Picking Nits

FDIC Bank Assessments Change on April 1st as Dodd-Frank Comes to Banking

2011-03-16T10:19:00.000-07:00

The Federal Deposit Insurance Corporation (FDIC) is the buck stops here office of U.S. bank regulation. Chairman Sheila Bair and company are checkbook behind the sign on every bank’s door sign guaranteeing that your deposit is FDIC insured. Funding America’s Deposit Insurance Fund (DIF) is done by charging banks an insurance premium. It’s this cash paid by the banks themselves that is supposed to maintain the DIF’s reserve. Come April 1st the rules for how banks get charged will be changing dramatically.

The FDIC approved 2011 Final Rule changes to 12 CFR 327. The rule is effective April 1, 2011, and will be reflected in the June 30, 2011 fund balance and the invoices for assessments due September 30, 2011. The final rule incorporates many policy changes based on the intent of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The most important change of all is in something called the “base assessment amount”. In the past this number was – and until March 30th is – the domestic deposits held by a bank. But as Dodd-Frank recognizes, banks have become more complex and leveraged. Most importantly, since the demise of Glass-Steagal, many of the larger institutions have incorporated the complexities of investment banking into their business models. The FDIC assessment methodology essentially gave a free ride to these aspects of a bank’s operations. Well come April Fool’s Day, the free ride is over. The “base assessment amount” changes to a new formula. From now on it’s the bank’s total assets minus its tangible common equity (TCE) that determines the base amount. I do note though that it’s actually the Tier 1 Capital that the FDIC will be using at first because despite the popularity of the notion of TCE by Wall Street, the Treasury and the Federal Reserve, no one’s quite sure how to properly calculate a TCE for an FDIC unit certificate holder just yet. We ran the computations both ways using IRA’s methodology for unit level TCE estimation just to confirm that the Tier 1 approximation is, as they say, close enough for government work. It is.

The no more free ride for investment banking policy slant of the 2011 rules is a huge shift. And yes it affects the largest complex banks most. We completed an estimation method – available in our Professional IRA Bank Monitor product – that looks at the change in assessment base and also implements the guidance of the new rule to estimate the DIF premiums. As with all IRA analytics, data is available for all 7,500+ FDIC certificate units plus 4,500+ bank-only components of BHC’s. Just for grins, we back computed “what would it have been” data for prior periods quarterly to 1995. Looking at this new mass of data we saw the following,

• Smaller banks that have traditional unleveraged business operating models generally see little change from the new rules.
• Mid-size and larger banks, over $10 billion assets, generally see an increase in their assessment base.
• Within the largest banks, the ones that are heavily involved in investment banking are most impacted by the new rules.

There’s also an important second point embedded in these new rules. The math for estimating risk category assignment is done using FDIC’s CAMELS scoring system. CAMELS stands for Capital Adequacy, Asset Quality, Management, Earnings, Liquidity, and Sensitivity to Market Risk. It uses privileged data and is sharable only between a bank and its regulator. For those of you that are old Basel II aficionados, think of it as “everything is IRB”.

So what’s the big deal about this?

The “2011 Final Rule” specifically states that the going forward process eliminates “the use of long-term debt issuer ratings for calculating risk-based assessments for large institutions”. The methodologies of the Nationally Recognized Statistical Rating Organizations (NRSRO’s) are no longer part of the process. This reduction in official dependence on rating agencies that failed to detect the last wave of systemic risks is also consistent with the intent of Dodd-Frank.

For our estimator tool, we used IRA’s public data “Shadow” CAMELS methodology we developed in 2009 as part of a contract to support the Securities and Exchange Commission to set up our Risk Category analysis. That contract requires us to compute these shadows for every bank unit and bank holding company in a timely manner every quarter. It turned out to be fortuitous for our look into the FDIC 2011 Assessment Rule. SEC specified we compute “Shadow” CAMELS to 1/10th’s and this allows our tool to pick off a point within the cap/floor limits of the assessment rate range specified in the statute to set up a better 2011 FDIC Initial Base Assessment Rate or IBAR. This refines the remainder of computations that depend on this number. Yes good people. That is math talk for the deep end of the pool. Translation to English = blah-blah-blah.

CFO’s, Treasurers, Bank Risk and the Adequacy of Internal Controls

2011-02-17T15:44:00.000-08:00

The only constant about risk analysis is that it is ever changing. It’s 2011 and make no mistake about it keeping up with understanding bank risk continues to evolve. The FDIC just released 2011 Rule 1 that updates the bank assessment rules to protect the Deposit Insurance Fund (DIF). Banks must now begin to adapt to these new statutes. For everyone else, it would be prudent to keep paying attention.

As of Feb 16, 2011, since the beginning of 2008, three-hundred and forty banks have failed in the United States. As banks have failed, we’ve been making forensic summaries available on our website to help improve transparency over what happened. We have seen the focus of worry facing the banking industry’s customers shift from looking at operating stresses stemming from unsafe or unsound operating practices – the primary objective of IRA’s Bank Stress Index (BSI) testing approach -- to looking for tactical warning about when banks are degrading in condition and in danger of failing.

Mathematically, the crux of the demand is to deliver analytics capable of maintaining linear tracking of banks past something called the investment grade threshold deeper into the degradation curve of the system. In English, people want to know when to get out of the way of the icebergs because it’s become all too clear that there’s no such thing as a ship that is too big to fail. To respond to this need we have constructed a Counterparty Quality Scoring (CQS) measure that provides tactical warning as to when it may be prudent to consider reducing exposure in case there is an FDIC failure. IRA’s CQS is less sensitive than our bomb detector dog nose BSI technique but it reveals something very interesting about the FDIC. Most of the time a bank will fail while there’s still some meat on the bones so that a pre-packaged resolution makes sense. And while there are the occasional oddballs, most of the time, the stress and trouble writing on the wall is clear as day with sufficient time to react.

For CFO’s and Treasurers, we are finding that companies are beginning to become aware that their corporate treasury “investments” in banks are in fact “bank liabilities” potentially subject to loss in the event of a bank failure. We did see a few instances in 2010 of companies calling up to subscribe to our system “right now” because they had taken a real loss following a failure and found out the hard way what the term uninsured deposits really means. We’ve talked to a number of companies now and we think it’s important to begin to explain the variety of internal controls strategies we’ve been running into.

First of all, corporate America can have some very complex interrelationships with banking. The classic notion that a company only needs one “too big to fail” banker to tend to all their needs turns out not to be how things work in real life. For certain things, these large institutions provide efficient solutions and integration costs can lead to very stable and sticky long term relationships indeed. But we also found that companies can and do shop around among the services offerings, a finding that validates the assertion that there’s no such thing as “run off proof” deposits, not even for the most cozy of historical banking relationships. The bottom line is that even for those for whom “size matters,” there are many horses to bet on.

We’re also finding that America’s companies carry a lot more exposure to middle and small sized banks than most people think. Certain industries such as retail, franchising, and integrated supply chains -- to name a few -- have business models requiring dozens and in extreme cases hundreds of separate bank interactions. In a number of cases, maintaining good “local” geographic presence is responsible for enlarging the number of banks a company interacts with.

Lastly we are finding that, in our opinion, far too few corporations practice active risk mitigation. The penchant to “find comfort” and nest in it remains very much a characteristic of U.S. business at this time. There’s even a component of the old culture of “plausible denial” that continues to permeate the system – something that the rules governing the “adequacy of internal controls” of Sarbanes-Oxley should have long driven out of corporate America. We also find a number of companies relying on indirect measures testing techniques to gain their comfort about the banks they do business with. The most common of these is relying on their investment bankers who package their corporate bonds to use market inference indicators to imply the soundness of their banking relationships. So things like stock price and CDS indices substitute for looking at the real FDIC CALL reports.

But we've also seen that some companies do avail themselves of approaches out of the banking world that have mitigating effects protecting against bank failures; the most common of these being to engage in forms of deposit risk placement spreading either directly or via a brokered deposit program technique. So not everyone is behind the curve.

With all this as a backdrop, we find ourselves reminding companies that it’s critical to “know” not guess about how healthy their banks are, what their alternatives are, when they need to act and how they will act if they have to.

First, companies need to remember that risk surveillance is only useful when it’s reporting on reality. The consequences of the “Imagineering” of Wall Street have already wreaked havoc on the U.S. economy and the days of granite reputation banks are long gone. The characteristics of what constitutes risk behavior in banking are understood well enough that they’re codified in legal statutes. Interpreting it is somewhat of an art form but ultimately there’s no valid business reason not to know. What is important to do is focus surveillance on the action thresholds. If all banks were healthy, the focus would be on the best yield/services offering bundle. But, given the state of things, asset preservation or loss avoidance is presently equally important.

We believe that when it comes to loss avoidance with one’s bank(s), marking to reality means looking at FDIC data. Secondary market surrogate measures can have volatile spin in them that could cause false alarms. Next to realizing a "Black Swan" loss because you weren't looking, the next worst thing to do is mistakenly abandon a banker who was acting in your best interest. It’s a waste of opportunity cost best avoided by any depositor, business or consumer.

We further believe that it takes two surveillance data points to gain perspective on a bank’s soundness. One should be an early indicator that allows one to assess confidence in a bank’s operational leadership before trouble ever happens. Second is a present state indicator benchmark that delivers a relevant warning to act while there’s still time to do so. One thing we will note for those wishing to do internal analysis is that certain regulatory benchmarks like capital adequacy are designed to be lagging indicators of strength and soundness. If you look at those forensic reports on the failed banks, you’ll see they tend to falter only at the very end of the life cycle. Acting in a rush is no way to manage one’s larder. So if you choose to read those CALL/TFR reports directly off the FDIC website and gain comfort yourself you’ve been warned. Also, remember that things like TCE’s and Texas Ratios are investor’s analytics tools. That’s potentially useful stuff if your company’s trading desk book holds stock or debentures in a bank but it’s not quite the same thing as treasury asset protection of your cash and cash equivalents.

If you’re really lucky it’ll never happen, but real world odds are that sooner or later everyone will ponder what valid alternatives there are to one’s current bank relationships. Bear in mind that change events also happen for positive reasons. Ideally, for every bank you are in, you want to know what the next three best alternatives are to that institution in case you decide to move your money. Your criteria may have minimum/maximum size, geographic, service offering set, switching cost and other narrowing criteria, but you still always want to know your short list of where to go if you have to. We believe your list should always include apples-to-apples quality benchmark soundness criteria so if you elect to deviate from the norm you’ll know it and by how much. Of course, you may have to explain why at the next shareholders meeting. And please remember that while IRA is authoring is this article, it’s not the only bank ratings company focusing on a next generation of tools for independently risk testing banks. The point of this note is that having a rational basis for knowing one’s alternatives is good internal control procedure. Whether you use external reference sources or do it yourself is up to you.

And last but not least of course, have specific, measurable, actionable and achievable plans to act for each option you intend to execute.

XBRL Usability Part 2: Checking the Extension Cord

2011-02-08T14:34:00.000-08:00

In our previous installment of IRA’s testing of U.S. XBRL filings we reported that one only needs the EDGAR Accession file to be able to properly monitor and locate SEC filings both with and without xml exhibits. We are now confident enough to cease monitoring of the SEC’s experimental XBRL feed and begin using a true production version to process filings via the standard EDGAR system.

As we await the arrival of a new wave of filings in June 2011 we thought we’d check out the library of variables that will be available. In addition to US-GAAP data elements, filers are allowed to add “extensions” to their submittals. These extensions are independently defined by each company and do not require external coordination or rationalization at this time. The way extensions are added to a filing is via the xsd file, an XBRL definitions file that starts with statements to bring in standardized taxonomies followed by the company’s independent extension set. Every SEC filing with an XBRL exhibits file set has an xsd file. Not all of them have extensions.

We instructed our computer to count up the population of 10-K, 10-Q and 20-F filings for the past year and rummage through the xsd’s. On the particular test run we did there were 36,136 SEC filings meeting our test run criteria in the Accessions tape. Of these 3,880 included XBRL exhibit attachments representing 1,488 Central Index Key (CIK) SEC Registrants. This was roughly one fifth of the population expected to start submitting in June 2011.

Of the 3,880 filings, we found that 3,039 (78%) contained extension elements. The remainder only used primary taxonomies in their construction. The number of extensions in these documents ranged from a low of one extension to a high of nine hundred twenty-two extensions in a single filing. The total number of extension elements created by the sampled filings was 183,846.

Extrapolating this to an estimated 8,100 companies submitting beginning in June 2011 (8,100/1,488 = 5.44X) says that we are looking at an annual extension library to keep track of just over one million independently created elements in addition to the US-GAAP set. Wowie!

This actually doesn’t bother us that much. We have expected for a long time now that the extensions work around for the taxonomy architects not being able to anticipate every possible data element would create this type of algal bloom in the data. It merely points out two things.

First, unless one is doing merger and acquisition work, one can probably ignore most of these extensions and do most first and second level screening analytics just using the US-GAAP subset. This replicates – if not surpasses – the detail coming out of the best of the fundamental feeds. Besides if you are doing M&A diligence, you are looking at more than just financial reporting filings anyway.

There’s always been the notion among analysts that the first true use of XBRL filings exhibits would be based on subset analytics as opposed to extreme diligence tracing of every nuance item in a filing. From what we see, the June 2011 filings population should provide the first near-census test opportunity to do aggregate and sector analysis on U.S. public companies where the data goes directly from SEC’s EDGAR system to the research department without needing to pass through an intermediary processor. And it is chain of process traceable to the government evidentiary source. We like that!

Second, from our cursory inspection we believe many of these company created extensions are undoubtedly common in nature. They can – with proper effort - be aligned into new standardized taxonomy elements over time. As these winnow down, we expect what remains will be the types of specifics that are truly company unique. Still, seeing a million data elements to catalog is once again a good lesson to all that in data management for information to be usable, less is more.

SEC Interactive Data: Approaching Usefulness in 2011

2011-01-24T15:01:00.000-08:00

By the second quarter of 2011, we will see another wave of machine-to-machine interactive financial data become available directly from the U.S. government. In June 2011, approximately 8,700 companies will begin to file supplementary “xml” files accompanying their quarterly and annual financial statement filings with the Securities and Exchange Commission. XML files can be read directly by computers allowing instant absorption by the analysis programs -- institutional and individual – to evaluate public companies. At its most grandiose, it means that investors, litigants and policy makers will be able to examine and assess the official legal version of these filings as fast as Regulation FD (Fair Disclosure) will allow.

This latest technological jump in financial information transparency is the result of a number of years of work by the SEC. The process included having to develop a specific sub-dialect of xml called XBRL, a many year exercise to turn the free form reporting of the U.S. Securities Act into a workable codified set of data construction rules. Because it blends management statements, the legal requirements of speaking about both “Financial Statements” and “Safe Harbor” discussions, and numerical precision of form-like data enhanced by company unique extensions, it is the most complex attempt of this type to date.

Not that the SEC is a stranger to XML. It originally started the process by requiring the relatively simple Forms 3, 4 and 5 that report on company ownership to be submitted per an XML specification via an online form. Hundreds of thousands of these documents have been filed and machines capable of reading them are able to render who has what at the most complex companies transparent. The SEC is also working on the XFDL specification that will codify many more form types submitted to the SEC.

Prior to this the most complex government financial data collection exercise took place in the parallel universe of the U.S. Banking Act. The FFIEC had brought the reporting of FDIC Call Reports into a Central Data Repository (CDR) and pioneered a three tongued publishing methodology that delivered perfect synchronization among a human viewable HTML file and two computer readable data files, one in xml format and one in CSV format thus covering 99.99% of possible downstream analysis interfacing cases. It set a high standard for all direct government-to-public dissemination to follow.

Getting Ready for Prime Time

One of the true tests of a new idea is whether or not it still works when one shuts down all the “experimental versions” of the process. The U.S. government version of this is beginning this phase now. Being analysts who use filings data to assess companies as opposed to XBRL developers seeking to make a living by filing documents with the SEC, we decided the time has come to do a “production acceptance test” of things as we wait for June 2011 to arrive.

Test number one was to ignore all experimental filings data feeds from the SEC and ask the key question, “ Is it possible to find and catalog these documents using only the official EDGAR Accessions file?“ And our favorite follow up government accessibility and transparency question, “Is what it takes to do that sufficiently low hurdle that anyone can do it for free or near free?” This is a critical operational issue because in the end, if it doesn’t work via a truly publicly accessible librarian pathway it isn’t soup yet.

We are happy to report that the answer is yes and yes. One needs nothing more than the SEC Accessions Catalog file to generate a complete table of the URL pointers to every xml filing. It’s implementable as a lights out program and we plan to create a look up utility with the link pointers to all the xml support files that will be incorporated into our IRACorpFilings.com site. Each filing has a set of xml files that together constitute the XBRL submission supplement to the main filing document.

The SEC’s implementation of downstream transmission support does not presently have the CSV check file version of the data alongside the xml as is done by the FFIEC. For one thing that makes it slower to process back into an RDBMS but that’s just an inconvenience and not a show stopper. What bothers us on this one is that we would like to see the CSV check file accompanying the xml file set – or at least the main xml file with the blocked data elements in it -- because having two machine readable versions of the same output file from the evidentiary source will help immensely for downstream users who need to automate testing for internal consistency in the incoming reports. We recommend that SEC OID look into this as a production feature to come online hopefully by the end of 2011.

We did note that the earliest 1,503 companies from the first and second wave of these filings did something odd … to us anyway. They prefixed the filenames of their xml files with their stock ticker symbols, an identifier that is not an internally verifiable construct – CIK is the real U.S. Securities Act legal identifier and is already in the header of the filing. You have to look up the stock symbol using an external “private” source and we flagged it as something that will become a “human reader” issue later on. There will come a point when the filers reach beyond just the major exchange traded public companies to what we like to refer to at IRA as the remainder of affected SEC Registrants.

It’s not an issue for machine-to-machine reading by the way. Computer programs don’t read and any unique string of text constituting a valid filename is sufficient. The bottom line is that locating usable URL links to XBRL xml file sets in an SEC filing is not a make or break issue requiring any sort of global Legal Entity Identifier. The xml files accompanying each filing could be named “Fred” and can still be successfully targeted by any well programmed computer. The SEC Accession Catalog is dandy and we look forward to our program – and ones written by others -- reading out and data basing the links to xml from these filings as they continue to appear.

Next installment, we’ll talk about what’s in the files themselves and what we think about using them to do surveillance and assessment analytics. Once you know where the files are the next question is, “Can you do anything with them besides print them out?” The real value after all is in the distillation.

A Deepening Dearth of Lending

2011-01-20T14:15:00.000-08:00

I was on Canadian network BNN last week. It is earnings time for banks and as much as I loathe talking about economic safety and soundness through the distorting lens of equities I attempted to field questions. It seems that “earnings per share” is looking better at some banks this quarter and people are asking if the time is “now” to get in on the gamble. The buzz must be hot to get people to pony up because I’m getting emails asking if I think this is the bottom of the well. Just a reminder, brokerages earn a living by charging commissions on the volume of transactions, not on the gain or loss of the investment.

As I tried to explain on air, picking through the lint in my belly button I’m not sure that today is the equivalent of the day Ford was at $1.00/share for the banking sector. We’re still seeing a lot of accounting based earnings coming from numbers in a computer being moved from one ledger to another creating what – in the time of Sarbanes-Oxley (remember that?) – would be categorized as one-time events. As for me, I still see banking as a supporting cast service provider to the economy. I’m waiting to see indicators of fundamental change in the direction of Main Street. Everything else is what the Wall Street townies call “optics” when happy hour comes around.

The continuing decline of domestic economic reinvestment

It’s not looking all that great on Main Street. Domestic economic reinvestment continues to slumber like Sleeping Beauty waiting for true love’s kiss. It’s weird really. How else can one explain the juxtaposition of “exceeds analysts expectations” with “six one-hundredths of a percent of real growth” in the same news cycle? These are the times when the solace of perspective is best found by ignoring volatility and focusing on the deeper trend lines.

Just so you know the overall amount of commercial and industrial lending by banks in the United States eroded by about 1/3rd from roughly $1.4 trillion in Dec-2007 to a bit over $1 trillion at the end of Sep-2010. Not to make light of a $400 billion dollar loss in going concern domestic economic investment by the banking system, but the really shocking numbers are in the unused line of credit commitments of banks to U.S. business. This is the canary number I like to look at because it is a direct expression of banking and finance confidence in Main Street industry. It’s gone from $92 billon in Dec -2007 to just $24 billion as of Sep-2010. More importantly, the vast majority of this contraction of credit availability to American industry has been by the larger banks, C&I LOC from $87B down to $18.8B by the institutions with assets over $10B. Poof!

We are now entering the fourth year of our saga. The kicking the can down the road approach to preserving banking infrastructure as a vital national resource continues. It’s now been husbanded by both a Republican and a Democratic White House. Both have succeeded in preserving banking. The “can” itself – the US domestic economy -- is still getting smaller. Is that really the best plan we can come up with?

So what can you do?

Next time you interact with your bank, ask them to tell you more about they are doing about expanding loan production. Ask specifically to tell you some details about what they are actively doing to clear away their remaining impediments to new lending. Are they modifying or disposing of whatever non-performing assets they have to get them back on track? How else are they using their resources to invigorate the Main Street economy? How are those line of credit commitments to small business commercial and industrial borrowers coming along towards recovering to pre-2008 levels?

Some bankers will balk that you'd dare to ask such questions. Others will gladly wax on about all the things they are doing to make things better. You'll certainly learn something about who's being a responsible banker and who isn't. Be prepared to be both disapppointed and pleasantly surprised.

Bear in mind that these questions aren't about small versus large. They are about discovering where decency and responsibility still are in America. It's there. The task at hand is to find and reward it. Remember that in America the voices of ordinary people still matter. Don't let anyone tell you otherwise.

Bank Failure Observations Worth Noting ...

2010-06-08T09:20:00.000-07:00

In case you didn't see it, the last few days have seen some interesting things happen over in FDIC land.

Last week, the FDIC took down two micro banks. These small institutions basically imploded in one quarter, a pattern that has not been the norm in terms of bank closures. Most are allowed to struggle along for as many as 5 to 8 quarters before facing the inevitable. These are different. Disaster strikes quickly. The pattern first appeared with the demise of La Jolla Bank in San Diego when a large fraction of their commercial R.E. loans went sour en masse. The question I asked at the time was "how many other banks on the edge are looking at 'walk away obligor' risk?"

Last week tiny Arcola Homestead Savings Bank in Illinois and First National Bank of Rosedale, MS also did dramatics power dives to oblivion. Also last week the FDIC shut down long struggling Tier One Bank in Lincoln, Nebraska.

You can look at them on IRA's Casualty List Forensics page if you like.

http://us1.institutionalriskanalytics.com/pub/Forensic.asp

2009 Commercial and Industrial Lending Trends at Large and Mid/Small Banks

2010-05-14T09:37:00.000-07:00

I decided this blog would be a good place to take on answering more questions. This week a compare and contrast request about what's been going on in commercial and industrial lending and how reactions to market pressures in 2009 affected the large and small strata of the banking industry.

Here’s my take on it:

During 2009, C&I loans outstanding by large institutions declined from $1,200B to $953B between 12/2008 and 12/2009 confirming the Federal Reserve’s observation of a 20% contraction in lending. Of note, this shrinkage is equal in magnitude to the lending of the entire mid and small bank lending base. During the same period, the under $10B asset banks went from $310.8B to $281B in C&I loans outstanding, an estimated contraction of only 9.5% based on an IRA examination of the universe of FDIC CALL/TFR Reports from the period. On the surface that would seem to single out the big banks as being the sole culprits of diminishing credit availability in the U.S. That’s not quite true and here’s why.

Another important part of the credit availability story for U.S. business in 2009 reveals itself more clearly if one looks at unused commitments for C&I Lines of Credit (LOC). During 2009, large bank C&I LOC commitments went from $46.7B up to $49.8B for the year even as their annualized gross experience factors tripled from 113.1bp at the beginning of the year up to 294.9bp by December. Granted the terms demanded by these big banks became more onerous. However on the mid/small bank side of the industry, credit availability completely collapsed in 2009. LOC commitments for these banks plummeted from $17.3B at the beginning of the year to $8.8B by year end. For them, gross defaults only doubled going from 98.9bp to 218bp for the year but it still resulted in a more severe commitments contraction.

The real question then is what’s behind the disparity in reaction patterns to what I personally believe are actually two parallel sub-groups within a larger complex industry?

Smaller banks don’t have the reserves depth of their larger counterparts so their reaction to systemic stress is to pull back from risk taking. They embark on a flight to quality and that ultimately results in fewer, but not that much fewer, loans and tighter limits on commitments to lines of credit. Borrowers are faced with the task of overcoming much higher acceptance standards.

Big banks, who had been far more liberal in their lending when winning market share was the mission at all costs, begin to cull their lower quality loans under the pressure of improving operating risk management. They can then draw on government subsidies and use them to issue new loans on more onerous terms because portfolio theory dictates they need these higher terms to recoup the loan quality mistakes now manifesting as higher default rates. To attract customers, they grant somewhat more liberal lines of credit that are of course shrouded in covenants designed to make actually trying to use these lines an obstacle course. That’s what’s meant by “loss management” strategy.

The net result from these independent parallel responses to the common systemic shock? U.S. commercial industry is more difficult and costly to conduct.

Here are the reference data links:

Large Bank C&I
http://us1.institutionalriskanalytics.com/Widgets/Factoid.asp?view=112

Mid/Small Bank C&I
http://us1.institutionalriskanalytics.com/Widgets/Factoid.asp?view=113

Bank Crisis Casualty List

2010-04-27T16:42:00.000-07:00

Here's the link again for the failed banks casualty list with the IRA forensics reports.

http://us1.irabankratings.com/pub/Forensic.asp

After Bastille Day: Is There a Future for Big Banking?

2010-04-27T16:40:00.000-07:00

As bank reform continues to grind through Congress something sorely lacking so far is concentration on safely managing down "points of risk" from Too Big Too Fail business models. We are awash in anger but remain devoid of constructive action. Perhaps it's because finding better basis for the role that big banks play in the U.S. economy is so important that we are paralyzed? And in this I'm including both the government and industrial side of the fencing. We all know this is the next step in the evolving theater so why aren't we infusing this latest round of legislation with constructive guidance and authorization to put the U.S. on a path to a solution? Possibly because we need someone to define a better mousetrap. Here's my stab at thinking about what that might be.

I've been observing with great interest the Johnson and Kwak hypothesis about limiting maximum bank size as a function of risk to U.S. Gross Domestic Product (GDP). The thesis is that we need to somehow cap TBTF exposure so that it's no more than 4% per business entity. It's an intriguing thought that causes me to wonder - as many other people are - about how one might go about slicing up the population of TBTF's to achieve this in a way that does not trigger unwanted side effects to the remainder of the economy in the process.

Over the years IRA has piled up mountains of data on banks and I've designed tools to support all manner of what-if modeling for acquisitions and divestitures. Some of these tools were used to confirm that the objectives of the Move Your Money initiative would indeed be positive contributors to the economy before we committed to donating our support to this cause. The tenets of building solutions strategies that are stable and achievable are central to my own comfort zone going all the way back to my Cold War days as a strategic military analyst. These cautions apply even more so when it comes to turning screws on the nuclear devices of finance, the TBTFs.

So the thought hit me that it might be interesting to ponder the stoichiometry - the math behind the chemistry - of the TBTF rebalancing issue. Butchering mastodon into chewable portions along logical lines turns out to be a rather complex process of avoiding unintended consequences. It's clear that doing careful impact analysis on things like regional competitiveness and market share up and down the national to local strata of the economy is critical. We do not want "machete-scale" TBTF action at the high end to cause undue damage to other parts of the banking and finance system.

For instance, parametrically slicing any one of the big banks is probably a combination of separating lines of business, dividing operating geographies and in some cases further dividing share within over dominated specific markets. The appropriate sizes and lines of business combinations are in turn driven by the landscape of incumbent competitors, large and small as well as healthy and stressed, within the affected sub-markets. Because we still do want to improve economic system efficiency not degrade it, there remains an overarching need to preserve whatever economies of scale and technology leverage have been gained from these big banks' combined corporate learning curves.

While the populist thinking is to send these banks to the gallows, that's not necessarily the safest or even achievable approach to furthering long run U.S. economic stability. Note that one does not necessarily need to legally slice up the institution to accomplish many of these risk management objectives. In fact, in some cases, it might be strategically counter-productive, causing a disastrous series of "knee jerk" responses further destabilizing the system. What's important to consider here is what's in the best "national interest".

As the nation ponders bank reform, I suggest that opening a line of discussion about a series of stringent rules imposed on banks that are either over a certain size or if they engage in certain combinations of lines of business. Such a discussion would say that they must set up set up certain new "walls" between segments of their business and run them as silos might be enough to bring some aspects of net risk to GDP per institution into better alignment. In other aspects of the process, forcing the creation of true arms length separations might be more appropriate.

I also believe that both government and banking need to be exploring this, if not together, then certainly in parallel. TBTF banks can make it proactive corporate policy to set up internal controls so that no single silo within their business can generate a "bail out" triggering risk. Banks within a certain exposure class can do the right thing and elect to disclose more transparent data so their combined systemic risk exposures can be tracked by both regulators and markets to emphasize promoting - as opposed to hiding - earlier warning and avoidance of future broad crisis conditions. Just like we did with things like Sarbanes-Oxley give them a fixed number of years to change, instruct the regulators to track the changes and adjust the regulations during that period to take advantage of what's learned during the process, then make the resulting more stable rules mandatory. Anyone who resists the tide? That's what liquidation is for. Now you've got a true carrot and stick enforcement strategy with a specific and actionable set of objectives. Better mouse trap.

Only in this way can government once again begin to operate as a guiding hand instead of a slapping one. If we don't do this we're going to break something. This is industrial engineering on a grand scale no less far reaching other great things in America's history. It cannot be done by the seat of one's pants or the smell of one's nose. But it can be done.

Investment Banking and California's Municipal Bonds

2010-04-27T16:38:00.000-07:00

California State Treasurer Bill Lockyer is a man with a lot of questions. On March 29, 2010 his office sent letters to Bank of America Merrill Lynch, Barclays, Citigroup, Goldman Sachs, JP Morgan and Morgan Stanley asking about their Credit Default Swap practices. In his letter, he expressed worries that these firms - who are hired to market California's General Obligation (GO) bonds and also sell many other municipal debt issuances across the United States -- also participate in the credit default swap (CDS) business of betting against these bonds.

Mr. Lockyer notes that the State of California has never defaulted on its' obligations, he asked each bank to explain why they both sell for the State on one hand and bet against the State with the other. Responses were due back by April 12, 2010 and the State of California posted all of the responses on the Treasurer's website at this URL http://www.treasurer.ca.gov/cds/index.asp.

Why is there a market in California defaults? Basically an opportunity for arbitrage - what I like to call a mathematical gap between reality and financial modeling - exists. In an article published by Bloomberg News on April 19 on L.A. Unified's latest bond issuance, they note that California has "the lowest-rated U.S. state, is ranked Baa1 by Moody's, three steps above non-investment grade, and A- by S&P, four levels above." Bookies call this the "spread" and so does Wall Street.

The language of the banks responses to California are steeped in the murky language of finance but translated into English the banks say the answer is because there's money to be made playing both sides of the street. In the finance business it's acceptable for institutions to happily take fees and commissions both on the "sell side" as they market California's debt to primary buyers and on the "buy side" making markets - that means promoting business - for people betting against that debt using, among other things, CDS. Of the banks asked, the response by Goldman Sachs was the most direct.

They explained that working both sides is fine and dandy because a "Chinese Wall" separates the two sides of their activities. The message is that California - or any municipality - is a client only of the sell-side. California is not a client of the buy-side on the other side of the "Chinese Wall. That's some other "client" in need of insurance because the rating agencies say your State isn't a risk free investment. In effect, they take the business position that the job of a Wall Street middleman is to make as much for the house from both business channels. The other banks admit they do this too though the demeanor of their letters seem somewhat less ebullient probably remembering that there's money to be made on the sell side.

The letters tell California State Treasurer Lockyer that CDS is actually a good thing because someone buying insurance on the predicted mathematical default probability somehow means they are creating a bigger market to buy more of it. Huh? That's what the letters say. The common theme says because someone buying California GO bonds can also buys CDS protection they can lever up and buy more GO bonds. They've hedged their position against California defaulting on its' debts even though it never has. Remembering that their sell-side services business is also lucrative, they also say that California's bonds are among the most desirable on the planet. This brings up two questions. One, are you sure that Chinese Wall is sound proof? And two, why do you need default insurance on bonds that don't default again?

Citigroup, one of California's staunchest sellers of tax-exempt municipal issuances, did note with what I felt was a hint of sympathetic frustration in their response that they thought the buy-side hype about California's so called modeled default spreads has been overblown and at times out of control. Insurance is about selling perceived risk even if that perception is purely mathematical. So maybe we need to ask if, just as people wonder if some ratings were pushed up to help sell certain types of now toxic securities, might there also be a need to see if we need to weed out systemic pressures to push risk spreads on CDS arbitrage?

If your head isn't hurting too badly yet read on. It gets weirder.

On February 17, 2009, President Barack Obama signed the American Recovery and Reinvestment (ARR) Act. Part of this stimulus package created something called the Build America Bonds program known in finance circles as BAB's. Most municipal bonds are tax-exempt financial instruments. BAB's aren't. They are federally subsidized taxable bonds sharing some of the characteristics of corporate bonds.

BAB's opened a door for taxable bond investors, who had previously not been as active in this area, to become active speculating on municipals. In case you haven't figured it out by now the finance universe consists of micro-communities that get along about as well as the bi-polar opposites of the U.S. middle-class, Progressives and Tea Partiers. Taxable bond investors are used to working with corporate bonds. Unlike sovereign debt, corporations carry tangible default risks and corporate bond investors live by the motto that it's prudent to take on insurance to hedge their positions. So what happens when these people come to play in the municipal bonds sector?

Their deeply ingrained habits about the "investment tripod" of position, hedge and financing will begin to alter the market for municipal bonds. Corporate bond CDS spreads are based on the perceived problems of the company. Anything and everything imaginable is fair game for arguing what the spread should be. And these folks can be a mite jittery. Can Municipal BAB's be any less risky than a heavily government subsidized entity like General Motors? And so California's legendary polar politics, budget woes and legislative gridlock become the shrapnel far outweighing the payment history tapes.

Reading their letters, all of the respondents noted that they weren't quite sure what this means. Alignments of unsteadiness like that are significant in finance. BAB's are new, a very recent invention on the Obama Administration's watch. All of them were careful to assure California that this won't affect demand for the State's General Obligation bonds. But the letters also said the CDS desks of these institutions fully intend to continue to make markets from this new source of transaction clients interested in purchasing CDS insurance on things like BAB's. They also indicated the possibility that the CDS' written on these BAB's may result in an uptick in both rational and irrational analysis of municipal issuer default quality. That could make all municipal bonds harder to sell. Given that the credo of charge what the market will bear is almost irresistible to Wall Street, one needs to ask if the law of unintended consequences just manufactured another future systemic challenge to deal with.

One additional note, the statutory issuance window for BAB's ends in January, 2011. However, other federally subsidized taxable bond programs such as the Qualified School Construction Bond (QSCB) program authorized under the very recent Hiring Incentives to Restore Employment Act also exist. So it's not like these things are going to disappear. Per the Bloomberg article mentioned earlier, QSCB's trade more thinly than BAB's so the pressure to help them liquefy is even stronger.

My point is that finance is never quite as simple as calling for solutions one can make with a machete. Bill Lockyer's stack of letters deserves a broader reading. They are a canvas to learn a little more about the perturbations we make to the very complex system that is the U.S. economy.

Thanks to Tom Petruno from the L.A. Times for pointing me at the letters.

Off Balance Sheet Derivatives: Show Me the Money!

2010-04-27T16:36:00.000-07:00

It's always good to have something to ruminate on over the weekend. With bank reform being the "trill thrill" of the week, what's this derivative thing? And more important, who's got how much in play at the casinos? So print this out and ponder it with your buddies while watching that ball game.

Remember, this is all about life inside the Matrix. "It'll feel ... a little weird." Derivatives are made up transactions. Two people, each of whom thinks he or she has the brass to out model the other, agree to bet on what will happen to an arbitrary amount of money. The winner of the bet gets the difference in the outcome. The winnings or losses are leverage that helps the bank participate in more betting both on-balance sheet real investments - they call that improving liquidity - or, if they like the trader/analyst team that did it, authorization from the risk and compliance officers to do more innovating.

They call the imaginary bet the "notional balance". Because it's not real money auditors won't let you book it on a balance sheet and that's why it's tracked as an off-balance sheet line item. For you aficionados, please see form RC-L of the Call Reports. To get the bigger picture, IRA sums these amounts across the individual FDIC Certificate (CERT) units of a bank holding company (BHC) and runs a variety of calculations on these numbers. One of my personal favorite measures is the ratio of the OBS notional balance versus the balance sheet assets of just the operating bank portion of the BHC. This figure gives you an idea of how much leverage derivative activity within the bank contributes to ongoing business operations.

There's one final thing to note before flashing the stash. These families of instruments were originally meant to be back office activities that served primarily to offset market risks against things like interest rate or currency exchange rate fluctuations. In many cases they still are. This aspect of derivatives is what people mean when they say they serve a financially useful function. Many of the banks listed below can and do use derivatives for these purposes. It's the appropriateness of innovating leverage for leverage sake that accelerates systemic speculation we need to assess as we reform.

Ok here goes. What ya'll make of these?

Top 50 Banks Reporting Off Balance Sheet Derivatives Notional Balances to the FDIC as of 4Q2009(amounts in $ millions)Source: IRA Bank Monitor/FDIC

	Off Balance Sheet Derivatives Notional Balance, per CALL/TFR	"Bank-Only" Assets, per CALL/TFR	Ratio of OBSDIR to CALL/TFR Assets
JPMORGAN CHASE & CO.	$78,608,811	$1,729,229	45.5
BANK OF AMERICA CORPORATION	$44,470,772	$1,674,099	26.6
GOLDMAN SACHS GROUP, INC., THE	$41,597,107	$91,050	456.9
CITIGROUP INC.	$37,982,426	$1,278,882	29.7
WELLS FARGO & COMPANY	$4,193,794	$1,187,315	3.5
HSBC HOLDINGS PLC	$2,934,372	$169,142	17.3
BANK OF NEW YORK MELLON CORPORATION, THE	$1,326,055	$178,254	7.4
STATE STREET CORPORATION	$644,678	$153,779	4.2
PNC FINANCIAL SERVICES GROUP, INC., THE	$294,358	$275,877	1.1
SUNTRUST BANKS, INC.	$237,963	$164,341	1.4
NORTHERN TRUST CORPORATION	$182,241	$83,456	2.2
REGIONS FINANCIAL CORPORATION	$115,590	$138,007	0.8
KEYCORP	$100,180	$90,195	1.1
U.S. BANCORP	$93,875	$282,169	0.3
TORONTO-DOMINION BANK, THE	$86,133	$150,102	0.6
BB&T CORPORATION	$68,275	$162,061	0.4
FIFTH THIRD BANCORP	$65,733	$112,736	0.6
UK FINANCIAL INVESTMENTS LIMITED	$57,936	$149,385	0.4
CAPITAL ONE FINANCIAL CORPORATION	$48,629	$165,351	0.3
MORGAN STANLEY	$41,467	$66,159	0.6
MITSUBISHI UFJ FINANCIAL GROUP, INC.	$40,394	$90,357	0.4
HUNTINGTON BANCSHARES INCORPORATED	$27,219	$51,111	0.5
GMAC INC.	$25,915	$55,303	0.5
DEUTSCHE BANK AKTIENGESELLSCHAFT	$21,994	$46,644	0.5
BOK FINANCIAL CORPORATION	$21,053	$25,966	0.8
COMERICA INCORPORATED	$20,339	$59,161	0.3
BANK OF MONTREAL	$18,347	$44,661	0.4
ALLIED IRISH BANKS, P.L.C.	$17,609	$68,768	0.3
MARSHALL & ILSLEY CORPORATION	$17,380	$58,361	0.3
FIRST HORIZON NATIONAL CORPORATION	$17,379	$25,842	0.7
METLIFE, INC.	$15,907	$14,107	1.1
ZIONS BANCORPORATION	$14,781	$52,336	0.3
BANCO BILBAO VIZCAYA ARGENTARIA, S.A.	$14,703	$70,131	0.2
BNP PARIBAS	$11,472	$73,706	0.2
BARCLAYS PLC	$10,182	$12,614	0.8
PACIFIC COAST BANKERS' BANCSHARES	$6,442	$616	10.5
PRIVATEBANCORP, INC.	$5,863	$12,101	0.5
UBS AG	$5,188	$30,174	0.2
CIT GROUP INC.	$5,017	$9,146	0.5
BANCO SANTANDER, S.A.	$3,562	$80,431	0.0
ASSOCIATED BANC-CORP	$3,352	$22,582	0.1
SYNOVUS FINANCIAL CORP.	$3,306	$34,539	0.1
ROYAL BANK OF CANADA	$3,074	$27,667	0.1
LAURITZEN CORPORATION	$3,070	$15,785	0.2
POPULAR, INC.	$2,769	$34,136	0.1
CULLEN/FROST BANKERS, INC.	$2,499	$16,344	0.2
CITY NATIONAL CORPORATION	$2,082	$20,749	0.1
FIRSTMERIT CORPORATION	$1,931	$10,522	0.2
SOUTH FINANCIAL GROUP, INC., THE	$1,929	$11,876	0.2
CITIZENS REPUBLIC BANCORP, INC.	$1,889	$11,820	0.2

January 2010 Failed Bank Forensics

2010-01-24T18:27:00.001-08:00

This is the list of links to IRA's failed banks forensics pages for the banks that were closed by the FDIC in January 2010. These pages are part of our ongoing studies to understand the nature and sensitivities surrounding bank risk. We share them here so other researchers can also ponder the "patterns in the noise".

Columbia River Bank - The Dalles, OR 1-22-2010

Evergreen Bank - Seattle, WA 1-22-2010

Charter Bank - Santa Fe, NM 1-22-2010

Bank of Leeton - Leeton, MO 1-22-2010

Premier American Bank - Miami, FL 1-22-2010

Town Community Bank & Trust - Antioch, IL 1-15-2010

St. Stephen State Bank - St. Stephen, MN 1-15-2010

Barnes Banking Company - Kaysville, UT 1-15-2010

Horizon Bank - Bellingham, WA 1-8-2010

First Bank Closure of 2010

2010-01-13T18:26:00.000-08:00

On January 8, 2010 the FDIC failed Horizon Bank in Bellingham, Washington. Here is the forensic page for this bank.

Horizon Bank

Note from the data that the first indications this bank was in trouble was in early 2008. At the end of 2007, the bank's Federal Home Loan Bank (FHLB) advances exceeded the 15% maximum and crossed into territory the FDIC considers to be a Moral Hazard. One quarter later(in March 2008), the lending default rate went from 1.6 basis points to 26.1 basis points. A basis point is 1/100th of 1 percent.

The track record of the next two years shows things worsening progressively finally resulting in the first FDIC closure of 2010.

Failed Banks. The December 18th Group

2009-12-21T11:37:00.000-08:00

The FDIC failed seven (7) additional banks on December 18th. Two in California and one each in the states of Illinois, Alabama, Michigan, Florida and Georgia. The jump from an average of four per cycle to seven indicates that the build up of the FDIC's task force for bank closures has reached operational status and we can expect that the pruning of weaker banks from the system will proceed at a brisker pace in 2010.

This is a good thing. Clipping off the low tail of a moribund system serves to eventually bring the overall industry up the quality tree. It's an example of a regulatory agency doing what it's supposed to. Yes I do hear those of you lamenting "if only we could do the same over in the large bank and investment bank segments of the system." True there's a lot more politics involved in arresting the risk shifting gamesmanship at the upper end of the spectrum to actually achieve some productive pruning. I'll take a little larger view though. The remainder of the banking system is being "trained up" by what the FDIC is doing and eventually this higher quality population of competitors will make their mark on the landscape. There may be some "mastodon stew" for these emerging hunter gatherers to feast on yet.

So here's the next installment of what I think will be a weekly forensic report by IRA. Your feedbck is important so let me know if you want to see more of these.

First Federal Bank of California, FSB Santa Monica, CA
Imperial Capital Bank La Jolla, CA
Independent Banker' Bank Springfield, IL
New South Federal Savings Bank Irondale, AL
Citizens State Bank New Baltimore, MI
Peoples First Community Bank Panama City, FL
RockBridge Commercial Bank Atlanta, GA

As you'll see in these forensic tables the IRA Bank Stress Index letter grading methodology picks up on the stresses with a fair bit of warning. More than enough to implement tactical plans to mitigate exposure and shift assets to more stable institutions.

Survey Invitation

IRA is taking a survey of how CFO's, Treasurers, bankers and bank counterparties feel about the current financial landscape. It's a short survey and we invite you to participate. If you'd like to take the survey please email Diana Waters before January 15, 2010.

Failed Banks: What was knowable when?

2009-12-14T22:00:00.001-08:00

Bank failures happen at close of business on Fridays. A team of operatives from the FDIC shows up at the door and by the time those doors open again on Monday morning the bank has been inventoried, valued and transferred to a new owner. This story institutional devastation has happened so many times in 2009 that it become a footnote fixture in the weekly wrap up of financial news. Americans don't quite understand how it really works except to take assurance in the fact that the Federal Deposit Insurance Corporation (FDIC) somehow takes care of them even as tumult rages on.

So is it possible to see this kind of trouble heading towards a bank? And if so, how far in advance of disaster do the indications begin to reveal? That's the question that comes across my desk frequently. Everyone wants to know if the IRA Bank Monitor can see it coming. The direct answer is yes. IRA's A+ through F grading system was in fact developed specifically to illustrate these Bank Stress Indices or BSI's so as to begin warning early enough while there might still be time for bank directors and officers to attempt to avoid or mitigate a crisis that could result in regulatory action. But not all banks make it. For some, the fate of failure manifests. It is from these that it's possible to study the "What went wrongs?" so that the clues in the rubble can help others avoid the same fate.

On December 11, 2009 the FDIC closed three banks. The links point to IRA's Failed Bank History Report that shows the prior twelve (12) quarters of stress history for the failed institution. They are presented here as forensic examples.

Solutions Bank
in Overland Park, Kansas

Valley Capital Bank, N.A.
in Mesa, Arizona

Republic Federal Bank, N.A.
in Miami, Florida

I highly encourage serious students of banking and bank risk to study them. Reports on live institutions are available to subscribers at http://www.irabankratings.com/ .

Industry and Bankers: Chasing Quality

2009-12-08T15:17:00.000-08:00

Today we turn to looking at the banking scenarios facing CFO's and Treasurers. As 2009 ends we see the Obama Administration preparing to gear up its job restoration strategy. President Obama and his team, along with pretty much every other financial expert, correctly surmises the importance of bringing US unemployment down and restarting the Main Street economy as critical to maneuvering the economy away from the vortex created by the collapse of the leveraged finance house of cards.

I must say that I personally find the thought of a grassroots approach based on emphasizing small business recovery to be refreshing. The concept that "many hands make light work" makes good sense to me. The best of breed from the old ways will do well regardless. Encouraging and supporting smaller more maneuverable business to fill the needs voids will almost surely result in a revitalized and globally competitive United States of America. It's the kind of thing this country, encompassing all our political and cultural persuasions, is good at. It's certainly a more persuasive use of precious national wealth than continuing to prop up obsolescent "sucking sound" infrastructures. The question is of the new year will be can the Administration steer a course to the correct balance. I wish the President and his team the best in this effort.

The Flight to Quality, A Never Ending Journey

The impact on banks and businesses by what is about to unfold are many but ultimately it boils down to quality. The quality of the commercial and industrial entities that will seek and use business financing in 2010 and the quality of the banking institutions that will serve the new landscape. The banks will need to contend with two things to clear the way serving Main Street again.

First is completing the transition into a new reality that the country has moved into a post real estate boom phase. Shedding exposure is a tactical necessity. This means banks need to tend to their own health particularly with respect to the lingering cancer of losses from distressed real estate still in their bloodstreams. Projected real estate loan losses still to come are massive. The bulk of Option-ARM reset dates are in the still to come in 2010 and 2011 bucket. The reality is that these loans were never meant to survive the reset. Unless an alternative is created, the human pain and loss will be massive. The current loan modification program has an applicant failure rate of over 60% and the actuarial probability is that the remainder might just be a delaying tactic slowing the inevitable. Here's the truth. We have a lot of U.S. homeowners who can only afford to be U.S. renters. Until their relationship with finance and banking is morphed to reflect that truth the cancer will remain in the national bloodstream. Statutory loss reserves and FDIC insurance premiums will continue to suck discretionary capital away from new lending and a credit availability crisis will hamper the President's recovery agenda. Still, looking at the various piecemeal components of proposed solutions to this that have crossed my desk in the last year, I have a degree of belief there is a way to do this. It needs someone to architect it into a cohesive strategy then sell it to what is clearly still a weakened and hesitant hospital patient.

The second challenge to banks is to make the transition back to becoming a competitive marketplace for quality lending. Specifically, for the supporting the President's agenda, quality commercial and industrial lending. C&I loans and lines of credit are the fuel that grows economies. Targeted C&I for small firms may be forthcoming if the Administration follows through turning policy into substance. We should not be surprised if keen competition for the highest quality C&I customers will become all the rage next year. Indeed CFO's and Treasurers of well positioned firms should be insulted if they don't have several bankers knocking on your door courting their business accounts. There's some evidence of that happening already. Expect to see all kinds of spin about why your current bank is a pile of poop and you should become a client of bank X. It'll be all to the good because a competitive Main Street financing market is a sign of an improving economy. Don't believe bank advertising material on it's face though.

CFO's of commercial and industrial companies are well advised to exercise some "Trust No One Agent Mulder" prudence. We've seen a fair few "we're better than your old bank" pitches that turn out to have higher risk and stress ratings than a company's existing banking relationships. When asked we tell companies it's worth the peace of mind to obtain even the basic IRA report on one's bank and any bank pitching you for business. CFO's need an independent eye. Think of it as getting a "CarFax" before signing the papers. Making banks compete in the bright light of day could even sweeten the pot for a CFO particularly when being approached by equally good and competitively motivated banking alternatives. Finally, in these days of SOX compliance, it's also important to prove to the finance committee and to satisfy potential adequacy of internal controls challenges that one did use at least one independent criteria to base one's decision on.

In parallel, Treasurers need to look at their deposits placements and cash management strategies with a keen eye on bank quality. There are 8,500 or so active banks in the U.S. Not all of them are healthy. Some of them are "hazardous" and that's not a term I made up, it's a category they fall into based on business conditions exceeding regulatory criteria thresholds. And just relying on ladders and brokered deposit spreading isn't enough. Treasurers still need to pick one or more primary banking relationships where sizable balances may have to sit as part of enabling the smooth operations of the CFO and COO of the firm. The same reality that hit the Wall Street finance universe applies to industrials. Shifting risk is no substitute for reducing risk.

Teeter Tot: Third Quarter Stable at the Brink

2009-12-06T17:01:00.000-08:00

There's good news of sorts from the third quarter data. The risk distribution of the banking system looks to be in a holding pattern. Life is still full of pain of course. Credit availability remains tight. The prospect for more mortgage losses in 2010 remains looming. Leveraging vehicles for finance are sparse. And the valuation of the real assets underlying capital continues to shrink. But here's the good news. There's a pattern to the pain. The volatility and uncertainty surrounding much of 2009 has morphed to a collection of set piece issues. And that gives me some hope because set piece battles are things we can begin to work on. We Americans tend to be as good at tactical problem solving as we are bad at strategic vision. But this means that overall our problems are moving towards our strenghts rather than our weaknesses.

The risk map at the end of September 2000 was as follows,

IRA Bank Stress Grade Distributions

Period	A+	A	B	C	D	F
200909	3,308	1,481	410	429	77	2,337
200906	3,518	1,449	417	421	72	2,256
200903	3,959	1,431	452	437	88	1,820
200812	3,918	1,448	376	390	98	2,003
200809	4,498	1,293	315	356	63	1,793
200806	4,884	1,323	329	326	66	1,458
200803	5,167	1,271	349	334	68	1,233
200712	5,556	1,196	298	315	70	1,029
200709	5,931	1,083	262	274	37	902
200706	6,056	1,090	236	273	60	824
200703	6,075	1,112	249	284	63	795
200612	6,370	1,087	212	204	39	697

And asset distributions are,

IRA Bank Assets Stress Distributions

Period	A+	A	B	C	D	F
200909	$1,756	$1,938	$4,316	$584	$94	$4,535
200906	$2,005	$2,097	$4,132	$518	$68	$4,458
200903	$3,202	$3,131	$3,587	$729	$86	$2,784
200812	$2,366	$5,398	$403	$694	$46	$4,033
200809	$2,907	$5,504	$525	$704	$144	$3,772
200806	$2,897	$5,256	$400	$695	$51	$3,983
200803	$3,461	$5,119	$384	$630	$36	$3,719
200712	$7,613	$1,719	$1,629	$1,248	$107	$705
200709	$8,384	$3,203	$129	$568	$13	$395
200706	$8,619	$2,804	$98	$497	$56	$170
200703	$8,378	$2,629	$209	$550	$31	$170
200612	$9,004	$2,029	$165	$483	$78	$88

Amounts in $ Billions.

The risk map is roughly identical from 2Q2009 to 3Q2009 give or take a little because of continued but now predictable hemmoraging. So where are America's challenges ahead?

Do we have the political will to do the right thing?

Bringing Wall Street back into the service of Main Street remains elusive. Finance remains a universe separate from the rest of our reality. The excesses of a decade and a half of "financial innovation" have been exposed but the inertia behind the collapse continues to fight on delaying the finance system's reintegration into mainstream society. What else can you say when you witness artifacts such as a stock market that pushes up prices on the arithmetic of expense management paid for by the unemployed and underemployed. Or a derivatives market so steeped in its' habits that it remains hell bent on preventing the kind of transparency that would help ensure the debacle we are living through won't happen again? These are not economic fundamentals, they are social and political risks that this nation cannot afford. The Administration and Congress are by now well aware of these forces and their effects. There is no reason the citizenry should not expect our leaders to do the right thing.

Refocusing industry incentives to make things right.

Just under 2/3rd's of the banking industry's assets lives in the A+/A/B stress range according to our calculations. The remainder have issues clearly requiring some degree of extraordinary administration. But so far, the remediation efforts of the United States remain piecemeal and nearest I can tell, overly focused on a few large entities that fall within the fashionable coverage limit of the major news bureaus. We have so far failed to systemically tap into the single largest source of recovery strength we have, the healthier banks. They are there but they are hamstrung from acting lumped in with the weaker and louder players who's calls for mercy and aid via taxpayer dollars retain our attention. In my job I see and talk to some of these A+/A/B banks and even some really smart C grade banks on the mend that struggle to take advantage of their positional strengths. But what should be a downhill run competitive advantage is an uphill struggle for the best of breed. So here's the challenge to our leadership. Refocus the process from a smattering of narrowly selective aid packages to a tidal of movement to change the nature of the industry so it gets back to an 80 good/ 20 bad ratio. This will involve a much larger shifting of impaired assets to sound foundations. It will undoubtedly manifest as a newsworthty mix of debacles and recombinations. But we need to return to a process of natural selection based on value instead of clout.

Make Main Street the political priority already.

We cannot make lemonade from rotting lemons. You can take comfort deluding yourself looking at day to day economic indicators but the reality is that as of September 2009 the total amount of bank balance sheet real estate loans outstanding by FDIC reporting banks was around $4.5 trillion dollars. That is about the same amount as it was in March 2007. It peaked at a high of $4.8 trillion in March 2008 just as the "crisis" was becoming common knowledge to America.

But here's the thing. In 2007 the annualized default rate on these loans was 11.8 basis points. Today it's 194.3 bp. Main street home ownership is struggling. Let's look at a few more then and now comparisons.

In March 2007, 30-89 Day overdue loans was $43.7 billion. Today, it's $100.8 billion.
Over 90 Day overdue loans were $11.2 billion in 2Q2007; today that figute is up to $88 billion.
Non-Accrual residential real estate loans were $29.2 billion in March 2007; we are at $202 billion now.
And bank real estate owned was $6.9 billion in March 2007. Today banks own $37 billion worth of real estate.

The challenge is pretty clear. The degraded real estate portfolio of America's banks massive and does not yet shows no signs of abating. Surrounding this challenging financial scenario is a loan modification program that by best estimates will work for no more than 1/3rd of the problem. An infrastructure solution needs to be found for the balance of the U.S. homeownership problem. Banks saddled with such problems cannot lend and therefore cannot help re-stimulate the economy. In economic terms this is a massive downward accelerating force if not dealt with. Numerous proposals surrounding this subject abound as we reach the end of 2009. None yet cohesive enough to represent anything amounting to a solution. We have a collective choice to focus on it or not.

As Subsidies Subside

2009-09-11T12:13:00.000-07:00

So here we are on another September 11th.

Today I’m pondering next week’s expected beginning of the removal of government subsidies from the U.S. banking system. The stock market has been showing off its’ new found love for driving up equities regardless of the fact that computed stockholder’s equity numbers are now driven not by top line revenue improvements but by the modeled mathematics of cutting back on expenses. According to the Wall Street Journal, economists buoy about the world getting better. Exactly for whom I’m not quite sure because unemployment benefits are soon to permanently run out on people (and their families) for whom these same economists say no jobs are forthcoming for at least another year. I'm not sure I would advise the President to stand between the pitchfork wielding public and the “Black Swan” academicians with Christmas approaching.

And so into this "theoretically improving" world President Obama is expected to inform Wall Street next week that the one of the government's bank subsidy programs ends in October. The Troubled Loan Guarantee Program (TLGP) is a less well known subsidy vehicle than the Troubled Asset Relief Program (TARP) but it is nevertheless one of the pillars of the rescue plan that was put into place by the combined efforts of the Bush/Obama administrations.

TLGP is another one of those things that never really took off in the way people imagined it would. Like TARP it was meant to encourage banks to continue to lend under extraordinarily stressful conditions. However, we’ve all seen that credit availability dried up anyway because ultimately banks backed away from subprime lending as they collectively de-leveraged and shut down the exposure manufacturing aspects of their business models. So because there was no new lending the opportunities to make use of TLGP by the industry were relatively sparse.

So now here’s where it gets a little interesting.

Over the past year we’ve been tracking the system wide trends in defaults, non-accruals and finally other assets owned by banks and we’ve been seeing continued degradations in net lending assets quality. That means that the business need to eventually take advantage of trouble loan guarantees has been growing not receding. The TLGP concept may have been instituted before it’s time and that time may be still be in the future, probably not that far. One might ask, “are we pondering confiscating subsidy tools just as banks might be on the verge of using them?” And of course the even more fun questions "Why?" and “Is this a good idea?”

Of the 8,800 or so active bank units reporting to the FDIC around 3,500 or so have formally opted-out of the TLGP. Yes there’s a list floating around out there that has double that number but if you look real closely people that list has many banks listed twice, once under its’ FDIC Certificate ID and again under its’ Federal Bank Holding Company identifier. So that means 5,300’ish of the brethren have stayed silent on their intentions. This includes most of the bigger banks by the way. It they all activated under the program the Unites States government could quickly find itself running out of another kind of clunker money pool. TLGP extension by exception means a lot of case-by-case evaluation workload for the FDIC’s staff.

Could you put that in English please Mr. Santiago, "I think it means someone is setting up a high hurdle filter."

To be honest one can argue that banks have had ample time these past months to ponder their business positions and make their plans on how they will steer their way into the second decade of the 21st century. Apparently it’s time to test their mettle and let the forces of competition winnow the winners from the losers. If this is so, making TLGP extensions available only to those with true survivor potential as opposed to keeping the program open for zombies actually has national policy merit … as long as it’s applied objectively that is.

To me this means that the administration may be preparing to send a potentially uncomfortable message to Wall Street that it wants to begin to divert capital away from obsessing on artificially floating up the DJIA and redirect it back into economy building uses of private capital. By making it so that banks will soon need such private capital to survive the anticipated loss scenarios of 2010 it means that only collective and focused investment as a cadent nation of citizens can stave off the further withering of a weakened broader economy. It’s a glitch that changes the where and how the nation’s wealth reserves are to be employed. Pretty gutsy move. Wake up and smell that coffee!

“A déjà vu means they’ve made a change in the matrix.”

After Six Months, Deja Vu

2009-08-31T13:17:00.000-07:00

The first half of 2009 has certainly seen an extraordinary outpouring of big government flexing the power of treasure and policy to alter the course of a business cycle. U.S. taxpayers and the world have been asked to participate in a massive co-investment of mind over matter. So has it worked? Has the government indeed shifted the stress profile of the banking system to safer ground?

Unfortunately looking at the 2Q2009 industry stress distribution numbers based on the latest FDIC research master file the numbers tell a tale of doubt. Table 1 shows the population distribution of IRA bank stress indices computed over the weekend. The data includes every active bank in the United States for the end of 2Q.

Table 1: IRA Bank Stress Index (BSI) Grade Distributions

Period	A+	A	B	C	D	F
200906	3,518	1,449	417	421	72	2,256
200903	3,959	1,431	452	437	88	1,820
200812	3,918	1,448	376	390	98	2,003
200809	4,498	1,293	315	356	63	1,793
200806	4,884	1,323	329	326	66	1,458
200803	5,167	1,271	349	334	68	1,233
200712	5,556	1,196	298	315	70	1,029
200709	5,931	1,083	262	274	37	902
200706	6,056	1,090	236	273	60	824
200703	6,075	1,112	249	284	63	795
200612	6,370	1,087	212	204	39	697
200609	6,666	951	186	198	44	628

At first glance you might not see much change. The return to 2008 reveals dramatically looking at the asset values of the institutions in each stress bucket. One does indeed see a bump of improvement at the end of 1Q2009 no doubt due to the combined gallant efforts of the administration and the one before it. But I have to report with what I will admit is a sinking heart that it's all but evaporating according to the second quarter results. We are back to the stress patterns of 2008.

Table 2: IRA Bank Stress Assets Distributions

Period	A+	A	B	C	D	F
200906	$2,005	$2,097	$4,132	$518	$68	$4,458
200903	$3,202	$3,131	$3,587	$729	$86	$2,784
200812	$2,366	$5,398	$403	$694	$46	$4,033
200809	$2,907	$5,504	$525	$704	$144	$3,772
200806	$2,897	$5,256	$400	$695	$51	$3,983
200803	$3,461	$5,119	$384	$630	$36	$3,719
200712	$7,613	$1,719	$1,629	$1,248	$107	$705
200709	$8,384	$3,203	$129	$568	$13	$395
200706	$8,619	$2,804	$98	$497	$56	$170
200703	$8,378	$2,629	$209	$550	$31	$170
200612	$9,004	$2,029	$165	$483	$78	$88
200609	$9,223	$1,918	$57	$430	$31	$86

Amounts in $ Billions.

So where are we? Where are the big banks in all this one might ask? Generally, that would be them beginning to pile up in and around column B country. The regional and community banks remain split in a barbell pattern that's been emerging for some time.

Mission Element Need Assessment

Any analyst who isn't in complete denial about being on planet earth should clearly see at this point that a one size fits all unified theory of problem solving is a load of hooey. We now have on our hands a much more complex battle with at least three elements that need to be maneuvered cleverly if this is to turn out alright.

The A+/A's are our economy's anchor. We need to make sure they are advantaged to capture market share and rebuild our foundation to good operating standards. They aren't necessarily the politically connected. But I do not believe the other two legs of banking can survive without them. Left to me, this is where I'd design the most favorable incentives to encourage private investments. Why here? Because it creates implied financial forces to herd the other two groups towards safer and sounder outcomes.

The B/C banks are the one's still carrying excess leverage from the prior business cycle. We need to bring them back to earth in a controlled fashion. Destroying them is not an option. Though wounded, they are still a tool with a real purpose in our economic landscape. Rather, we need to mend and reposition them so that their penchant for chasing great opportunities can be recycled to help power the next leap of the American dream.

The D/F banks are the great turnaround opportunity of our economy. These are the institutions whose business models have become so mismatched to current conditions that it's showing in red ink net incomes, hazardous exposures to government advances, and unsightly loan loss scenarios. These are the banks that will require the iron hand of the Banking Act reborn to restore discipline to safe and sound principles. Turn them around we must for the sake of our own peace of mind. Mark my words, for each 5% of them we fix we'll feel a quantum of joy better about life in these United States.

The search for solutions goes on.

300 or 2,000? How can we change destiny?

2009-06-01T13:44:00.000-07:00

At the end of every nightmare, a new day dawns. - D. Santiago

This observation about bank stress trends from the IRA Newsletter garnered some attention.

"At the current rate of deterioration, that could put the Stress Score for the entire industry over 10 by Q4 2009 or a full order of magnitude above the 1995 baseline. Such a worst case scenario suggests that we could see one in four US banks merged or resolved through the cycle. In the event, that suggests that over 2,000 institutions, large and small, will be resolved. Put that into context with the FDIC's "official" dead pool of 300 or so institutions and that gives you a tangible measure for how much "spin" might live within the official version of the problems facing the US banking industry."

One email from a respected reporter asked,

"Is this the same thing as saying one in four banks may fail? How realistic is it to assume what the data suggests? What specificially would drive so many banks out of existence? In other words, what's their Achilles heel in your judgment?"

When a bank fails it is resolved, that is, merged by government edict into another "healthier" institution. Yes it is possible that we will see a good portion of now weakened banks become the subject of a merger feeding frenzy later this year. This could indeed lead to the emergence of a smaller industry populated by larger more economically resilient and politically powerful companies. Some people believe that it's a good thing to concentrate banking power into a more consolidated industry. Me? I just see fewer banks charging higher fees for basic services.

What the IRA analyis of 1Q2009 FDIC data is saying is that lacking any improvement in the infrastructure that supports banking, our analysis indicates that the deterioration of the industry will continue to spread potentially affecting a larger population of institutions as the year progresses.

As has been stated in previous observations, banks have been migrating down the path towards weaker net incomes as a result of stalled lending engines and ballooning anticipated losses on existing loans. The pursuit of good lending begins to look more like balance transferrals instead of true blue new loans that expand the U.S. economy. Anything riskier carries the stigma of being just another balance sheet item eventually headed for the REO pile. It's not easy to make a living under such conditions and the biological sustainment capacity answer is that the population must shrink to equilibrate with the environment.

Dude I don't like that answer either. There's no reason why a country like the United States of America should "equilibrate" to a lower quality of life at this stage in our history. It just does not make sense to me that we'd let something like this happen when we have it in our power to create a different destiny.

The Achilles heel in this equation is the bastard cousin of banking ... finance. Finance is the leverage we create to make our money do more for us. It is a powerful and dangerous tool that can both create and be driven by good and evil. Behind banking's ailments is the fact that securitization, a central element in leveraging the operational processes of main street banking, is now dormant. Driven by greed and excess, it's caretakers have been driven into discredit and trust in it has evaporated. Entire industries that enabled it have ceased to exist in the last 24 months. What's left of it is stored in Federal financial toxic meat lockers. We've done all this at the very peril of our quality of life.

The fact of the matter is that unless we get the financial engines supporting our banking product inventory restarted in some rational fashion banking will continue to de-leverage. Does that mean giving the greedy back their licenses to steal candy from babies? Of course not. What I think it does mean is making a national effort to construct the apparatus to deliver a new range of financial vehicles to enable banking to do it's job again. And do it at a quality of life target design point at oh say "the pursuit of happiness" once more.

And so begins the search for a new dawn.

Preliminary Q1 2009 Stress Test Results: Significant Increase in Stress Across the Banking Industry

2009-05-06T21:50:00.000-07:00

UPDATED: May 6, 2009

“Young man sometimes the only way to win is to lose gracefully.”

Gen. Bill Creech, Commander,
USAF Tactical Air Command
to Dennis Santiago years ago

Technology Innovation That Actually Works

We admire the Federal Deposit Insurance Corporation for many reasons. This month, we applaud them once again for the fine job they have done to bring the Central Data Repository (CDR) online in a way that serves the growing public demand for timely US bank data. Made operational just in January of 2009, we’ve just collected Q1 2009 CALL reports for over 7,600 reporting units, a goodly portion of which came out of submittal confirmation only a couple of days ago.

These CALL reports are submitted to the FDIC during a 30 day submission window beginning the first day of the quarter. We’ve been testing a variation of IRA’s ratings analyzer on these Q1 CALL’s since April 1st. The result is that IRA is now positioned to deliver preliminary bank stress estimates for the new quarter roughly two to three weeks ahead of the FDIC’s mid-quarter research master file release. Based on this maiden run, we are pleased to report that the FDIC’s CDR engine has the potential to enable a quantum leap in granularity looking at the U.S. banking industry.

Coupled with our analyzers, it’s possible to generate analysis on bank units as they file their CALL’s and, based our findings, generate a industry picture in around 36 to 48 hours after the close of the CALL submittal window. That’s pretty good!

Stable Pie Slices, But Dramatic Increase in Banking Industry Stress

Based on looking at sample set of around 91% of the test population used in Q4 2008, we observe that the distribution of IRA Bank Stress Rating grades for Q1 2009 retains the roughly 2/3rd to 1/3rd ratio of banks with A+/A grades versus elevated stress institutions IRA detected was characteristic of the banking industry throughout 2008.

Q1 2009 Preliminary IRA Bank Stress Rating Grade Distribution (Based on data for 7,519 bank units from the FDIC CDR*) Source: FDIC/IRA Bank Monitor
IRA Bank Stress Grade	2009 Q1*	2008 Q4
A+	3362	3918
A	1909	1705
B	135	119
C	411	390
D	87	98
F	1615	2003
There were an additional 108 banks in the initial data set that were found to have some holes in the data thus preventing computation for the preliminary analysis run.

We see indicators of a continued migration of banks from the A+ range where stress fall below the index Dec-1995 = 1.0 start mark into the A range indicating more banks are now feeling the effects of economic conditions regardless of the business practice models they’ve had in place.

At this time we do not know what the disposition of the remaining 750 or so institutions that are not in the CDR as of 5/3/2009. We have not yet had a chance to determine who these missing units are.

IRA Historical Bank Stress Grade Distributions based on FDIC Research Master Files Source: FDIC/IRA Bank Monitor
Period	A+	A	B	C	D	F
2008 12	3,918	1,705	119	390	98	2,003
2008 09	4,498	1,325	283	356	63	1,793
2008 06	4,884	1,248	404	326	66	1,458
2008 03	5,167	1,042	578	334	68	1,233
2007 12	5,556	610	884	315	70	1,029
2007 09	5,931	395	950	274	37	902
2007 06	6,056	354	972	273	60	824
2007 03	6,075	304	1,057	284	63	795
2006 12	6,370	134	1,165	204	39	697
2006 09	6,666	29	1,108	198	44	628
2006 06	6,729	0	1,155	194	35	613
2006 03	6,752	2	1,131	187	39	608

At first glance the situation as of Q1 2009 may seem to be getting better. But it’s not. In prior quarters, banks wound up getting “F” grades because they were barely making money; that is, they had small but positive net incomes that produced ROE’s sufficiently below industry averages to indicate elevated business operating stress. A lot of these institutions were suffering due to mark-to-market accounting, goodwill write-downs and other ROE issues.

In Q1 2009, the data indicates a dramatic climb in the industry aggregate average Bank Stress Index from 1.8 at the end of Q4 2008 to a whopping 5.57 coming out of 1Q 2009 or half an order or magnitude above the 1995 benchmark. The reason for this is the number of banks who delivered negative net incomes in the first quarter of 2009, one thousand five hundred fifty-seven (1,557) of them as updated on our system after the data run on May 5, 2009.

Keep in mind what the Q1 2009 FDIC data is saying: Even with the change in the FASB rule for M2M accounting, and Fed liquidity programs, the leading factor driving higher industry stress scores remains ROE degradation, not charge-offs or operational factors such as efficiency. When charge-offs are the leading factor in the IRA Banking Stress Index, then the industry will be through the worst.

Number of Bank Units with Negative Net Income in 1Q2008 by State updated as of May 5, 2009 Source: FDIC CDR/IRA Bank Monitor
AL	27
AR	11
AZ	39
CA	135*
CO	27
CT	12
DC	4*
DE	11
FL	149*
GA	139*
HI	1
IA	29
ID	5
IL	108*
IN	10
KA	1
KS	37
KY	20
LA	11
MA	27
MD	16
MI	53
MN	77
MO	64*
MS	7
MT	10
NC	36*
ND	10
NE	27
NH	4
NJ	26
NM	5
NV	23
NY	30*
OH	22
OK	19
OR	14
PA	41
PR	2
RI	3
SC	18
SD	8
TN	33*
TX	89*
UT	23*
VA	20
WA	49*
WI	22
WV	1
WY	2
* items updated since 5-3-2008. Please note that th FDIC CDR system continues to release data. The definitive lock down of quarterly numbers happens when the research masterfile is released later this month.

The Q1 2009 results calculated by IRA are looking a little like a table from the CDC’s H1N1 confirmed laboratory cases page. Our overall observation is that U.S. policy makers may very well have been distracted by focusing on 19 large stress test banks designed to save Wall Street and the world’s central bank bondholders, this while a trend is emerging of a going concern viability crash taking shape under the radar.

We’ve noted in the past that US banks have been migrating down the quality slope taking an average of 9 months to complete the journey from “A” to “F” on the stress scale. The story is predictable. It begins with business losses and recriminations. This is followed by lending engine contraction as the propensity to create exposure narrows towards risk aversion and “quality lending” exclusivity. This is a rare diet to try to live on in these times. The bank, which makes its’ living wage from the interest it collects from its’ lending engine slowly starves.

At a certain point the carry cost of the infrastructure outweighs the earnings rate. Then you start to see strange shifts to seek incremental income from service fees, a move that often only serves to increase customer reluctance and mistrust. The end result is a stressed business model that can only be remedied by getting the core business, its’ lending engine, running again.

Counting the fourth quarter of 2007 when IRA’s data indicates this phenomenon began to emerge, we are now eighteen (18) months or one-half of a business cycle dragging this massive boat anchor the behind the US economy. We may have wasted valuable time trying to save Wall Street at the cost of Main Street.

At this point the reasons no longer matter. It’s time to win by thinking gracefully. The numbers indicate we need to seriously ask the question as to whether economic recovery for the United States can still come just from repairing Wall Street – or whether instead we should be worried about addressing the underlying loss rates that are driving the provisioning behind these poor ROE results. Has the time come to shift the policy focus away from the things that we love, namely big zombie banks, to tackle things that are truly hurting us?

Readouts on all 7,519 bank units collected by IRA to date are now available to our Advisory Clients. The Beta version of unit level preliminary indicators now appears in the IRA Bank Monitor for Professionals. Preliminary grade indicators appear in pink if available. It will begin to appear in the IRA Bank Ratings Service for Consumers as soon as Beta testing is completed. IRA is presently working on adapting the accompanying bank-holding company (BHC) extension of our ratings system to also feed from CDR collected preliminary data. We continue to support our “prime solution” philosophy that it takes everyone with fair, equal and transparent access to risk information to collectively guide our economy to recovery.

Mary Schapiro's SEC

2009-05-01T12:27:00.000-07:00

In reference to,
SEC's Schapiro Shows Little Interest in Cox's Pet Projects
http://blogs.reuters.com/summits/2009/04/28/secs-schapiro-shows-little-interest-in-coxs-pet-projects/

Personally, I applaud SEC head Mary Schapiro's caution. Technology (old or new) is not a substitute for policy and it seems right that the SEC should pause and assess initiatives on an ongoing basis.

Supplement? Yes. Replace? That's a stretch.

While much work has been put into XBRL, stepping back given the present economic cycle, I can see no driving national interest why the United States needs to rush to catch up to a vision of replacing a body of material encompassing accounting, legal and forward looking commentary people can read with a narrower set of digital files as the primary evidentiary source for corporate reporting.

Proof of efficacy is essential. Within the SEC itself, has the question of the utility of this wonder tool been properly assesed? I respectfully submit that it's not unreasonable to demand that an investment of this magnitude must at least be shown to streamline and magnify effectiveness of the case load work within the Corporate Finance and Enforcement Divisions of the SEC as a stringent proof of concept. I mean is that kind of payback hurdle too much to ask of something that could impact corporate America like the second coming of Sarbanes-Oxley?

Does this mean XBRL won't happen? No. Does it mean that in the end it's just another data file format and not as some would hope a fundamental business language and process sea change? Speaking as both a CEO and a techie, I hope so.

Changing technologies, with regards to the internet versus the wire services, visceral reactions aside, it's likely best to consider all sides of the argument when it comes to the dissemination of corporate action data. Fairness is a process of constantly finding ways so that everyone gains access to information equally. Wire services, for all their synchronization, always reach professionals first. Enabling and encouraging pathways that allow individuals to negate this long time Wall Street advantage seems to be something always worth pondering. ... Tweet!

And finally, grander reporting and regulation topics seem ripe for one of those restart buttons like Secretary of State Clinton uses to manage foreign policy. The Obama White House has already stated its' intent to a process of review for financial markets regulation for the remainder of 2009. Make it so!

Statement on Relative Positioning Buckets for the Nineteen Stress Test Banks

2009-04-27T08:57:00.000-07:00

Statement Date: 23 April 2009

What is bank stress? The question is complex and anyone who attempts to simplify the answer probably is doing themselves more harm than good. There are operational stresses, financing stresses, and regulatory stresses that play like a noisy orchestra keeping bankers up at night and sadly sometimes driving them beyond the edge of despair.

In the U.S. government’s bank stress test, the question being asked is essentially “how well can a particular institution withstand the stresses of certain economic scenarios designed by the government”. As Fed Chairman Ben Bernanke stated in his testimony to Congress on February 25, these tests are not designed to pass or fail a bank. Rather, they are designed to help identify to what degree and in what areas each key institution participating in the stress process shows strengths or weaknesses so that the government can better determine how to use its’ resources to help alleviate the crisis.

That’s the plan and so far that’s also where the Federal Reserve and Treasury seem headed. We see no reason not to expect that a genuine attempt will be made to use the results of the stress testing process to help allocate government resources with greater precision.

Regardless, America and the world has a never ending obsession with picking winners and losers; or lacking closure, making odds. Right now if you want good odds probably better to place your bet on Susan Boyle. What follows is our response to the press asking for some way to shed a little more light on who likely stands where in the landscape.

Nothing in the list that follows represents an assessment by IRA as to how any of these institutions will fare with respect to the government’s stress tests. The question posed to us is how would IRA rank these nineteen banks relative to each other using our IRA’s independent benchmarking processes. It is quick analysis based on using some of IRA’s top level criteria to identify where these banks sit relative to each other in their ability to respond to the stresses we feel are of most concern under the current economic climate. At best, these figures could provide some visibility as to what the government may decide is the right individual prescription one by one.

Two Criteria, Three Buckets

For this we elect to focus on two criteria. The first is our IRA Bank Stress Index which is a measure of the operating stresses on a bank viewed as a going concern. The objective of this measurement is to identify whether an institution’s business model is working or potentially in need of adjustment. The criteria used are based on bank safety and soundness principles and have little to do with assessing the equity attractiveness of a bank. Remember only 900 or so banks are publicly traded out of the over 7,500 that report to the FDIC. The second criteria we focus on is financial leverage and for this we use another IRA proprietary measurement based on Economic Capital versus Tier One Risk Based Capital. The combination of the two gives a rough approximation of the business stresses a banker must contend with.

So from these two criteria we make three buckets – buckets that roughly align with the four buckets reportedly being used by regulators in the bank stress tests. They are:

• Upper Bucket – the institution metric measure well on both criteria.
• Middle Bucket – the institution is good on one out of the two criteria.
• Lower Bucket – the institution flags on both criteria.

We now present 4Q2008 information on 17 out of the 19 stress test banks. The arbitrary cut-off criteria for bucketing is the number 2. We did not have data for GMAC and American Express available for this snapshot.

December 2008 Bank Holding Company	IRA Bank Stress Index	IRA EC to T1 RBC Ratio	Is Stress Index > 2?	Is ECtoT1RBC > 2?	Probable Bucket	Simple Ranking via column B plus C
BB&T CORPORATION	0.95	0.377	No	No	Upper	1.327
U.S. BANCORP	1.11	0.744	No	No	Upper	1.854
COMERICA INCORPORATED	1.4	0.563	No	No	Upper	1.963
NORTHERN TRUST CORPORATION	0.66	1.484	No	No	Upper	2.144
SUNTRUST BANKS, INC.	1.49	0.885	No	No	Upper	2.375
PNC FINANCIAL SERVICES GROUP, INC., THE	1.36	1.576	No	No	Upper	2.936
BANK OF AMERICA CORPORATION	1.61	1.908	No	No	Upper	3.518
WELLS FARGO & COMPANY	1.47	2.146	No	Yes	Middle	3.616
CAPITAL ONE FINANCIAL CORPORATION	2.33	1.495	Yes	No	Middle	3.825
BANK OF NEW YORK MELLON CORPORATION, THE	0.81	3.963	No	Yes	Middle	4.773
STATE STREET CORPORATION	0.62	4.975	No	Yes	Middle	5.595
JPMORGAN CHASE & CO.	1.3	4.513	No	Yes	Middle	5.813
MORGAN STANLEY	20.43	0.256	Yes	No	Middle	20.686
KEYCORP	21.17	0.623	Yes	No	Middle	21.793
REGIONS FINANCIAL CORPORATION	21.11	0.715	Yes	No	Middle	21.825
FIFTH THIRD BANCORP	21.57	0.961	Yes	No	middle	22.531
CITIGROUP INC.	21.54	4.588	Yes	Yes	lower	26.128
GOLDMAN SACHS GROUP, INC., THE	20.6	7.905	Yes	Yes	lower	28.505

Anyone familiar with the banking industry is unlikely to be surprised by the above relative positioning of these banks. Good operating performance combined with limited economic leveraging most likely translates into greater ability to withstand the stresses of economic shock scenarios. As combinations of leverage and operations positioning degrade there’s less business as usual wiggle room and thus greater need to implement more extensive strategies to respond to shocks. Do not count any of them out. All of these institutions are large businesses capable of a great deal of flexibility in responding to even the most massive business environment challenges.

Take Goldman Sachs. It sits at the bottom of the list because it’s a brand new bank holding company fresh from being an almost pure investment bank. It has little in the way of the kinds of classic bank operations that contribute to traditional operating stability and soundness measurements. More, it has no deposits to speak of and is entirely market funded, like American Express and Morgan Stanley. One could look at them and just as easily ask the question why they should be a BHC at all if they can find a business model that doesn’t require depositor backed lending engines to round out their operations.

The point is that the government is right to treat these institutions as individual cases each of which will have independent paths to journey their way back to being confident contributors to the economy.

Yes there will be commonalities and hopefully guidance templates that can use the information exposed by the process of close scrutiny to guide government policy with regards to other institutions beyond these nineteen few. That would be the best outcome of the process. We wish the government the best in their efforts and stand ready to assist in whatever way we can.

But if you plan to go long or short on any of the above, nothing in what you just read will mean much. Remember that at the start of this note that there were three stresses listed; operational, financial and regulatory. It’s the third one that’s the real wild card in the deck. Normal market forces are not the driving coefficient at the moment.

More Musings on the PPIP

2009-04-07T13:38:00.000-07:00

Today I'm pondering the old adage "buy low/sell high". In this case as it applies to toxic asset speculators looking for arbitrage gain from buying troubled assets low hoping to reap gains selling same to the government high. That's a whopper of a gain for the club members who can pony up the ante, something that most taxpayers who are funding the public side of the PPIP cannot.

So here's a what if. What if the regulatory implentation of things like the PPIP were set up so that the government would only buy troubled assets from documentable non-speculators for say the first year of the program. This would focus taxpayer dollars towards flushing toxic assets from the operating institutions most in need of capital stress relief.

Then to further benefit the public what if the agency managing PPIP implementation followed a path where assets purchased for speculation would not be looked at until they seasoned a minimum 12-months holding period. This would allow truly skilled pool holders time to cherry pick promising items from the mix prior to disposal. The PPIP could also require the remainder collateral pool to be marked at the seasoning date prior to being purchased into the program. This would seem to be the right thing to do instead of relying on factors of a spreadsheet ... again.

Just thinking out loud.

- DS

Way to go Kenny!

2009-03-25T17:41:00.000-07:00

Thanks to JJ Hornblass at BankInnovation.net for bringing the Los Angeles Times story about Ken Lewis' intent to pay off Bank of America's TARP debts as soon as possible. While people may quibble over whether or not it's doable, all I can say is bravo sir.

In my comment on JJ's site I wrote, "There's absolutely no reason for a bank to retain TARP subsidies if they can effect a business strategy to configure assets and operations to go forward after paying them off. In fact I believe that's an essential mission challenge all banks that took TARP funds need to make part of their strategic planning. Banking is a highly competitive industry and global competition among the largest banks is hypercompetitive. That universe did not cease to exist when the United States legislated the current suite of laws into existence. Institutions saddled by government strings are disadvantaged in that universe. Mr. Lewis has his head on straight. An independent Bank of America is a better Bank of America. He's looking out for his shareholders and his depositors. If he can find a way to turn TARP into a short-term liability instead of an LBO more power to him."

Can Bank of America accomplish this? Based on the information we have in the IRA databases if any of the large banks can do this it's going to be BAC. It remains one of the strongest super-regional banks in our economy and we in our distillations of their Call Reports see the artifacts of an organized strategic plan to reign in their stray units quarter by quarter. Is it perfect? No. But what is in these times. Bank of America inherited some serious challenges as part of their 2008 acquisitions and Mr. Lewis is right to point out that there's some luck involved as to how the economy will evolve to making his dreams come true.

The bottom line is it's a plan that I personally believe benefits the National Interest. I wish you all the success in the world sir.

We respectfully suggest that other banks, particularly the better off mid-size and community banks, should take note of what Bank of America hopes to do. The next phase of this industry may not be centrally governed but instead highly competitive and possibly fratricidal. There's a lot of private capital out there just waiting to prove that the United States remains a nation with the means to pursue happiness. Speed and flexibility are strategic assets not to be underestimated.

***

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Idle F’s: Asset-Rich Operationally-Stressed Banks

2009-03-23T17:30:00.000-07:00

An emerging phenomenon is coming into the banking landscape. Banks are appearing that are capitally adequate but operationally stressed. These banks have low letter grade ratings driven by weak net incomes. They simultaneously exhibit strong capital adequacy test numbers and large unused credit capacities. In short, their lending engines have idled.

During the second and third quarters of 2008, banks were shutting down new lending as defaults rose and fear gripped the new loan landscape. Stress scenarios computing Maximum Probably Loss (MPL) in turn force many to allocate heavily into provisions for loss reserves further tightening credit availability. The process took several months but the lack of new lending production is now beginning to manifest as degraded interest and fee earnings on loans. That’s the primary source of transaction revenue in the banking industry. So even though these banks have capital, they have no revenue.

Essentially these banks have slipped back into what is effectively a de novo start up configuration. It’s well known that new banks are capital rich and revenue poor. Their business model challenge is to grow lending to reach profitable operational returns. In the Institutional Risk Analytics (IRA) system this tends to make a bank display a bank stress rating we call a “start-up F.” The business stress is real. There’s tremendous pressure on the bank to get the lending engine up and running on a timely basis. Our system generates a special flag for this condition. The logic that triggers flag is appearing for these older banks that have anemic lending.

We have not seen many older strong capital banks drop down into this “de novo like profile” as a phenomenon until recently. But now we believe as much as one quarter (1/4th) of the low rating grades population in our system may be exhibiting signs of underperforming lending engine stress.

The condition is worrisome because during 2008 we saw a number of FDIC resolutions centered precisely around banks that were still capitally adequate but displayed worsening operational stresses. The banks the FDIC resolved often displayed adequate regulatory capital but weak income statements and deepening loan loss trends. We optimized the IRA system to detect the very real threat of regulatory resolution action around this degrading safety and soundness condition.

It’s clear that some banks avoided further loan losses by decreasing or ceasing new loan production. The result was the Fall/Winter 2008 credit squeeze. Time moves on and now the stress has morphed. All bankers know that growing one’s lending base is a tedious process. You make good loans one at a time. So the institutional risk question is can they get their loan engines moving again?

These banks must address the business issue of competing for new lending to bring net income back on stream before cost of capital catches up with them. The fundamentals say these banks need to begin aggressively competing for new loans in order to build up their interest and fees sources of income. We’ve heard a number of anecdotal cases of this beginning to happen. We have adjusted our automated detectors to indicate when a bank is exhibiting this “restart/de novo challenge” condition in our reporting.

Tangible Common Equity: Useful Tool or Wild Goose Chase

2009-03-09T10:47:00.000-07:00

T.C.E. has suddenly become one of those vogue things everyone wants to know more about. Pundits have begun asking, some proclaiming, about the notion of T.C.E. becoming the “new Tier 1 Capital” for investors. In a world where wiping out equity investors is rapidly becoming a “too bad for you buddy” event as the banking community strives to bankrupt common equity to protect pay off losses over in the neighboring fixed income casino, people are right to ask the question.

But what is the real T.C.E. condition of these banks. An equity investor sees their investment through the eyes of the Securities Act. They buy stock through a market regulated by the Securities and Exchange Commission (SEC). They analyze their investments looking at the whole entity which in the most complex institutions is only partially a regulated bank.

For those of you who don’t know this, the regulated bank portion of your stock is overseen by an entirely different set of regulators operating under the authority of the Banking Act. The Securities Act and the Banking Act are immiscible. They do not interact. The identification numbers at the SEC and the FDIC are separate lists. There are 885 publicly traded banks and over 5,000 bank holding companies. So for over 80% of the banking industry, publicly traded stock price doesn’t figure anywhere in the analysis. And it’s the bank regulators who hold the power of U.S. law when it comes to capital adequacy. It’s their equations that govern what is enough, when prompt corrective action is required and when resolution is necessary. The computations are specific and they are not based on reading 10-K’s.

There are a number of T.C.E. figures floating around right now and we thought it would be a good idea to assess whether these are in fact helping public transparency or distorting it. The most common one we’ve found is the simplistic method. It’s,

T.C.E = (Common Equity less Intangible Assets) divided by (Total Assets less Intangible Assets)

These numbers are found in SEC 10K’s and are part of the standard 800 or so fundamental variables in all of the vended data feeds. It’s quick to calculate and it gives reasonable data for banks with business models that are primarily in the basic business of banking. It begins to distort as the bank participates in exposures to external risk sensitive activities such as trading and securities that are better tracked using Economic Capital (EC) analysis. And it can be as much as 200% to 400% off the mark for large complex multinational public companies with portfolios of operations that include significant portions of non-banking lines of business. For this last set of companies you really do have to separate them in to their bank and non-bank components and analyze the risk of each using differing techniques and then make the equity decision. Yes it’s more complex that quick glancing at the 10K and watching the price-volume but we’re in a brave new world and the winners are going to be the ones that figure out the new math.

Take poor Citigroup. I saw an article with a table indicating Citi’s T.C.E. was down to 1.8%. We ran the simplified formula for Citi and came up with 1.78% for 3Q2008 pulling figures from the 10-Q's matching the number from the source quoted in the articles. The figure is alarming because the conventional rule about T.C.E. is that it should be 3% of higher to be “adequate” from a banking safety and soundness perspective. The outcome of the equation puts quite a bit of “market” pressure on Citi to say the least. Adding insult to injury, it also opens up an arbitrage gap. The question in the end of course, is it real?

At the moment we’re not so sure at IRA because certain cross checks don’t fit. The three official tests of Capital Adequacy(1) for the Citi’s banking operations all show that this portion of the business is capitally adequate. Citi does carry a high degree of stress in our Bank Stress Rating system but it’s not because of any regulatory capital adequacy issues. Their loss provisions are in line with the Maximum Probable Loss (MPL) stress factors in our system so it looks like their operations scenario planning is being done properly as far as capital reserve positioning is concerned. So we ran a version of a bank operations-only T.C.E. and came up with a figure of 5.53% for Citi at the end of 4Q2008. This last figure for the bank portion of Citi agrees better with the regulatory indicators from the three official Capital Adequacy tests. We remain a little wary because the oddball number out of the lot is the simple calc TCE.

If all the numbers are true one thing it might imply is that the interests of the banking regulators, counterparties, et al and the interests of equity shareholders are not aligned by a conflict ratio of 3-to-1. That gets kind of interesting when the two become one.

Bottom Line

I’m not saying that banks like Citi don’t have their share of challenges. They certainly do and yes they are scary daunting. But what I am saying is that they, the other banks, and this country’s economy do not need imaginary ones. In these times, we need to be sure the dots are connecting.

Note : The three official regulatory tests for bank capital adequacy are as follows,
a. Tier 1 Leverage Capital Ratio must be greater than 5%.
b. Tier 1 Risk Based Capital must be greater than 6% of Total Risk Weighted Assets.
c. Total Risk Based Capital must be greater than 10% of Total Risk Weighted Assets.

If you want to see IRA's Bank Stress Ratings reports you can buy them here. http://us1.institutionalriskanalytics.com/Cart/Request.asp.

Stress Testing Banks

2009-03-04T15:38:00.000-08:00

About 18 months ago we were showing our then newly minted Economic Capital and RAROC computations to one of the banking regulators. Calibrate in your head what the world was like back then. It was one of those big phone calls with lots of analysts. Objections were raised due to the fact that the IRA method arbitrarily set the cutoff point for EC’s analysis at the B or better rating bond equivalent, that’s roughly 1,000 basis points (bp) maximum allowable loss. Looking at the output, the following ensued,

Unknown voice: “Dennis if your numbers are correct it would mean that there’s no way some of these large banks could possibly stay in business.”

My response, “Yes it does indeed question their viability.”

Next question, “So will you change your numbers?”

Response, “No we will not. I believe the numbers are correct.”

I went on to explain that we had in fact “parametrically stressed” the Economic Capital factors as an exercise to locate the point where one would again get analytical indications of business viability for some of these larger vulnerable institutions. Our findings were that the allowable loss margin threshold needed to be raised to around 3,000 bp to make that happen. I reminded everyone that the cutoff between investment grade and junk was around 2,800 bp, the term toxic was not yet in vogue. This was simply not “real world viable” as a modeling ground rule. Doing so would imply that IRA would be buying into sanctioning operational and strategic policies saying a banking industry averaging at least as risky as a junk bond was "normal". That’s just far too much rope to give to banking institutions that are supposed to operate safely and soundly. The notion fails the common sense test.

Silence. That pretty much ended that phone call.

Now some stress testing numbers to keep in mind.

There are rougly 885 publicly traded banks.

There are around 5,000 regulated bank holding companies.

There are 8,500'ish individual FDIC reporting bank units.

IRA publishes a detailed Bank Stress Rating for every one of the above for every quarter going back to 1995.

Each bank is tested using identical criteria.

The most recent reports cover the operating period ended December 31, 2008. Anyone can buy one for $50.00 on our website.

Our indexing methodology uses an analytical census of all active institutions in order to locate accurate behavior distributions.

Why bring this up?

The U.S. government is working on creating stress tests for a group of supposedly "mission critical" banks. There's a rule in analysis that when in doubt people do what they know. You have to watch out for that. Given the people working on this there's a good chance that the risk-stress methodology is likely unique per bank akin to the construction of an elaborate (that usually means opaque) boutique multi-asset class security with many of the risk inputs supplied by statistics provided by the bank being examined. Basel II called this type of thing the Internal Research Based (IRB) approach.

Some reminders are in order. IRB was meant for use by healthy institutions able to prove the empirical validity of their inputs and the stability and accuracy of their methods. Also IRB's are supposed to be accompanied by external research benchmarks and include an explanation of the differences, if any. The process is meant to promote counterparty confidence.

Surveillance 101: Tracking bank degradations over time.

2009-02-11T12:28:00.000-08:00

Case Study: Alliance Bank of Culver City, California

Alliance Bank was taken over by the FDIC last week and the assets sent to California Bank & Trust, a unit of Zions Bank. The Alliance case was typical case of a small institution that got trapped in the aftermath of a deflating bubble. It ended life the owner of a growing portfolio of foreclosed properties stemming from a lending default rate dragging operational earnings deep into the negative. Their Aggregate Loan Default Rate went from a miniscule 26bp (basis points) to 496bp and their Loss Given Default rate was 96%.

As it has been doing with regularity, the FDIC performed it's designated regulatory function taking the troubled entity into the arms of a better positioned and healthier financial institution. In fact, the degradation of Alliance's position took approximately nine months to gestate. The bank's overall stress ratings over time are shown below.

IRA Bank Stress Ratings: Alliance Bank, Culver City, CA
Sep-08 - F
Jun-08 - F
Mar-08 - B
Dec-07 - A
Sep-07 - A+

Like many other institutions who were caught in the bubble a migration of business from income producing to dead weight ensued. Non-Conforming assets went from $17.7M in Sep-07 to $96.5M in Sep-08. During the same time Real Estate Owned(REO) went from $1.1M to $16.6M.

Note: I was interviewed about Alliance on Monday by KNBC-TV Los Angeles. The segment aired on Tuesday Feb. 10.

IRA Bank Reports Timing - Why Mid-Quarter?

2009-02-04T16:39:00.000-08:00

IRA reports are based on FDIC CALL/TFR Reports. We need these more detailed reports to accomplish the level of bank safety and soundness analysis that we do. Bear in mind that IRA’s bank analytics covers all FDIC reporting institutions. Of these only some are publicly traded companies. Our analysis engines run detailed analytics on the universe of active U.S. bank holding companies as well as the individual unit institution members of a holding company.

Timing of production is keyed to the FDIC’s internal processing schedules. The FDIC holds release of the master dataset for each quarter’s filings for 45 days to perform internal cleaning prior to releasing it for analytics use. We get the data and process it to build the industry stress statistics typically just before the FDIC does its’ mid-quarter press conference. We try to release our reports to coincide with the FDIC conference date provided the FDIC arrived on time. An email is sent to all clients informing you that the reports have been updated.

FYI, catalogs of SEC filings for public companies are available on the IRA website. SEC filings contain top level information on companies aimed primarily at stock investors. They typically begin to appear just before the 30 day point after the end of the reporting period, hence the end of month follies in the markets. That’s a little ahead of the FDIC’s much more comprehensive data needed for safety and soundness analysis on banks to help assess the risk within a person/company’s cash and cash equivalents assets. Different portion of the wealth portfolio.

- Dennis

The thing about economics ...

2009-01-28T14:35:00.001-08:00

Humans are creatures of hope. It occurs to me that we place too much blind faith in things sometimes. Take economics. The thing about macro models is that they depend on input that has been smoothed and homogenized far below the noise levels of real life. Sort of like smoothing loan collateral pool risk into simplified spreadsheet factors. Economics too often depends on the systems finding balance presuming computational isolation from discontinuitues, externalities and outliers. The law of unintended consequences always applies when we simplify. Murphy's leverage is amplified by the alchemy of theories reaching far beyond their stable linearity. When you hear someone say "it's not perfect but it's better than nothing" that's the sound of a match being lit in a room full of dynamite. Sometimes we forget that we are the monkeys with keyboards trying to write Shakespeare.

So here's one for you to ponder. The same colleges that train some of the best economists also train some of "the best" structured finance designers. It's the same math. I'm just sayin'.

- D

TARP and Tangibles

2009-01-15T09:29:00.000-08:00

Here's something interesting. We computed the IRA Tangible Equity Capital Ratios for Largest Bank Holding Companies
. The link takes you to an excel file containing four worksheets covering 3Q2008 and year-end for 2007, 2006 and 2005.

The technique for this requires rolling up the bank only assets of each of the units of a BHC to make the computation. We actually set the computers up to run the metric for all 5,000 or so bank holding companies for every reporting quarter we have in our databases. Naturally the popular press seems fixated on the top tier. The "Prime Solution" for the U.S. economy probably lies in deploying TARP money among the best of breed of the 5,000 though.

Enjoy the peek at the tip of the iceberg.

- Dennis

IRA Bank Stress Ratings. Why Letter Grades?

2009-01-13T09:05:00.000-08:00

Professional bankers live and die by their CAMELS rating. The system uses a grading method ranging from 1 to 5 (1 = best) and is used as part of official interactions between the bank and its' regulator. The six factors in a CAMELS are,

C - Capital adequacy
A - Asset quality
M - Management quality
E - Earnings
L - Liquidity
S - Sensitivity to Market Risk

CAMELS include privileged information on objective numerics, subjective discussion and judgement and external exposure analysis measures that help the regulator determine whether a bank is being run adequatetely or requires prompt corrective intervention.

Pattern Analysis to find "The Signal in the Noise"

IRA analysis uses publicly available information to perform similar analyses to the CAMELS process but using an outside observer approach. We opted to design a system that concentrates on bank stress indicators because this is what "main street Americans" actually worry about.

Unless one is a regulator, it's impossible to talk in detail to every bank in the United States. So we designed a more clinical statistical analysis approach to characterize behavior patterns at the census level (looking at all FDIC filers ... yes all!) to replace one-on-one subjectivity. The objective of our system is to allow a consumer to locate a bank's performance both in terms fundamental safety and soundness and in competitive context with its' peers. We believe this improves transparency for depositors as well as the decision matrix process for investors.

Why letter grades?

When we looked at how to set up the final grading scale we were sensitized to the need to make the grading system intuitive for consumers by the media. So instead of emulating the CAMELS 1 to 5 scale we opted for the more familiar report card of A to F letter grades.

In the CAMELS system a bank is considered well run if it has an overall CAMELS rating of 2 or lower and has issues if that rating slips to 3 or higher. Anecdotal comparisons to the IRA Bank Stress Index rating system indicate that one can expect the following,

IRA A+ generally finds banks with CAMELS 1
IRA A finds banks with CAMELS 1 and 2
IRA B finds banks with CAMELS 2 and 3
IRA C thru F corresponds to banks with CAMELS ranging from 3 to 5

CAMELS ratings seem to move more slowly than IRA Risk Ratings which are computed on a per period basis algorithmically. This makes sense given that CAMELS involve deeper private information examinations of an institution to complete.

We think the IRA rating may function like a leading indicator but it's hard to tell because one cannot get a look at all the CAMELS and their inputs unless one is at the FDIC. We do have the structure of the EXAM table in our computers, but not the content. Doesn't matter. If we did the law is such that we could only show the results to the regulators anyway.

- D