The economic and political environment in this country has become very toxic.  There are many problems and much finger pointing.  At Alhambra, we represent our clients, citizens.  We have been skeptical of the banking and government sectors not for who they are but for how they affect our clients.  During this latest crisis we have been especially critical of these two sectors.  Government intervention in the economy and favoritism to the banking sector has caused a misalignment of risk and reward.  This misalignment, coupled with a steady dilution of our currency and a lack of ethics, spawned excess credit expansion.  The credit expansion wasn’t pulled from the banks for productive enterprise, but pushed on the country in the form of misallocation and speculation.  The result was the formation of an unsustainable credit bubble most recognizable in real estate.  Retrenchment has followed and we have all witnessed the carnage.

We are left to survey the damage.  We need to stop the bleeding.

Our capitalist economy is mature.  Private consumption makes up approximately 71% of GDP, investment is running 12.5%, Exports are -4% and Government is about 20.25% (Source: BEA).

The non-farm private sector has $110trn in assets, $32.5trn in liabilities (debt) equating to a net worth (equity) of $78.5trn (Source: FRB).

Where’s the problem?

We hold a combination of debt and equity in order to increase our assets or quality of life.  The banks are the means by which we borrow, invest in ourselves, to grow our asset base.  The argument is that these banks are faltering.  Banks take equity from the private sector, leverage it and lend it back to the private sector.  Banks are merely the facility with which we finance ourselves; fractional reserve banking produces the leverage.

When investment in ourselves fails to produce desired returns, perhaps increased employment and wages, we get retrenchment.  If we are forced to sell assets for less than we paid, we destroy equity.  This is the reason for capital ratios, down payments and reserves.  These all provide a buffer for deleveraging.

The financial sector participated in dubious and potentially fraudulent lending practices, some on request from our government.  They caused assets prices in the real estate market to increase to unsustainable levels.  Using bloated asset values as collateral, they lent more to all areas of the economy.  They are now destroying equity, selling these assets at a loss.

So how bad is it?

Let’s look at their loan books and profitability.

Total Loans and Investments:

Total Equity/Assets: 

Non-Performing Loans: 

Loan Loss Reserve:

Net Charge Offs:


Return on average assets:

Commercial banks are currently earning .85% return on assets and writing off 1.78% of assets.  4.74% of assets are non-performing and they have a loan loss provision of 3%.  Unfortunately, the non-performing portion of their book is not decreasing proportionally to their write-offs which means non-performing loan levels remain elevated.  The good news is that all ratios are currently moving in the right direction.  If they could get write-offs in line with ROA, they could stop burning through equity.  When write-offs are 1% higher than ROA they burn 9% of their equity capital and must replace it with increased trading profits, fees or sell other assets.  Average loss provisions for the last 25 years have been 2.05%, just about in line with average non-performing ratio of 2.1%.

A best-case scenario equates to everything immediately returning to the 25 year average.  Banks would write-off 2.37% of non-performing loans down to 2.1%.  .9% gets eaten away by the elevated loss provision leaving it at 2.1% as well.  Banks eat 1.47% of assets equating to a 13% loss of equity all else aside.  Equity is currently 11.17% of current assets, about $1.2trn.  The equity capital would drop to 9.7%, above the minimum 8.5% BaselIII buffer but below 11% high end requirement.

What we need is for non-performing loans to drop back down below 3%.  Banks could then write-off loans at the same rate as ROA.  If this were to happen, we essentially stop the bleeding and anchor for growth.  ROA increases and we walk away from the ashes.  Alas, kick the can proposals from Washington only extend the healing period and burden our recovery.

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