It is what it Is Wednesday, May 13 2009 

When one looks at the stress tests recently completed by the US government one has to properly filter the noise. The government has released the results and metrics used in the ‘stress tests’ which have been picked apart by many people. You can crunch the numbers and manipulate the statistics all you want but in the end it comes down to loss recognition on bad assets.

Right now there is a tug of war going on between the private sector and the government. On one hand, we have the government looking for greater oversight of the financial sector. On the other hand, we have a banking industry looking to get out from underneath the government’s umbrella believing that they can fix the problems on their own. In this case, both sides are wrong.

The financial sector can be self-policing with a greater emphasis on risk management as is the case in Canada. But the participants in the sector must accept a greater responsibility for their actions and that includes the potential for failure. Capitalism is not about bailouts it is about letting market forces dictate winners and losers.

The government cannot expect to go the route of pay regulation as it will contribute to a brain drain in the financial sector. Just ask anyone working for a Big 4 auditing firm if they are having problems recruiting talent after the Arthur Andersen debacle. This should be a warning to those who seek to regulate items like executive pay.

Sarbanes-Oxley did more harm to the US financial markets by forcing small to medium sized businesses to go private and chased away IPO dollars to markets such as Toronto, London, and Hong Kong.

For those who wish to pursue further regulation in the financial markets, it should be done in a way similar to the regulations which came into effect after the 1987 market crash. In other words, capital formation should not be inhibited in any manner.

Everything is Getting Better Tuesday, May 12 2009 

Back in the middle of the financial meltdown last October I penned a quick article entitled [url=”“]Everything will be All Right in the End[/url]. At the time the world seemed to be falling apart but it is important to understand that although the skies seemed dark at the time, there is a light on the horizon.

Since then the banking industry has undergone stress tests, the creation of various governmental funding mechanisms, and the thinning of the herd in terms of smaller weaker banks being acquired by larger organizations. A sense of normalcy is slowly returning to the industry and as banks spend the appropriate time in recovery.

We are currently at the point where lending standards have tightened and banks feel that the risk/reward ratio is tilted in favor of holding government and corporate bonds rather than making loans. Good people with good credit can get loans in this environment however people who have no income and no job will have no access to credit as it should have been over the past five years. This has been lost in the noise about banks writing off mortgage balances and foreclosures.

We are in the same position today in terms of lending standards as we were at the bottom of every credit cycle going back as long as records are kept. What makes this cycle different from the rest was the movement of mortgages on the edge of the lending bell curve to the mean. Because these mortgages were securitized into illiquid MBS and then chopped and diced into even more illiquid securities the healing process in the banking system will take longer than normal.

So where do we go from here? The healing process will take a number of years as banks continue to deal with problem loans and rebuild their capital structures. The key is loss recognition. The quicker losses are recognized and put behind the bank the quicker they can move forward in terms of rebuilding the capital structures.

Once the capital structures are rebuilt, banks will continue to choose to hold bonds over making loans to less than creditworthy clients until the risk/reward ratio favors making loans to those clients. Any efforts by the government or private sector to return to the lending practices in the middle of this decade should be looked at as a worrisome sign. Even more worrisome would be a return to these lending practices by banks of their own accord.

One recommendation would be to allow Canadian banks, who have very strong capital bases, to acquire weaker banks in the United States. TD Bank made a sizable acquisition in acquiring Commerce Bank but other Canadian banks should be allowed to make acquisitions as well. After speaking with a number of professionals in Canada, they are showing a keen interest in expansion south of the border. Given the strong capital base and risk management practices employed in Canada, where the banking sector was recently rated the strongest in the world, the US government should be opening doors for our neighbors to the north. This would only strengthen the US banking system as a whole and strengthen any economic recovery.