MUST READ: A TWO PART CREDIT CRISIS

June 9, 2009

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Here’s a must read, courtesy of The Pragmatic Capitalist

MUST READ: A TWO PART CREDIT CRISIS

The latest McKinsey Quarterly is a gem of a research report that details many of the issues I have been banging the drum on for months now. They say this crisis is made up of two parts: a securities market credit crisis and a commercial credit crisis. The first of these crises is likely ending as we speak, but the second portion is only just getting started. Regular readers are familiar with my constant ramblings (and thus far accurate calls) on the banks and the impending credit card losses, ARM resets and commercial real estate losses. These are the issues that McKinsey is referring to when they speak of this “second part” of the credit crisis:

The good news is that we have probably turned a corner in the credit securities crisis that last fall forced big financial institutions into collapse, nationalization, or extreme survival tactics. But the contours of a broader resolution of the crisis will remain fuzzy for some time to come. That’s because what many have been regarding as a single credit crisis is in reality the tale of two closely related but different crises, each with its own pace, duration, and demands on banks to rediscover operational discipline in a harsh economic and regulatory environment.

The first credit crisis was centered in the securities markets and initially manifested itself in the subprime and mortgage-backed securities markets. Because of the fair-value accounting that broker–dealers and investment companies use to mark assets to current market expectations, these firms began to suffer deep losses on mortgage-backed securities long before large volumes of loans started to default. This credit crisis started in mid-2007 and peaked in 2008, resulting in the demise of Bear Stearns, Lehman Brothers, and Merrill Lynch, and forcing Morgan Stanley and Goldman Sachs to become bank holding companies in order to survive. It also heaped huge losses on the securities arms of major US banks and forced government takeovers or mergers on AIG, Fannie Mae, Freddie Mac, National City, Wachovia, Washington Mutual, and others.

The good news is that we appear to be seeing the end of this credit securities crisis. That is in part due to the clarity provided by the stress test exercise and the ongoing commitment on the part of government not to allow a large-scale bank failure. The other credit crisis is a commercial-bank lending crisis. While this crisis also stemmed from bad residential mortgages, it involves a broader array of lending, including commercial real-estate loans, credit card loans, auto loans, and leveraged/high-yield loans, all of which are now going bad because of the economic downturn. The bulk of these loans are subject to hold-to-maturity accounting, which, in contrast to fair-market accounting, typically does not recognize losses until the loans default. The bad news is that this crisis is still in its early stages and may take two years or more to work through the credit losses from these loans.

McKinsey believes the firms with broker dealer arms and large financial management branches have a greater chance of earning their way out of the crisis. In essence, McKinsey argues that they are less reliant on hold-to-maturity assets and have already taken their lumps due to fair value accounting. McKinsey fails to mention the fact that Q1 earings were padded by FICC trading that was bolstered by AIG. Not to mention the fact that this form of income is variable and hardly a reliable source of income (especially in volatile markets). Nonetheless, it is true that these firms are less reliant on traditional banking income, but it should be noted that these firms are equally (and to some extent more) exposed to weak economic times.

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I detailed the jumps in commercial credit losses as each bank reported this past quarter. The increases were largely ignored by the markets as the markets stood in amazement at the “better than expected” earnings (Q1 bank earnings came as no surprise to regular readers). As we saw in Q1 earnings the defaults on commercial related loans are increasing:

While the worst may be over for the broker–dealer sector, first-quarter 2009 results tell a different story for commercial-banking activities at the same major banks. These banks took $38 billion in loan-loss provisions in the first quarter, $16 billion more than in the 2008 period. Most of this increase—$12 billion—was from retail-banking and credit card credits. In other words, the pace of defaults on these credits is rising.

This merits concern because loan provisioning under hold-to-maturity accounting is a lagging indicator of future loan losses. Under hold-to-maturity accounting, loan losses are delayed even when they are highly probable, because loan-loss provisioning doesn’t take place until the loans actually default. And since many of these loans have terms and conditions that allow the borrower to pay interest out of a line of credit, such loans won’t default until the line of credit is exhausted. Hence, eventual losses may grow as the lines are drawn down, but the timing of the losses is delayed. When loan-loss provisions start rising rapidly, it is likely that more losses lie ahead.

McKinsey estimates the total losses from part 2 of the crisis to total $3T. We’re through roughly $1T of these losses already.

McKinsey research estimates that total credit losses on US-originated debt from mid-2007 through the end of 2010 will probably be in the range of $2.5 trillion to $3 trillion, given the severity of the current recession (Exhibit 2). Some $1 trillion of these losses has already been realized. Since US banks hold about half of US-originated debt, the US banking and securities industry will incur about $750 billion to $1 trillion of the remaining $1.5 trillion to $2 trillion of projected losses on this debt, which includes residential mortgages, commercial mortgages, credit card losses, and high-yield/leveraged debt. These numbers are in the same range as those of the US government, which calculated a $600 billion high-end estimate of credit losses for the 19 largest institutions.

Since the middle of 2007, the US banking and securities industry has absorbed some $490 billion of losses, or $80 billion per quarter. If the industry incurs additional losses of $1 trillion in 2009 and 2010, the losses will be about $125 billion a quarter. As noted, however, these losses will be concentrated in commercial-banking loans. Importantly, many of these losses will be concentrated in the banks that the stress tests revealed to be undercapitalized.

Because we failed to force the banks to take their losses or allow the markets to function in their natural Darwinian fashion we are now left with a zombie banking system that will attempt what Japan did – they must earn their way out of the crisis. Unfortunately, the earnings picture going forward is cloudy at best and Q1 earnings are in no way sustainable. As McKinsey says:

The challenge for many adequately capitalized banks is that they will find it difficult to generate enough income to cover loan-loss provisions over the next two years. Moreover, it is unclear how long net interest margins will hold up. Since 2006, net interest margins have actually increased for the stress-tested banks, despite rising nonaccruals (that is, when a loan defaults and a loan provision is made, it no longer accrues interest). For these banks, net interest margin has actually increased from 2.1 percent to 3.0 percent, which represents $70 billion of income annually. Much of this increase is due to rapid declines in funding costs thanks to the US Federal Reserve, which has lowered the rates banks pay faster than the interest on their loan and securities books. As more loans go on nonaccrual and as loans roll over, net interest margin may come under pressure, even if the Federal Reserve keeps rates low.

Now we’re getting into the real meat and potatoes of the crisis. Bernanke has caused inflation in all the wrong places. He knows the banks aren’t entirely healthy so he is unlikely to risk raising rates and increase the probability that the banks suffer a relapse. On the other hand, the price of raw materials combined with spiking interest rates has to have him shaking in his boots. This is quickly turning into a very bad long-term scenario. Quantitative easing was supposed to solve the interest rate problem, but Mr. Bernanke once again ignored Japan and assumed that we could succeed where they failed. He is wrong. The Fed Chief is in a most unenviable predicament.

The McKinsey conclusion:

There is no clear path to restoring the industry to independence from the US government. Major changes in regulation are coming, and the industry is going to be subject to more government involvement and oversight than it would like for a long, long time. Against that backdrop, stress testing has removed much of the generalized fear that painted all institutions with the same brush. It has also removed the uncertainty related to how the US government is going to treat individual institutions. But it will remain for the industry’s leaders to put in place the operational efficiencies and discipline that may determine when—and how—the credit crisis is finally resolved.

Even the strongest of the major US banks face a challenging environment for the foreseeable future. Not only has the economic shock thrown financial markets and industry structures into flux, but the process of saving the banking and securities industry has transformed the nation’s social contract with the industry. The entire industry is now dependent on government support of all kinds, ranging from low-cost funding (courtesy of the Federal Reserve), to debt guarantees, asset guarantees, and capital injections.