The Cream Always Rises To The Top

Posted on March 16, 2012

Do you remember the long standing expression “the cream always rises to the top”?

Cream is considered expensive, more desirable, and therefore better than alternatives. When something is better than the rest (the cream), it is inevitable that it will rise to the top. The U.S., or the cream in this analogy, is slowly emerging out of its worst economic recession since the Great Depression.

Retail sales in the U.S. rose 1.1 percent in February, the most in five months. The economy is growing in spite of higher gasoline costs. Led by the biggest jump in automobile stockpiles in more than a year, companies increased inventories in January at a faster pace than projected. The Department of Commerce reported on February 29 that the economy grew at a 3 percent annual pace in the fourth quarter of 2011. Even employers boosted payrolls more than forecasted in February, indicating companies are growing more optimistic about the expansion. Despite this expansion, the jobless rate held at 8.3 percent (but that’s another story).  According to real estate analysts, potential homebuyers and sellers are growing more confident that the U.S. real estate market will begin to recover as soon as next year. While foreclosures and declining home prices have contributed to a six-year real estate slump, recent rising employment and low mortgage rates may be reinforcing buyer confidence.

All of these components are essential to grow the economy, but the underlying lynchpin is our banking industry. Banks provide the mortgages and construction loans for housing, the financing for small-medium businesses (the base for employment), home equity loans for consumer spending, home repair loans, and auto loans.  It is imperative that our banks not only appear to be financially strong but have the ability to withstand a slowdown in the economy or even another deep recession. To make evident the banking industry’s recovery from the financial crisis, the U.S. Federal Reserve Bank released the results of its latest bank stress tests on March 13. These findings help establish the latest indications of renewed strength in our economy. The Fed reported that “15 of 19 banks would be able to maintain capital levels above a regulatory minimum in an extremely adverse economic scenario, even while continuing to pay dividends and repurchasing stock.” Those results were affirmed by the Fed through examinations on capital payouts over the past three years. For the financial sector, including traditional banks and Wall Street firms that were not only at the heart of the panic during the crisis but probably the catalyst for this predicament, the recovery has been slow but steady with some banks recovering much faster than others.

Using these tests, the Fed is trying to predict how capital levels at the 19 largest banks would withstand an economic downturn even more severe than the one that the U.S. is presently recovering from.

The Fed stress test envisions a 50 percent stock market decline and an 8 percent contraction in real Gross Domestic Product. In addition, the scenario presumes an unemployment rate of 13 percent, well above the 10.2 percent peak attained in October 2009. An escalation in unemployment would increase exposure and losses for banks on mortgage and credit card debt. Furthermore, the Federal Reserve is contemplating what would happen to bank assets if a market jolt hit Europe and reverberated in the United States, determining the extent of losses for American financial institutions.

These assessments were not simply an intellectual exercise. If institutions fell short, they could be required to raise billions in new capital. If they pass, dividend increases and stock buybacks by the strongest institutions will follow as they did after the second round of tests a year ago, pleasing investors and shareholders.

Citigroup Inc., the financial institute that took the most government aid during the financial crisis, did not make the grade. They will try again to win approval for its capital plan after failing to meet minimum standards in the stress test.

The resilience of the largest U.S. financial firms when tested for a recession more severe than the last one confirms that regulators have succeeded in pushing banks to build fortress-like balance sheets.

Despite differing opinions, the Fed stepped up to safeguard the creditworthiness of the American banking industry. By initiating a substantial financial firewall, the U.S. Federal Reserve Bank served notice to all that they are the lender of last resort, protecting and guaranteeing the status of the major U.S. banks. Unlike the European Central Bank that allowed speculation and uncertainty to continue unchecked, the Federal Reserve stopped the bleeding before it got started.  The Fed could also be called the lender of last resort for the ECB.  The Fed stepped in at a crucial time to prevent a major credit and liquidity crunch among European banks. The ECB finally followed in the Fed’s footsteps and created two major borrowing opportunities for their key banks preventing a major financial institution meltdown.

One last observation, while different currencies take turns riding the wave of popularity and safety, governments, speculators, and investors seek the sanctuary of the U.S. dollar in time of crisis, uncertainty, and now economic resurgence. The cream (US dollar) always rises to the top.

For questions /information, contact Joel Borshof

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