Sunday, October 28, 2007

A Review of the Banking Industry – Is a Credit Crunch On The Way?

The excerpts below from an article at MSN.Money gives a very good summary of the current state of the banking industry and why a credit crunch may be on its way. Text in bold is my emphasis.

The horrors let loose among mortgage borrowers and lenders by falling housing prices have begun to sink their fangs into the market for auto loans and credit cards, too. We're inching dangerously close to the point where consumers run for the hills -- taking their wallets and prospects for economic growth in the United States with them.

The damage came from two directions: mortgage delinquencies and assets backed by mortgages. At Citigroup, for example, delinquencies soared in September. The percentage of first mortgages more than 90 days past due climbed that month to 2.09% from 1.29% a year earlier, and second-mortgage delinquency rates doubled from earlier in 2007. And losses from Citigroup's investments backed by mortgages climbed to $1.56 billion for the quarter. That was well above the $1.3 billion loss the company had pre-announced just weeks earlier.

The damage was similar at other big banks:

Washington Mutual reported a net loss of $222 million from selling mortgage loans that it didn't want to hold in its own portfolio. That was a big switch from the $192 million gain on sale in the second quarter. Nonperforming mortgage assets increased to 1.65% at the end of the quarter, up from 1.29% at the end of the second quarter.

At Bank of America, the quarter saw a $527 million loss from structured debt products including mortgages and a doubling in nonperforming assets to $3.4 billion.

Wachovia reported a $587 million increase in non-performing residential real-estate loans and a $127 million increase in residential mortgage foreclosures.

At Wells Fargo, net credit losses rose to $892 million from $663 million in the third quarter of 2006.

Altogether, U.S. banks raised their reserves against loan losses by $6 billion in the third quarter from reserve levels at the end of the second quarter of 2007.

That's bad news for bank stocks, certainly. Every dollar that goes into reserves is a dollar less that can be lent out to make money. And the levels of reserves don't look likely to fall in the near future. Washington Mutual, for example, told Wall Street analysts that it expects that charge-offs in its mortgage portfolio will increase by 20% to 40% in the fourth quarter.

But the really scary news for the general economy is that the banks' problems aren't limited to mortgages and the housing market. They're starting to see rising delinquencies and charge-offs in their portfolios of auto loans and credit card debt.

Wells Fargo, for example, said that charge-offs on its credit card portfolio rose to $176 million from $161 million in the second quarter. At Washington Mutual, managed credit card delinquencies climbed to 5.73% of the bank's portfolio from 5.11% in the second quarter.

A "credit crunch" means that banks cut back on lending because of past losses. But now credit card companies are "crunching" customers -- raising fees, cutting limits and more -- and that could hurt spending, says MSN Money’s Jim Jubak.

But the most stunning news -- and the most troubling indicator that credit problems aren't limited to the mortgage market anymore -- came from the credit card companies. Because these lenders have neither direct nor indirect exposure to the mortgage market, the trends here are an indicator of what's happening with consumer credit outside mortgages. And the news in the third quarter wasn't good.

For example, American Express in its Oct. 22 third-quarter earnings report, put aside an additional $196 million in the third quarter, a 44% jump from the end of the second quarter, for loan losses in its credit card portfolio. The company's total provision for loan losses climbed 25% in the quarter to $982 million. Outstanding loans climbed 23% for the quarter, trailing both the percentage increases in credit card and total loan-loss provision.

At Capital One Financial, credit card charge-offs climbed to 4.13% and delinquencies to 4.46% in the third quarter. The company increased its loan-loss provision in its auto-loan business by 34% from the second quarter. Total loan-loss provision climbed 32% from the third quarter of 2006 and 28% from the second quarter of 2007.

There are other explanations for some of these numbers. Capital One Financial recently moved to add an indirect channel for making auto loans, which has led to a jump in delinquent loans. During its conference call, Capital One Financial called this move a mistake and announced that it was moving the auto-loan business back to a direct-lending model.

Rising industrywide delinquency and default rates are, to some degree, a return to normal after atypical lows following the rush to bankruptcy caused by a change in bankruptcy laws that took effect in October 2005, which cleared a lot of bad debt out of lenders' portfolios.

But taken together, with evidence of rising delinquency and default rates coming from so many different lenders operating so many different business models in so many different markets, the possibility that we're seeing the troubles that borrowers are facing with their mortgages spill over into problems with credit cards and auto loans is disquieting.

These problems could indeed slow the economy in 2008 more than investors now believe is likely.

The biggest danger, though, doesn't come from the consumers running behind on their credit cards and their auto loans. With delinquency rates still below 5% at a credit card company like Capital One, reduced spending by consumers with credit problems probably isn't enough to tank the economy.

It's the folks in good shape that the economy has got to watch out for. If consumers who are in good shape decide to cut back on spending in order to reduce their credit card balances, that would take a considerable amount of spending out of the economy. There is some evidence that this has started to happen. Repayment rates are running about 1 percentage point above their long-term average, according to And credit card utilization rates -- the amount of available credit that consumers actually use -- are near 15-year lows.

The banks aren't helping the situation. Certainly, you understand why a bank that's been burned by higher-than-expected mortgage default rates would think first about cutting back on mortgage lending. It's too little, too late, but the impulse is almost irresistible. In the mortgage market, lenders have lowered the amount they'll let consumers borrow against their homes, done away with teaser rates and no-income-verification loans and raised the credit scores they require to approve a loan. The result is a credit crunch where people who want to borrow today can't -- even though they meet the lending standards in effect just yesterday -- because lenders have stopped lending.

Something similar may be brewing in the credit card market. Through the first six months of 2007, direct-mail offers to consumers with the best credit have dropped by 13%, according to Mintel International. (On the other hand, offers to consumers who are in danger of defaulting on their home loans have actually climbed by 41% in the same period.)

At the same time as they're sending out fewer card offers to the best prospects, banks have been increasing the rates they charge on cards:

Regular monthly interest rates are going up.
Penalty interest rates are going up -- to as much as 34% in some states -- for cardholders who make even one late payment.
More cards are adding a universal penalty clause where missing a payment on one card you hold can trigger a rate increase on all your other cards.
Late fees have zoomed and so have over-limit fees.
Grace periods that allow you to pay before interest charges kick in are getting shorter.
It's harder to get a credit card company to raise a credit limit on an existing card, and new card offers come with lower initial credit limits.

A "credit crunch" means that banks cut back on lending because of past losses. But now credit card companies are "crunching" customers -- raising fees, cutting limits and more -- and that could hurt spending, says MSN Money’s Jim Jubak.

Most of those changes, in my opinion, are simply attempts by banks and other credit card issuers to pull in more revenue from cardholders to offset the squeeze on their profits that results from putting more money into loan-loss reserves. They don't intend to create a credit crunch. But by lowering credit limits and by making it more expensive and more aggravating to use a credit card, the result is still the same. We're witnessing the very early stages of a classic credit crunch in the credit card market.

It's too early to tell if the crunch will get crunchy enough to take a percentage point or two out of the 1.9% growth rate projected for the U.S. economy in 2008. But in this part of the debt market -- as in so many others from mortgages to buyout loans -- the trend is clearly toward less available and more expensive credit. That's never a recipe for faster economic growth.

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