U.S. Financial System: One Year After the Crisis

As the U.S. fi nancial crisis unfolded in the fall of 2008, policymakers rushed to provide emergency support to the fi nancial system, whose provisioning of credit is the lifeblood of any economy. In the months and years to come, the revival of the fi nancial system will be critical to the magnitude of the economic recovery, and therefore infl uential to the performance of various asset classes.

Rapid turnaround as conditions improve There is no question that the fi nancial system is in dramatically better shape than one year ago, with credit markets coming off life support and demonstrating continuous improvement during the past several months.

Borrowing conditions in the capital markets have improved markedly since the end of 2008 (see MARE article, U.S. Credit Markets: Borrowing Costs Continue to Decline). Issuance of new debt, particularly by corporations, has expanded dramatically and the cost of new borrowing has declined precipitously from record high levels one year ago. According to the Bloomberg Financial Conditions Index, which measures the cost and availability of borrowing, the overall stress in the U.S. money market, bond market, and equity market is back to late-2007 levels (see Exhibit 1, page 2). High-quality corporate issuers now access the investment-grade bond market at 2% spreads above Treasuries, down dramatically from the near-record 5% spreads a year ago.

Many large banks in particular have returned to profi tability and bolstered their balance sheets. Stalwarts such as J.P. Morgan and Goldman Sachs have paid back the emergency TARP money loaned to them by the government one year ago, and they have parlayed trading gains and other capital markets activities into stellar corporate earnings results for the third quarter of 2009. In addition, several large banks— even those that have yet to repay TARP funds—were able to ride the improvement in market sentiment by issuing new equity shares during the past several months, thus replenishing their capital positions.

Meanwhile, the conditions for future profi tability remain extremely supportive. The Federal Reserve (Fed) continues to maintain short-term interest rates near 0%, which contributes to making the yield curve—the difference between short-term and longterm interest rates—extremely steep. At 2.36 percentage points, the Treasury bond yield curve at the end of Q3 2009 was roughly three times as steep as the average since 1976 (0.77 percentage points). Steep yield curves provide a favorable backdrop for bank lending profi tability because banks are typically able to borrow (attract deposits) at lower short-term rates while making loans at higher longterm rates. The Fed recently indicated its intention to hold short-term interest rates near zero percent.

Other more extraordinary monetary policies also remain supportive for the financial system. For example, the Fed plans to fi nish purchasing $1.45 trillion of agency bonds and mortgage-backed securities. Maintaining an extraordinary level of credit to the fi nancial system by keeping its balance sheet well above historical norms continues to be accomplished by unprecedented growth in U.S. banking reserves. Most of these reserves are “excess reserves” that represent extra money (above the required reserve ratio) that banks keep in deposit with the Fed, indicating banks have more than enough funds available to make loans.

However, for now, much of the extraordinary increase in bank reserves is sitting idle, as banks remain generally cautious because growing loan defaults still act as a threat to their capital positions. The banking system is a far cry from being completely healed. The biggest problem, even for the larger banks, is that delinquencies and defaults on many loans are still rising. High and still-rising loan default rates, particularly in real estate and consumer loans, have continued to force banks to divert profi ts into adding provisions to guard against future loan losses (see Exhibit 2). With delinquency rates (loans with overdue payments that are not yet in default) still ascending, loan defaults are broadly expected to keep rising in the near-term. This may keep many banks more focused on preserving capital and protecting their balance sheets, rather than new lending.

The largest source of concern is commercial real estate loans. While residential housing prices have showed signs of stabilization, commercial real estate prices have continued to drop, and now have fallen back to early-2003 levels. As a result, commercial real estate loan defaults have continued to rise significantly, forcing write-downs on bank balance sheets. Commercial real estate loan losses have been particularly hard on small- and mid-sized regional banks that generally had a larger exposure to this loan category.

The stress on small- and mid-sized banks is demonstrated by the steady increase in bank closures throughout 2009. The Federal Deposit Insurance Corporation (FDIC) has closed more than 100 banks so far this year, the highest number since 1992. Although the number of bank failures is nowhere near levels reached in the aftermath of the bank and savings and loan crisis in the late 1980s and early 1990s, it is expected to continue to rise, as the FDIC currently lists more than 400 banks on its “problem institutions”-list of troubled banks. With the growing number of bank closings straining its fi nances, the FDIC recently proposed making member banks prepay three years’ worth of fees to replenish its deposit insurance fund.

As concerns about future loan losses potentially depleting capital linger, banks have continued to tighten lending standards for new loans. Underwriting standards have tightened most noticeably in the areas of real estate and consumer loans.

Ultimately, the true test of the health of the fi nancial system is whether it is providing adequate credit to support the incipient U.S. economic recovery. In this respect, the one-year report card remains mixed. Large corporations, which have ample access to issuing debt in the recovering bond markets, have enjoyed a dramatic improvement in their access to credit at reasonable terms. Smaller businesses, which remain largely dependent on their smaller, regional banks to provide loans, are facing much more restrictive credit conditions, as these banks generally remain preoccupied with rising loan losses and balance sheet concerns. According to a recent sentiment survey, small businesses feel credit conditions are roughly as bad now as at the height of the fi nancial crisis in October 2008, representing the worst borrowing conditions in nearly three decades.

For U.S. consumers, borrowing costs are reasonable but underwriting standards are signifi cantly stricter. Due in part to extraordinary support from the Fed, mortgage rates—in addition to rates on credit cards and other consumer loans—are extremely low. However, they are only low for those consumers who qualify for loans, which is a dramatically lower number of people today than before the crisis. Most experts agree that underwriting standards have been appropriately tightened following the mortgage and consumer lending binge that resulted in record-high consumer debt levels and contributed to the economic aftermath of the fi nancial crisis. In the aggregate, consumers in general do need to continue to “deleverage” their balance sheets by bringing debt levels down, meaning the problem may be due as much to a lack of demand from creditworthy borrowers as it is to a lack of supply of credit.

Historically, economic downturns that follow financial crises have tended to be longer-lasting and more severe than other downturns, with recoveries that take a long time to get back to previous levels of output and employment. One major reason for the lingering impact of a fi nancial crisis is that it tends to leave an impaired fi nancial system that does not provide suffi cient credit to support a quicker economic recovery.

After two decades of massive increases in the levels of debt in the U.S. economy, some de-leveraging— particularly of the fi nancial system and consumers—is probably necessary. However, the real test for the fi nancial system is not whether it is providing the same level of credit as before, but rather whether creditworthy borrowers can access credit inexpensively. One year after the fi nancial crisis, large corporations and consumers may indeed be close to meeting this standard. However, smaller businesses, which historically have been critical for new job creation, may be facing tougher credit conditions due to continued diffi culties in the banking sector. More than half of all private sector jobs are in small businesses, and this sector of employment has been growing more quickly than overall employment since 2000.vii While dramatic improvement in the financial sector over the past year has contributed signifi cantly to the rebound in stock and bond markets during the past several months, more progress will be needed to achieve a vibrant credit sector that is fully supportive of economic recovery.

Freepers, don’t pass up the gains in the stock and real estate markets that we will probably see for a while. The long term implications of the garage coming out of Washington will take a little while “cook”. I’d stay away from long treasuries, though.

The flaw in all the analysis flowing out of DC is the notion that more credit is all we need to get the Economy growing. Dear Reader and all his minions keep saying this but it is nonsense.

Business crave certainty above all else. A sense of certainty encourages business leaders to take on risk, uncertain causes a “bunker mentality”.

Everything the 0 regime is doing is causing uncertainty in the minds of private business. No amount of easy credit will get them to borrow if they are uneasy about their ability to pay it back eventually. Cap and Tax, Health Care, the hints of coming war taxes etc all cause Business to fear it will be saddled with ever increasing Government imposed costs in the years to come.

To get business out of this bunker mentality the Government should simply let business keep more of it's own money by cutting government taxes and spending. A business that knows it is going to be able to keep more of the money it all ready has, rather then take on more debt obligations, is the best way to get business out of the “bunker mentality” it currently is in.

So...the Govt becoming the entire mortgage market and much of the rest of the economy, via unimaginable levels of borrowing and spendiing is sustainable without destroying the dollar and impoverishing the citizens?

If the Govt was a doctor, it would prescribe more booze for alcoholics and more drugs for addicts.

The government treats the privilege of being granted credit, as an extension of charity.

A company don't need to borrow if they can't meet their obligations because of government imposed expenses. Piling on business is a job killer. Piling on higher energy costs, forced health insurance, higher matching payroll taxes does nothing for promoting the general health of business. I can understand why government economists would ignore these financial realities since they have adopted Enron style accounting practices.

Ok, I’m setting myself up to being accused of huge paranoia but was this really just a spontaneous occurence with the economy or was it a weak economy that was pushed to the edge, conveniently before a crucial election, by someone (or those...) who had the means to influence the market? That is a question that has been floated out there for over a year and has yet to be answered...or doesn’t want to be answered...hmmmm...

I totally agree with you that the current system is unsustainable. My comment was for the next period of months, maybe a year or so. I’ve made the mistake of being long term right and short term wrong before. Right now there is money to be made from recovery in the markets....not the fundamentals of the economy. Very different things.

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