I like to think that I have a pretty strong stomach for risk.  I am used to losses.  I have my sell disciplines, and I act on them.  I also try to be forward-thinking about risk; not just reacting, but trying to anticipate what the markets are likely to deliver.  Every now and then, I get a surprise.  Here’s the surprise, which I got from The Big Picture (Barry’s blog).  Institutional Risk Analytics does some good work, and this article is representative of their work.  In it, they describe the two risks facing the large banks — risks from their assets, and risks from their derivative books.

The second link made me pause.  I know things are bad, and I can’t vouch for Institutional Risk Analytics’ risk based capital model for banks, but the level of notional derivatives exposure at many of the major banks to their tier 1 surplus made me pause.  There are two claims on surplus — losses from direct lending, and losses in the derivative books.

Those who have read me for a long while know that I think the derivative books at the investment banks are mismarked and possibly mishedged.  When accounting rules are not well-defined, and instruments are illiquid, even well-meaning managements tend to err in their favor in the short run.

This is significant in a number of ways, but the main one was pointed out in the first link, that with the continuing failure of small banks, how will the FDIC make depositors secure if a large-ish institution fails, when reserves are relatively low?  They need to raise their fees that they charge solvent banks to replenish their coffers.  They are also bringing back retirees with experience in dealing with insolvent banks.

So, are the banks in trouble?  Some of them are experiencing stress, and that is coming through higher credit spreads on their debt.  Given the higher costs entailed in funding for banks, it is all the more important in your investing to look for companies that don’t need much external finance.  After all, many banks may find it harder to lend.  Consider the difficulties in funding InBev’s purchase of Anheuser-Busch.  Large banks are straining at their limits.  They don’t have enough parties to sell loans off to, nor do they want to hold onto so much of the risk.

The bank loan and and bond markets are closely connected.  Troubles in one tend to spill over to the other.  Loans have a higher priority claim, so the yields are lower than for bonds.  As it is, investment grade corporate bonds, particularly financials, are facing higher yields.  The high yield market has slowed considerably.

So, what does this imply?  The banks are hunkering down.  They are scrutinizing all risk exposures.  They aren’t expanding lending, which is showing up in MZM, M2, and my M3 proxy.  Credit is getting tough/sluggish.

Money Supply

And the degree of leverage that banks are willing to use versus the Fed’s monetary base is dropping, and hard (the graph covers 28 years).

Bank Leverage

So, I’m not optimistic here. I believe in the value of “long only” money management as having better chances of risk control than hedged strategies, but this is making me queasy. What it makes me think, is that the FOMC’s next move is a loosen. It hurt to say that, particularly given my dislike of inflation, but the solvency of the financial system comes ahead of inflation in the Fed’s calculus, even though loosening won’t help much.

With that, I am looking to continued problems in banks, and perhaps for the economy as a whole.  Our next president will have a fun time with this…