Banking System on the Verge of a Major Crisis

A couple of posts ago, I described how the delinquencies were creating a liquidity crisis for mortgage lenders. Many of them have had to declare bankruptcy because they haven't had enough financing to make up for the lack of cash flow they are facing due to rising delinquencies and defaults.

The overall leverage of modern US banks and their exposure to real estate loans has become extreme just at the point when loan defaults are getting out of hand:

The lessons learned from the bank runs that led to the Great Depression have long ago been forgotten by regulators. Banks need to have reserves on hand in order to remain solvent in difficult economic times. Unfortunately holding cash reserves cuts into profit margins, so banks have lobbied the Fed to reduce reserve requirements and allow much greater leverage. Now that banks are developing a strong need for cash many are realizing that they don't have enough of it available:

Both of the above charts display historical data from the Fed's H8 reports. Looking at more recent H8 data gives an indication of how the current banking crisis is unfolding. Over the past year, Banks were very aggressive in expanding real estate lending, commercial lending, corporate bond purchases and lending to securities speculators. Meanwhile, they were extremely lax in setting aside reserves in cash, US treasuries and Agency debt. Here are the year over year increases from March 2006 to March 2007 for the main categories of banking assets:

Real Estate Loans and Leases: +10.56% to $3,316 Billion
Treasuries and Agency Debt: +1.96% to $1,186 B
Other Securities: +12.72% to $1,051 B
Commerical Loans: +12.78% to $1.074 B
Interbank Loans: +21.30% to $365 B
Security Loans: +15.99% to $313 B
Cash Assets: -6.27% to $294 B
Other Loans and Leases: -1.59% to $525 B
Total Bank Credit: +8.40% to $8,366 Billion

Up until Mid-February, most banks didn't think there was a whole lot to worry about because they were able to sell off as much real estate exposure as they liked to investors through mortgage backed securitizations. That source of liquidity came to a grinding halt a couple months ago, and since then there have been some eye-catching developments on banking balance sheets. Real Estate Loans and Leases suddenly reversed course, recording the largest single month decline on record (-1.83%). Cash assets also declined suddenly (-3.32%). In the past, February and March have been big months for banks to acquire US Treasury and Agency debt, as the Treasury faces its tightest season before Tax day in April. Here's the February+March net buying totals for the last 5 years:

2003 $36.2 Billion in Treasuries and Agency Debt to $1075.7 B.
2004 $95.8 Billion to $1200.2 B
2005 $33.3 Billion to $1217.4 B
2006 $34.3 Billion to $1185.9 B
2007 $11.1 Billion to $1209.1 B

The lack of buying by US banks is probably another reason why Foreign Official Accounts had to step up in a big way during Q1 (adding over $140 Billion in securities during the 13 weeks ending last Wednesday).

In recent years banks have been net sellers of treasuries and agency debt from March to January. This time they'll probably be especially large sellers as the need for cash increases. Foreign official accounts are probably the buyers of 2nd-to-last resort, but many of them have been indicating for awhile that they want to reduce their exposure to US debt. The Fed is the buyer of last resort for treasuries, as they can create as much money as they desire and purchase treasuries with permanent injections (they did two last week). Of course doing this would be highly inflationary at a time when inflation numbers seem to be coming in above the Fed's acceptable range.

How long will foreign officials and investors be willing to buy up US debt at these historically low interest rates?
How sharp will the contraction be in real estate lending?
How many banks will be ruined in the process?
How long will it be before other areas of excessive bank credit begin collapsing under their own weight?
How deep of a recession will this all cause?

Stay tuned. As the data keeps coming in, I'll keep blogging what I see in the numbers.