A Tale of Two Banking Worlds

An Associated Press article, dated July 19 (here), discusses the possibility that U.S. banks may fail to address bad debts in a timely manner.

Instead of addressing poorly performing loans directly, a process may be followed of extending time for payments, tolerating delinquencies and modifying terms that will simply be "kicking the can down the road".

This is the type of action that caused Japan to spend much of the past 20 years in cycles of recessions linked by weak recoveries. The result of not cleaning up bank balance sheets is that the banks are not able to function effectively in their role as provider of credit to commerce and industry.

David Rosenberg, Chief Economist at Gluskin Sheff, has two revealing graphs in his July 20 newsletter (here):

Rosenberg writes:

We continue to hear from strategists and economists that the credit clouds have parted, and yet the U.S. commercial paper market continues to contract (by $40 billion in the July 15th week) to a level not seen since 1998. And, the declines are right across the board — financial issuers, non-financial, asset backed — in fact, the asset backed market is all the way down to $440 billion of outstandings from $1.2 trillion at the credit bubble peak in the summer of 2007. Commercial bank balance sheets also continue to shrink — by $12 billion in the latest week, with outstanding consumer credit falling the fastest.

There are some features of the commercial paper market worth noting.

1. Comparing to the 2001-2002 contraction, the collapse of commercial paper has been as steep for most of the past three years as if was briefly following 9/11.
2. The decline in commercial paper is likely to continue after the official end of the recession, as witnessed in 2002-03.
3. We have contracted to a 1998 level of commercial paper and are likley to move lower to levels last seen earlier in the 1990s.
4. The bottom in commercial paper volume occurred more than two years after the end of the 2001 recession, and six months after the peak in unemployment.

There is no reason to anticipate a recovery in commercial paper during the next couple of years.

The most notable feature of the commercial deposits graph is the 12% jump in assets from March to June, 2008. Rosenberg does not comment on that and I have no explanation. Perhaps a knowledgeable reader will comment.

Since that spike, about 25% of the gain has been lost over the last 12 months.

For the last two quarters, another banking world has been telling a different story. Some of the super banks are showing large profit increases, and, in the case of GS and JPM , record profits in investment banking and trading areas. These are not coming from the traditional commercial banking activities of collecting deposits and lending money to real economy enterprises.

Because of the economic contraction, the demand for credit has diminished and the underwriting for creditworthiness has been tightened. It is not clear to me whether the demand for credit or the availability of credit is the limiting factor. Probably both.

But because the poorly performing assets are not being addressed in a timely way by these banks, if the demand for credit starts to increase, availability could be the primary factor that stops an incipient recovery in its tracks.

The super banks with exposures to the consumer (JPM and Cin the credit card markets and BAC and WFC in mortgage markets) are experiencing losses in those activities. The large profits reported by C and BAC last week for the second quarter came entirely from asset sales. These consumer related banking activities probably have several quarters of continued negative activity with additional default writedowns coming and a continued low level of new business.

The following graph shows earnings for the six "big ones" for the past five quarters, with asset sales proceeds subtracted.

Investment banking and trading will probably be making money in the coming 1-2 years. Traditional banking, for both consumer and commercial markets, will continue to struggle. Both BAC and C may have to shed more assets in order to survive, especially C.

There may be trouble brewing in the banks below the top tier, as well as smaller regional banks, with large exposures to commercial loans. As mentioned in the AP article referenced in the opening paragraph, commercial loan defaults are an increasing risk for these banks. Recent changes in accounting rules allow banks to defer recognizing defaults until the last minute, when they can pile up and overwhelm a weak balance sheet.

A post on Calculated Risk (here) quotes Moody's investment Services:

Banks have failed to make adequate provision for the losses on loans and securities they face before the end of next year ... U.S. banks may incur about $470 billion of losses and writedowns by the end of 2010, which may cause the banks to be unprofitable in the period ...

“Large loan losses have yet to be recognized in the banking system,” Moody’s said. “We expect to see rising provisioning needs well into 2010.”

Other posts on Calculated Risk address the burgeoning commercial real estate default problems here and here and here and here. And that's for only one day, July 20.

To put things in perspective, bank failures are expected to be far less in absolute numbers now compared to the S&L crisis of the late 1980s and 1990s and the Great Depression. This year the expectation is that there will be around 100 bank failures (57 have occurred so far). This is less than either of the two earlier periods.

For example, in the 1930s, the worst years saw failures of the order of 500 annually. Like the Great Depression, though, this crisis involves the largest banks, and this time the largest banks have had an oursized role in our economy. The financial sector earnings reached record earnings levels, over 40% of S&P 500 earnings in 2005 and 2006. This compares to historical levels that averaged 15% for decades. The S&L crisis, which also saw higher numbers of bank failures, did not seriously impact the big banks (commercial and investment banks).

There are two banking worlds, like the town with two sides of the tracks. Unfortunately, a lot of the bank population is living on the wrong side of the tracks with maxed out credit cards and prospects of losing income.

Disclosure: The author, family members and clients own SKF, an ETF short the financial sector.

Comments

[john s. gordon:]

very enlightening article, thanks.
> jack

Jul 22 12:18 PM

[basehitz:]

Thanks John for another informative post. What you say is intuitive, and corroborates what we see going on around us. But the market seemingly refuses to recognize any danger. The bulls have the tape and everything is spun to their liking. But in the real world, this is a sampling of some troubling remarks in earnings reports:

WFC
Many analysts, though, have expressed worry that Wells Fargo will need to raise more capital to cover potential losses from real estate loans, including the option adjustable-rate mortgages it inherited when it bought Wachovia.
CFO said the bank expects credit losses and nonperforming assets to increase, despite "some moderation" in the rate of growth in some consumer portfolios.

BAC
Like JPMorgan, it did report continuing losses from failed loans. Bank of America said it recorded a $13.4 billion provision for loan losses during the second quarter as consumers struggled with debt amid rising unemployment.

JPM
These results were negatively affected by the continued high levels of credit costs in Consumer Lending and Card Services, which we expect will remain elevated for the foreseeable future.

C (excerpt from John’s 5/6 article)
One of the ways Citigroup achieved this gain was booking a profit of $2.7 billion on the decline in Citi's own debt. Say what? Under accounting rules, Citi was allowed to book a one-time gain equivalent to the decline in its bonds because, in theory, it could buy back its debt cheaply and save $2.7 billion over time. Of course, Citi didn't actually do that. Even though more consumer loans went bad in the first quarter, Citi reduced its loan loss reserve from $3.4 billion in the fourth quarter to $2.1 billion in the first quarter, thereby picking up another $1.3 billion of 'earnings'. And the recent change in mark to market accounting enabled Citi to book an additional $413 million in 'profit' on impaired assets. Without these one-time adjustments, Citi's $1.6 billion in first quarter profit becomes a $2.8 billion loss.

I purposely ignored the casino banks. I don’t care how much Goldman Sucks can make by the many shenanigans cited by bloggers.

Jul 22 01:05 PM

[Ferdinand E...:]

A few more articles like this and I might have to forget about energy and start reading my finance book again. This is really an excellent article, and I just hope that I find time to read it a couple of more times.

Jul 22 01:51 PM

[Steven Hansen:]

this was the best connection of dots on banking i have read. i was particularly interested in the "earnings less asset sales" graph.

i realize in my last article i failed to connect the liquidity issue the FOMC stated was a concern later this year to the issues you connected together in this article.

you remain one of the most talented and underappreciated authors.

Jul 22 09:26 PM

[sleepless_o...:]

Does anyone want to offer some analysis (or even opinion) about why I should consider buying C? I have read some commentary the past couple of weeks recommending C as good investment, but I didn't bookmark anything so I don't where these comments might have been. I don't understand how a bank that appears to be undercapitalized (if you believe the stress tests) and is losing many billions quarter after quarter from operations can have any prospects other than selling off assets until it goes out of business.

Anybody want to enlighten me?

Jul 22 11:05 PM

[Angry Banker:]

I think C is still a good long term investment (and indeed I am long C myself). You can click my name to find the relevant articles and comments.


On Jul 22 11:05 PM sleepless_on_wall_street wrote:

> Does anyone want to offer some analysis (or even opinion) about why
> I should consider buying C? I have read some commentary the past
> couple of weeks recommending C as good investment, but I didn't bookmark
> anything so I don't where these comments might have been. I don't
> understand how a bank that appears to be undercapitalized (if you
> believe the stress tests) and is losing many billions quarter after
> quarter from operations can have any prospects other than selling
> off assets until it goes out of business.
>
> Anybody want to enlighten me?

Jul 23 03:14 AM

[think befor...:]

How 'bout the simple fact that you could liquidate the bank at 50 cents on the dollar and still get 5 times your common equity dollar. Marry that together with it being the world's biggest retail bank brand and the US gov't is standing behind it, and now in it. There are many other reasons but space doesn't permit. You'll note most of the detractors don't do any real financial analysis. I suggest that you compare what you get for what you have to pay for C versus the other large caps. It looks good to me!


On Jul 22 11:05 PM sleepless_on_wall_street wrote:

> Does anyone want to offer some analysis (or even opinion) about why
> I should consider buying C? I have read some commentary the past
> couple of weeks recommending C as good investment, but I didn't bookmark
> anything so I don't where these comments might have been. I don't
> understand how a bank that appears to be undercapitalized (if you
> believe the stress tests) and is losing many billions quarter after
> quarter from operations can have any prospects other than selling
> off assets until it goes out of business.
>
> Anybody want to enlighten me?

Jul 23 12:41 PM

[skwestorange:]

You buy C if you want an out-sized risk/reward proposition in your portfolio for say five years or more. It is like a lottery ticket but one with the US Government backing.

Jul 23 02:34 PM

[Mark54:]

C is a long term buy for sure.... its not for the weak of heart. This is an organization that even the executives will admit is going to be very very different in a year. Not an owner... the only bank I own is PNC.. not a value here but if it gets back to 50% of book I'd add more.


On Jul 23 03:14 AM Angry Banker wrote:

> I think C is still a good long term investment (and indeed I am long
> C myself). You can click my name to find the relevant articles and
> comments.

Jul 23 08:49 PM