All Shoes May Drop for the Banks

With Lehman (LEH) in Chapter 11, AIG (AIG) just downgraded three notches by S&P and potentially following Lehman's fate in the near future, who else will be the victim of this financial tempest? If the Bernanke & Paulson team continues the policy of trying to patch the holes without addressing the actual problem, unfortunately the answer will be everyone, although some will suffer earlier than others.

First we are going to see more pain among the major banks driven by further writedowns. Mark to market has been the main source of trouble so far and it will continue to occupy the main seat for the next several months. There are three things in play here:

• Mark down of already discounted assets to reflect latest pricing: An example of this is Citi (C), which currently holds $20B in commercial real estate assets which it has only slightly marked down and which, judging by this weekend's Lehman talks, are not held in very high regard by other banks.
• Mark down of assets that were previously undisclosed: Except for MBS, who really knows what's lurking on the balance sheets? While MBS have certainly been toxic, the performance of other securitized instruments like credit and auto loan securitizations is rapidly deteriorating, and with hundreds of billions outstanding, banks are bound to hold a significant amount. And then who knows what was the exact exposure of each bank to Lehman's debt - Citi was a trustee for $130+B, Bank of NY for another $15+B, someone actually holds these assets, and that someone will have to take heavy marks.
• Mark down of assets that were "hedged": This is one of the devastating effects of Lehman and potential AIG fall-out - a lot of the assets were considered hedged, but with the CDS counterparty disappearing, they all have to be marked down to market values. This will put big (potentially lethal) dents in banks' capital ratios.

While the writedowns have been huge so far, they are dwarfed in size by the estimated credit losses of commercial banks that for the most part have yet to recognize them. Washington Mutual (WM) has been among the leaders in disclosing its holdings, recognizing the losses and raising capital. However the main result has been to focus investors' attention on them, rather than others.

According to the CDS market, there is a significant probability that WaMu will default on its obligations, and while that may very well happen, I suspect WaMu is better capitalized than most of the U.S. banks. Hundreds of banks would be effectively insolvent right now if they marked down their holdings to WaMu's standard, however they choose to use optimistic assumptions in their models, assume that their loss rate on mortgage (that account for 65% of average bank assets) will magically improve in the next quarter, and keep plugging along.

One scary implication of this is a dent to the argument that U.S. will avoid a Japan-style recession because banks recognize the losses quickly. This has only been true of the broker-dealers, while the commercial banks have chosen the "Japanese" path, leading to a potential dragged-out recession. The alternative to this is equally scary though - failure of WaMu, crisis of confidence, rush to withdraw money and, again, bank failures on massive scale.

To suppose that the rest of the economy will remain unaffected by the financial Armageddon is optimistic, to say the least. We are already seeing a reduction of demand in non-consumer discretionary industries (like Dell's (DELL) warning yesterday), and plummeting earnings will follow soon. Then we will see further increases in unemployment, decreasing demand for durable goods, causing further decline in employment, more declines in housing, and with all that - more drops in the stock market.

The next victim of all this will be the U.S. government. The budget deficit will climb as the FDIC, after riding to the rescue of failed banks, will need to be recapitalized, Fannie (FNM) and Freddie (FRE) will need more money, and tax revenues will drop off more. The supply of Treasuries will increase tremendously to finance all this, while the demand will fall, along with confidence in the U.S. economy and falling oil revenues for the Saudis and Russians. This will mean the rise of real long-term yields, which will be a significant impediment to future growth, and also may precipitate a prolonged bear market a-la 1970s in which multiples compress given the increasing attractiveness of bonds. Add to that the increasing reluctance of investors to lend to financial institutions, as they keep discovering they're much more risky that previously thought, and we get even higher real interest rates for the consumer, which doesn't bode well for long-term prosperity.

What is to be done? Unfortunately there are no gimmicks that the Fed can use that worked in the last recessions. Interest rate changes have not worked: even though the Fed rate has come down, corporate and mortgage rates have barely budged. Pumping in liquidity, a solution that Ben Bernarke thinks would have prevented the Great Depression and is actively pursuing right now, is not working either as the Fed has already exchanged a good chunk of its balance sheets for securities of dubious value while lending growth continues to slow.

The issue is not liquidity – when you are a bank holding souring mortgages you prefer to hoard cash rather than lend more, as you remain the owner of those mortgages whether you temporarily borrow against them from the Fed or not. The real giant problem is the lack of capital in the system. All banks are overlevered as even Bank of America (BAC) only has $70B in tangible equity on an asset base of almost $1.7TR (prior to ML acquisition), and it is not immune to collapse if house prices drop another 20% which will happen in case of en-masse bank failures.

If there was a magical solution, like giving the American people a pill that would re-instill confidence in the U.S. financial system - that would be ideal. Unfortunately the pill does not exist, Barack Obama (or John McCain for that matter) are not close substitutes and Paulson's assurances of "soundness" look at the same time humorous and sad.

The only route I see is a government capital injection into the U.S. banking system that is not sponsored through further borrowing from foreign governments (which will lead to interest rate increases and long-term decline in growth), but through a massive cut in non-productive (and I'm not just talking defense) spending. Then the government can use those funds to buy preferred shares in all major banks, rather than pursuing sporadic bail-outs that just shift market attention from one failing institution to another.

The infusion will allow real capital ratios (not the bogus Tier 1 ratios which are used now) to go up to reasonable levels, lending to resume and interest rates for the consumers to come down. Over time, maybe 5-10 years, the banks can go back to 10x tangible equity/assets leverage and repay the government its preferred shares. Even with this measure the growth will be lackluster as consumers have to shift consumption into savings and reduce their historically-high debt burdens to lower levels, but it can prevent an enormous crisis that may take decades to untangle.

Comments

[Alan von Al...:]

Good idea. Well presented. Thank you.

2008 Sep 17 08:52 AM

[Schweizer:]

Probably the most concise and defendable article posted here in weeks.

Well done, and thank you.

2008 Sep 17 09:07 AM

[JudeJin:]

pure wishful thinking. it ain't gonna happen...
US is toast!

2008 Sep 17 09:11 AM

[Rick Hoff:]

Cuts to government spending? Before an election? After, if the Dems win? Dream on.

2008 Sep 18 08:05 AM

[Donulvi Dolam:]

Something's amiss here, I've heard reports of US dollar (cash) shortages as well unavailability of Gold or Silver bullion, etc. Am I wrong or has someone just suddenly created this cash crisis by removing US dollars and other valuables out of the World's economy.
I know Wall Street's in trouble of its own doing but whilst you can blame everything on too much debt, this still does not account for all the missing cash, where is it?
Has someone been cooking the books or what?

2008 Sep 18 08:18 AM