaps.  Via the internet, I caught some of the testimony before the Senate Agriculture Committee.  I particularly enjoyed Rick Bookstaber’s assessment, “Derivatives are the weapon of choice for gaming the system.”   After acknowledging the original economic purpose of derivatives, i.e. risk managment, he continued:

As time progressed, however, derivatives found use for less lofty purposes. Derivatives have been used to solve various non-economic problems, basically helping institutions game the system in order to:

  • Avoid taxes. For example, investors use total return swaps to take positions in UK stocks in order to avoid transactions taxes.
  • Take exposures that are not permitted in a particular investment charter. For example, index amortizing swaps were used by insurance companies to take mortgage risk.
  • Speculate. For example, the main use of credit default swaps is to allow traders to take short positions on corporate bonds and place bets on the failure of a company.
  • Hide risk-taking activity. For example, derivatives provide a means for obtaining a leveraged position without explicit financing or capital outlay and for taking risk off-balance sheet, where it is not as readily observed and monitored. Derivatives also can be used to structure complex risk-return tradeoffs that are difficult to dissect.

These non-economic objectives are best accomplished by designing derivatives that are complex and opaque, so that the gaming of the system is not readily apparent.

For a balanced and thoughtful view of the regulation of derivatives, you might want to read his entire written testimony here (pdf file).  His piece offers an excellent summary of the uses and misuses of derivatives and how that can spill over into market and economic consequences.

Another witness before the committee, Professor Lynn Stout of the UCLA Law School, pointed out how Credit Default Swaps have become overwhelmingly used as speculative tools, not risk management tools:

[I]t is clear that by 2008, the market for CDS, for example, was primarily a speculative market….  We know this with mathematical certainty because by 2008, the notional value of the CDS market (that is, the dollar value of the bonds on which CDS bets had been written) had reached $67 trillion.  At the same time, the total market value of the underlying bonds issued by U.S. companies outstanding was only $15 trillion.  When the notional value of a derivatives market is more than four times larger than the size of the market for the underlying, it is a mathematical certainty that most derivatives trading is speculation, not hedging. And both economic theory and business history associate speculative markets with serious negative economic consequences.

The overwhelming speculative volume in the Credit Default Swap marketplace is a good example of “overspeculation,” an excessive diversion of investment capital away from traditional vehicles and into pathways that ultimately distort and undermine the markets.

The hearings were quite interesting in tone as well.  As opposed to many of the hearings last year (like the one I participated in with the House Agriculture Committee), the financial services industry seemed very much on the defensive yesterday.  Hopefully, this will allow some of the much-needed reform of the derivatives market to proceed.

Notes from Congressman Frank’s Speech

June 2, 2009

Last night I had the pleasure of attending the Boston Bar Association’s annual Law Day Dinner as the guest of Ruberto, Israel & Weiner.  Congressman Barney Frank, chair of the House Financial Services Committee, was the featured speaker.   His remarks seemed fairly off-the-cuff, but contained some insight into what the financial service industry can expect in new regulations. 

I had never heard Congressman Frank speak live before, and found myself impressed that he was much more of a “thinker” than he comes across on television (I didn’t realize it before, but he holds both undergrad and law degrees from Harvard).  The bulk of his remarks focused on issues regarding the rule of law and the relationship between the judiciary and the legislature in protecting minority rights.

Frank ventured into the regulatory realm in several areas.  I thought he made a good point in that financial innovations may require new forms of governance.  He professed a strong belief in the compatibility of regulations and free markets, saying that free markets need laws, and pointed to a host of laws (anti-trust, banking reforms of the 1930s, etc) that fostered free markets.    I have to admit to a sense of unease that the Congressman did not seem to recognize any limitations to this concept — one definitely got the feeling that more regulation was always better in his eyes.  As I’ve written before, I think it would be useful to make a distinction between rules of market governance which assist the function of free markets, and regulation that restricts market activity in the name of some other goal.  Frank also highlighted that those opposing regulations often exaggerated the costs and risks; here he set up a “straw man,” citing those who had claimed that “everyone’s going to move to London” in the wake of Sarbanes Oxley.  I don’t know any who made such blanket claims, but the fact of the matter is that the U.S. lost a competitive edge in the IPO and exchange listing race, and Sarbanes Oxley has certainly been a factor in driving companies into the private equity arena, which is plagued by higher leverage and less transparency. 

The Congressman gave one example of regulatory reform that he felt was critical — requiring originators of certain mortgages to retain a principal interest in the loan, doing only a partial securitization.    This specific reform is wrapped up in a number of items in HR 1728 which Frank co-sponsored and passed the House last month (there’s a good overview here).  Again, the Congressman set up a bit of a “straw man,” saying that  he knew he was on the right track when he heard complaint from those who had no capital; this is a bit disengenuous, since the GSEs which the Congressman oversaw played a huge role in facilitating that type of originator.

Securities backed by loans where originators retain an interest are known as “covered bonds.”   These are fairly common in Europe — it’s interesting to note that there is not even a regulatory framework for covered bonds in the U.S.  I came across an interesting analysis of why the U.S. lags in this area — not surprisingly, market distortions caused by the existence of GSEs like Fannie and Freddie Mac impeded this area. 

I walked away from the evening with 2 thoughts:  1) Barney Frank is a very smart guy, and 2) there’s a great risk of our policymakers making the kind of mistakes that smart people make — figuring they are more clever than the market and can dictate better outcomes.  Perhaps this is just politics, but the Congressman certainly did not acknowledge the role that previous government policies had played in distorting market incentives.  While I was gratified that Frank appeared much more thoughtful than he is sometime caricatured in the financial world, I would have preferred a better sense of balance in his approach – the regulatory picture is much more complex than he positioned it.   A more comprehensive approach would acknowledge that, yes, in some areas we need more market governance, but some of our woes have also been the result of too much or downright bad regulation.

Farewell, TED… See you again?

May 28, 2009

I’ve written a few times about the TED Spread (e.g.,  here), that historically reliable indicator of systemic risk.  I’ve updated the chart:

The TED Spread: 3-month T-bill vs. 3-month Eurodollard Deposit (LIBOR)

The TED Spread: 3-month T-bill vs. 3-month Eurodollar Deposit (LIBOR)

The TED spread has now returned to about 50 basis points, levels I would associate with the “normalcy” that preceded the Panic of 2008.  There was always a question as to whether the TED would return to such low levels or would forever reflect some kind of unforeseen-event-risk (the “fat tail” of the probability curve that’s been much discussed in the trade).  Cynics might argue that the TED returning to such low levels shows that market participants have learned nothing from the financial system’s upheaval.  I prefer to see this as a recognition that the U.S. government does have the will and power to prevent a systemic meltdown (obviously, there are costs involved).

The TED’s narrowing is good news for the economy as it typically leads other credit spreads and allows the Fed to once again be in control of short-term interest rates.  In this low rate environment, this translates to lower interest rates for borrowers, starting with adjustable rate mortgages tied to LIBOR.  Corporate borrowers using short-term instruments are also direct beneficiaries.  Those who borrow at longer term rates have a mixed picture — higher Treasury yields but narrowing credit spreads — by and large, the credit spread factor is now the more important ingredient so those borrowers are beneficiaries. 

I’ve now been following the TED Spread for 23 years.  For many, many years, the wisdom was that “the TED is dead,” forever locked in a narrow range (call it 30 to 50  basis points).  I, like many others, simply stopped watching this important intermarket relationship.  Has the TED gone back to this dormant state?  I’m not so sure.  For one, the TED has historically been impacted by the general interest rate level — that is, the higher the interest rate environment, the greater the TED spread, even given the same perceived credit risk.  Given the inflationary forces that the monetary and fiscal stimulus may unleash, I can easily envision a scenario where the TED widens on the back of Fed tightening.  Moreover, our ability to successfully fend off a financial meltdown was partly due to the flexibility available in an environment with relatively manageable levels of government debt and limited inflation.  Our ability to fix an unforeseen future crisis may be constrained by the costs of the policies we’ve employed to address the current situation.  Given the advance warning the the spread signaled in 2007, I’ve made a promise to myself to keep an eye on the TED Spread for the rest of my career.  I wish I could say, “goodbye” to TED, but fear it may really just be, “au revoir.”

Don’t Count Out the Dollar

May 26, 2009

There’s been a good amount of anxiety over the U.S. Dollar’s decline over the past few weeks.  While unsettling, much of recent dollar action has been determined by the general level of anxiety in the global markets — the dollar benefited from “flight to safety” concerns, spiking higher as the financial crisis peaked in the fall of 2008, and then stengthening again as global equity markets faltered in the first quarter of this year.  The chart below illustrates the past six months performance of equities (the S&P500 bar chart) versus the U.S. Dollar Index (line chart) — the plots are virtually mirror images:

U.S. Dollar Index (line) vs. S&P 500 (bar)

U.S. Dollar Index (line) vs. S&P 500 (bar)

The longer term direction of the U.S. dollar versus other major currencies may well be. “sideways.”   Some perspective here is useful.   Consider the following chart of the U.S. Dollar index going back to the beginning of 1975:

U.S. Dollar Index: January 1, 1975 to present

U.S. Dollar Index: January 1, 1975 to present

As happened after the precipitous fall of the dollar in the late 1980s, the recovery period required a multi-year basing process, where the dollar essentially traded in a limited range for roughly five years.  At a minimum, anecdotal evidence suggested that on a purchasing power parity basis alone, the dollar was oversold by the end of 2007.  Speculative excesses and leveraged speculative trades against the dollar eventually relaxed and were unwound by the financial crisis. 
The main argument for a further weakening of the dollar, our aggressive monetary stimulus, is indeed compelling, but only when viewed versus hard assets, and not against the currencies representing the weak developed economies around the globe.   Investors fearing dollar devaluation may find better solutions in U.S. equities tied to hard asset prices rather than foreign securities that traditionally benefited from a weaker dollar.

The Coming Derivatives Battle

May 19, 2009

Bloomberg carried a story the other day citing  Brooksley Born in dicussing the way that major derivatives trading firms are fighting the administrations efforts to govern the over the counter (OTC) derivatives markets, particularly the swaps market.  Born has credibility on this issue.  In 1998, as the head of the Commodity Futures Trading Commission, she fought unsuccessfully to regulate the growing swaps market.   In truth, Born’s efforts were focused on regulating the interest rate swaps market which has not played any meaningful role in the present crisis.  However, governance of the OTC swaps market would have eventually included both the credit default swaps and the commodity swaps that have played such a destructive role.

As the battle over establishing proper governance gets going, I’ve found an insightful article on Rick Bookstaber’s blog.   Rick is a seasoned Wall Street risk management veteran and author of the prescient book, “A Demon of Our Own Design.”  In his latest post, he argues that many of the industry’s arguments against regulation are (unsurprisingly) false.

What went so wrong in the OTC derivatives market?  Contrary to the revisionist history being promulgated, I would argue that the initial deregulation of these markets in 2000 was well intentioned and reasonable.  Interest rate swaps dominated these markets and were being used as risk reduction tools by bona fide institutional hedgers — i.e., sophisticated institutional investors who had offsetting real positions in traditional securities.   Over the last few years, however, certain derivatives instrument were used in ways never imagined a decade ago, and these markets became dominated by speculators — those taking on risk in what is essentially a “bet,” whether on a company’s credit quality, on the price of food or energy, or other metrics.    In another post, Bookstaber lays out some of the new applications for these instruments:

They are used to: avoid taxes (for example, total return swaps are used to take positions in UK stocks in order to avoid transactions-based taxes); take exposures that are not permitted in a particular investment charter (for example, index amortizing swaps were used by insurance companies to take mortgage risk); speculate (for example, the main use of CDSs is to allow traders to take short positions on corporate bonds); lever beyond an allowed level; and take risk off-balance sheet, where it is not as readily observed and monitored.

All this allowed for an explosion of this marketplace.  The problem with all this massive expansion is that these are not traditional investment markets, but rather contract markets, akin to the futures exchanges.  And just like the futures markets, the OTC derivatives market would benefit from some of the tried and true governance of those markets:  a clearinghouse structure, margin requirement to ensure contract performance, and, for underlying markets with limited liquidity, speculative position limits to ensure that these side bets don’t end up distorting underlying prices.  

The regulatory battle will be hard fought.  These are complex issues where most (but not all!) of the knowledgeable players work for firms that are making a lot of money from these transactions, no matter the risks they pose to the economy in aggregate.   The credit default swap mess is contained for now by the general industry disarray.  However, given continued indications that commodity inflation is resurfacing,  I believe we may well see the commodity problems of last year return, and potentially with greater magnitude.   The only way to prevent more damage is with appropriate market governance.   The administration has taken a good first stab at this issue; let’s hope that Congress can follow through.

Republicans Need to Find a Voice on Regulation

May 11, 2009

I try very hard to avoid politicizing my blog, so I’m reluctant to bring up any political party in the my writing.  However, I caught the following chart on Greg Mankiw’s blog:


The divide between Democratic and Republicans on the relative threats posed by big government and by big business is startling.    While these positions appear to have hardened over the past few years, our public policies have often found a moderate balance.  Considering the position of independent voters in the Gallup study, it seems likely that most Americans could meet in some middle ground.  One could argue that, for the most part we’ve had success in that middle-of-the-road position.  I take issue, of course, with those that say all our present woes are the result of deregulation (the record clearly points to areas where we need more regulation, but also some in need of less, and mostly those that need updated and better quality oversight, not necesarily more of it).

Without regard to party affiliation or loyalty, there’s a strong argument to be made that we’ve all benefited from our 2-sided debate on the appropriate role of government and the appropriate restrictions on business.  This has resulted in middle-of-the-road policies that have worked.  Coming from this perspective, the current state of political debate is a matter of great concern.  I’d sum up the current debate as follows:

Democrats: We continue to believe in a greater role for government and more regulation of business

RepublicansWe used to believe in limited goverment and deregulation, but we’re not quite sure now

This is not a debate, it’s a massacre.  If you’re on one extreme of American politics, this is good news.  But for most Americans, this is a battle in which one side has not yet joined, and we may all pay the price. 

All Americans would be better off with a more vigorous policy debate.  The Democrats have clearly laid out their beliefs and an agenda, but the Republicans have been incoherent on the topic of market regulation.  I believe the GOP lost its voice as an outgrowth of this current “Crisis of Capitalism.”   Many Republican policymakers became reflexively against anything that anywhere, anyhow restricted a financial transaction.   This may have been a useful policy guide following the overregulated 1970s, but became less relevant following the generally pro-market stance of the 1990s.  In other words, the strategy that won the war (the battle for free markets begun in the Reagan years), did not serve well in the ensuing peace. 

Republicans can reclaim their voice by making a distinction between “regulation” and “governance.”   You can still be in favor of free markets, yet support more and better governance of those markets.  Rules of governance are no more contrary to free markets than rules of law are inimical to democracies.    By “governance” I mean rules that enhance market integrity and transparency, as opposed to much heavy handed regulations.  Examples of governance would include prohibitions against insider trading, while examples of other types of regulation would include, say, restrictions on credit card interest rates.  This is not, in my opinion, to say that one is bad while the other is good — but to draw the distinction between a type of rule free-marketeers could embrace versus those they should oppose.  It is true that one person’s governance might be an unecessary regulatory burden in the eyes of another.  Yet framing the debate in these terms would benefit the public:

  1. It would allow for agreement across party lines in some critical areas truly in need of governance.  The need for better transparency and restrictions in the over-the-counter swaps market comes immediately to mind.  Framed as a critical governance issue rather than a friends-vs-foes of markets, would get some resolution in this vital area.
  2. It would clarify the entire debate about regulation, and allow for more thoughtful public discourse.  I believe that we are ill-served by a political body where one party apparently can’t say no to any new rules, while the other can’t say yes.

This is not a question of being for or against any political party or set of beliefs.  The Republicans need to find a coherent and consistent stance on regulation so that we will all benefit from better public policy forged through rigorous debate.

Watch The Zombie Bank Lifeline

May 6, 2009

Much has been made of the bank “stress tests” which have focused on TCE (Tangible Common Equity) ratios.  Top-notch bank analyst Tom Brown rightly declares the regulators’ obsession with these ratios to be “insane.”  In his article on the Bankstocks blog Brown points out that the practical application of the stress test will result, not in net new capital in the system, but merely a conversion of the government’s preferred TARP stake into common, making the government a significant shareholder in these institutions.  Although not explicitly noted in the piece, this will make it even harder for these institutions to ever attract real net new capital as private capital becomes increasingly wary of partnering with a capricious government shareholder. 

At the end of the day, if the banking system truly needs new capital, it can: 1) simply inject more taxpayer money, 2) raise more private capital for existing institutions, 3) raise capital for new institutions, or 4) retain earnings over time.  Option #1 is a political non-starter, and #2 won’t work since the government’s involvement in marginal institutions scares off capital.  This leaves the possibility of #3, creating new banks , or letting existing problem banks earn their way out of trouble.  The government appears to be favoring the latter — the problem is that this is a slow and painful process.  Moreover, there’s a good case to be made that without being able to raise capital, operating earnings, excluding loss provisions, may not get much better — the current environment offers great spreads based on low costs of funds and lots of pricing power on the lending side — that still leaves plenty of room for profits, but maybe not profit growth over the long term, particularly if we get to the point where the Fed needs to tighten.  Creating new banks is an interesting idea, but most de novo bank creation occurs at the community bank level and is inconsequential from the perspective of the entire industry.  Significantly adding capital to the banking system through the creation of new entities could only occur if legislative changes ease the rules to permit the rest of corporate America into the banking arena.  There seems to be little support for this — some may remember how quickly WalMart’s attempts to move in that direction were thwarted.

At the end of the day, the stress test will do nothing to enhance the position of the banking industry.  The government’s new role as a large common shareholder may deter, rather than enhance the ability of troubled institutions to raise capital.   This means that we will continue on the path of creating Zombie Banks, the “living dead” of the financial world, not allowed to die, but to0 weak to lend robustly. 

The harm of Zombie Banks goes beyond simply tying up deposits in instutions that can’t lend.  Zombies hamper the stronger institutions, precluding them from growing market share or gaining pricing power.  Are we truly headed down this dismal road?  The Federal government is providing the lifeline that sustains the Zombies through the Temporary Liquidity Guarantee Program (TLG), which provides government backing not only to certain debt issued by banks, but critically also guarantees, without limitation, low interest bearing checking accounts.  This last provision indeed prevented a run on banks by corporate treasurers, whose deposits exceeded traditional FDIC limits.   Last fall this may have been necessary since there was general distrust of the whole system.  I would argue that this backing is now counterproductive — let the market decide which banks deserve uninsured deposits.  Perhaps this could be done in an orderly fashion by gradually limiting the protected amounts (e.g., only deposits under $5 MM are guaranteed, etc). 

The unlimited deposit protections of the Temporary Liquidity Guarantee Program are due to expire on December 31.   Investors should watch to see whether this “Zombie lifeline” is extended.  Deadline extension alone may ultimately not be the only action — if we ever get the Fed raising rates again, the TLG’s coverage of only low-interest accounts could result in disintermediation to money market mutual funds unless the guarantees are extended to higher interest deposits.  Any extension of the TLG signals that we are not yet facing the risks of Zombie Banks.  As long as these Zombie Banks walk among us, the prospects for robust economic growth remain dim and distant.