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Excerpt from fund manager John Hussman's weekly essay on the U.S. market:

According to the latest Mortgage Bankers Association survey, the loan delinquency rate increased during the fourth quarter of 2006 for all loan types. For prime loans, the rate increased from 2.44% to 2.57%; for sub-prime loans from 12.56% to 13.33%, and for FHA loans from 12.80 to 13.46%. Delinquency rates increased both for adjustable rate mortgages as well as for fixed rate mortgages. Foreclosure rates also increased across the board, to a record high.

The latest FDIC quarterly banking report notes that non-current loans registered their largest quarterly increase in 6 years during the fourth quarter of 2006, while reserves for loan losses, as a ratio of loans outstanding, fell to the lowest level in more than 20 years. Non-current mortgage loans increased by 15.6% during the quarter, while construction and development loans that were non-current increased by 34.8%. These increases were fortunately off of relatively low levels, but they have undoubtedly continued into 2007.

Among all FDIC insured institutions, total assets represented $11.8 trillion at the end of 2006, of which about 40% were real-estate related loans. Though foreclosures currently represent just over 1% of total mortgage debt outstanding, it's important to remember that the average return on assets (earnings as a percentage of assets) in the U.S. banking system is also only about 1%. So any continuation in defaults will quickly find its way into earnings figures, either by provisions for loan loss reserves or by actual charge-offs.

Remember also that banks operate on a ratio of about $10 of assets (generally loans outstanding) per $1 of shareholder equity capital. So a 1% loss of existing loans can wipe out about 10% of shareholder capital. Since banks are required to hold such capital against their loan portfolio, wiping out capital also wipes out part of their ability to originate new loans. Importantly, bank capital requirements are a separate constraint from the reserve requirements placed on a bank's demand deposits.

...But capital requirements impose a different constraint altogether. A Fed easing might loosen a binding constraint on bank reserves, but it does not increase shareholder equity capital. Loan losses still go straight to the bottom line, and if the losses are sufficient to reduce shareholder capital, they also limit the amount of new loans that banks can make. It's that risk of earnings weakness and “de-leveraging” of the U.S. financial system (not the risk of a general banking collapse), that is a growing concern here.

Source: How the Sub-Prime Mortgage Crisis Could Spread