US Banking System & Liquidity

The banks have expanded the book of interest earning assets by
10% over the past year. If a credit crunch has been on in this sector,
you could fool me. The crunch as it were has come in the primary
capital account, which, despite $ billions in new capital raised, has
grown by only 5%. Large increases in loan loss reserves have
greatly impeded capital growth as has a reduction of fees earned
because of sharply reduced deal flows. The suppression of growth
of capital has reduced bank liquidity sharply at the margin (the
ratio of Treasuries to C&I loans has increased substantially). With
the economic downturn deepening, loan losses will remain high,
and, since bank stocks are trading at very depressed prices, capital
was set to be starved further. Hence the gov.' s $250 billion "bail
in" via the acceptance of 5% preferred stock from the banks. This
development will increase system primary capital by more than
20% and will add immediately to bank liquidity. The feds have gone
for a large expansion in bank capital because they know there are
further loan losses ahead, and they want to keep the system
more liquid and able to grow.

Bank holding companies and their various up and down stream
conduits relied heavily on the commercial paper market to fund
mostly real estate, but, deal transactions as well. The paper market
in financials has declined by more than 35% or $800 billion over
the past 15 months. With this source of funding mainly closed off,
you can again see the gov. thinking on capital infusions and the
need for the Fed to make a market in commercial paper.

Banks have been tightening lending standards and with a weak
economy, private sector credit demand has fallen off. So, it will
be a while before we see how efficiently the system functions with
its new supports.

Over the past 6 months, my boad measure of credit driven
liquidity has increased at a paltry 0.8% annualized. To counteract
the freeze on liquidity, the Fed has moved to add well over $600
billion to its own balance sheet to liquify markets. As I warned in a
number of prior posts, the Fed took a huge gamble in withholding
net liquidity infusion for so long.

The Fed's action is a plus for the economy a bit down the road, but
viewed long term, this massive infusion of liquidity will be
extraordinarily destabilizing to the economy and the capital markets
if the Fed does not begin liquidating massive amounts of securities
as soon as it conveniently can. With the economic challenges the
US faces in the short run, the threats from a grossly expanded
Federal Reserve balance sheet should be viewed as a critical "memo
item" on your checklist.