The Worst Is Behind Us (unless massive bank failure is considered a bad thing)

I hear many bank CEOs saying they believe the worst is behind us. I am not a banking exec, and I am not on the street, but I definitely disagree. Bank of America (BAC) has missed estimates by about 44%, and has increased credit loss reserves by 500% to over $6 billion dollars, net income drops 77% amid write-downs, and it is forecasting a best case scenario of minimal GDP growth for the balance of 2008. 2007 was the year these same execs were forecasting no recession and a pick up in the following year. This is the same company that says it will buy Countrywide (CFC)), which has a severe credit and NPA problem - and has nearly as many assets in REOs and repossessions as it had in actual performing mortgages. Does this sound like the worst is behind us? Let's take a look at some more banks.

The Bank of England has decided to just go forward and bailout it's banks, "American Style": BOE Aims to Jump-Start Lending - The Bank of England launched a plan to allow banks to temporarily swap $100 billion of mortgage-backed and other securities for U.K. Treasury bills, in a bid to ease the current credit crunch. (Statement) Of course, I query (like the bloke I've been known to be), why dump a $100 billion into the market where the worst is behind us? That's a lot of money, considering they've probably pumped much more than that into the market for liquidity's sake over the last few months.

Of course, NatCity (NCC) is raising money for the hell of it: National City to Raise $7 Billion; Bank Cuts Dividend, Posts a Loss- slashed its dividend to 1 cent a share, shows $1.4 billion in loan-loss provisions, partially offset by $772 million in gains related to Visa Inc.'s initial public offering... Net charge-offs on uncollectable loans, tripled to 1.88% of total average loans, while nonperforming assets surged to 1.95% from 0.8%...

The Wall Street Journal is jumping on my bandwagon, saying "Smaller Banks Begin to Suffer".

Capital One ramped up production of commercial real estate loans at the very tippy top of the real estate bubble. Capital One is (now, or at least was) a very prolific commercial lender, and you know how I feel about the commercial real estate market. I ride around Manhattan and downtown Brooklyn (alleged luxury condo hi-rise mecca) and see "Financed by Capital One" signs all over the place. These are projects that are either just breaking ground or have yet to be completed in an area with at least a 2 year supply of condos going up and in the pipeline, and rising - as the condo market collapses.

Their loan delinquency rate spikes up sharply at the exact apex of the commercial rent bubble.

Now, look at where and when the rent spread in retail real estate inverted. What a coincidence! What timing on the part of Capital One. Not to pick on this bank, most banks ramped up mortgage and consumer finance lending at the very top of the bubble, and actually accelerated as the bubble popped and credit losses were apparent.

Core Capital (Tier 1) Ratios follow my favorite CRE chart as well.

Tier 1 capital (from Wikipedia), the more important of the banking finance ratios, consists largely of shareholders' equity. This is the amount paid up to originally purchase the stock (or shares) of the Bank (not the amount those shares are currently trading for on the stock exchange), retained profits and subtracting accumulated losses. In simple terms, if the original stockholders contributed $100 to buy their stock and the Bank has made $10 in profits each year since, paid out no dividends and made no losses, after 10 years the Bank's tier one capital would be $200. Regulators have since allowed several other instruments, other than common stock, to count in tier one capital. These instruments are unique to each national regulator, but are always close in nature to common stock. These are commonly referred to as upper tier one capital.

Well, take a look at this sampling of regional banks core capital trends, and compare it to the commercial graph above. It is amazing how correlated all of this actually is to the commercial real estate market.

The loans to deposit ratio shows significant risk inherent in internal funding for these banks. They, in general, have an unprecedented amount of their assets tied up in mortgages at a time when real estate is tanking at an unprecedented level. This is a bad combination. Remember, just 20 or so year ago more then 3,000 banks and lending institutions failed due to unsound real estate lending practices. This time around, it is about as unsound as it gets.

So, what do banks do when they get themselves in trouble lending long on bad real estate deals while borrowing short in fickle markets while they are in need of capital? They arbitrage thier implicit backing by our government by offering higher than market rates for savings and CDs that are FDIC insured. One way to find a "who's who list on Reggie's prospective short candidates" is to surf over to Bankrate.com and searchg for the highest yielding CD rates.

click to enlarge

As a point of reference, the Fed Funds rates is 2.23%. Capital One and Countrywide have a plethora of credit loss woes, GMAC is dragging down GM, one of the largest companies in the world, and M&T Bank has one of the lowest core capital ratios out of over 330 banks that I have screened, ex. it is walking on paper thin capitalization.

Do you remember when I said 3,000+ banks failed the last time we binged on band real estate loans? Well, they tried to increase their deposit base through deposit brokers and offering yields that where way above what was prudent, and way above the market rates. Well, as the monolines can attest, when you try to offer deals that are artificially outside of what the market charges, you will run into trouble - big trouble. These banks push rates to up to attract deposit capital, their NPA and defaults put so much pressure on them that they fold under the expense of offering all of this rich money, and then our government comes in to bail them out - with a dollar that is beat to death, inflation beating at the door (citizens rioting and killing over unaffordable food prices, oil at a record $118 and rising), and funding two simultaneuos wars courtesy of Mr. Bush, et. al. Let's not forget all of the investment banks that we are bailing out ala Bear Stearns, and even a few dozen billion here and there to bail out the homebuilders via engorged tax refunds. Bailout, Bailout, B-A-I-L-O-U-T!!!

As you can see here, these guys have a signifcant portion of their loans as non-peforming. In addition, if you were to look at the trend of 30, 60 and 90 days delinquencies, you will notice a big disconnect between those trends and the NPAs. The banks are actually allowing people to stay in their homes way past the 90 day delinquency mark without aggressively pushing for foreclosures, most likely to minimize the NPA numbers on their books. The truth of the matter is, if you have a loan on your books that is not being paid, it is non-performing, regardless of what label you put on it. It is my belief that the financial stress that these banks are going through is not being reliably reported on their financial statements. I have just heard from a reliable source that Wachovia has 120B of Neg Am IO that is presently estimated by an "open source" to be bid at $60. Lets say its $70. That is a loss of $36 B and they paid $28B for it. So, they are down $64B in less than 24 months. The market cap is $58B.

Well, after reading through my digital tirade, do you think that I think that CEOs really think that the worst is truly behind them? There will be a lot of capital raising going on according to the chart above. BASEL II, the Fed, the BOE and practically everybody else who oversees or had anything to do with the banking industry were way off in how much capital these banks need to remain firm in a risky environment. Even after capital raising, both I and the FDIC feel that we have a lot of failures coming down the pike. This will push down RE values. Remember the problems GGP is having? They can't even go to the banks for liquidity anymore.

Comments

[fxtrader07:]

a couple of good insights BUT I think the article is quite onesided and negatively biased. I don't trust those bank execs at all and I won't invest in any of the bank stocks, BUT: the author completely misses a major point. For the rest of the market, i.e. the broad economy, the worst may really be behind! That is not to be confused with "things only get better from here". It simply means, there is more pain and more writedowns and probably a couple of smaller bank failures to come, yes, but overall, the huge risk of a complete meltdown is gone now. And yes, that exactly is the meaning to me of "the worst is behind us". Whether that makes an investment in stocks worthwhile, is a different matter, especially given the stock markets ignorance towards the deteriorating economic situation. On the other hand, corporate bonds, even some bank bonds offer compelling value and for them, it matters a great deal, whether the worst is behind us. by focussing only on the risks, the chances get neglected - and they are right there, in bonds, not in stocks. the fed made it clear by letting Bear collapse right before they opened the refi-window for the other brokers that it will backstop every major bank but won't care for the shareholders.
Ironically, the bond markets have reacted much more to the evolving crisis than the stocks - meaning the bonds have upside from here, while for many stocks there are more losses ahead. you make most money when things go from bad to less bad - not necessarily to good. they are slowly going to less bad, overall.

2008 Apr 21 07:40 PM

[venividivici:]

Good article Reggie and good letter fxtrader. You have to be aware of the dangers but still keep you eyes open for the opportunities.

2008 Apr 21 09:16 PM

[smoothlid:]

If I had to guess, this won't all come out in the was until, say, right around December/January....af... the general election...that's when you will see large failures & a real meltdown.

Good luck to the next prez!

2008 Apr 21 11:06 PM

[Lockstep In...:]

Good job Reggie. In depth and methodical.

I didn't know Bankrate.com could be so profitable to me.

2008 Apr 22 04:47 PM

[DSX Lover:]

Banks are BUY BUY BUY BUY at these levels.
Shorting these things at these levels is asking for a serious BOOT STUMP. And the worst is truly over. The more capital they raise these low levels the easier takeover for the Giants (JPM,BAC,HBC) when the cloud clears.

2008 Apr 22 05:51 PM

[deefree:]

From STI conference call: "We are not enthusiastically optimistic about what’s going to go on in the home equity market. We think its going to be a pretty long haul over the next year to really if we move through the HELOC specifically. Our home equity loan portfolio is older and more mature and performing really well. It really is the brokered loans where we are really having the majority of our problems. That a little over $1.8 billion, as you look at that portfolio its going to continue to cause problems over the next two or three quarters."

2008 Apr 22 07:07 PM

[H2O:]

A GoldWater Girl - Delusional Prez – World Destruction

Clinton says U.S. could "totally obliterate" Iran

“”””WASHINGTON (Reuters) - Democratic presidential candidate Hillary Clinton warned Tehran on Tuesday that if she were president, the United States could "totally obliterate" Iran in retaliation for a nuclear strike against Israel.
On the day of a crucial vote in her nomination battle against fellow Democrat Barack Obama, the New York senator said she wanted to make clear to Tehran what she was prepared to do as president in hopes that this warning would deter any Iranian nuclear attack against the Jewish state.””””””

With the world doms manidesto’s – changing the rules – of pre-emption – Lets play it out – Iran peruses a weapon – Israel insist on a pre-strike – The manidestoes assume – a limited nuclear strike is best – So a few nukes are dropped - launched against Iran – Millions of barrels of oil is taken off the market – China is faced with rapid oil drops – The market goes crazy – China has to call it’s trillions of loans – and dumps the American dollar – the dollar drops to 2 cents – there is massive lay-offs across America - other countries – start selling based on the euro – Russia – then has trillions injected into their economy – and basically owns Europe.
Food prices sky-rocked – there is massive starving across the world including the United-States – Countries like India and Pakistan has little choice but to – apply the new rules and seek to alleviate there Starvation – and have there own nuclear exchange – china enters into the fray – looking for oil – Russia is pulled in based on there own security needs .
The Americans are starving – pissed as hell – no jobs – kids dying – and blaming Israel for all there woes – after all it was them – that started this.

So all I have to say – Is if America blue-collar workers want – a delusional prez at 3:00 in the morning – I say – You’ll get what you deserve – just like another gung-ho bush …….
So if you think the housing market is bad now – Just wait till there is another Clinton Prez ….

2008 Apr 22 10:21 PM

[fxtrader07:]

H2O, your scenario makes little sense. first, the chinese have long secured lots of oil contracts off market. loss or iranian oil will make a dent, yes but to everybody, probably more than to the chinese who have the dollars anyway.
second, the fallout of a nuclear strike against iran will be devastating. moderately western-friendly govts, like those in pakistan and turkey will get blown away. and lethal attacks on the usa and its allies by small groups carried out with chemical and nuclear (dirty bombs) materials will follow with a guarantee and no hillarious president will be able to do anything about it. this martialic rhetoric will not help anyone

2008 Apr 23 08:10 AM

[jimmy46:]

something you haven't mentioned is how much the lower cost of funds will add to bank earnings.

With lending rates still high and costs sharply lower, the banks should be cutting a fat hog on the interest spread.

2008 Apr 23 01:52 PM

[turb0kat:]

Hey Reggie, I love this article and keep coming back to it. Where do you find the loan-to-value data? Have you looked at Lloyds (LYG)?

thanks!
TK

2008 Jun 09 03:37 AM