Tuesday, August 25, 2009

Taipan Daily: Is the Next Bank Crisis Unfolding Even as You Read This?

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Tuesday, August 25, 2009
Taipan Daily: Is the Next Bank Crisis Unfolding Even as You Read This?
by Justice Litle, Editorial Director, Taipan Publishing Group

“The difficulty at the moment is finding enough healthy banks to buy the failing banks.”
 – Rochdale Securities analyst Richard Bove

“Credit fuels housing. It fuels consumer durable goods. It fuels business investment. It's in every part of the economy...”
 – University of Maryland economist Carmen Reinhart

Whew. It’s a good thing we’ve got this V-shaped recovery thing going on. If not for that, U.S. consumers would be in terrible shape. Oh, wait.

That was sarcasm in case you missed it. In 14 states plus the District of Columbia, the unemployment rate has now reached double-digit levels. Three of those states (including California) have hit all-time highs in the jobless rate. Michigan leads the pack with 15% unemployment. Nevada (your editor’s home state) comes in third at 12.7%.

According to an organization called the National Employment Law Project, the U.S. lost roughly 2.7 million jobs between March and July 2009. NELP also reports that a whopping 31 states have three-month average unemployment rates over 8%.

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To make matters worse, some 540,000 Americans will “exhaust” their unemployment benefits by the end of September. That number is projected to swell to 1.5 million by the end of 2009.

At the same time, mortgage defaults are skyrocketing. “The proportion of homeowners delinquent on their mortgage or in foreclosure rose to its highest levels in at least four decades,” The Washington Post reported on Friday. A record 1 out of 8 mortgage loans are now either delinquent or in foreclosure, according to a recent survey from the Mortgage Banker’s Association.

Against this backdrop, the sharp increase of existing home sales in July looks dubious as a “green shoot” data point. Of course short-term sales are going to spike at some point – prices are still falling and desperate homeowners are getting crushed.

The argument for a V-shaped recovery is that the recession we just lived through is like all the other recessions of the past few decades. But it isn’t.

Normally, unemployment is treated as a “lagging” indicator – something economists look at in the rearview mirror. In a downturn driven by financial crisis, however, unemployment becomes a “leading” indicator because of the impact of job losses on credit. As Americans lose their jobs, credit defaults rise, lending activity falls, and banks see their portfolios get hit.

That is exactly what’s happening now...

First Subprime, Now Prime

Remember the subprime crisis? (Hell, who can forget it.) Investors are breathing a sigh of relief now that the worst of the subprime meltdown is over. Bankers and politicians are also encouraging the return of optimism, speaking in warm tones of better days ahead.

But the optimists are forgetting (or intentionally denying) the way a financial crisis works. It starts in one area and then spreads to another area, like a nasty viral infection or hard-to-control forest fire. In that sense, the “subprime” crisis is now becoming the “prime” crisis, as the below WSJ chart shows.

View Seriously Delinquent Mortgages by Type of Loan Chart

The yellow line, representing subprime mortgages, has been the top troublemaker for some time. But now “prime” and adjustable rate mortgages, represented by the green line, are number one with a bullet. They are “what’s next” in crisis terms.

You can see the shift in the data too. “Prime” loans accounted for 58% of foreclosure starts in June – up from 44% a year ago – whereas “subprime” accounted for 33% of foreclosure starts in June, down from 49% one year ago. The baton is being passed.

Why is this happening? Because as jobs and benefits are lost, wave after wave of debt-laden Americans are being driven to the wall. We reported last week on the astonishing number of homeowners who are “upside down”... stuck with a mortgage nut bigger than the property is worth. When your equity is negative, your job is gone, and your benefits are running out, it makes more sense to stop paying the mortgage altogether and just live rent-free as long as you can. With unofficial “shadow” unemployment rates calculated as high 16%, that’s the logic that millions of Americans are being forced to consider anyway.

Needless to say, all this is very, very bad news for banks...

We Ain’t Seen Nothin’ Yet

Take a good hard look at this chart from the Calculated Risk blog. In contrast to rosy recovery scenarios, it gives a keener sense of what we are probably in for...

View Bank and Thrift Failures Chart
View larger image here

See that big blue structure with a faint resemblance to the Empire State Building? That’s the annual tally of bank failures during the epic Savings & Loan (S&L) crisis of the late 1980s. Impressive, no?

The peak of the S&L crisis saw 534 bank failures in 1989. Here in 2009, we have seen a piddly 81 bank failures thus far. If this banking crisis is going to measure up to the last one, we’ve got at least four hundred more to go.

“It ain’t over til the fat lady sings,” they say. As far as the banks go, she hasn’t even warmed her vocal chords up yet.

“But will it really be just as bad as the S&L crisis?” you ask. Probably not... chances are this banking crisis will be worse than the late ‘80s debacle. That’s right, worse.

Nor is that merely your humble editor’s opinion. As the NYT reported last week (emphasis mine), “Jim Wigand, the F.D.I.C.’s deputy director of resolutions and receiverships, says banks that are failing now are in worse shape — in terms of the amount of losses relative to the size of the banks — than the ones that collapsed during the last big wave of failures...”

Good Lovin’ Gone Bad

So why is this happening? Did the banks stumble into some new hidden reservoir of toxic waste? Did Wall Street’s financial engineers whip up a fresh scheme of epically stupid proportions behind our backs?

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Nope. This next wave is just plain-vanilla failure – boom-time loans going bad as old chickens come home to roost.

By some estimates, banks have $3 trillion worth of residential real estate and $1.7 trillion worth of commercial real estate loans on the books. That totals to a whopping $4.7 trillion worth of real estate loan exposure... and the bulk of those loans were made at gob-smackingly low interest rates based on boom-time property values.

Dan Alpert of Westwood Capital believes as much as 20% of that $4.7 trillion could be “uncollectable” – and that estimate is probably conservative. We’re talking nearly a trillion dollars, vaporized... and not only that, we’re talking about a huge, HUGE inverse money-multiplier effect. If the banks have to take a trillion-dollar kneecapping, then many multiples of that in terms of business and consumer credit will be withdrawn from the economy. (This is, in fact, already happening.)

The reverberating financial shockwave we will see from the next wave of the bank crisis – a crisis that could ultimately dwarf the S&L crisis – will be enough to make the first stimulus package, and the $250 billion or so injected into banks thus far, look like peanuts.

Two for the History Books

The FDIC (Federal Deposit Insurance Commission) has been so busy this year, staffers may well have switched from “Casual Fridays” to “Bank Closure Fridays.” The past few weeks alone have brought forth new annotations for the history books. Colonial Bank of Alabama was the sixth-largest bank failure in history. Guaranty Financial Group of Texas was the 10th-largest bank failure in history.

The failures are threatening to pile up so thick and fast now, the FDIC could well run out of rescue funds. Of course, they will simply be able to tap a line of credit at the Treasury if that happens. But how will that look to investors and taxpayers (not to mention nervous foreign creditors)?

Another serious problem: Banks are still lying through their teeth about the true state of their loan books.

When the carcass of the failed Colonial Bank was acquired by BB&T Corp, BB&T marked down the value of Colonial’s loans by roughly 37%. This represents a true, hard-nosed assessment, as BB&T would have no incentive to inflate the value of a loan portfolio it had just acquired. And yet, according to research from Goldman Sachs, the majority of failed banks had voluntarily marked down the value of their loans by a mere 18%... less than half the BB&T haircut.

The point is that bank loans are very hard to value – as they don’t trade on liquid open markets – and bankers have every incentive to pretend those loans are worth a lot more than they actually are.

Imagine a butcher with hundreds of customers who buy pork chops on credit. If the butcher has extended tens of thousands of dollars in credit (loans) to these customers, he has to make a realistic assessment as to how much his receivables are really worth. How many customers will pay only partially? How many will not be able to pay at all? Will he get back 90 cents on the dollar? Eighty cents? Seventy?

Unless you’re the butcher, it’s hard to say what those receivables are really worth. And in certain cases – like trying to refinance the storefront – the butcher has every incentive to make his books look better than they really are, by applying far-too-rosy recovery estimates. The banks operate in exactly the same way, on about a million times larger scale, when it comes to their dodgy loan portfolios. And if the 37% haircut that BB&T gave Colonial is at all representative, then the trillion dollars in vaporized capital we were talking about earlier could look more like two trillion.

Too Big to Bail?

Then, too, there is the problem of sheer size. The FDIC is already nervously watching its cash levels as a result of patching up relatively dinky banks like Colonial and Guaranty Financial. (A few billion here, few billion there... it starts to add up.)

So what is going to happen if one of the big behemoths gets in the soup again? Colonial Bank had $25 billion in assets. Guaranty had $14 billion. These are substantial enough sums to make it on the “top ten” list of bank failures, but absolute chicken feed in comparison to the mega-banks. In terms of total assets, Citigroup has $1.8 trillion... Bank of America, $2.3 trillion... JPMorgan Chase, $1.3 trillion,and so on.

What happens when the big boys’ loan books start going tapioca too? Will we see Sheila Bair’s FDIC make a Treasury funding request on par with the size of the first stimulus package? Boy, that would go over well in Washington...

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With Friends Like These...

And speaking of Washington... whatever happened to the helping hand? Weren’t all these struggling homeowners with their delinquent mortgages supposed to get federal help?

Ha ha, that’s a good one...

There is a simple reality that hasn’t yet dawned on many folks. This problem is simply too big for even Uncle Sam to handle by writing a blank check. Given the size of the pending bank crisis (and the highly inopportune time at which it arrives), the old strategy of just papering everything over with money would be a dire threat to the financial credibility of the U.S. government.

What’s more, many struggling U.S. homeowners are beyond any real help. Loan modification programs aren’t much of a saving grace for those who are upside down (in terms of home value) and out of a job... and the few modification programs in existence are starting to see strong legal challenges. Efforts by Countrywide Financial and other lenders to unilaterally reduce the burden of mortgage loans – “modifying” them as the White House desires – have been successfully challenged in court as a breach of contractual obligation. The investors who own the mortgages don’t want to take a haircut just because they’ve been asked to.

Last but not least, residential mortgages are part of the story but still only a part... for many of the small regional banks being driven to the wall, construction loans are the poisoned chalice that threatens to do them in. Many regional banks gorged on construction loan profits, inflating their exposure to 400% of assets or more after a loss-free run that lasted years and years.

China Does It Better?

In conclusion, when it comes to the looming banking crisis – now unfolding as you read this – the United States could actually learn a thing or two from China.

In China, it is widely observed, the government owns the banks. In the United States, in contrast, the banks own the government. (A recent editorial cartoon captures the gist – a plaque on the White House gates bearing the words “a subsidiary of Goldman Sachs” in small print.)

Neither of these arrangements could be considered healthy in the long run. But the Chinese version, at least, does not hold the entire economy hostage to the demands of the ailing banks for years on end. If we are lucky, the aftermath of the new banking crisis won’t resemble Wikipedia’s description of the panic of 1873:

Of the country's 364 railroads, 89 went bankrupt. A total of 18,000 businesses failed between 1873 and 1875. Unemployment reached 14% by 1876, during a time which became known as the Long Depression. Construction work lagged, wages were cut, real estate values fell and corporate profits vanished…

Warm Regards,


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