Professor Cole's Finance Blog

This past week, the FDIC released 2009 Q3 financial results for the U.S. banking industry, which, it turns out, is a testament to the transparency of U.S. financial markets. I often work for the International Monetary Fund as a banking expert, and have learned from my missions that many, if not most, countries, view the financial results of their banks as “confidential data” with which the public cannot be trusted. Of course, the primary concern is a run on the banks when financial results are poor, as they have been recently around the world.

In the third quarter of 2009, U.S. banks earned $2.8 billion in net income, which was quite an improvement from the $4.3 billion loss reported in the second quarter and much better year-over-year, as well, up from $878 million in Q3 2008. Hiding behind this headline number, however, were some far more disturbing numbers, indicating that the financial condition of the U.S. banking industry continues to deteriorate, which jeopardizes the “green-shoot” hopes for an economic recovery during 2010.

Net charge-offs of loan losses totaled $50.8 billion, up 80.5% from Q3 2008. The rate of net charge-offs, at 2.71%, was the highest on record since banks began reporting quarterly income in 1984. Non-current loans increased to $366.6 billion or 4.94% of loans and leases—the highest rate in the 26 years that banks have reported these items, exceeding anything seen even during the banking crisis of 1985-1992, when more than 1,000 banks failed.

Perhaps most troubling to hopes for an economic recovery is the decline in lending by banks. Loans and leases fell by$210.4 billion, or 2.8%, during the quarter. This implies that bank lending is declining at an 11.2% annual rate, which almost certainly will choke off any economic growth during 2010, should it continue. Commercial & industrial loans suffered even more, declining at an annual rate of 26%. These declines were the largest in the 26 years that these statistics have been collected by the FDIC—again, worse than anything seen during the banking crisis of 1985-1992.

The number of “problem banks”—those with CAMELS ratings of 3, 4 or 5—increased to 552, up from 416 in the second quarter, and the assets held by these problem banks increased to $346 billion, up from $300 billion. This increase took place in spite of the closure of 50 banks during the quarter—the most since the fourth quarter of 1992. More than 100 banks have been closed thus far in 2009—also the most since 1992.

When one looks at the balance sheet of the banking industry, one sees little reason to think that the situation will do anything other than continue to deteriorate, as toxic assets continue to pollute bank portfolios. As of third quarter 2009, banks held $1.93 trillion in residential mortgages, and another $667 billion in home equity lines of credit outstanding. The U.S. housing market continues to deteriorate, according to Lender Processing Services, the leading servicer of U.S. mortgages, which just reported that both non-current mortgages and foreclosures reached new records in October, just as they both had in August and September. Banks could easily face a half trillion in additional losses from their exposures in the housing sector alone.

However, banks’ problems are not confined to the housing sector, as they also hold $1.58 trillion in commercial real estate loans, of which $492 billion are the highly toxic “construction and development” loans that are responsible for most of the bank failures this year as well as for the surge in the number of problem banks. The values of commercial real estate assets continued to plunge during the recent quarter, with no bottom in sight, as vacancy rates skyrocket followed closely by delinquency rates. Compounding the problem for commercial borrowers is the fact that securitization markets remain frozen and lenders have no stomach for rolling over commercial mortgages. Look for another half trillion in additional bank losses from the commercial real estate sector.

As bad as the situation looks when evaluating residential and commercial real estate, it gets even gloomier. Banks hold $393 billion in credit-card loans, which also are experiencing soaring loss rates as unemployed Americans can no longer make even the minimum payments on their credit cards.

All in all, not a pretty picture, but not a surprising one, either. The Troubled Asset Relief Program, or TARP, was supposed to help banks remove toxic assets from their balance sheets, but this did not happen because then-Treasury Secretary Hank Paulson, aided and abetted by Fed Chairman Ben Bernanke and NY Fed President and now Treasury Secretary Tim Geithner, chose to concentrate on saving Goldman Sachs and the Wall Street mega-banks instead of saving the banking system. Now, the rest of the country is paying the price of this leadership.