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Thursday, June 11, 2009


two-part credit crisis

pragmatic capitalist muses on the latest mckinsey quarterly.

... [W]hat 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. ... 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. ...

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 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. ...

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. ...

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.

i harp a lot here on the long-term loss of loan demand as consumers pay down debt and businesses deal with overcapacity by refusing to invest -- and when i do so, i'm describing not a credit crisis so much as an economic crisis.

mckinsey, however, is describing a second-wave credit crisis -- one related not to mark-to-market but to mark-to-maturity, which constitutes 90% of the assets of the american banking system -- which would see banks largely unable to earn their way to solvency over the next few years as loan losses accelerate and net interest margin deteriorates even in an environment of stable or increasing loan demand. this dynamic will be particularly effective in killing off smaller banks, as they are both concentrated in commercial/industrial loans with exactly the delayed-fuse features mckinsey describes and suffering already from a deteriorating in NIM. these features will pinch banks like marshall & ilsley hard.

in other words, the remainder of 2009 will, as previously expected, very probably see a dramatic uptick in smaller bank failures up to and including regional banks.

UPDATE: chris whalen talks on tech ticker about JPM, in part on this issue and in part of credit default swap reform. interesting too to get whalen's view on TARP repayments:

[T]he decision to allow the larger banks to repay their TARP money is a mistake of the first order, in our view, and illustrates the degree to which Washington is letting the large dealers call the shots on regulatory strategy. If our estimates for loss rates by US banks prove correct, many of the TARP banks repaying capital now may be forced to come back to Washington seeking more help in Q4 2009 or in 2010. And the large banks not repaying the TARP money bear a stigma that may cause regulators and bankers serious problems as the year wears on.

UPDATE: also via pragmatic capitalist, gary shilling notes that a positive quarter of GDP does not an end to the depression make. in the context of a second-wave bank crisis, this becomes all too believable.

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On an unrelated note, I'm looking forward to seeing analysis of today's Z1 release. At quick glance, it shows that all private sectors are now (in Q1) actively deleveraging to varying degrees (household -152bn, business -28bn, financial -1792bn). Even adding in government debt (+1548bn) and foreign (+169bn), total debt still shrunk by 255 billion. So I still don't buy into the argument that treasury yields are rising because of too much supply. Everyone is banking on sustainable recovery of riskier assets.

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yeah, hbl, i think what we're seeing in long-end rates is at least in part related to bond volatility, which has gone off the charts. and there's a maturity mismatch, it would seem, where the mix treasury is selling is longer than maybe the market would like.

i do agree that deleveraging is continuing and very probably will continue for some time -- at least until banks have a funding profile far less dependent on wholesale.

but there is also this need of attracting foreign capital at the margin to fill the funding, and that competition will keep rates elevated. not 7%, but also not zero. that in no way means we will experience anything like a serious inflation, of course.

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there's another interesting aspect of this, which is the incentives of failed banks being kept alive. whalen discusses it in this very dour dispatch, beginning with "To shift to the condition of the large banks as we go through 2009" ....

bankers here are more likely to make large low-probability high-payout moves to resuscitate the dead bank, with the all-too-probable losses being the taxpayers' problem. this could have a large real impact as the crisis progresses.

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There are multiple dimensions to this secular crisis of America's: 1)the boomers have reached a point in their lives where THEY SIMPLY DON'T WANT ANY MORE STUFF.
2) with the losses to their retirement savings/pensions they can no longer borrow-they must save, and
3) the world must begin to reckon with running its economies, supply chains etc WITHOUT leverage, ie oil.

With the insane levels of debt the Fed is inflicting on the US, it has a fleeting window of opportunity - to reduce its debt:GDP ratio, per Woody Brock's insightful letter recently:


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