Where Are The Good Banks?

Can bad banks be made good by shifting toxic assets around?There are plenty of rumours that the UK government is to set up a “bad bank” to take toxic debt off the balance sheets of afflicted financial institutions.  This is supposed to set the stage for a return to financial health for the firms concerned, which can then get back to lending and supporting the economy.  Apparently this approach worked in Sweden in the early 1990s.

However the problems this time are more complicated to deal with, for a number of reasons.   First, the current recession and the deflating property bubble are a global phenomenon, making it that much harder to rescue institutions in several countries simultaneously.  Second, the scale of the debt bubble in the Anglo-Saxon world dwarfs anything that has gone before.  Third, the balance sheet leverage of the banks themselves has grown so high that many are already insolvent (i.e. the fall in value of the asset side of the balance sheet has already wiped out the value of the shareholders’ equity), and so government cash injections are equivalent to pouring money down a black hole.  Fourth, state intervention to relieve banks of their bad debt comes at a cost.  Just take a look at the credit default spreads on Irish sovereign debt, which have shot up to over 2.5% per annum after the Irish government had to bail out Anglo-Irish bank.  Investors are getting very nervous indeed about government default risk in a number of countries.

Are governments really prepared to risk their own bankruptcy to save financial institutions?  Letting banks fail wouldn’t be easy, even if in most countries the vast majority of depositors would be protected by insurance schemes.  But sovereign defaults would mean hospitals and schools closing, and the lights going out.

Up to now most central bankers and finance ministers have behaved as if there’s a bottomless pool of cash that they can access (and waste).  Recent trends in the credit markets may be telling us that that window of opportunity is closing.

So when a commentator on the FT Alphaville site this morning quipped, “We’ve already got a bunch of ‘bad banks’ – why not just set up a ‘good’ bank and let the existing banks go to the wall?”, I think he wasn’t far from the truth.

Some observers have noted that the US-based KBW Bank Index, which tracks 24 large institutions, yesterday hit its lowest point since 1995.  The index’s collapse has been dramatic, with yesterday’s low of 31.89 representing a 73.7% decline from the high of 121.16, recorded on 20 February 2007.

It’s possible that there will be some rallies starting from not far below the current level of bank share prices, since the KBW index formed quite a base in the 1993-95 period in the 25-30 price range.  Incidentally, if the S&P; 500 were also to retreat to the 1993-95 level (and many analysts consider financials’ share prices as a leading indicator for the rest of the market), we’d be looking at an index value of 400-500.

But caveat emptor – buying banks now would be a high-risk play.  Investing in the what are the most highly-leveraged firms in the economy during a period of general deleveraging is going against the trend.  And I suspect that the “bad banks” will remain “bad” for quite a while longer, and many are doomed.  The financial institutions that prosper during the next upturn, whenever it comes, may be entirely new firms.

[yasr_overall_rating size="large"]
error: Alert: Content is protected !!