‘Zombie’ banks a symptom of our times

“What’s a zombie bank?” That’s a question I heard a commentator on a prominent news network ask recently. The general topic was what the federal government would do with Citigroup.

The TV personality who received the question was a consumer finance expert. He likes to portray a breezy air of all-knowing simplicity. But he was caught flat-footed. He made something up which sounded knowledgeable. But it was clear that he didn’t know what a zombie bank was.

There are many complexities to the full scope of the current financial and economic crisis. Most experts are specialists and don’t know all of the details of every nook and cranny of the economy and Wall Street, including myself. But to understand the severity of the current economic situation, it would help to know why we are talking about zombie banks.

A zombie bank is one that is bankrupt. It has near zero or negative net worth. A zombie bank could not cover all of its liabilities if it had to close.

In the past banking authorities eventually closed zombie banks. But when there are too many of them or when they are too big too fail, the Fed tries to keep them on life support until another solution is found other than closure.

A zombie bank continues to conduct business even when it has no overall value left. It may still have millions, if not billions, of dollars in customer loans and deposits. Because deposits are guaranteed by the Federal Deposit Insurance Corp. up to a certain amount, depositors continue to deposit their paychecks and pay their bills not knowing their bank may fail soon. Borrowers continue to apply for loans. On the surface, zombie banks conduct business as usual. They appear to be economically alive.

How do healthy banks become zombie banks? In its most important features, it’s quite simple.

Like any business, banks have a balance sheet. On the asset side, banks have loan and bond portfolios. The loans typically are for commercial and mortgage lending purposes. Government and other types of bonds are often held as secondary reserves that could quickly be sold for cash. On the other side of the balance sheet are liabilities like deposits plus net worth. Net worth is the difference between the value of assets and liabilities and is typically positive.

A bank makes money by earning a higher percentage return per dollar of assets than it spends per dollar of liabilities. A bank is regulated. With regulation comes legal constraints. A bank has to keep about 10 percent in cash reserves against deposits and about 8 percent in capital or net worth. If either of these ratios is violated substantially, bank examiners take note.

With the subprime mortgage crisis, the fall of housing prices and the recession, many large money center banks have suffered a decline in the value of their loan portfolios. The losses appear to be much greater than 10 percent. However, most banks sell their mortgages and make money on origination fees. This mitigates some of the difficulties of asset contraction. But there is another problem — the bond portfolio.

Many large banks bought mortgage-related bonds and others known as derivatives. Many derivatives were bundles of other derivatives. When housing prices and mortgage-backed bonds crashed, so did derivatives on a grand scale. In terms of the balance sheet, falling asset values means that net worth needs to fall on the other side. Net worth of such banks has plummeted until little remains. They remain in business, but they are damaged severely.

The story of zombie financial institutions has a history in New Hampshire. In the savings and loan crisis of the late 1980s and early 1990s, New Hampshire was hit very hard. In proportional terms, our tiny state was the most severely affected one in the nation. Five of our largest six banks or S&Ls had to be closed and merged into larger financial entities. For a time we had a number of zombie financial institutions as well.

In this financial crisis, the Fed is having difficulty restructuring zombie banks like they did 20 years ago. There have been a great many mergers and consolidations. Banks are much larger. Also, globalization has occurred since the financial crisis of the late 1980s. The largest economies of the world are now much more interconnected than they were.

The Fed’s instinct based on its history would be to deal with bank failures in the same manner as the closing of Lehman Brothers last fall. But the closing of Lehman Brothers seemed to make things worse. Now the Fed is taking a new path. If banks are too big to close and too weak to merge, then that leaves one option. The government needs to become an investor and take an equity position in a nearly failed bank.

In the case of today’s zombie banks, the federal government becomes the bankruptcy partner if no private financial institution will do so. In my view, this will be temporary and is not tantamount to nationalization of the banking system.

The economic recovery will be hampered until every major zombie bank is restructured. This will take time. When the task is done and prosperity returns, then the government should sell its equity position leaving capital allocation to the private sector.

Jim Wible is professor of economics at the Whittemore School of Business and Economics at the University of New Hampshire.