I have written repeatedly over the past year (and longer than that) that the US banking system is very weak – more specifically, that it is weaker than the Fed, Treasury and financial press would have us know.  Here is an update, and a summary of what it means to how we are investing…

• The Economist magazine states that western (N America, Europe) bank funding has been getting worse in 2009, not better. Despite raising money via stock sales, and issuing debt, they are no better off because they are having to write down losses at a similar or faster rate. The Economist states that bank plans to wean themselves off government guarantees seem “wildly unrealistic”.
• If Goldman Sachs is building a war chest of $170B+ in cash, maybe there is a good reason. They are not known for having money lying around.
• During the 1980-1995 US savings & loan failure period, the FDIC borrowed $15B. That debt is still being paid back.
• The FDIC is woefully under-funded. It has seen its coffers depleted from $60B to $10B in the past year.
• Expected losses from bank failures in the US during this round of bank failures is estimated to be $300B-500B. $10B won’t do.
• Banks fund the FDIC from fees they pay (like insurance premiums). If US banks did nothing but take all their profit and give it to the FDIC, it still would not provide sufficient funds to make the FDIC solvent. So, the FDIC is likely going to end up borrowing more from the Fed (you & me).
• Banks will be forced to increase their payments (premiums) to the FDIC. This will be happening at a time when they are losing money on loans and trying to earn as much profit as possible to rebuild their own balance sheets so they don’t become an FDIC statistic too.
• Perhaps as many as 1000 banks will fail or be purchased in the recently started bank contraction. It will last for years (last time it lasted 15 years and was much smaller than this time).  There are over 8000 banks currently in the US. Close to 100 have already failed in 2009.

How does this impact how we invest?  Since the US banking system is in reality still very fragile, we are exposed to a sudden melt-down. This means for an extended period, we need to skew our investments towards higher quality assets. This point is important: because banks are going to be under significant pressure for many years to rebuild the FDIC, their ability to make loans (expand credit) will remain weak –or even continue to contract. It is exceedingly difficult to grow economic activity when banks are contracting their lending. Virtually impossible, really. So we will not look for a return to strong GDP growth in the US anytime soon. We’ll see a temporary GDP growth number posted for Q3 2009 in a few weeks, but you see the case for a double-dip.

We want to ensure we own highly liquid assets (buy or sell inexpensively and quickly). We also want to continue to own gold even though there is virtually no threat of inflation in the near term. Gold is held as a hedge against the US dollar sliding. We also want to add to our positions in countries with solid banking systems and if they have exposure to gold / other natural resources — all the better. Sounds like Canada eh?  Brazil too.