A Few Words from Steve Hussman

Reader OldVet sends along the picture below, together with a few paragraphs from Steve Hussman.

This from Steve Hussman, manager of the Hussman Fund 3/19/2007.

“Among all FDIC insured institutions, total assets represented $11.8 trillion at the end of 2006, of which about 40% were real-estate related loans. Though foreclosures currently represent just over 1% of total mortgage debt outstanding, it’s important to remember that the average return on assets (earnings as a percentage of assets) in the U.S. banking system is also only about 1%. So any continuation in defaults will quickly find its way into earnings figures, either by provisions for loan loss reserves or by actual charge-offs.

Remember also that banks operate on a ratio of about $10 of assets (generally loans outstanding) per $1 of shareholder equity capital. So a 1% loss of existing loans can wipe out about 10% of shareholder capital. Since banks are required to hold such capital against their loan portfolio, wiping out capital also wipes out part of their ability to originate new loans. Importantly, bank capital requirements are a separate constraint from the reserve requirements placed on a bank’s demand deposits

Note the difference. Reserve requirements apply to the liabilities of a bank (basically customer deposits), while capital requirements apply to the assets of a bank. If banks have insufficient reserves to meet, say, the demand of customers for cash, the Fed can intervene by buying up Treasury securities from banks and paying with reserves (this is what the FOMC really does when we talk about a “Fed rate cut”). Banks can then meet their obligations to depositors without having to call in loans. This is a legitimate “lender of the last resort” function for which the Fed actually does have a critical role (as I’ve noted elsewhere, except during banking crises, the Fed’s powers to affect the economy are largely imagined). While some individual banks may be at greater risk than others, we should not be concerned about a general banking failure, precisely because of the Fed’s ability to act as a lender of last resort.

But capital requirements impose a different constraint altogether. A Fed easing might loosen a binding constraint on bank reserves, but it does not increase shareholder equity capital. Loan losses still go straight to the bottom line, and if the losses are sufficient to reduce shareholder capital, they also limit the amount of new loans that banks can make. It’s that risk of earnings weakness and “de-leveraging” of the U.S. financial system (not the risk of a general banking collapse), that is a growing concern here.

That is not to say that the Fed is anywhere close to “coming to the rescue” here. The latest inflation figures were fairly hostile to any hope for a near-term rate cut. Meanwhile, overall U.S. capacity utilization has pushed up to 82% – a level at which the Fed has historically been much more inclined to raise rates than lower them. To call this a “Goldilocks” environment where inflation and economic risks are balanced is like the proverbial image of the guy with his head in the freezer and his feet in the oven, saying the temperature is just right. Inflation and economic risks are balanced because both are unfavorable.”