Holding Bank Doomsayers Accountable

Includes: KBE, KRE
by: PlanMaestro

Third quarter 2010 earnings are out and with several banks revisiting one year lows you would think that the credit situation is getting worse. That is simply wrong.

The New York Times finally started following the story with this Friday´s article “Banks Start to Dig Out From Troubled Loans“. My only complaint is the use of the word start--why is it that journalists are not only are late to stories but then downplay them? And don't only take my word for it, the same New York Times printed a graph that shows troubled loans peaking almost a year ago (click to enlarge):

Some will say that those numb:ers are still high, but before you jump to conclusions let me make a couple of points.

First, the USA is not Japan (click to enlarge):

It took more than 10 years after the bubble burst for Japan's non performing loans to peak at close to 10% of total loans and only then government pressures pushed banks to deal with the zombie keiretsu borrowers. In the US, instead, non performing loans were recognized faster, peaking at 7% in less than 3 years. Not to mention that the Japanese real estate bubble was crazier with much higher loss severities. And even after all that, when the Japanese finally decided to deal with their issues the banking sector NPLs decreased rapidly and stock prices recovered.

The second point is that American banks are very well capitalized (equity plus reserves) to handle the non performing loans even at these high levels. For illustration purposes let's bring back our old tool the Texas Ratio courtesy of bankregdata.com, updated for Q3 2010--it keeps improving from already manageable levels (click to enlarge):

So what is going on? My impression is, this just is another installment of the Fear of the Dark, Fear of Death series. Human beings do not react well to uncertainty and banks are part black box, so it is easy to say “there are many things to worry about banks”.

I have no problem with that, everyone is in within his rights to invoke the not-in-my-circle-of-competence amendment. What disturbs me is that it usually comes with a litany of measurable and testable arguments that when proven wrong are just simply set aside to be replaced by the next litany that justifies the preconceptions.

Click to enlarge

For example, in this blog we have been very skeptical of the Commercial Real Estate is the next shoe to drop argument. If anyone cares to see its recent performance, well here it is (click on chart above to enlarge). Already in the third quarter of 2009 CRE NPLs hit the second derivative and are stabilizing at less than 5% of total CRE loans, well below the real issues: mortgages and construction NPLs. Do you feel the fear? That is Elizabeth Warren probably around February 2010 when it was already clear that things were improving on the CRE front. Lucky for us she is more of an analytical doomsayer so she tried to support her points of view with a Congressional oversight panel report. And surprisingly, it is a very good report with very interesting data.

What made me skeptical of her conclusions was how easily she mixed and confused CRE construction and development loans, a real problem, with income producing CRE loans, a much smaller problem. Mixing both had the consequence of exaggerating the scale and scope of the problems.

This wrong thinking has been repeated again and again during the crisis. The confusion of resets with recasts was another one. Were not option ARMs and other recasts supposed to explode more than a year ago bringing down the banks with them? That must have been one of the most silent explosions I have ever heard.

As soon as one of the issues is proven wrong, the discussion moves to the new flavor of the month. Now the new issues are:

  • Europe: can somebody explain the contagion mechanism, since there doesn't seem to be a contagion mechanism this time.
  • Putbacks that even the worst loss estimate is less than one year of earnings
  • Foreclosure mess: that the banks badly mishandled. However, that has usually been the case in every real estate bubble in history and every time the banks managed to get their foreclosures.

Doomsayers sound smart and professorial but their ability to predict has been abysmal even by forecaster standards. Why? Partly because markets adapt, people adapt, and capitalist economies grow, solving a lot of issues in the process. But hey, the bogeyman and hell are just around the corner.

I sometimes miss people like John Templeton and Peter Lynch in 1989, right in the middle of the S&L crisis, sharing their optimistic long term perspective while grounded in the difficulties of investing. They were not just smart but wise. Instead we are now at the end of the beginning for banks and these celebrities keep playing on our fears without checking their thinking and numbers.

I am not going to say that some of these issues could not become real, even data-driven people like myself are susceptible to over confidence. I prefer to be detached with an open mind, since banks are still somewhat opaque and their issues in other situations are real. Just look at Ireland or some specific American banks like Flagstar Bancorp (NYSE:FBC) that is going through their third capital injection.

However, when you see one-hit-wonder celebrities that have been all wrong since October 2008 jumping to the new thing that confirms their preconceptions -and I think you know who I am talking about – take a pen, a napkin, run some numbers, but especially check the logical steps. Even with the more professional and less self promotion, like the excellent and bearish Chris Whalen, you should do so because there is no substitute for thinking independently and thinking correctly.