Magnifying the Credit Fallout

From The Wall Street Journal March 6, 2008 page A2

Even as financial firefighters try to douse the flames, the search is under way for the cause of the fire.

How could a mortgage-market meltdown -- losses of perhaps $400 billion, less than 2% of the overall value of the stock market -- cause so much of a disturbance and do so much damage to the U.S. economy? "After all," Federal Reserve governor Frederic Mishkin observed last week, "a 2% decline in stock-market prices sometimes happens on a daily basis, and yet leads to hardly a ripple in the U.S. economy."

And is the fire being fanned by the way commercial banks are required to keep their books and decide how much capital to hold as a cushion against bad times?

The short answer to the first question is leverage. The short answer to the second is yes. Leverage is borrowing money to make bigger bets. Invest $1, borrow $9, buy something for $10. If its value rises $2, you've tripled your initial investment. It works great when the market is on the way up. On the way down, it amplifies losses.

Banks are highly leveraged. That's how they make money. Peter Fisher of money manager BlackRock recalls giving a talk to a bunch of bankers and asking rhetorically: "What's the difference between a hedge fund and a bank?" Before he could answer, someone in the audience said, "Banks are more highly leveraged."

A bank has a set amount of capital. Based on regulatory rules and management's judgment, it borrows some multiple of that sum, either in the markets or by taking money from depositors. It puts that money into loans or securities, its assets.

Banks today find their assets worth less than anticipated, the consequence of a real-estate bust and falling market prices of securities. These losses erode a bank's capital cushion. With less capital, banks shrink their balance sheets; they lend less.

How much less? That's where leverage comes in.
Say for every $1 less in capital, a bank lends roughly $10 less. At a conference last week, sponsored by the Brandeis University and University of Chicago business schools, two Wall Street economists and two academics estimated that about half the mortgage losses, or about $200 billion, will be borne by banks and other leveraged financial institutions. That will lead them to shrink their balance sheets by about $2 trillion by lending less and selling assets.

With money cheap, banks gorged themselves with leverage in good times, making not only risky mortgages, but increasing leverage by investing in securities that rested on the riskiest slice of those mortgages. Bank balance sheets now are on a forced diet.

The impact on the rest of us depends on how much new capital banks raise and how much they reduce leverage. The four economists estimate all this will translate into $900 billion less in loans to households and businesses, and say that will reduce economic growth over the next year between one and 1.5 percentage points. Ouch.

That's the "what" and part of the "why." But the current approach to bank capital and accounting is exacerbating the ups and downs. When times are good, loans and securities look less risky, and banks increase leverage to make more money without building capital. When times are bad, they do the opposite.

"When asset prices rise, so does the value of collateral, which makes financing easier, increasing the demand for assets," Jaime Caruana, then Spain's central banker, observed in 2002. "That, in turn, pushes asset prices upward. In the downturn, as the value of collateral drops, financing possibilities decline, as does thus credit growth, a process often reinforced by financial institutions pursuing much more cautious credit policies as they are incurring losses or making smaller profits. ... Tighter credit policies reinforce recessionary forces and provoke additional reductions in asset prices."

For that reason, Spain, unusual among its peers, tweaked its rules in 2000 to require banks to set aside more capital when times are good so they have bigger cushions when times are bad.

The relatively new practice of requiring banks to value their loans and securities to market prices -- instead of assuming, unless there's good reason, the borrower will pay back the loan -- pushes in the same direction. It was a well-intentioned response to the mistakes of the past when Japanese banks and U.S. savings-and-loans were allowed to lie about the true value of their loans and collateral for years.

But, as economist Hyun Song Shin of Princeton University noted at last week's conference, when banks valued assets at what they paid for them, they had reason to sell when market prices rose and buy when market prices fell.

That welcome stabilizing effect has been lost. Banks today have incentives to buy more when prices are high, and are forced to sell when they are low.

As Mr. Shin and Tobias Adrian of the Federal Reserve Bank of New York wrote recently, "The expansion and contraction of balance sheets amplifies, rather than counteracts, the credit cycle." Capital standards and mark-to-market rules add to euphoria in good times and despair in bad.

That isn't smart.

Interest Rates - If only we knew where they were going...

For the week ending Jan. 3, Freddie Mac reported that the average rate on a 30-year fixed-rate mortgage was 6.07%. By the week ending Jan. 24, the average rate dropped to 5.48% -- nearly a four-year low for the mortgage.

But rates reversed course, and for the week ending Feb. 28, the 30-year averaged 6.24% -- the highest it has been since November.

This comes after months of stability, with rates inching up or down week to week. So what's with all the recent volatility? Ask people who follow the rates and you'll get a variety of answers as to why rates have gone back up: inflation worries, weakness in the U.S. dollar, a reaction to the economic stimulus package. But many agree that issues being worked out in the credit markets will probably cause long-term mortgage rates to be somewhat volatile in months to come.

The experts who commented this week were basically split on whether rates would go up or down in the week ahead. Surprise, Surprise...

"This market is psychotic," as quoted by the president of Mortgage Grader. "In spite of a dwindling economy, rates have climbed back to 6%, which is where rates were before Mr. Bernanke took action 30 days ago. Stagflation should become part of everyone's vocabulary."

It takes a good crystal ball to know how mortgage rates will fare in the weeks ahead. But there's a good chance that this roller coaster of a rate ride isn't yet at a full and complete stop.

FDIC doesn't see bank failures surging

The Federal Deposit Insurance Corp. is trying to rehire 25 former employees specializing in bank insolvency, but the agency that insures bank deposits said it does not expect a surge of failures in the industry.

Federal Reserve Chairman Ben Bernanke raised some eyebrows this week when he suggested during congressional testimony that the U.S. will likely see some banks fail in upcoming months due to the ongoing credit crunch and a weakening housing market.
"There will probably be some bank failures," Bernanke told Congress Thursday. "There are some small and in many cases de novo [new] banks that have heavily invested in real estate in locales where prices have fallen. Among the largest banks, the capital ratios remain good and I don't expect any serious problems among the larger banks."
"Our problem bank list has 76 institutions, low by historical standards," said Andrew Gray, a representative for the FDIC. "In 1990, there were close to 1,500 on the list. Typically, the number of failures for a given year does not approach the number of banks on the list."

In contrast, more than 800 banks failed between 1990 and 1992 after a severe recession brought on by the savings and loan crisis proved to be too much for many overleveraged smaller banks.

Analysts also cried foul on Bernanke's suggestion, with Punk Ziegel analyst Dick Bove pointing out Friday that even when three small banks failed during the fourth quarter of 2008, the market barely registered the change.

All three of those were regional banks: Douglass National Bank in Kansas City, Mo., Miami Valley Bank of Lakeview, Ohio, and NetBank in Alpharetta, Ga.

"Virtually no one was even aware that this happened because it was akin to the proverbial tree falling in the forest," Bove said Friday, adding he isn't worried about the 76 banks currently on the FDIC's radar.

"The average asset size of these troubled banks and thrifts is less than $300 million. All of them could fail and it would have no impact on the system," Bove said.
FDIC report shows issues, but agency says they aren't terminal.

Recent data from the FDIC support the idea that these days most U.S. banks are well positioned to ride out any approaching storm.

"The industry as a whole is coming off a golden period of record profits," FDIC Chairwoman Sheila C. Bair said in the agency's Quarterly Banking Profile, released earlier this week. "Because of this financial strength, the overwhelming majority of banks and thrifts remain well-capitalized and profitable."

The report showed that 99% of insured institutions were currently well-capitalized at the end of 2007 and close to 90% of those were also profitable, despite the fact that profits at the banks and thrifts fell to a 16-year low in the fourth quarter of 2007.

Indeed, American banks posted earnings above $100 billion for the sixth consecutive year. But the industry as a whole took a bath on overall loan losses last year, with loan loss provisions more than doubling in 2007 to $68.2 billion from $29.5 billion a year earlier. "The rising trend in noncurrent loans indicates that write-offs and loss provisions will likely remain high for the near future," Bair said.

So far, banks are girding for the tough times ahead by shoring up close to $30 billion in capital during the fourth quarter alone. And while losses at American banks grabbed headlines in 2007, much of that news is attributable to a few highly publicized missteps by the banking sector's larger player.

"The magnitude of the decline in industry earnings was attributable to a relatively small number of large institutions," Bair said, pointing out that the median return on assets only fell 14 basis points compared with the much higher drop of 102 basis points for some larger banks.

"Seven large institutions accounted for more than half of the total year-over-year increase in loss provisions," Bair said. "Ten large institutions accounted for the entire decline in trading results."