Bad Bank Loans at Extreme Levels

Includes: IYR, XLF
by: Jeffrey Bernstein

"Darling I don't know why I go to extremes
Too high or too low, there ain't no in-betweens
" - Billy Joel 1990

Yes folks, we are back to early 1990s levels on bank loan delinquencies and charge-offs. This according to the latest Federal Reserve Board data just out. I'll be referring to a bunch of charts in this piece, but I am going to make most of them pop-ups, because large charts eat up so much space. For illustrative purposes I am featuring the chart below of delinquencies as a percentage of all loans.

As you can see, with the latest surge of delinquent loans from 3.67% of all loans in Q3 2008 to 4.84% of all loans in Q4, delinquencies are now firmly back in late 1980s S&L crisis territory. Surprised? At this point neither am I. But remember when people were saying that mark to market was grossly distorting what eventual losses would be like, etc. Recall that these delinquencies are not market trading related; these are loans where the borrower has gone delinquent and is no longer making payments to the bank. This is a true indication of the trend of loans going sour and it's ugly - real banking crisis ugly. All loan charges also surged in the quarter, rising 55 basis points from Q3 2008 to 2.01%. As you can see (View image), charge-offs have moved up even more rapidly than they did in the early 1990s, at higher rates of delinquency. This signals that banks are actually being more aggressive in reducing the values at which they are carrying these loans and hopefully portends a greater velocity of dealing with these problem assets than in the prior crisis.

The difference between the banking crisis of the early 90s and this one is that commercial real estate delinquencies were much worse and really drove the banking crisis. Don't get me wrong, the residential downturn was bad and killed a bunch of S&Ls, but it happened on a rolling basis, moving from geography to geography over a period of several years. Once the system was weakened in this way, the recession of 1990 sparked a collapse of commercial real estate, which is what really put the large banks and insurance companies on their backs. As you can see from the following graph, residential loan delinquencies are literally off the charts (View image). After surging 100 basis points from Q2 2008 to Q3 2008, residential delinquencies tacked on an additional 181 basis points in Q4 2008. This is a runaway freight train and if it isn't stopped, I really fear for the consequences. Residential charge-offs are just absurd, but at least banks are writing these loans off and presumably liquidating them with abandon (View image).

I don't like to be wrong, but I freely admit when I am. When I first started monitoring these data over a year ago, I couldn't imagine the commercial real estate market getting anywhere near as bad as it was in the early 1990s, because we didn't have the tax-driven over-building that took place in the late 80s. I was wrong. As I work with building owners and developers who are trying to de-lever their portfolios and I see the intimate details of how aggressively commercial real estate was financed and underwritten, I understand why we are experiencing such a painful commercial real estate downturn. I also have a theory about why we are seeing a surge in commercial real estate charge-offs (View image) to early 1990s levels, despite a slower trajectory of delinquencies.

I believe that the initial commercial loan charge-offs are largely tied to new construction projects, particularly residential condominium projects and land loans). Evidence for this comes from the recently published Q4 2008 FDIC bank statistics. The year-over-year increase in quarterly net charge-offs reported by the FDIC was led by real estate construction and development loans at $6.1 billion. As I noted in my piece Zombie Condos II - Day of the Charge-Off, when condo construction loans go bad, the severity of the losses can be incredible. So as we begin to see interest reserves on construction loans from the tail end of the bubble roll-off and these loans roll from delinquency to default, we will see a surge in charge-offs. The surge may start to dissipate in the next 6 months. At that point new delinquencies will more likely be from loans on "stabilized" investment properties, where owners paid too much for the property, experienced increased vacancies (particularly in retail, office and industrial) and don't have deep enough pockets to make their loan payments. While values for these loans will be haircut when they are charged off, my guess is the process will be much less severe depending on the market....malls in suburbs full of empty foreclosed homes could still experience pretty ugly writedowns, for example. This is in no way meant to minimize the trend in delinquencies, which is pretty ugly. Commercial real estate delinquencies surged 91 basis points to 5.42%, nearly doubling their rate of ascent from Q2 to Q3, but they are still well below the 10-12% levels seen at the peak of the early 1990s cycle.

I get accused of painting dark pictures of NYC real estate for some really weird reasons, like I am talking down the markets so I can profit by it - I wish I had about $100 million to spend buying buildings in NYC over the next 18 months - but unfortunately, I haven't raised it, yet donors are welcome to see me after class. Contrary to the doomsayer characterization, I have been an unabashed optimist regarding credit card losses this cycle because of all the warning that card companies had about a coming economic contraction. They saw the residential real estate market topping out in 2005/2006 and consequently tightened up their lending practices. For this reason, I expected the credit card companies to experience less horrific losses this cycle than many have been expecting. I have noted in the past that I also believed that the dysfunction of the securitization market was a much bigger problem for the credit card companies than credit losses. From the data we are seeing now, I have to admit that credit card delinquencies are about as bad as they have ever been (View image), I would note, however, that the credit card business was a much more conservative one in 1990 than it is today. On a relative basis I think these guys are actually hanging in there okay. The charge-off data only go back to 1995. As of today, we have not breached the prior highs seen post 9/11 (View image).

In summary, residential delinquencies are driving the banking system into the grave and we saw an acceleration of this problem in Q4. I prefer to look at non-seasonally adjusted data, and perhaps, there was some acceleration in charge-offs to "clean up" the books, but there is no putting a positive spin on this; it's an unmitigated disaster. Commercial losses are surging, but are still nowhere near the early 90s levels. However, I expect the next 6-9 months to bring the maximum pain levels here, and the severity of losses will be ugly. This may moderate some by year-end. Lastly, I'm not crying for the credit card companies; they are doing relatively okay and continue to aggressively pull back on lending, (check this article on American Express (NYSE:AXP) customer buyouts,) which will reduce their ultimate losses.