The Rise (But Not From The Dead) Of Zombie Banks

As share prices of financial firms have continued to climb this year in the face of an uncertain economic recovery, the discussion about the role of so-called zombie banks is beginning to come up again.

Wednesday, Reuters’ Rolfe Winkler pointed out a discussion between three economists about how zombie banks are hoping that a sudden return of liquidity to mortgage-backed securities will one-day raise them up from the dead.

Winkler highlights Boston College finance professor Ed Kane’s comments about this kneel-and-pray strategy. It’s worth re-posting:

Kane: Another point is that these so-called “hard-to-price assets” have much more value to “zombie banks” than to anyone else, which is why there is no liquidity in that market. The deeply insolvent institutions want what everyone else calls “toxic assets” because it gives them a chance to climb back if the economy recovers well into solvency.

Bergman: Ed, you coined the term “zombie banks” in the S&L crisis. What inspired you?

Kane: It was just an attempt to make clear to people the dangers of keeping an institution that was deeply insolvent alive, or at least walking. The notion of the zombie is that it would be put in its grave by its creditors if it weren’t for the black magic of government credit support guarantees and loans. These institutions have very distorted incentives, just as the zombies do in the horror movies. They’re looking for things that even might have negative present value but have a possibility of producing good results. It’s a long shot bet to plug a hole in their balance sheet.

The trouble with the zombies is that they ruin the market for everyone else. They’re not looking for solid investments but something that has a chance of a big payoff. They’re willing to pay more for deposits or funding generally than other institutions, so they spread “zombieness.” They make other institutions have trouble earning a living.

Todd: It is the dead feeding on the living.

These are actually similar sorts of comments to those made by fund manager George Soros earlier this year, when he cautioned that any rise in the role zombie banks play in the economy without strong demand everywhere else (think home sales, retail sales, and declining foreclosures) would in effect, constitute a bear market rally, no matter how long it went on for.

Soros added that, as a result of the zombie banks: “The recovery will look like an inverted square root sign … You hit bottom and you automatically rebound some, but then you don’t come out of it in a V-shaped recovery or anything like that. You settle down, step down.”

Looking at the latest (rather erratic) economic activity, zombie banks certainly don’t seem to look any more independent of government capital than they did at the beginning of the year. Yesterday, the government announced it would be purchasing up to $1.25 trillion of mortgage-backed securities and $200 billion of agency debt.

It would be one thing if all the spending was leading to a massive slow-down in foreclosures and rise in housing sales. But that’s not the case: housing sales fell 2.7 percent in August, according to an announcement by the National Association of Realtors today.

Worse still, many argue that federal spending is beginning to artificially prevent foreclosures, meaning we are delaying the pain again once the Fed runs out of breath.

It’s easy to see how the scenario is adding up to a more zombified economic environment in general, with fresh capital chasing down the defunct. But it still seems increasingly likely that many of the zombie banks’ derivative assets will simply lag worthless for a long period of time, until the banks are forced into bankruptcy.

That process will of course put massive pressure on additional banks, and lead to more shutterings. The only difference is, this time the federal government won’t have any more cash lying around to bail them out.