Is there Another Shoe to Drop?

Many officials and private investors are concerned about the deterioration of the commercial real estate market. It is been widely discussed and on radar screens. What appears to have gone largely unnoticed though was the jump in secondary credit to depository institutions revealed Thursday with the Fed's weekly report on its balance sheet, credit facilities and custody holdings.

Secondary credit to depository institutions reached a new record high. This is, in effect, discount window borrowings to banks and thrifts that do not meet the ordinary requirements to borrow from the discount window or primary credit facility. It rose to $805 mln in the week ending Wed Aug 12, which is almost 3 times higher than levels reached last October.

Of course given the size of the Fed's balance sheet, the $805 mln is not very significant. Yet it seems to be warning of some problem among regional bank/thrift space.

According to Bloomberg data there are around 150 publicly traded US banks that have non-performing loans 5% or higher. This is seen as a key threshold for viability/sustainability issues, though of course loan loss provisions are important as well. This is reportedly twice the number of banks that are at or above the threshold from June 08. Some 73 banks have failed this year, the most since 1992. Even with these failures, the US is over-banked with nearly 8000 banks.

Just like we can talk about the excess capacity in industry, the US financial sector has excess capacity. It was hidden by what officials (at the time) said was a significant mispricing of risk. To the extent that risk is more appropriately priced, it revealed the excess capacity. When plagued by excess capacity, other industries have adjusted through driving inefficient producers out of business and through industrial consolidation. The financial sector should not be immune to those same forces. However, because of the nature of the financial sector, the adjustment is far from smooth.

Investors may want to monitor the secondary credit growth at the Federal Reserve in the weeks ahead. The FDIC often announces bank failures/take-overs after the markets close on Friday.