Monday, January 14, 2008

More Losses Ahead for the Banks and a Few Questions About the Future

The banks (both investment and commercial) will soon be announcing more losses in the fourth quarter. Text in bold is my emphasis. From Market Watch:

There are a couple of points that need to be added to this article to give it additional perspective.

First, there is a lot of confusion about these losses. Banks do not take write-offs (writedowns) against the income statement like an industrial company might. These write-offs are taken against a reserve account for loan and lease losses. The real issue to watch for is how much the banks have to contribute beyond their normal amount to bolster their reserve account for loan and lease losses. This amount comes directly from the income statement.

Secondly, the financial stress resulting from the housing market slide is spilling over into the credit card and auto loan sectors. This will cause additional loan and lease losses for banks beyond those already suffered from mortgages. This financial stress could ultimately eat into the prime mortgage market as the economy softens (economy softens, people lose their jobs, and a former good customer can no longer make their reasonable house payment, etc.), causing additional deterioration in the mortgage portfolios for banks. Specifically, those banks that held prime first and second mortgages in their portfolios.

Thirdly, there are many estimates of losses for the next few years. I have seen losses due to the US subprime mortgages of $250B to losses for the total US mortgages of $700B which includes $200B in commercial real estate loans that will follow the collapse of residential property. If you throw in estimates of losses on corporate bonds of $250B to be incurred as the economy softens the number gets pretty large. Looking at the table below (double click to enlarge) it appears that the major banks have taken total writedowns of about $75B, which is causing a fair amount of stress on the banks. For example, Cititgroup and Merrill Lynch have already required equity injections from foreign organizations and more is needed. Whether you use optimistic or pessimistic estimates of the total losses due to mortgages and all the associated consequences it is clear that the banks and insurance companies have only absorbed 10% to 30% of the losses that they could incur and this is already causing problems. How are they going to absorb the remaining losses? Somebody in the know needs to give a quantitative answer to this question. In other words no qualitative remarks from the Fed or US Treasury.

Mortgage woes are spreading to other types of loans as the economy weakens and unemployment rises, producing a secondary pressure trend hitting bank earnings, experts said this week. . . . . Higher provisions to cover rising losses on consumer loans will likely eat into bank profits in the fourth quarter and beyond. That may squeeze the capital cushions of some banks that already have taken write-downs in the tens of billions of dollars because of exposure to mortgage-related securities.

"The story of this quarter is consumer loans," said Zach Gast, an analyst at The Center for Financial Research and Analysis, a unit of RiskMetrics Group.

Until the middle of last year, consumer loan losses were held in check as house prices climbed, allowing borrowers refinance mortgages or take out home-equity loans and use the cash to pay off credit card bills and auto loans.

But as the subprime-fueled credit crisis erupted in August, such activity ground to a halt.
Since then, credit card and auto loan delinquencies have begun to rise and will probably deteriorate further, Gast said.

American Express . . . . said it was forced to record a $440 million, fourth-quarter charge to cover the cost of increased delinquencies and loan write-offs. The company said it's seeing particular weakness in states such as Florida and California, which have been hardest hit by the real-estate meltdown. Capital One Capital One Financial Corporation, another big credit card company, slashed its profit forecast on Thursday for similar reasons.

The delinquency rate on banks' consumer loans, which include credit cards and auto loans, rose to almost 2.5% during the third quarter, from less than 2% at the start of 2007, according to CFRA data. Gast expects that to rise in the fourth quarter and keep climbing in 2008.

"Recent signs of economic weakness could lead to deterioration in other loan classes that have so far held up well, such as commercial, non-residential components of commercial real estate and credit cards," John McDonald, an analyst at Banc of America Securities, said this week.

As loan losses climb, banks will have to put more money into reserves. Such provisioning will whittle away at banks' capital, adding another strain to the big write-downs that investors are already expecting.

Citigroup, scheduled to report quarterly results on Tuesday, could unveil $8 billion to $11 billion in write-downs on mortgage-related securities such as collateralized debt obligations, or CDOs, analyst Mike Mayo at Deutsche Bank estimated this week.

J.P. Morgan Chase, which reports on Wednesday, has less exposure to mortgage-related securities like CDOs. However, Mayo still expects the bank to announce write-downs of about $1.7 billion from the fourth quarter.

The fourth-quarter will likely see the final big write-downs on mortgage securities, but it will mark just the beginning for actual loan losses and higher provisioning, Mayo warned.

Citigroup increased provisions for bad credit by $2.8 billion in the third quarter, mainly in its consumer businesses. The bank could add more than $1 billion to provisions in the fourth quarter, Mayo estimated.

J.P. Morgan lifted reserves by $480 million in the third quarter and the bank could set aside more in the fourth quarter, Mayo said.

Wells Fargo is expected to report earnings on Wednesday. The bank has already announced a $1.4 billion special provision to cover rising losses on home equity loans. . . .

"The main focus for us and investors will be on credit quality and the degree of acceleration in loan and asset deterioration," Mayo wrote on Friday in a note to clients. "While losses should not reach the size of the losses incurred from CDOs and other structured products, they nevertheless should continue to increase over the next few years and provide a meaningful headwind to bank earnings."

Investors could be surprised by the combination of higher provisions and big write-downs in the fourth quarter, CFRA's Gast said.

"The surprises will come when banks have to take specific provisions for credit quality and that cuts into capital adequacy," he said.

Citigroup's Tier 1 capital ratio, a closely watched measure of the spare financial resources banks have to maintain, could decline to 7.1% in the fourth quarter, Deutsche Bank's Mayo said.

That's well above the 6% level that regulators require for a bank to be considered well capitalized, but below Citigroup's long-term target of 7.5%, the analyst noted.

Given such pressure, Citgroup is reportedly considering several ways to boost capital. The giant lender is mulling slashing its dividend in half and hopes to raise $8 billion to $10 billion from investors, according to a report by the Wall Street Journal.

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