Second Round of Massive Deleveraging About to Hit U.S. Banking System?

Prepare for another round of deleveraging. That’s the message going around Wall Street, just as some banks have paid their TARP funds back early.

In a typically extensive, dry, and informative piece Tuesday, Howe Barnes Hoeffer & Arnett suggested in Barron’s that banks may need to write down bond losses. For its significance, the passage is worth quoting at some length:

Near term, banks’ ability to monetize unrealized gains in their portfolios and thereby convert the gains to regulatory capital has declined sharply; or, from a more functional perspective, harvested gains have been a source of income to partially offset heavy provision expense, which has not yet peaked for the industry.

First-quarter results were supported via sizable bond gains and big gains from mortgage-origination activity. No doubt heavy harvesting occurred during April as treasurers moved to lock in gains for the second quarter, but barring a rally we would look for this source of income and capital augmentation to evaporate in the third quarter.

In other words, the income banks showed and which most of us suspected was fleeting in the first and second quarters of this year, is in fact, just that. Or to put it more bluntly still: most banks’ profits are entirely dependent on risk appetite right now.

At Seeking Alpha, Bill Zielinski asks: “Are The Banks Paying Back TARP Money Too Soon?” That’s a question I pondered here at BNET Finance a week ago when Morgan Stanley (MS), Goldman Sachs (GS), and JP Morgan (JPM) announced they were paying their loans back to the government. Actually, it’s hard to believe more people haven’t been pondering the same point until now.

That’s especially true since even as the early applications for TARP loan repayments were being approved by Treasury, the program’s congressional oversight panel was asking for another round of stress tests.

Zielinski is primarily worried about what he sees as huge pending mortgage writedowns:

The big question is will the banks be able to earn enough to offset the huge amount of future write downs that will be needed on their troubled loans? Earlier this year, Bloomberg reported that the International Monetary Fund (IMF) estimated U.S. banking losses through 2010 at $1.06 trillion. To date, the banking industry has taken write-downs of only half that amount, indicating further write-downs of an additional $500 billion will be necessary.

In addition, delinquency rates on $1 trillion of commercial real estate loans held by banks have been increasing at a higher rate than anticipated. Credit card losses for the banks have also been rapidly mounting from previous estimates.

What is worrying is that a mixture of bond writedowns followed by mortgage writedowns six to twelve months later could easily contribute to a second round of massive deleveraging. In that instance, banks all begin to reduce their loan exposure to one another, and the whole financial situation goes back into near-collapse. The only party liquid enough to save the day again will be the government, which will have to print even more money to do so.

For now, there’s little sign that this process is getting underway yet. But one of the most startling things about deleveraging is how quickly and severely its jaws enclose on the financial system. That’s the reason Bear Stearns and Lehman Brothers went from being reasonably-capitalized to insolvent in a number of weeks.

Allowing some banks to repay their TARP funds early looks more and more like a short-term momentum strategy with potentially catastrophic long-term consequences.

Comments

[whidbey:]

Good review. The larger implications are nasty to contemplate. It means the economy has a chance of going into the tank again, or worse. The weakness of the demand side of the economy is only going to get worse over the next 6 months. The conjunction of falling employment, reduced consumer spending and chaos in the banking world could equal the dreaded depression. We must learn to disregard the administrations happy talk and guard against a slow descent into an ice age.

Jun 25 05:46 AM

[apppro:]

When is enough.. enough with you shorts and naysayers!

Doesn't any of you see the self-fullfilling scenarios going on here? Oh I forgot, that's what you want!

Deplorable! Just deplorable!

Jun 25 06:51 AM

[MadScientist:]

Deplorable? No. The facts reported here are from reputable sources, and the opinions are just that - opinions. As valid as yours.

Only time will tell if they are correct or not - if they are wrong they'll be punished financially when they have to cover their shorts.


On Jun 25 06:51 AM apppro wrote:

> When is enough.. enough with you shorts and naysayers!
>
> Doesn't any of you see the self-fullfilling scenarios going on here?
> Oh I forgot, that's what you want!
>
> Deplorable! Just deplorable!

Jun 25 08:37 AM

[Mad Hedge F...:]

You can count on it. What is the new normal? This is the debate that is raging in hedge fund research departments around the world. I’m afraid that today’s equity investors are not taking into account some unpleasant new realities. The last thirty years have seen an average PE multiple of 15 times, and peaked at 20 times during the really great years. Unfortunately, this multiple expansion was fueled by an explosion in leverage. Even companies that hated debt had to drink the Kool-Aid to compete. Now we are moving in reverse on the leverage front double time. Debt/EBIDTA has shrunk from three times to two times in just two years. Even if corporations want to leverage now, they can’t, because the lenders have gone missing. If you wean the patient off of steroids, shouldn’t this mean that the range of PE multiples is permanently downsized? Should the new normal of 1-2% economic growth and an “L” shaped recovery demand an average of only 12 times, 10 times, or Heaven forbid, the eight times low we endured in the seventies? Logic like this makes today’s 13.4 multiple look frightening rich, and the stock market insanely expensive.

Jun 25 08:38 AM

[Bruce Krasting:]

I am not sure that the equity line of some of our banks means much. It is a timing issue. If they recognized all of the embedded losses today they would have no equity. So they are running on 100% leverage. Their marginal cost of debt is near zero and will remain so for the foreseeable future.

They have about 10T in assets. What is the after expense (but pre credit loss) return on that? Call it 5%. That is $500b a year of cash flow to offset the losses.

I think the banks are looking at $1 trillion of losses. So if this can be stretched out over three years there is a soft landing scenario out there. Push that recognition to two years and it is going to get shaky. Push it to one year and we will be back to having TARP parties.

Jun 25 08:42 AM

[Moon Kil Woong:]

What is most worrisome about bank repayments were why they wanted to repay. They wanted to repay so they they could get out from under more scrutiny and regulation. If anything, that's what big banks (esp. too big to fail ones) need most. If they don't like it they should breat up so they aren't too big to fail. If they broke up along the lines of Glass Stegal that would be even better.

It is possible that they go to the government well again. Sadly though, the biggest loss is really not the amount of money or cost we will incur in that event, it is that nothing fundamentally has been fixed with our financial system to keep them from repeating the mess that caused what we are in today.

As far as I'm concerned, banks whether they repay TARP or not should not be able to tell the one that has saved their proverbial hide to get lost. The ones they are thumbing their nose at is none other than us.

Jun 25 08:42 AM

[Ishortyou:]

difficult to predict the future...but the housing market is the key to recovery and so far some data points out is heading at least to stabilization...house appreciation seems it will take a little longer to show up.

Jun 25 08:43 AM

[axelrod608:]

Big financials like GS can repay their TARP with no problem because their earnings are heavily weighted to trading. It's the banks that hold their own loans, securitized MBS's and credit card acciounts that will get slashed by the next round of deleveraging.

Today's unemployment numbers verify that the economic down cycle is still in charge. Here in Florida, the state's unemployment fund runs out of money before summer ends. Who's going to pay those UC compensation benefits ??

Good article. A frank discussion of facts is necessary to combat all the "talking heads" and cheerleaders that think they can talk the recession to death. When one looks at all the numbers as a totality - rather than cherry picking a positive tidbit here or there - the risk of another serious meltdown is apparent.

Jun 25 09:54 AM

[The Simple ...:]

There is little support for what seems to me to be the author's excessively bearish view on the banks. Certainly the situation warrants investor caution, but to some extent that is almost always the case.

Even in a fairly dire scenario, there is no reason for a run on any of the major banks, just as there wasn't in the Lehmann case. That was a policy failure. See for example Elizabeth Warren's discussion on this matter in the recently aired PBS Frontline documentary, and her interview on the program's website.

Jun 25 10:56 AM

[Michael Clark:]

Businesssmen (and Republicans generally) believe they can cheerlead with positive thinking and all the problems will go away. That's part of the 'fight, fight, fight' mentality of John McCain -- fight the bringer of bad news and put him to flight and the light will return.

During the Day-Cycle (expansion, construction, city-building, positive energy) cheerleading and positive thinking works beautifully; during the Night-Cycle (contraction, de-construction, 'return to nature', negative energy), cheerleading and positive thinking are hollow and meaningless. Negative energy is a disorganizing force. Cheerleading organization during the Night-Cycle is like trying to be disciplined and do your math homework while you are dreaming.

The problems in the economy will not go away just by pretending they are not there. And they will not be 'solved' with rational systems, which work wonderfully during the day -- better to use Chaos Theory during the Night Cycle, when energy changes direction and 'fixing problems' becomes an exercise in attempting to herd cats.

What saves us from the Chaos of the Night-Cycle? Time. Nothing else.

Jun 25 12:24 PM

[Warm_Paw:]

By reading this message board, I'm amazed at how many of you invest without realizing less than half of the toxic assets have been unwound.
Did you think we were on the golden road to recovery?
The Fed has to cheer lead you fools into putting your money into equities so that the masses hold the lost assets, not the banks.
How else did you think they'd be unwound.
Just keep your head in the sand, you'll be broke soon and no longer posting on message boards. You'll be working OT.

Jun 25 02:28 PM

[WS1835:]

I have to chip in on the "glass half empty" side of the discussion here.

If one accepts the rough estimates of the value of worldwide derivatives prior to the crash along with recent estimates of the value of bad mortgage paper still in the system, one has to conclude that we aren't even halfway unwound. That is not being "bearish", it is a simple read of the data. For example, look at USA default data for residential/commercial loans over the last 3-4 months. Subprime residential defaults are tapering off but still high while Alt-A and prime defaults are starting to rise above historic highs. Commercial defaults are just starting to increase, but everyone (bulls and bears) expects a large wave of commercial defaults later this year. The raw data makes it pretty clear that the next 6-9 months is going to see a commercial default wave potentially on par with the first wave of residential defaults, and a second wave of residential defaults as unemployment and tight credit drive Alt-A and prime loans into the same tank as the sub-prime. Add to the scenario a major readjust of ARMs and the ongoing rise in interest rates due to unprecedented federal borrowing.

With all of that in the hopper, exactly how does the financial sector come out in the black? One doesn't have to borrow trouble in order to be a bit pessimistic. However, you could easily throw in the default of a major state (California), multiple failed Treasury auctions, the loss of jobs/industry due to adopting cap and trade, and/or the emergence of significant inflation sooner rather than later. Hard for me to find much of a silver lining at the moment.

Jun 25 03:43 PM

[Snitzer:]

Warm Paw, you wave your wand a bit too wide; there are many other investments/trades to be made other than in financials/banks/etc. True, the financials are in for a bumpy ride, but energy, tech, aerospace, materials, etc all offer sweet pickings. And the financials will not all fall down, and neither will the global economy. These message boards will be active for a long time to come.

Jun 25 04:16 PM

[pepe:]

Every reference to mortgages resetting allude to them being reset at higher rates which is definitely not the case for those mortgages tied to LIBOR or the "weekly average yield on U.S. Treasury securities adjusted to a constantmaturity of one year". With both of these rates at a near all time low, the home owners are seeing drastic reductions in their currently resetting ARM monthly payments.
Why is there so little mention of this considerable reduction in monthly ARM rates which produce euphoric results for the effected home owners?

Jun 25 10:05 PM

[Mark54:]

No one can argue against facts... Credit quality of loan portfolios are horrible and trending worse. Balance sheets are clogged with too many non-performing loans to effectively manage. Unemployment isn't bottoming for another 2-3 quarters and the vast majority of these people are borrowers. Unemployment benefits are going to expire soon for a huge population of the unemployed. An arguable point but by and large expectations are rooted in fact.


On Jun 25 06:51 AM apppro wrote:

> When is enough.. enough with you shorts and naysayers!
>
> Doesn't any of you see the self-fullfilling scenarios going on here?
> Oh I forgot, that's what you want!
>
> Deplorable! Just deplorable!

Jun 25 11:58 PM

[Paul H. M.:]

I'm afraid to be overly bearish or bullish. Just trying to get in and out of positions with a profit.

The VIX is low, so who knows how long it will take to get another major downward correction.

Jun 26 01:00 AM

[Tack:]

Everybody got faked out the first time around by focusing on GAAP mark-to-market paper writedowns that were manipulated by big traders, hedge funds and others, shorting the ABX and other bond indices that served as proxies for debt assets on the books of banks and other lenders. The result was a massive panic and overwritedown of loan values in a manner that in no way represented the actual underlying performance of the loans.

This was a situation ripe for a snap back, as it finally occured to the market that, with Uncle Sam backing the banks (and others), there was no real solvency risk --even a paper one-- and that meant that the real issue was cash flow analysis. not paper book values.

With the yield curve about as steep as it can get, the banks should be minting money on spreads which more than offsets the real --not paper-- losses on their loans, as long as there is not a huge delta in real losses. Remember, the banks get the spread advanatge on their entire portfolio, while the delta in the deliquency/default rate affects a much smaller percentage of loans.

With the outlook that the Fed will retain low rates for the foreseeable future, lenders will continue to enjoy good lending and internal refinancing conditions, which should buttress their cash flows.

Even so, it remains to be seen if another "run" on paper values can be fomented by the shorts and whether the market can get faked out twice by the same issue.

Jun 26 02:12 AM