More on the Banking Backdrop: Never Before So Many Loans

This is another installment of my series on the US banking system and the Asset Securitization Crisis.

In the graph below, you will see that commercial banks have gorged themselves on consumer finance risk over the last 20 years. It is not just the investment banks that took chances with leverage and concentration.

The primary benefit of securitization was the virtualization of the bank's balance sheet. Through securitization, banks were able to underwrite a vast amount of risk relative to their balance sheet capacity, by selling off the risk to the open markets. Despite this, banks have steadily increased the amount of risk kept on (and off, through SPEs) their books over the last 20 years, with a forced increase of this concentration in 2007 when the securitization market simply shut down - cutting off the liquidity spigot for these assets. Starting at about 2004 near the height of the securitization bubble, banks increased the pace of securitized asset retention.

At the same time the banks increased the pace of asset retention, the debt service ratio of the lending products backing the securities started climbing very quickly. Thus, not only were the banks increasing risk from a concentration perspective, they were increasing risk from a credit quality perspective simultaneously. This was all occurring during the near peak of a bubble. Unfortunately, for most of those involved in bubbles, it is nigh impossible to see the bubble until after it is too late! With debt service ratios so high, levels will trend down to the mean, either through increased income or decreased debts (charge offs).

My bet is on charge-offs leading to the way. Charge-offs have more than tripled in the last 7 quarters. The last two recessions have seen charge-offs average 1-2% of total loans outstanding. I believe that that macro environment, fundamentals and general weakness of the consumer will cause an even higher level of charge-offs this time around.

What most pundits fail to realize is that despite all of the fear, loathing and hoopla regarding mortgages, foreclosures and declining home values (most of which is quite justified, may I add), consumer loans have higher charge-off rates than mortgages. That means those credit cards and auto loans are to cause the banks more stress, at least for now. In addition, the recoveries for these products are bound to be lower. Real estate charge-offs are increasing faster, and will probably catch up, but if they do, the combination is bound to put pressure on the businesses through slowed consumer spending in combination with the lax debt that was consumed by those very same businesses, and cause the business loans delinquencies to spike as well. I have been predicting a spike in business delinquencies for the last two quarters to take effect right about now.

Loan charge-offs, in aggregate, have spiked significantly during the last two recessions and I expect them to spike even higher this time around.

Now, what do you think all of this adds up to? Well, looking at these top commercial banks and thrifts against the backdrop of the info just gleaned... Delinquencies are spiking, just as I anticipated, in the risky 2nd lien product class where high LTVs and decreasing home values portend 100% losses and zero recoveries in many cases. In order for this to happen, though, the delinquencies must become actual charge-offs.

Well, guess what... Delinquencies are quickly becoming net charge-offs!

Comments

[vaduz]

why are there analysts who believe that the worst is over?

[john1]

Good article.

[john1]

Good article. You've got a good site.

[fatcat]

right on again,Reggie..I continue to be short financials since Nov. and still don't have a lot to show for it,but still convinced..

[Kostya Tszyu's right hand]

I started buying my favorite financials this month and will continue until next year at this time...but then again, I was buying energy after the Enron scandal and everyone thought I was insane. I only wish I was smart enough to buy at the bottom, alas, I am not.