Could a credit storm be coming?

The big banking news of recent days is that the “SIFI” banks (Systemically Important Financial Institutions) passed their annual stress tests administered by the Federal Reserve.

Stress testing was the idea of Timothy Geithner, Secretary of the Treasury under President Obama. Its purpose was to tamp down fears that the very largest banks were insolvent. There’s an interesting description of the genesis of this idea in Geithner’s book, Stress Test: Reflections On Financial Crises.

Following the stress test news, there followed several days later the news that the capital plans of these banks—including the plans of several banks to significantly increase dividend payouts to stockholders and of a few to buy back equity in the open market—had been approved. A reduction in the number of shares of outstanding stock of an issuer, all else being equal, will have the arithmetic result of increasing an institution’s Return on Equity ratio, one of the fundamental measures of a bank’s financial performance.

This is certainly good news on one level that the largest banking institutions have strong capital positions. This led Federal Reserve Chair Janet Yellen to comment that there is unlikely to be another severe financial crisis within our life times.

But I’m troubled by Yellen’s comment and by the plans of at least a few of the biggest banks to buy back equity.

Looking back at ‘80s troubles

During the 1980s I was directly and deeply immersed in the problems of two large banking companies that were severely impacted by the severe downturn in the oil field due to the decline in the commodity value of oil and gas. These problems were followed by severe commercial real estate problems two or three years later.

In 1983, First National Bank of Midland, one of the largest independently owned oilfield banks collapsed under the weight of sinking oil prices. Oil went from a high of $32 a barrel in 1982 to a low of about $8 six years later during one of the worst oil price contractions in modern economic history.

I had been the credit administrator of that bank prior to my assuming responsibility for a portfolio of distressed energy credits. A key lesson learned: No matter how conservative the bank’s lending policy is, how does one cope with that sort of unanticipated price swing in a significantly concentrated market?

My next experience was at Liberty National Bank of Oklahoma City, where I was the manager of the Special Asset function comprising all of the seriously criticized energy credits. Thanks to the very deep pockets of several of the directors, the bank was successfully recapitalized in 1987, the first successful recapitalization of a major bank to that point in the credit cycle.

A reminder from those days: During that dark time, the OCC, the primary regulator of both banks, was continuously reminding us that there is no such thing as “excess capital.”

Yet I am now reading and hearing that very term in the financial press—and from many bankers who are anxious to return equity to their owners in the form of higher dividend payouts and the repurchase of outstanding common shares.

Why the collective amnesia?

What troubles me about this today is how short our memories are.

Jamie Dimon, CEO of JPMorgan Chase, has on numerous occasions referred to his bank’s equity capitalization and credit quality as a “fortress balance sheet.”

It probably is, by the standards of today. But for me as one who has been through the trials of the 1980s, there’s a sixth sense that a bank, virtually any bank, can’t have too much capital.

The bankers running these SIFI institutions are competing for investor attention and market support to advance the price of their companies’ shares. That in a nut shell is their job.

But they also have to run their banks in a conservative way given the manner that banks are capitalized. Our debt-to-worth ratio as an industry is in the average range of ten to one—$10 of debt to $1 of capital. Most American industrial companies are capitalized with considerably lower debt-to-worth ratios.

To belabor what is perhaps obvious, this means that the assets owned by a bank (such as loans and securities) have to be absolutely pristine. But pristine asset quality is not the same thing as a “stout” equity account.

Any efforts to improve a company’s Return on Equity Ratio (net earnings divided by owners’ equity) independent of improved financial performance smacks of “financial engineering.” Equity buybacks to me in effect destroy the bank’s seed corn.

I don’t believe it, Janet

And what are we to make of Chairman Yellen’s comments that the threat to big bank solvency has been eliminated in our lifetimes?

Talk like this from a person in such a position seems to be irresponsible, particularly when coupled with all the banker talk about “excess capital.”

Frankly, I’m getting nervous. Consider these points:

• We are experiencing one of the longest upward-sloping business curves in a great many years.

• The banking system is probably the most liquid it’s been in modern times.

• Market rates of interest are at unnaturally low levels owing to the magnitude of the last recession and the Fed’s actions to deal with it.

Add to this the fact that most bankers and examiners who 35 years ago dealt with the down turn of the 80s are now retired—as are some who were in the trenches 10 years ago.

There are many fewer veterans of those credit quality wars left still at work in the day-to-day sense.

And then how should we view the fact that the banking industry is doing less functional credit training in the career development sense?

We may be facing issues of both capital and asset quality in the years to come and our collective actions seem to be aggravating the potential future risks.

Just how prepared will we be when the business cycle turns down, as it certainly will one day?