JasonC

Analyst: Commercial Banks Are Undervalued [Housing Tracker]

Um, everyone knows that banks will lose money on some mortgages. The question is, can anyone do math?

No, they aren't nefariously delaying loss recognition, they just don't have the processing capacity to deal with so many loan workouts at once. That is why they are hiring everyone they can and paying them to perform workouts for them.

The rate of loans going into default on prime credits has increased to all of 2.5%. The spread on prime credits is 2.5% over their cost of capital. If they recovered nothing they'd still break even with spread that wide. They aren't recovering nothing.

The problems all stem from (1) prime mortgages written at tiny spreads and the rates lock in via derivatives at the time or (2) deadbeat mortgages with default rates well into double digits - 10-15% on alt-As and 35% on junk paper - where the spreads didn't cover that rate of default.

How much does a bank lose on a default? They expected something like 20% counting workout costs, but the reality these days is more like 50%, and if costs are high enough or resale hard enough, it can go still higher. But there is some recovery, of course. They get houses that aren't worth zero.

The math of it is, spread times 1 minus default rate (that is the profitable part) minus default rate times (100 minus recovery rate) - that being the loss part. With the spread part being per year and the rest causing loan exit and so being one-off.

Take prime mortgages at a 3% spread (e.g. 3% funding cost via CDs or whatever, and 6% mortgage rate), and a 2.5% failure rate (triple the long run average, but seen right now). They earn on the good ones .975 * 3% = 2.925% of total book size. Suppose the losses on prime loans run 50% when they default, then that is 1.25% of loan book, and the net is positive 1.675%. Push the recovery rate down to 30% and the losses rise to 1.75% of loan book, and they are still ahead 1.175%. Prime loans even in distress conditions, pay. The distress conditions cause low short rates on the funding side and thus keep the spread wide, and that is more than enough to cover even steep losses on the modest portion of prime loans that default.

But consider a subprime with a spread 3% higher (higher loan rate) thus 6% overall, but with a 35% default rate. The good portion of the subprime book earns 0.65 * 6% or 3.9% of total amount written. But the bad portion at 50% recoveries costs 17.5%. That still won't lead to 80% losses, only 13.6% losses. If the recoveries are only 30% it leads to 20% losses on the written book. The much steeper writedowns being taken on such loans reflect the banks conservatively projecting that they are going to be that bad every year over their expected lives of five years or so. By which time 90% of the loans will have defaulted and the book will have evaporated.

Loans to deadbeats don't pay, even at moderately higher spreads. They made them in the expectation that the losses on non-performing loans would be moderate, moderate enough that the spreads on the performing portion could cover them. That was false.

But it won't make loans on prime credits losers at wide spreads. It isn't the losses on non performers that matter, it is the spread on performers and how many perform.

FWIW...

Analyst: Commercial Banks Are Undervalued [Housing Tracker]

The ones who can't do business math are the permabears and the end of the world trade herd.

You can't lose money as a bank with 5% spreads. Banking is all about the spread. They have losses now because they entered a ton of business at narrow spreads in the 2003-2006 period. But right now they can get all the funds they'd ever want at 3% or less, and they can lend them to A corporations at 7%, or government backed paper at 5.5%.

All you have to do to value them properly is look at their asset size and expect the ROA to revert to the long term mean in a year or three. Then for the weaker ones you have to leave some allowance for dilution in the meantime - present shareholders may not own the whole bank 3 years out. The more an individual bank has already raised and reserved, the less than forward dilution is going to be.

The system isn't going to work without profitable banks, and it is going to work. Spreads cure everything, the solution is already baked in. They just take time, as the higher earnings from them chomped their way through past mistakes.

The error the bears all make is to focus on the balance sheet only, or at most the current earnings without averaging them over full cycles. When they aren't just chasing the headlines. Commercial banks are franchises with funding cost advantages that always come back. They are just cyclical is all. People who can't be bothered to take a 7 year average of ROAs shouldn't touch cyclicals, but anybody who can add can see the banks were sells at 2006 prices but are buys at these prices.