BondSquawk

by Rom Badilla, CFA – Bond Trader and BondSquawker

April 29

Illinois is known for the Windy City (my home town) and of course, football’s Chicago Bears.  Unfortunately a different kind of bear, as in the bull market’s arch-nemesis, has a reason to sing in the Mid-Western state.  Illinois was hit hard as the Federal Deposit Insurance Company (FDIC) updated their Failed Bank List several of days ago with the addition of 7 more banks, all in the Land of Lincoln.  The List stands at 57 failures for 2010, which total to $35.2 billion in bank assets.

FDIC Chairman Sheila Bair stated in a Financial Times report, “The projected number of bank failures will still be higher than last year, but less than we originally thought.”  In 2009, the FDIC shut the doors on 140 banks, which was the highest number since the height of the Savings and Loans Crisis in 1992.  2009′s bank failures cost the FDIC and U.S. taxpayers about $30 billion.  Comparatively, there were 3 and 25 bank failures in 2007 and 2008, respectively.

While the report appears upbeat, there is still cause for concern that would give any Superfan indigestion.  Specifically, there are over 702 institutions on the troubled bank list as of December, which is up from 552 in September of last year (historically only a percentage of the total fail).

Small banks typically have greater exposure to commercial real estate loans as a percentage of their total assets, than their much larger peers.  This exposure is definitely a problem with the risk that it could get worse if left unchecked.

Last month, Treasury President, Timothy Geithner said in a CNBC interview, “Commercial real estate’s still going to be a problem for the country. But we can manage through this process.”

Management of this process will be difficult for the trillion dollar market as delinquencies remain elevated. Credit ratings agency, Realpoint said that March’s delinquency rate for the securitized commercial universe is at 6.4 percent, an increase from the 6.0 percent reported in February. To put that in perspective, March’s reading is four times the amount reported from a year ago.  Furthermore, Realpoint said that delinquencies could potentially reach 12 percent by the end of this year.

Former Federal Reserve President, Alan Greenspan said earlier this month that commercial prices are already down and less of an issue going forward.  Move along.  There is nothing to see here.  Granted, commercial property prices declined 41.8 percent from the highs in October 2007 to February 2010.  However, the bigger issue going forward is the large amount of loans that will be coming due in the next four years.  These loans, which many of them are underwater due to the massive decline in prices, will need to be rerolled into new debt.  Commercial property owners are hoping that the loan origination machine will thaw out by then so maturing debt can be refinanced (If this sounds familiar, it should. See Greece).  If a mechanism such as a robust securitizations market which helps facilitate the extension of credit is not in place, defaults could pick up even further.  This would negatively affect banks to a large degree.

Given these hurdles, banks especially smaller ones, should continue to feel the pressure.  Sure, larger banks have scored a few touchdowns by posting stellar earnings recently.  However, most of those revenues come from proprietary trading, which isn’t the bread and butter of a bank.  This should point to continued accommodative monetary policy, which should keep the yield curve steep.

The upward sloping nature of the curve allows banks to do what they do best, which is borrow short at one rate and lend/invest farther out the maturity spectrum at a higher rate.  This secret recipe is why banks love a steep yield curve as this spread usually spells profit.

This construct when given enough time, has historically allowed the economy to exit a recession by extending credit and investment which in turn, leads to growth and jobs.  As the world of finance and Wall Street goes, so does the rest of the economy.

Because of their excessive risk-taking, which arguably is a result of the Fed generated flat to inverted yield curve in 2006, banks are still on the defensive by repairing balance sheet and shoring up reserves.  Once that is done, banks can go on the offensive and start playing to win on a much larger scale.  Until then, expect additions to FDIC’s list and economic activity that is both natural and sustainable, to remain in hibernation.