Friday, July 10, 2009

This Week in Bank Failures

Printing money doesn’t help if people won’t accept the money you print. That’s the new problem in my ancestral homeland of California. Banks have been accepting the state’s promissory notes, essentially a form of money backed by nothing but political will, as a convenience to customers, but only until today. Really, banks have no business accepting promissory notes as money, and the strategy could come back to bite them if they can’t cash out the notes before their next balance sheet September 30. On a bank’s books, at this point, California promissory notes probably have to be recorded as illiquid bonds, with implications for the bank’s financial condition that are quite different from those of cash.

California is issuing promissory notes, or IOUs, to employees, retirees, college students, suppliers, contractors, and others it should be paying money to because its financial squeeze has made it impossible for legislators to come up with a budget for the fiscal year. The deadline was June 30, and at this point, there is still no resolution in sight. California, by some measures the richest state in the United States, has done this before, but that was so long ago that no one is quite sure what rules ought to apply. The state is not even sure it is legally permitted to accept its own notes as tax payments. The Securities and Exchange Commission (SEC) is trying to help out by issuing a ruling last night that classifies the California promissory notes as municipal debt securities. This could lead to an orderly market in which Californians can sell the promissory notes to investors. Banks could participate in order to help their customers cash out the notes at market rates. Just don’t expect banks to be the buyers in that market.

Where I live in Pennsylvania, there is a buzz about another June 30 deadline. Harleysville National Bank, one of the oldest and largest banks in the state, is undercapitalized and missed the OCC deadline to shore up its capital. The bank says it is working on this, is making good progress, and does not expect any immediate regulatory action — but that is what a bank would say. In an unscientific survey of people I know who are the bank’s customers, there is more amazement at the bank’s financial decline (reflected by a stock price down 85 percent since its peak in 2003) than concern about their own deposits. It says a lot about how well people understand and trust the deposit insurance system. But one longtime Harleysville customer I talked to turned out to be a former customer, after getting “a better offer from another bank” last month.

Remember AIG? This secretive company was the key to the world’s financial system barely a year ago, but now might worry about being forgotten as Wall Street has moved on. AIG has made headlines again this month. A 1:20 reverse stock split on Jul 1, as the stock was falling below $1 per share, might as well have been 1:100, as the stock has fallen by half just since then. According to an analyst this week, recent prices mean Wall Street gives AIG a 70 percent chance of bankruptcy. Meanwhile, AIG is asking the U.S. Treasury to review its new round of bonuses. The last bonuses it paid sparked one of the defining political controversies of the year.

In the United Kingdom, authorities promised a more intrusive style of bank supervision. For the first time, the Financial Services Authority will have some say in the compensation of bank executives and may curtail some of the riskiest lending practices at banks.

Does it make sense to get private equity involved in buying out failed banks? The FDIC is proposing rules that won’t make it easy for private equity players to bid on failed banks, and for good reason. The culture of private equity involves pie in the sky, secret owners, huge debts, and a high failure rate, and none of that will fly in the banking business. Private investors wouldn’t mind buying up a portfolio of failed banks and having four out of five fail again within a couple of years, but if they took that approach, they would be abusing the deposit insurance system. The FDIC’s rules are meant to warn private equity investors that they have to play by the rules of the banking business, and of course, most private equity money won’t go along with that.

Other banking regulators have said that the FDIC’s proposed rules on private equity are too restrictive, and they may have a point. Nevertheless, it is hard to bridge the gap between the “try anything” attitude of Wall Street and the insistence on integrity and stability that makes the banking system tick. It simply isn’t possible for the FDIC to adopt the kind of rules that Wall Street’s billionaire-investor class will be happy with. Besides, it would be a systemic risk if the bank failure process created a loophole by which unqualified people could become owners and managers of banks. As much as the FDIC needs private investors in the bank failure process, all that goes for naught if the same bank fails again.

On Wall Street, the root causes of the financial meltdown are still going on. According to reports, Morgan Stanley is about to unveil a new scheme to issue investment-grade bonds based on junk CDOs. This kind of scam, in which derivatives are promoted as being safer than their underlying assets, should have been stopped last year when it caused the financial system to seize up, but no such statutory reforms have even been considered so far. Worse, the main reason Wall Street is so intent on creating these supposedly investment-grade derivatives is to sell them to banks. These phantom securities allow banks to pad their balance sheets, making the banks look like they are more solvent than they are until just a short time before they collapse. The fact that Wall Street is still adding fuel to the fire suggests that we may have years to go before the financial sector begins to rebuild.

On Monday the NCUA liquidated a very small credit union in California. Watts United Credit Union, in Los Angeles, was put into liquidation by California after it became insolvent. According to the NCUA, the credit union at the end had less than $1 million in deposits. The NCUA is sending checks to the credit union’s depositors.

Tonight bank failure hit Wyoming for the first time in 18 years. The bank that was closed is Bank of Wyoming. The bank was not as big as the name makes it sound. Based in Thermopolis, a relatively isolated town of 3,000 in the mountains of central Wyoming, it had one office and $67 million in deposits, which will be taken over by Central Bank & Trust, also based in the central part of the state. Central Bank & Trust is also buying most of the assets of the failed bank. The FDIC estimates its costs at $27 million.