From the Daily Capitalist:

I want to follow up on several things I mentioned yesterday, mainly the state of banks and credit in America.

In yesterday’s article, “Goldman Says Fed May Need To Print $4 Trillion To Start Inflation,” I said:

Before we get back to the Fed, I think it is important that we are seeing a growing trend in regional and local banks to dump nonperforming assets. This is critical to any recovery. Banks have been reluctant to foreclose on commercial real estate (CRE) for a lot of reasons, but mainly that it would negatively impact their Tier 1 capital. Recent reports show that they are making money mainly by releasing nonperforming loan reserves which were set aside to reserve against loan losses. This indicates that they are more aggressively dumping nonperforming loans. In the banks surveyed by American Banker, Fifth Third, BB&T Corp., SunTrust Banks Inc., First Horizon National Corp., Comerica, M&T Bank Corp., and TCF Financial Corp., all were selling off hundreds of millions of dollar of CRE and more aggressively foreclosing on residential loans.

Based on the data I am seeing, it appears that banks, especially the regional and local banks, are starting to solve their nonperforming loan problems. This is very relevant to the credit crunch we are having. There are two aspects to it. First is that banks have tightened credit because they are unsure of the future with a ton of problem commercial and residential real estate on their books. They would rather hold on to their capital until they see a recovery in the economy. Second is that businesses aren’t borrowing, at least not as much as they would if we were in a recovery. Business owners also see uncertainty ahead because of a lack of consumer demand and because of the impact of Obama’s legislation and the political future (regime uncertainty).

There are two bits of data that are actually encouraging in the face of a lot of bad data. I will describe them and then put them in perspective.

First, regional and local banks are reducing their problem RE loans, mainly CRE loans. Instead of extend and pretend, they are starting to foreclose and sell off the properties, as noted above. Since these banks are the source of loan capital for most small businesses (under 500 employees) who create half of the jobs in America, it is important for a recovery that they clean up their balance sheets, raise new capital, and prepare for the future. They have a lot of incentive to do this since the large banks see a promising business strategy by poaching on their territories.

This fact is showing up in the following nonperforming loan data:

As you can see these nonperforming loans of small banks ($1B to $10B) are starting to flatten out for the latter part of 2010.

Also, as evidence that they are disposing of the loans or the foreclosed properties, their loan loss reserves are also declining. What this means, as noted in the above quote, as loan are dealt with, banks can remove capital from reserves and that shows up as revenue for them. See this chart which shows a reduction in loan loss reserves starting in about Q2 2010 — the first time since Q4 2009:

Don’t get too excited because consumer loans are still way down:

But there is a change in business loans from all banks. This chart shows YoY percentage change in business loans:

This chart is a bit exaggerated to show the change in percentage terms, and it is significant, but it distorts the data. Here is a chart showing loans of large commercial banks:

It is flattening out, a good sign as it has stopped declining.

You would think that if banks are making loans to some businesses, then it should show up in a reduction of banks’ excess reserves, and it does:

Another look (from Bloomberg):

As you can see, there is about a $100 billion reduction which has found its way into loans. Not huge, but not insignificant. The major banks are all reporting very modest loan gains from mid-size companies. This is significant because it is the first time since the crash in 2008. Note that the big 500 don’t need banks as much since they have access to the commercial paper and debt markets.

This is starting to show up in money supply. The True (Austrian) Money Supply has been rising, some from lending activity and some from QE1. Michael Pollaro, who collects this data says:

The money supply aggregates based on the Austrian definition of the money supply (TMS) continued their recent surge, with narrow TMS1 posting an annualized rate of increase of 10.7% in September and broad TMS2, The Contrarian Take’s preferred money supply metric, posting an annualized rate of increase of 16.5%.  As a result of this surge, the year over year rate of increase in The Contrarian Take’s preferred TMS2 metric has risen to 11.2%, 5 bps higher than August’s 10.7% and 9 bps higher than July’s 10.3%, the month of its most recent year over year low.  September not only marks the 21^st consecutive month of double digit increases on TMS2, but as discussed below, may suggest a brewing acceleration in what is an already high rate of monetary inflation.  This even without the help of QE II.

Is there a trend? I think it is with regard to banks cleaning up their nonperforming loan portfolios. Word on the street is that investors are taking these projects off the banks’ hands after hard bargaining. While one could say that these investors are suckers, real estate investors take a longer term view of the world and cycle after cycle, the money is made at the bottom, buy-low-sell-high conditions. It takes a certain amount of guts to do this.

With the nonperforming loans at a ratio of 2.5% of all loans, normal being about 1.0%, we seem to have quite a way to go. But the important thing to keep in mind is that it is finally happening.

Will loan demand improve? This is the big question. A lot depends on political conditions and the ability of the government to keep its hands off businesses.  If the Democrats lose the Senate and/or shave down their House majority, legislative gridlock will be good for business. Perhaps even some of the more egregious aspects of Obamacare can be delayed or stopped. Perhaps the wasteful fiscal stimulus can be stopped. Watch and see.

A lot of it also depends on how much inflation the Fed will generate through QE2. If we have 2% price inflation, then demand will pick up temporarily and we’ll see a mini-boom from the new QE2 money. It will be another fake boom, but I’m not sure most businesses or consumers will understand that. How long it will last is anyone’s guess, but, because I believe we haven’t created enough real capital to sustain a real recovery, I don’t think it will last long. If inflation really takes off, then loan demand will fall as high inflation ruins capital investment, and the economy will stagnate and unemployment will stay high (stagflation).