Saturday, May 31, 2008

FDIC Comments About Q1 2008 Bank Earnings and Loss Reserves

Earnings are down and the provision for losses are up for banks in Q1 2008 according to the FDIC. From the Market Watch:

The real estate sector was a major drag on banks in the first quarter, the Federal Deposit Insurance Corporation said Thursday, as falling asset quality of real estate loan portfolios pulled earnings down substantially.

Earnings for the quarter totaled just $19.3 billion compared to $35.6 billion a year ago, a decline of 46%, the FDIC said in its first-quarter banking profile.

"Higher loss provisions were the primary reason," the agency's report said.

Commercial banks and savings institutions insured by the FDIC set aside $37.1 billion in loan-loss provisions in the first quarter, more than four times the $9.2 billion set aside in the first quarter of 2007.

Just over half of banks reported one-year declines in quarterly earnings, the report said.
But big banks took the brunt of the earnings decline. Almost two out of three institutions with more than $10 billion in assets reported lower net income in the first quarter, the FDIC said.

Four big banks accounted for more than half of the earnings decline.

Restatements shrank fourth-quarter profits down to $646 million, from a previously reported $5.8 billion.

It was the lowest quarterly net income for the banking industry since the fourth quarter of 1990, the FDIC said.

Meanwhile, the agency said, the number of banks on its "problem list" rose to 90 from 76.
It marked the sixth straight quarter that the number of problem institutions has risen.
Total bank assets grew by 2.6% in the first quarter, even as loan growth slowed. Almost half the banks that pay dividends cut them, the FDIC said.

This Weekend's Contemplation - Peak Oil

Due to the recent run up in the price of oil the news has been full of a series of articles on "peak oil". In my mind peak oil is a very simplified (and misleading) explanation of what is occurring in an extremely complex market that includes a whole host of geological, technical, market place, and political issues. Below is a link to an interview with Matt Simmons, an energy investment banker, that has been in the business a long time. The reason I like the interview is because he discusses many of the technical issues (problems) involved in oil production. From CNBC:

Friday, May 30, 2008

Is the Credit Crisis Hitting a Second Phase

In keeping with my continued concerns about the adequacy of bank capital below is a recent article in Business Week. The long and short of it is if losses abate banks will have adequate capital to keep lending. If losses continue than banks will come under severe capital constraints and lending will be sharply curtailed. If you couple the latter scenario with increasing energy prices, which will result in higher food prices then US consumer is going to be in for a very rough ride in 2008 and 2009. My guess is we will know what is going to happen by election time. Text in bold is my emphasis.

Nobody was expecting an easy year for U.S. banks, but many observers thought the bulk of the industry's credit troubles would come in the first quarter. Now, it seems the rest of the year may be even worse. Case in point: A May 28 announcement from KeyCorp (KEY). Mounting loan losses at the regional bank company suggest the banking industry's troubles with bad loans are just beginning.

Cleveland-based KeyCorp, which holds $97 billion in assets, says the year's net loan charge-offs—a measure of how much bad debt the bank may have to write off—could almost double previous predictions for 2008. The bank expected charge-offs of 0.65% to 0.9% of total loans just three weeks ago, but now says they could be in the range of 1% to 1.3%.

The main culprit is the bank's portfolio of loans to residential homebuilders, KeyCorp said in a Securities & Exchange Commission filing. Losses have also increased on education loans and home-improvement loans.

Worry Shifts from Wall Street to Main Street.

Investors responded May 28 by fleeing banking stocks. KeyCorp shares tumbled 11%, to 19.59, on May 28, just above the stock's 52-week low. Other similar, regional banks suffered, too. Shares of Wachovia (WB), Fifth Third Bancorp (FITB), and Regions Financial (RF) all dropped 4% or more to 52-week lows.

Subprime securities had already decimated Wall Street banks and other financial firms. For investors, the worry now seems to be shifting from debt securities to simple, traditional loans, and from Wall Street to Main Street.

"Near-term credit trends appear to be getting worse," said R.W. Baird analyst David George. Those hoping for a recovery in the second half of the year will be disappointed, he wrote in a May 28 note, "as loss rates appear to be rising."

Higher losses on loans to developers and homeowners are disturbing enough. But what also unnerved investors was the suddenness of the change in KeyCorp's outlook.

Estimates for losses jumped just a month after the company's most recent earnings announcement. That suggests, Deutsche Bank (DB) analyst Mike Mayo wrote on May 28, "either misjudgment before, or a significant deterioration in, asset quality." The news flow from banks had been relatively quiet since they reported first-quarter financial results in April.

After months of a credit crisis and a weakening economy, most banks did see profits fall. But since the collapse of Bear Stearns (BSC) in March, there was a sense that losses on subprime-related securities had peaked. Major banks "have now probably weathered the worst marks on holdings of various asset-backed securities" and other debt instruments, Stifel Nicolaus (SF) analyst Anthony Davis noted earlier this month.

However, other troubling trends remained, and threatened to get worse. There is no sign the depressed housing market is perking up. In data released May 27, the S&P/Case-Shiller national home price index dropped 14.1% in the first quarter of 2008, the largest drop in 20 years. Loans to struggling homebuilders are a primary credit issue right now, according to Davis' note, but concerns are also rising about consumer loans.

Despite housing and credit troubles galore, banks such as KeyCorp have been able to attract investors with generous dividends. On May 28, KeyCorp sported a dividend yield of 6.9%, while Wachovia's yield was 6.1%. Yields from Fifth Third and Regions Financial were even higher, at 9.1% and 8.1%, respectively. Those high yields suggest some investors expect dividends to be cut so banks can hoard capital. Otherwise, an 8% or 9% return would be irresistible to most.

Baird's George said the tough credit trends mean KeyCorp probably won't earn enough in the second and third quarters to cover its dividend. However, he wrote, "It appears that [KeyCorp] has adequate capital to maintain its payout, provided the earnings challenges are temporary."

If credit troubles are brief, banks can afford to maintain their dividends. Bank investors might overlook a brief dip in earnings, however severe. However, the longer the credit crisis continues, the more questions are raised about whether they have enough capital.

Borrowers, particularly homebuilders, are clearly having a harder time paying off their bank loans. The best hope for banking stocks would be if the trends stressing out those borrowers—the weak economy and housing market—start to ease, or at least stabilize. Otherwise, it could be a long and gloomy year for investors in bank stocks.

Wednesday, May 28, 2008

Head of the OCC is Calling for More Reserves to Cover Home Equity Loans

John Dugan, head of the OCC, is calling for banks to build reserves against the increasing losses in home equity loans and lines. The important portion of his comments are: 1) banks are in uncharted territory and 2) the reserve build-up is still an earnings issue and not a capital issue. What is important about these comments is that the OCC is publicly acknowledging what most in the banking industry has been saying for some time. The real concern is that reserves remain an earnings issue. When it becomes a capital issue the credit markets were really sieze-up. Text in bold is my emphasis. From the OCC:

Comptroller of the Currency John C. Dugan said today that accelerating losses in the home equity business show the need to build reserves and to return to the stronger underwriting standards of past years.

Home equity loans and lines of credit grew dramatically in recent years, more than doubling, to $1.1 trillion, since 2002. In part, that’s because of the rapid appreciation in house prices, the tax deductibility feature of home equity loans, and low interest rates.

“But another contributing factor was perhaps not so obvious: liberalized underwriting standards,” Mr. Dugan said, in a speech to the Financial Services Roundtable’s Housing Policy Council. “These relaxed standards helped more people to qualify for loans, and more people to qualify for significantly larger loans.”

These relaxed standards included limited verification of a borrower’s assets, employment, or income; higher debt to equity ratios; and the use of home equity loans as “piggyback” loans that helped borrowers qualify for first mortgages with low down payments and without mortgage insurance, resulting in ever-higher cumulative loan-to-value ratios.

Consequently, once house prices began to decline in 2007, home equity lenders began to experience unprecedented losses. While losses have traditionally run at about 20 basis points, or two tenths of a percent of loans, they shot up to nearly 1 percent in the fourth quarter of 2007 and to 1.73 percent in the first three months of 2008.

Looked at in dollar terms, losses on all home equity loans, including HELOCs and junior home equity liens, rose from $273 million in the first quarter of 2007 to almost $2.4 billion in the first three months of 2008 – a nine-fold increase. And the largest home equity lenders are now saying that they expect losses to continue to escalate in 2008 and beyond, Mr. Dugan said.

The Comptroller said these loss numbers need to be viewed in perspective. Though accelerating quickly, they are still much lower than the loss rates for other types of retail credit, such as credit card loans.

It’s true that home equity credit was priced with lower margins than these other types of credit, and it’s true that the product has become a significant on-balance sheet asset for a number of our largest banks,” he said. “Nevertheless, the higher level of losses and projected losses – even under stress scenarios – are what we at the OCC would describe generally as an earnings issue, not a capital issue. That is, while these elevated losses, depending on their magnitude, could have a significant effect on earnings over time, with few exceptions they are not in and of themselves likely to be large enough to impair capital.”

For the near term, Mr. Dugan said, the OCC expects national banks to continue to build reserves.

“I can’t stress enough how crucial reserves will be in helping the industry manage its way through this situation,” he said. “At some banks, the portion of reserves attributable to home equity loans just barely covers 2007 chargeoffs. With losses accelerating, those reserves are simply not going to be adequate, and that’s why our examiners are encouraging more robust portfolio analysis and loss reserve levels.”

In assessing loan loss reserves for home equity loans, he said, banks need to recognize that they are in uncharted territory. “New product structures, relaxed underwriting, declining home prices, potential changes in consumer behavior – all of these factors make it difficult to predict future performance of home equity loans,” he said.

Circumstances have changed fundamentally, and historical trends have little relevance in estimating credit losses. As a result, qualitative factors such as environmental analysis and changing consumer behavior clearly should be factored into the reserve calculation. Likewise, lenders should take into account the very real possibilities that unemployment or interest rates will increase from their quite low current levels.

Mr. Dugan said that while lenders have begun to take steps to improve underwriting on new home equity loans, more needs to be done.

“Even as banks begin to work their way through the current problems, we need to ask some hard questions about home equity product structure and underwriting criteria,” he said. “In particular, we need to revisit the problems that landed lenders where we are today – particularly some of the “shortcuts” established in reaction to aggressive competition.”

Among the practices that warrant close scrutiny are:

• The use of home equity lines to finance down payments.
• The appropriate use of collateral valuation tools, such as asset valuation models, which the Comptroller said must be closely managed, periodically validated, and supported with sound business rules.
• Income documentation. Although the overt use of stated income has been largely abandoned, some lenders now ask for income information and authorization to verify it, but do not follow through. “This practice is only marginally better than expressly relying on stated income, since it is questionable whether the borrower’s belief that income will actually be verified will really induce a higher level of honesty in providing information,” Mr. Dugan said. “We need to think carefully about whether anything short of actual verification of income is acceptable from a safety and soundness perspective for most borrowers.”
• The extended interest-only structure that home equity credit lines have in the early years of the loan term. Payment patterns can only be a proxy for a borrower’s capacity to handle a given debt level if he or she is asked to make payments that are meaningful. “Interest-only payments reflect a borrower’s capacity to pay interest on a debt, but not the debt itself,” Mr. Dugan said. “Further, this lack of structured payment discipline encourages borrowers to assume greater levels of debt, often to the limit of their ability to make minimum monthly payments. In contrast, higher payments that reduce principal address both these concerns.”

Friday, May 23, 2008

This Weekend's Contemplation - Let's End Speculation in the Commodities Markets

It is the Friday before Memorial Day weekend and everyone is beginning to slow down in anticipation of the weekend. Below is an article that is worth a read and worth thinking over. I understand the problems of fiddling with markets, but I also understand the problems when speculators get involved in day-to-day life. From Market Watch:

It's one thing to make risky bets in the capital markets. It's another when speculation is too closely linked with the basic, everyday things that make society tick.

There has long been debate over whether Wall Street is the economy or the economy is Wall Street. Many say the markets are related to the economy but day to day operate outside of the price-setting that immediately affects us: energy, food, housing, etc.

Well, the advent of futures trading and increased investing by the general public as well as more sophisticated techniques by institutions should quash the notion that market indexes cannot make -- or break -- an economy.

When the costs of food, energy and water as well as other commodities are soaring because of prices in the futures markets we have a problem on our hands. This is exactly what is playing out before us now.

Futures are derivatives, remember, the total notional value of which exceed an estimated $300 trillion. That's exponentially more than the actual value of the global stock markets.

The problem does not lie with just that exponential hedge, it lies with the ramifications of futures, or derivatives, pricing at the gas pump and the checkout counter.

Futures contracts were originally designed so actual asset owners and producers, such as farmers, could better manage production -- for the betterment of us all -- and avoid large swings in harvests. For example, a lower crop this year could be hedged by selling futures on next year's crop, allowing that farmer to stay in business and keep putting food on our plates.
Now enter nonasset owners, otherwise known as speculators.

Earlier this week, the Senate's Homeland Security and Governmental Affairs Committee held a hearing on commodities speculation. This is what it found out: The commodities futures markets have seen an enormous amount of new business from funds and institutions shying away from the stock markets. And this, many claim, has sent prices soaring above historic levels.

Meanwhile, the Commodity Futures Trading Commission blames a series of events -- in one report likened to a "perfect storm" -- for price hikes, not just futures trading itself. Limited supply due to weather-related events, increased demand and -- yes, they admit -- Wall Street interest has pushed commodities futures contract prices way up.

Supply-demand issues are nothing new in the commodities markets. Neither are weather events' affects on prices. But what is new are the speculators, index funds, and large institutional interests in the market. This is rightly where the focus should be. Talk of new regulations to modify pension funds investing in the commodities futures markets is exactly where the focus should begin. Funds too should have tighter regulations.

In 2000 Enron pushed through a provision that allows energy securities to be traded outside the New York Mercantile Exchange, which has oversight rules and regulations. These third-party electronic markets also need oversight, as the farm bill Congress passed, but which President Bush vetoed, calls for.

It's terribly clear that investment interests are usurping the common good. Think about it: If oil production has remained relatively consistent why have prices soared? If we have had food crisis issues before, why are the prices on the shelves so inordinately high?

There is another agent at work in the commodities markets, one that is setting the prices of our natural resources and in turn the food on our table and the price of the gas at the pump. This agent isn't a farmer or an oil producer. This agent wears a suit and tie and sits in front of a trading screen. His or her job isn't to produce anything, it's to exploit anything. And it's time we curbed this profession.

Speculation in the commodities futures markets needs to be limited.

Thursday, May 22, 2008

UBS to Sell Its New Shares at a 31% Discount

I hear on the news all the time that the worst of the credit crisis is over and it should be smooth sailing from here. Allow me to ask you a question. When UBS is selling a new equity issue at a 31% discount does that sound like the credit crisis is over? When the IMF says that banks have only worked through a quarter to a third of their losses does that sound like the credit crisis is over? I suspect there will be another round of balance sheet strengthening for US banks this year. Text in bold is my emphasis. From Market Watch:

Switzerland's UBS on Thursday said it will sell new shares at a nearly one-third discount to raise the 16 billion Swiss francs ($15.6 billion) it needs to strengthen its balance sheet.

The firm, which has been Europe's biggest casualty of the credit crisis, said shareholders will be able to buy seven new shares for every 20 they hold at a price of 21 francs a share. That represents a hefty 31% discount to Wednesday's closing price of 30.64 francs. UBS said at the start of April that it would need to raise the cash after revealing a further $19 billion of write-downs from the credit crisis.

Shares in UBS fell 1.1% in early European trading to 30.30 francs. The stock has fallen 60% in the last year, but is still above its low of 23.05 francs at the end of March as investors are hoping the massive share issue will help draw a line under its credit-crisis losses.

The share issue is the second major capital boost for UBS after an ill-timed focus on U.S. growth saw it increase its exposure to risky mortgage assets shortly before the credit crisis. It previously raised around 13 billion francs from the government of Singapore and an unidentified Middle East investor.

Other fallout from the crisis includes the departure of former chairman Marcel Ospel and plans to cut another 5,500 jobs or roughly 7% of its global workforce, with many of those losses to come in investment banking.

Also on Wednesday UBS said it has completed the sale of around $15 billion or primarily subprime and Alt-A residential mortgage backed securities to a newly-created fund that will be managed by BlackRock Inc.

The fund purchased the securities using approximately $3.75 billion in equity raised by BlackRock from investors and a multi-year collateralized term loan of $11.25 billion provided by UBS.

Yes, I understand that the book of securities cost $15B, but what was it originally worth?

While UBS has taken the heaviest credit crisis losses in Europe, it is far from being the only European bank to ask shareholders for more cash.