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Dwight Johnston
Vice President, Economic & Market Research
2009 Forecast: After the dust settles
-- Part One
Since the beginning of the credit crisis, there have been at least nineteen “major” initiatives by the Federal Reserve and the U.S. Treasury Department. These have included the “Special Purpose Liquidity Fund,” “Hope Now,” various “new” Fed lending facilities to banks and brokerage firms, the Bear Stearns rescue, the Fannie/Freddie takeover, and the ill-fated TARP legislation. With each of these announcements came this standard line from the various officials: “This will help restore confidence in the financial system.” Many popular financial market gurus even echoed that sentiment.
Flawed responses
Yet each of these responses to each new crisis resulted in less and less confidence in the financial system. The events of the past few months have proved that restoration of the financial system, as we have known it in recent years, is not possible. Structural damage to the system is too extensive. Confidence in the old system will not be restored. The dramatic government actions that were forced on officials will ultimately result in a new rebuilt system. The entire financial system from top to bottom will look radically different two years from today.
The last big fix was the recent coordinated actions by the world’s central banks to guarantee most bank liabilities and inject capital directly into the banking system. This was announced on October 12. As of this writing, we are seeing indications that this last “fix” might work. The $700 billion TARP program was originally designed to buy distressed mortgage-related assets from banks, but we expect only a few face-saving auctions will actually take place. Paulson has already directed that the first $250 billion will go for capital injection into banks.
To date, banks have admitted to roughly $600 billion in losses but have been able to raise only $350 in new capital. Banks have yet to realize the full extent of loan losses on their books from existing mortgage debt, commercial real estate loans, loans to corporations, and other consumer related debt. Some very well respected banking analysts believe bank losses will reach the $1.5-2.0 trillion range. While some banks will be allowed to fail, Paulson will eventually use virtually all of the TARP allotment for bank capital.
Confidence lost
This massive government bailout program will come at a cost beyond the cost to taxpayers. Investors, financial institutions, and the public will not accept simple government guarantees of banks without changes in the ways banks and other components of the system operate together. It will no longer be business as usual. Institutions will be reducing leverage on a permanent basis, off balance sheet risks will no longer be considered no risk transactions to the institutions, and securitization of loans of all types will return only extremely slowly. This means that in the short run, the credit crunch has much further to run.
The goal for the next two years will be to continue to improve capital ratios, which will come at the expense of making new loans. In the long run, what will emerge is a much healthier financial system— but one that will grow at a slow, sustainable pace. Currently, the government is solely focused on stabilizing the financial system. Once the dust settles in the credit markets, the government will undertake what is likely to be the biggest overhaul in financial history.
The new landscape
What will the new financial market landscape look like? It will look familiar—but there will be significant differences.
First, we’ve already seen the demise of the once-great stand-alone investment banking houses. They are all moved into the shelter of the banking system. This fact alone means that the leverage, which in the good times provides a lot of the grease of the financial system in creation of new products, is gone. Banks will do that now, but the leverage that fuels the engine and provides liquidity will be less powerful.
Second, some big names in banking will disappear and some old ones will be profoundly different. During the next few months, the government will be injecting capital directly into “healthy” banking institutions. In other words, they will buy equity stakes in major banking institutions that will survive but need more capital to provide the cushion to manage out of some of the bad assets on the books. Effectively, we will have a partially nationalized banking system. But, the government will not save all banks. Some will fail. The government, by guaranteeing all deposits and inter-bank transfers, is merely taking out the risk that depositors and liability holders will lose money once the government seizes these banks. The government took these steps to lessen any chance of a general run on banks. The potential is that one or more very big names will not be here a year from now, and several larger regional banks will fail. But as long as the public’s confidence remains that the U.S. stands behind the deposits, bank withdrawals should be limited.
Third, the entire regulatory and oversight structure will be overhauled. It’s likely that the Fed will be the central regulatory authority over all types of financial institutions. I suppose the Treasury Department could also take that role, but I believe control at the Fed is the more likely. The look and functioning of the Federal Reserve will change and grow more powerful than ever. The argument of whether this is a good thing or not is irrelevant.
Fourth, there will be some general banking oversight on an international basis. Leaders in the UK and Europe are already calling for a super regulatory force that will be responsible for monitoring the top thirty international banks. This might strike fear in the hearts of the “One World Conspiracy” theorists out there, but the U.S. will not go along with any ceding of regulatory powers to an outside source. What the U.S. will likely agree to is uniform reporting requirements by major international institutions and some central facility that will be charged with monitoring financial conditions at the world’s largest institutions.
Fifth, after an extended period of bank consolidation, banks will then start trying to realize cost savings through “economies of scale.” This will mean closing a number of redundant branches around the country.
Sixth, tougher regulations and stiffer bank capital restrictions will begin to really kick in once the economy starts to recover. Regulators will not resort to draconian regulatory changes until the immediate credit crisis eases and the economy starts to show signs of life. Acceptable leverage ratios will be reduced, and we are likely to see regulations that will require that banks keep some “skin in the game” regarding any off balance sheet activities. In other words, banks will no longer by able to use securitization vehicles as a way to push risk off the balance sheet. This last element is important because the lack of diligence in lending requirements can at least partially be traced to the fact that banks felt less responsibility for conscientious lending when the loans were not going to remain on the balance sheet.
Seventh, the mortgage market will be dramatically different. Frankly, I have no idea what will happen here. At this point in time, it appears we’ll be facing an almost entirely government guaranteed animal. We’ll likely see a further push for programs to reduce the principal on mortgages of distressed homeowners, but those will see only limited success in the environment of a deteriorating job market. But the government only mortgage market could be merely a transition phase. Once home prices stabilize and recover, there could be a push to return to a purely private mortgage market over a period of years. The only certainty is that the mortgage industry will look radically different.
Part Two -- "2009 Forecast: But what about credit unions?" will be December's Top Story.