Sunday, January 20, 2008

This Weekend’s Contemplation - More Bad News Ahead for the Banks!

The article below from the WSJ discusses the current and future state of the banking sector (both commercial and investment). Test in bold is my emphasis. The article is in italics.

There are a couple of comparisons in the article that require some additional comments. Namely, more money was lost in the S&L crisis of the late 1980s then is lost so far, both in dollar terms and as a percentage of GDP. Second, there were more bank failures in the 1990s then now.

My response to the first point is that losses of have just begun to increase. The real losses started in early summer and have already topped $100B with no end in sight (this only took 7 months). Most realize that the banks are probably looking at another 2 – 3 years of losses assuming no serious recession. Furthermore, who cares that the losses in the S&L crisis was 3.2% of GDP as opposed to the current 0.7%. The primary difference between the S&L crisis and now is which financial sector is taking the losses. The collapse of the S&Ls almost 20 years ago was the final chapter in the slow death of that financial sector due to the disintermediation of the S&Ls resulting from the growth of money market accounts. Or as money markets gained in popularity people pulled their money from the S&Ls and put it into money market accounts (disintermediation). To counter this loss of revenue the S&Ls became more aggressive mortgage lenders with fewer sources of cheap funds. The crash of the housing market in the 1990s just finished off a financial sector that was already in decline. Basically, the S&Ls did not play that large a part in the consumer and small business portion of the credit cycle.

In the current situation the losses are hitting the commercial banking sector very hard and this is the primary source of credit for consumers and small businesses. If the banks have more credit problems this will make it tougher for consumers and small businesses to borrow, the primary drivers of economic growth.

The second is the number of bank failures. As stated above the S&L crisis was really the death of a financial sector so one would expect bank failures to be high. It will take another year or two for bank failures to start developing in the US. However, just realize that the purchase of Countrywide by B of A, cash injections in Citibank and Merrill Lynch, negotiations between Washington Mutual and J P Morgan Chase are not signs of strength in the banking sector. These moves were completed to prevent bank failures.

Citigroup Inc. posted its largest loss in the bank's 196-year history this past week, driven by $18 billion of write-downs on its mortgage and other fixed-income investments.

With write-downs of an additional $14 billion by Merrill Lynch & Co., total losses reported by the world's biggest banks since May have climbed to more than $100 billion as a result of U.S. subprime mortgages.

Foreign investors paid $19.1 billion for stakes in Citigroup and Merrill this past week, spotlighting a shift in financial clout as U.S. institutions look abroad to help shore up their balance sheets. The losses have analysts wondering if the worst of the write-downs are over. Citigroup, for example, ended the fourth quarter still exposed to $37 billion of subprime mortgages, and $43 billion of corporate-loan commitments for leveraged buyouts remain on its balance sheet.

Still, losses from the current credit crunch -- nearly equivalent to 0.7% of U.S. gross domestic product -- haven't reached the level seen in the savings-and-loan collapse in the late 1980s, when losses reached $189 billion, or 3.2% of average GDP.

What's on the horizon for the banking industry? Here's a closer look:

Credit cards and consumer loans: Rising home prices allowed borrowers to refinance mortgages or take other loans to pay off credit-card bills and other loans, which prevented consumer-loan losses from rising. But that stopped in August, which has spurred a rise in loan and credit-card delinquencies since then.

Credit-card delinquencies and charge-offs increased by one percentage point to 6.83% last October from November 2006. But the figure jumped 0.8 percentage point in November 2007, to 7.63%. "That's the kind of jump you normally see after Christmas and not before," says Zach Gast, an analyst at RiskMetrics Group. Earnings reports this past week suggest that credit-card-debt repayment in December may have been as bad or worse. Moreover, losses stemming from delinquencies on holiday purchases won't show up until the summer, says Dennis Moroney, a bank-card analyst for TowerGroup.

Credit-default swaps: The sale of securitized loans using complex financial instruments can distribute risk broadly while democratizing credit, but the explosion of those complex investments may have gone too far because investors -- big banks, insurers and others -- never knew the real worth, or risk, their investments carried.

The market for credit-default swaps, which protect investors against borrowers defaulting on their loans, has soared in recent years to an estimated $43 trillion. If defaults in investment-grade or junk corporate bonds return to historical norms of 1.25% this year (from 0.5% last year), sellers of insurance on those loans could face losses of $250 billion, enough to match the losses some predict will result from subprime mortgages, says Bill Gross, chief investment officer at Allianz SE's Pacific Investment Management Co., or Pimco.

Loss reserves: Bank earnings could fall by as much as 20% over the next three years, suggests Mr. Gast, because they face a double whammy: Loan delinquencies are outpacing the capital reserves they are required to set aside, according to Mr. Moroney. As losses mount, banks have had to commit more of their revenue to loss reserves.

Those low reserve levels, coupled with deteriorating credit, could force banks to increase their loan-loss provisions by $30 billion to $85 billion, according to Mr. Gast, which would put further pressure on earnings. Loss reserves fell to 1.28% of total loans in the third quarter of 2007, nearly half the 2.57% share reached in 1991.

Regulation: Bank deregulation in the 1970s and 1980s spurred the creation of larger banks, but it also fostered greater competition. Between 1970 and 2005, the number of banks fell to 7,500 from 13,500, but the number of banking locations nearly doubled to 80,300. Some argue that recent deregulation -- such as a 1999 law that repealed the Depression-era Glass-Steagall Act separating investment- and commercial-banking activities -- has made it too easy for banks to take bigger risks, even as they grow so large that the government can't allow them to fail.

But the problem may have more to do with management than regulation -- indeed, top executives have been booted from the banks that posted the biggest losses. Banks have struggled to eliminate blind spots for risk, in part because banks have grown so large, says Guillermo Kopp, a former Citigroup information-technology head who is now TowerGroup's executive director. "Citi was supposed to be the quintessential diversified financial institution. But because it's so big, the leadership has been finding it hard to keep all of the pieces working together."

And regulation has its limits, says Alex J. Pollock, a resident fellow at the conservative American Enterprise Institute. "No matter what any regulator or legislator does, financial markets will create as much risk as they want."

* * *

• Since 1934, there have only been two years when no U.S. banks failed: 2005 and 2006, according to the Federal Deposit Insurance Corp.

• During the savings-and-loan crisis of 1988-89, U.S. banks failed at a rate of more than two every business day.

• Nearly 58% of Americans believe the globalization of the U.S. economy has been bad for the country, up from 48% 10 years ago, according to a December NBC News/WSJ poll.

• Real-estate holdings accounted for 58% of total assets for U.S. banks in 2006, up from 45% in 2000, according to the FDIC.

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