The gombeen like a spider sits

Surfeited; and, for all his wits

As meagre as the tally-board

On which his usuries are scored.

“The Gombeen Man” – Joseph Campbell, 1913

A vast gap seems to have opened between the market’s perception of the potential risks facing the US banks and the pricing of bank risk.

Even television news shows have got around to talking about the coming wave of commercial real estate defaults, yet the risk spreads on bank paper have come in to pre-crash levels.

By last week, for example, five-year credit default protection on Bank of America had fallen to 112 basis points, less than a third of where it was back in March, and about where it was priced back in April 2008.

It is not just commercial real estate that is heading in the direction of the big banks. The accountants, it is feared, will be forcing the banks to “consolidate”, or take on to their balance sheets, rafts of disintegrating off-balance sheet structured financings.

For example, Christopher Whalen of Institutional Risk Analytics, a bank risk rating firm, says: “It was issues like the impending financial bloodbath on hidden [off balance sheet] exposures …which we believe led to the decision by Ken Lewis to walk away from Bank of America.”

The wearily cynical will tell you that the investing public knows that all the bad bank debt will be monetised in some manner by the Federal Reserve, or paid for by taxpayer-supplied capital injections.

This, they toss off with the certainty of wine-fuelled genius, also explains the rise in the gold price.

Actually, I do not think that is how the bank risk paradox will play out.

There are going to be much larger write-offs and reserves taken at all the big banks, with the peak in reported bad news probably coming next year. However, the taxpayer will not be asked for more capital, and the Federal Reserve and Treasury will gradually dismantle the temporary support structures, just as they say.

How is this possible? Because the public will pay through usury, not taxation. There is a big difference, of course. Usury is less visible, and you cannot effectively vote against it.

Blood will flow, yet it will do so not as a catastrophic bath for the banks but as a gradual transfusion to them from their customers.

There will be headline risk for the banks’ management and public securities, which is why I think that their CDS protection is too cheap at the moment.

One source of headline risk is the spectre of Federal Government reform of the financial system. God knows there is a good case to be made for de-cartelising the industry but that is not going to happen.

A financial industry without waste and monopoly profits would be a financial industry without money for campaign contributions and other holiday presents for the political class.

You can expect some breaks for the consumer. For example, the exorbitant fees for overdrafts will be cut back by legislative action.

In the end, though, the losses on the credit bubble have to be paid for and Congress and the administration know that.

As one New York commercial real estate banker explained to me: “We’re going to pay for the losses by screwing our solvent customers. I just today rolled over a CRE [commercial real estate] loan with a good customer. The spread went from 60 basis points over Libor to 400.

“He couldn’t argue with us; after all, where else could he go? All of us are using the same loan pricing formulas, which for the good customer give you a spread of 300 to 400 over.”

That is for the commercial loans. Credit card rates for middle-income customers have risen by several hundred basis points, before new rate increase restrictions come into effect.

All those loans are funded with cheap money from the Fed, or, in the case of strong banks, from low-cost customer deposits. Joseph Campbell’s Irish moneylender, or “gombeen man”, would envy the banks’ margins.

Bert Ely, a Washington- area banking consultant, says you can see the effect of this playing out, for example, with the Bank of America, even before all those spread increases go into effect.

“In the first half, BoA had pre-reserve earnings of about $35bn, so call that $70bn a year. Annualise that for three years and you have $200bn of cash flow to pay for losses. BoA accounts for a little less than a 10th of the US banking assets, so there you have coverage for up to $2,000bn of additional losses, which would be very, very high.”

Not all banks will make it, of course. The cost of “resolving” them through the Federal Deposit Insurance Corporation will ultimately be covered by premiums collected from the solvent banks. But those premiums, in turn, will be passed on through one fee or another to the customers.

So while we may well have higher inflation, and higher Federal spending, it will not be due to the socialisation of credit losses through the tax system or the central bank.

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