This morning Chris Whalen made some comments on CNBC that hit the nail on the head regarding the U.S. banking crisis: there is a huge wave of old-fashioned loan losses coming down the pike. The writedowns we have seen to date are largely confined to tradeable securities that must be marked to market.

There are much bigger unrealized losses sitting on balance sheets right now. $700 billion will not be nearly enough to cover these losses. If the Federal government doesn’t step in and re-capitalize the U.S. banking system with more money, we are going to suffer a major deflationary spiral as these losses are realized. The WaMu-JPMorgan transaction is an example of a best-case scenario in recapitalizing the sector. However, the government will need to get involved now proactively as opposed to waiting until crisis hits again.

Where are these losses hiding?

• Residential Property (Alt-A, Payment Option, Negative Amortization Mortgages)
• Commercial Property (Commercial Real Estate and Construction Loans)
• Leveraged Loans and High Yield Bonds (from Private Equity LBOs)
• Credit Card Receivables and Asset Backed Securities
• Auto Loan Receivables and Securitized Auto Loan Bonds

While everyone is breathing a sigh of relief about the bailout package that Congress is about to pass, we need to keep our eye on the ball. There is still much work to be done. Do not be fooled into thinking that this will be the end of it.

Most people think $700 billion is a lot of money and are angry at having to fork over this sum. However, the scope of the problem in U.S. finance is much bigger than that. The bailout of the financial services sector has just begun and we need the government to admit this to the American people and get on the case.

Ultimately, if done correctly, bailouts will cause a net loss to U.S. taxpayers that could be much less than $700 billion despite large nominal outlays. If we wait until crisis again, the losses will be greater.

Related posts
Consolidation through merger over bankruptcy
Why is this blog named Credit Writedowns?
Bankrupt global financial institutions
Credit Crisis Timeline

Related posts:

• JPMorgan Chase: Large exposure to real economy downturn
• Danish banking crisis the worst in Europe
• Where is the global economy headed?
• Why is this blog named Credit Writedowns?
• The Dummy’s Guide to the US Banking Crisis

I named my blog “Credit Writedowns” because I anticipated an historic wave of credit writedowns in the global banking system which would lead to a wave of deleveraging, systemic risk, and bank failures — in short, a massive financial and economic bust to rival the Great Depression.

Up until now I have masked this dire view because, honestly, most people do not want to hear this sort of thing. I reckon they are watching “America’s Next Top Model” or “Grey’s Anatomy” to escape the grim reality out there (Those are two shows I like very much, thank you). So, I apologize in advance for the downbeat nature of this post.

This is probably the first time I am on record admitting the depth of my concern for the U.S. and global economy. But unfortunately, present events are now confirming my thesis and I want to step up the attack on our policy makers by highlighting the lurking dangers. Maybe that way we can get real solutions to our problems.

The largest equity bubble of all times spells economic pain?
Rewind back to 2001.

Soon after the tech bubble hit, it was obvious to me that the United States and the United Kingdom were two societies that had developed an unusual and excessive reliance on financial services as an engine for economic growth.

Back then, it was a foregone conclusion that the United States would be hard pressed to escape what was the largest stock market bubble in history with a garden variety recession. I felt that the United States, at minimum, faced a deep and protracted downturn similar to the 1973-1975 or 1980-1982 period, if not one of Japanese proportions.

All of the problems that felled the U.S. economic juggernaut in 2007 were evident in spades in 2001. And quite honestly, that would have been a healthy cleansing process for a global economy hooked on a savings-short, over-leveraged American economy as its growth engine. The problem was severe but manageable.

Reckless Fed policy
However, I was wrong. Alan Greenspan’s Federal Reserve resisted this necessary unwind by lowering interest rates to 1%, well below the rate of inflation. While U.S. businesses did reduce leverage from 2001-2003, low interest rates and poor bank and financial market regulation led to risk taking on a massive scale.

Because interest rates were low, lower-risk assets offered poor returns. The financial services industry was unable to make significant return on equity without increasing risk. Therefore, most players increased both leverage and risk. This includes banks, investment banks, mortgage lenders, asset managers, private equity companies, and hedge funds.

Asset classes included:

• Residential Property (Subprime, Alt-A, Payment Option, Negative Amortization Mortgages)
• Commercial Property (Commercial Real Estate and Construction Loans)
• Leveraged Loans and High Yield Bonds (from Private Equity LBOs)
• Credit Card Receivables and Asset Backed Securities
• Auto Loan Receivables and Securitized Auto Loan Bonds

Alan Greenspan literally gambled with the world economy on a bet that low interest rates would allow the U.S. economy to recover before the magic elixir of leverage and risk became a systemic risk. Rather than fold his hand and accept a protracted period of weakness, Alan Greenspan decided to go all in. The result was not just a housing bubble but a credit bubble more generally, involving unsustainable price increases in all of the asset classes above and more. Trends in all of these asset classes suggest large credit writedowns to come from these assets as well.

Housing Bubble
When Greenspan went all in in 2003, the U.S. residential property market was arguably already in a bubble. The same was true in many parts of the UK as house price increases had already far outstripped the rise in inflation and house rent increases. So, had the Fed decided to follow a more hawkish and appropriate monetary policy in 2003, it is quite probable that house prices would have been pressured and none of the excesses since that time would have occurred.

However, the Fed allowed these excesses to occur and allowed the shadow banking system to become yet more leveraged in the process. All of the data pointed to excess: average debt per household, debt servicing costs as a percentage of income, debt to GDP, the savings rate, the value of housing stock as a percentage of GDP, the ratio of house prices to rent, the median/mean equity owned in homes, etc., etc., etc. Why could I rent a house for $2000 that would cost $4000 for 10% down on a 6% 30-year fixed mortgage? Why would I buy a house in that scenario?

I found this period — 2003-2006 — to be very, very frustrating because the data were all pointing to an unsustainable bubble. Yet, everyone seemed to be caught up in the tonic of paper wealth and excess consumption. The more house prices rose, the more they were taken as prima facie evidence of the sustainability of the previous increases. I felt like your classic Cassandra.

Systemic risk- credit writedowns
If the numbers looked bad in 2001 and we hadn’t unwound the excesses, but had simply papered over them with more debt, the problem in 2006 was obviously even bigger. That was my greatest concern in 2005-2006. But, more of concern to me was deleveraging and credit contraction. See, the Tech bubble was limited to shares and capital spending. The banking system was not as affected. So credit was not as restricted as a result of the popping of that bubble.

This is not the case in a housing bubble. Housing goes to the core of our credit system. When a housing bubble pops, loans go bad and credit losses must be recorded. These credit losses are called ‘Credit Writedowns.’

What is a credit writedown? It is a reduction in the value of an asset carried on a company’s balance sheet. As these losses must also be reflected on the income statement, credit writedowns result in massive losses. For example, a company may believe a number of mortgage-backed securities are permanently impaired and are carried on the balance sheet at values that do not reflect market prices. As a result, they may decide to take a writedown by reducing the valuation.

The bubble we have just experienced was the mother of all housing bubbles. It saw large and sustained price increases across a greater percentage of the developed world than any other housing bubble we have ever witnessed in history. The amount of credit writedowns that we should see from this period of credit excess will be much, much more than is currently anticipated by the mainstream media or the general public.

So, that is why this blog is named Credit Writedowns. My hope had been to draw attention to the systemic risk associated with the deleveraging process necessary to purge these excesses. Quite frankly, I was cautiously optimistic that our policy makers would avoid the worst of the potential policy mistakes which could worsen the situation. However, over the past month we have witnessed key policy mistakes, which I believe will likely lead to further downside risk going forward.

Realistic future assessment
I am not painting a particularly rosy picture here. And it pains me to not be able to do so. We have seen over $500 billion in credit writedowns at the world’s major financial institutions, the collapse of the largest mortgage lenders in the world in Fannie Mae and Freddie Mac, and the bankrupting of two of the largest investment banks in the world in Lehman Brothers and Bear Stearns. We have witnessed the end of the investment banking business model as Merrill Lynch was acquired and Goldman Sachs and Morgan Stanley became bank holding companies. And finally, we are now experiencing the largest series of bailouts and government market interventions since the Great Depression.

I would like to say that this thing is going to be over soon. However, the truth is that we are not even halfway through this. We have at least $500 billion more in writedowns to come. As a result credit will contract generally and many banks will fail. The knock on effects of this credit contraction will be higher unemployment, major commercial bankruptcies and a deep recession. The other bubble asset classes like commercial real estate will also fall. And the stock market will follow the real economy and probably bottom lower in inflation-adjusted terms than 2002 or 1998.

We need leadership
To deal with this crisis, we need policy makers who understand the gravity of the situation and its effect on people’s lives. None of the current proposed bailouts are addressing any of this. Do you think Paulson’s plan will help people find jobs? Do you think Barney Frank’s plan will help people from losing their homes. Will any of the market manipulations like banning short selling stop even good banks from falling prey to liquidity concerns? The answer to all of these questions is no.

So, my role at Credit Writedowns is to continue to point out where the minefields are, what we can do to avoid them, and what has historically been done before. I do not like to be the messenger of bad news. But, someone has to hold our policy makers’ feet to the fire. My hope is that I can play my small part in helping ensure the policy response we get going forward is better than the one we have had thus far.

Related posts:

• Connecting Fed cuts with credit writedowns and quantitative easing
• Liquidity trap of a different sort
• More credit card writedowns are coming
• What’s different about 2008?
• The inflation-deflation debate

Back in June, I wrote about financial investors in bank shares having lost $10 billion. Then, I predicted that losses would mount and bank shares will fall. It seems that one part of that equation is true already as bank shares have fallen precipitously in the last several days on the heels of turmoil with the GSEs and with IndyMac.

However, I think it is time to revisit the chatter about why bank shares are falling and why investing in them is like catching a falling knife.

In June, FT Alphaville, a blog for the Financial Times said this about the early investors in financials:

Investors who backed the recent drive by U.S. financial companies to raise capital are sitting on nearly $10bn in paper losses amid a continued slump in the sector’s shares, an FT analysis shows. The negative returns suffered by investors are likely to make it more difficult and expensive for U.S. financial groups to tap equity markets if, as expected, they are forced to raise more capital. Investors who bought the $65bn-plus in common and convertible shares issued by large U.S. financial institutions since last October have seen their total investments fall by more than $9.7bn – a negative return of about 15% – according to an FT analysis of Dealogic data.
-FT Alphaville, 16 Jun 2008

Today, Bloomberg had an article highlighting the worsening state of losses in banking shares:

TPG Inc.’s plan to profit from Washington Mutual Inc., the biggest U.S. savings and loan, may be sinking with the housing market.The private-equity firm, led by David Bonderman, anchored a $7 billion cash injection into Washington Mutual in April by purchasing stock at a discount. The Seattle-based lender’s share price has since plummeted, wiping out two-thirds of the investment’s value.

Washington Mutual tumbled to the lowest since 1991 yesterday on the New York Stock Exchange, leading the drop in home lenders after IndyMac Bancorp Inc. was seized last week by U.S. regulators. Bonderman’s firm, which invested $2 billion in Washington Mutual for a 13 percent stake, has been stung by record foreclosures, particularly in California, home to half of the bank’s loans.

-Bloomberg, 15 Jul 2008

With share price losses having mounted significantly (the S&P500 Bank Index is down below 150 from near 300 in February and almost 400 one year ago), one gets the feeling that actual losses on net income and bankruptcies are coming.

Where?

Soon after this crisis began in February 2007, U.S. Treasury Secretary Henry Paulson said the sub-prime mess is:

“going to be painful to some lenders, but it is largely contained.” “We have had a significant housing correction in the U.S.,” Paulson said in an interview on CNBC. “The correction has been significant. You can’t have a correction like that without causing some dislocation. It is too early to tell whether it has bottomed. We’ll know more in the next month or two.”
-13 Mar 2008, MarketWatch

However, the mess continued on and on until $400 billion in assets had been written down. But that part is done. Bridgewater Associates, a respected hedge fund in the US, recently said that sub-prime is 90% over. So the losses are obviously not going to come from sub-prime.

There are three obvious places to look:

1. Other mortgage areas beyond subprime that have been ‘tainted’ by the subprime mess and that are showing signs of distress.
2. Other credit classes that exhibited the same levels of euphoria during the upswing
3. Other unrelated credit classes that might be affected by a negative feedback loop that credit contraction has on the real economy.

As far as Mortgage classes go, Alt-A is the class to watch now. This class between sub-prime and prime is now exhibiting many of the hallmarks of distress previously seen in sub-prime before it cratered. (See posts under the tag mortgages and home loans for more). IndyMac, now bankrupt, was a major provider of mortgages in this sector. In April, Moody’s began downgrading Alt-A Residential Mortgage-Backed Security (RMBS) bonds.

Moody’s Investors Service issued more Alt-A downgrades on Thursday morning, this time taking a heavy hand to 32 different Aaa-rated tranches from 10 different Alt-A deals. Many of the downgrades even pushed former Aaa’s into non-investment grade categories — a stunning descent for top-rated Alt-A mortgage bonds that underscores two key points.

First, defaults are obviously accelerating. Second, many Alt-A deals were issued with less in the way of overcollateralization — which, in plain English, means that these deals will start to see downgrades sooner, compared to the relative stress that a typical subprime RMBS deal can withstand before the hits start coming at the Aaa level.

The rating agency placed an additional 254 Aaa-rated Alt-A classes on negative ratings watch Wednesday.

All underlying collateral for the downgrades issued Thursday was originated by Impac Mortgage Holdings., Inc., the agency said in a press statement, making the Irvine, Calif.-based lender among the first major Alt-A lenders to see significant Aaa- downgrades to mortgages it originated.

-Housing Wire, 24 Apr 2008

One shouldn’t rule out prime mortgages either.

When it comes to other asset classes that were exuberant on the upswing, my list includes:

• CRE (Commercial Real Estate)
• Construction Loans
• Leveraged Loans
• Credit Card and Auto ABSs (Asset-backed securities)
• High Yield corporate debt
• Emerging market sovereign debt

Now, those same classes are all ones that should suffer along with the global real economy downturn.

Conclusion
My prediction is that Alt-A RMBS losses will be the first to appear en masse followed by other asset backed securities as these have to be marked to market. This will mean significant additional losses for the money center banks in particular. But not only in the U.S. but elsewhere as many global players have exposure in these areas.

Construction and CRE loans will sour next as the regionals are forced to increase loan loss provisions in the commercial and residential real estate sectors. Real estate is the hardest hit sector to date. Therefore, I would look for losses to come there first.

Finally, we will begin to see losses in other asset classes as the real economy starts to struggle. High Yield (particularly lower grade bonds) and leveraged loans will suffer. When and how sovereign issues enters the picture is dependent on asset class contagion. Spread products like high yield sovereign debt is vulnerable to wholesale risk repricing and could fall at any point with other debt asset classes.

This scenario certainly spells bankruptcy for a few money center global players ad a raft of regional and local banks. With IndyMac as a canary in the coalmine, I suspect we will see these bankruptcies in the very near future.

All of this is reason to believe that investing in financials is going to be like catching a falling knife for some time to come.

Related posts:

• New Writedown Risk: Alt-A
• Investors in Financials lose $10 billion
• Prime looks terrible
• Bailouts: catching a falling knife
• Bank bankruptcy or bailout?

The Washington Post has a story on regional and healthy banks that I highly recommend. Essentially, we are past the first wave of writedowns and are moving into phase two where it won’t be about derivatives and RMBS’s as much as underlying loan losses and collateral damage in commercial property and construction loans. In the U.S., this puts the regionals front and center

The one and only reason I would support bailouts or nationalization of mortgage debt is because of systemic risk. I am very dubious on the bailout plans presented to date.

Ultimately, when good companies go down with the bad, as happens in a recession, it is a shame. But, there comes a point when systemic risk threatens to paralyze an economy. It is still early days. Nevertheless, we should keep this in mind as the credit crisis unfolds.

Increasing struggles by consumers and businesses to make payments on a variety of loans, not just mortgages, are setting off a new wave of trouble in the financial sector that is battering even institutions that had steered clear of the subprime-home-loan debacle.

Late payments on home-equity loans are at a record high, according to fresh data from the Federal Deposit Insurance Corp. The delinquency rates on loans for cars, small businesses and construction are spiking to levels not seen in a decade or more.

Unlike last year, when soaring mortgage defaults sparked a crisis of confidence in the financial system, the root of these problems is the downturn in the broader economy. Simply put, consumers and businesses are strapped for cash with job losses growing and retail sales falling, economists said.

“We are not finished with the mortgage problem, but you are starting to see increased delinquencies in other forms of consumer debt,” said Paul Kasriel, an economist at Northern Trust Securities. “We are in the eye of the hurricane. We had the first wave of the credit crisis, and it was quite damaging. But there’s another wave coming, and it’s likely to be as destructive.”

The institutions most at risk in this new phase of the credit crisis are regional and local banks, many of which stayed away from subprime mortgages. These firms are key drivers of economic activity in communities across the country. Without them, consumers would lose a source of personal loans. Small businesses would struggle to stay afloat. Construction companies often can’t finance local projects without these banks.

Because they have fewer options than big Wall Street firms for raising emergency funds, these regional and local banks tend to be more vulnerable in a crisis.

In the Washington area, the stock prices of several local banks have already plummeted, with shares of Virginia Commerce Bank falling nearly 50 percent and Alliance Bank dropping about 45 percent since the beginning of the year.

-Washington Post, 22 Jun 2008

See: Credit Crisis Timeline for a full list of writedowns and capital raising by institution and a timeline of the credit crunch.

Related posts:

• More warnings on regional banks
• Wave of regional bank write-offs?
• The regionals versus money center banks
• Regionals are exposed to credit crisis
• $35 billion in missing writedowns

From Bloomberg News:

Regional Banks Tumble

Zions, the lender with operations in 10 Western U.S. states, tumbled 10 percent to $33.44 for the steepest decline in the S&P 500. “Weakness” in residential construction and land values in the Southwest will harm loans and is “expected to persist into 2009,” the lender said in a presentation attached to a regulatory filing today.

This dragged other regionals down. As of 1:00PM EDT, regionals looked like this:

Related posts:

• Revisiting regional banks
• Regional banks: examples of risk from SoCal
• Michael Panzner: regional banks in trouble
• Regional banks are suffering
• Financial shares now diving

Regional banks have not suffered the writedowns suffered by the major banks and investment banks due to their lack of derivatives exposure. But, loose lending standards are starting to bite. The LA Times has an excellent story out, which details how the community or regional banks will be affected by the housing slowdown. Notice, it is construction and commercial real estate loans that are now hitting the regionals.

I fully anticipate most bankruptcies in the financial sector to come from community banks because of their lack of credit exposure diversification. So, this is a sector to watch as the downturn gathers steam.

When developer Empire Land sought protection in U.S. Bankruptcy Court in Riverside in April, its biggest debt by far — $5.1 million — was to PFF Bank & Trust.

Southern California’s oldest bank, PFF — formerly Pomona First Federal — had doubled its loan portfolio to $4 billion over the last decade, in large part by financing residential developers and builders of affordable housing in the Inland Empire.
-LA Times, 17 Jun 2008

Add these stories in SoCal to the stories coming from Ohio and the Midwest as harbingers for what to expect in other depressed and bubble markets.

Related Posts
KeryCorp craters after dividend cut
National City is on probation
What’s happening at Fifth Third?

See also: posts with ‘regional banks‘ label.

Related posts:

• More warnings on regional banks
• Wave of regional bank write-offs?
• Michael Panzner: regional banks in trouble
• What if a large US regional bank goes to the wall?
• Revisiting regional banks

This morning, I posted a blog entry regarding KeyCorp’s wise decision to cut its dividend and to raise capital. They paid the price in the market today, sinking to a 17-year low below $12.00 a share and down 24% on the day.

Shares of KeyCorp sank to the lowest level in almost 17 years, following news that the Cleveland-based financial services company will halve its dividend and raise about $1.5 billion to shore up its balance sheet.

The stock dropped $3.73, or 24 percent, to $11.98, and bottomed at $11.64 – its lowest point since July 1991.

In order to save about $200 million, annual dividends will be cut by 50 percent to 75 cents per share, starting in the third quarter.
-AP via Forbes, 12 Jun 2008

Market participants seem to have belatedly recognized the risk inherent in the balance sheets of U.S. regional banks due to the downturn in construction and commercial real estate loans. KeyCorp has lost nearly 35% in the last five trading sessions.

See: Credit Crisis Timeline for a full list of writedowns and capital raising by institution and a timeline of the credit crunch.

See also: Other posts under the label ‘regional banks.’

Related posts:

• KeyCorp to raise $1.5 billion, cut dividend 50%
• Regionals are exposed to credit crisis
• Fifth Third to raise $2 billion
• What’s happening at Fifth Third?
• Bank of America cuts its dividend

I have posted a few times on the problem surrounding an imminent writedown wave for commercial real estate (CRE) and construction loans in the US. A few days back, I had intended to post more about regionals. The Wall Street Journal had a good article about this problem, singling out Wachovia and Bank of America as the major banks most exposed to construction loans. The article begins

“While Wachovia Corp.’s residential-mortgage woes have gotten most of the blame for the ouster of Chief Executive G. Kennedy Thompson, another real-estate specter looms.

Wachovia has been the country’s second-largest maker of construction loans after Bank of America Corp., with $23.9 billion of debt outstanding to developers of single-family homes, condominiums, office buildings, stores and other commercial projects at the end of the first quarter, according to Foresight Analytics, a research company based in Oakland, Calif.”
-Wall Street Journal, 03 Jun 2008

Watch developments in CRE and construction loans because they will mean significant exposure to write-offs by smaller local banks.

Sources
After Mortgages, Construction Crisis May Be Building, Wall Street Journal, 3 June 2008
Community Banks Move into Mortgages; So, Too, Does Credit Crunch, HousingWire, 5 Jun 2008

See also:
National City is on probation
The Credit Crisis Timeline for a full list of writedowns by institution.

Related posts:

• Commercial property hits the front page
• Commercial real estate is next
• What if a large US regional bank goes to the wall?
• Global Bank write-offs and failures
• New Crisis Threatens Healthy Banks

The bad news in the financial sector keeps coming. Today, the news is about National City, a Cleveland-based regional bank in the US. The Wall Street Journal reports that the Office of the Comptroller of the Currency (OCC) has put Nat City on probation.

“National City Corp.’s banking unit, which has been buffeted by rising bad loans, has recently entered into a “memorandum of understanding” with federal regulators, effectively putting the bank on probation.

The confidential agreement with the Office of the Comptroller of the Currency was entered into over the past month or so. It illustrates the growing regulatory pressure some financial institutions are under as they struggle to deal with fallout from the credit-market turmoil.”
-WSJ, 06 June 2008

Apparently, they were at risk of failing. No wonder they raised all that money and were looking to be bought out by Fifth Third.

As you know, I think the regionals are going to be hammered these next few quarters by souring commercial real estate (CRE) and construction loans. They have much bigger exposure here since they were pushed aside in the residential mortgage lending deals by aggressive national operators. At least one of these institutions will go bankrupt.

If you are wondering how the market rallied to close way up yesterday after the MBIA and Ambac news, well you’re not alone.

Today, it’s Nat City and the bad employment report. Stay tuned.

Sources
National City Is Under U.S. Scrutiny, WSJ, 06 June 2008
Report: National City On ‘Probation’ With Banking Regulators, Housing Wire, 06 June 2008
May see bigger U.S. bank failures in future: FDIC, Reuters, 05 Jun 2008

See also: Other posts under the label ‘regional banks.’

Related posts:

• National City sold
• National City gets approval to raise cash
• National City Faces `Informal’ Probe Tied to Lending
• FDIC Friday Night Special: First National Bank of Anthony
• Market turmoil confirms FDIC’s tough position

The President of the Boston Fed, Eric Rosengren, has in effect said that small and regional banks are at risk in the next wave of writedowns for U.S. financial institutions. He sites construction loan exposure in particular as a place to worry. I give the story of small and regional exposure to construction loans six months before it hits the fron t page.

“To date, the financial market turmoil has impacted mostly large international banks, but smaller financial institutions may yet get dragged into the tumult, said Eric Rosengren, the president of the Boston Fed on Friday. A weak housing market has turned into one with “major declines” and have begun to impact some financial institutions that had taken outsized positions in construction loans or focused on other types of consumer debt, he said. Research into the collapse of housing prices in New England in the 1990s shows that foreclosure issues can last much longer than most economists assume, Rosengren said. Riskier loans in general have made delinquencies in this downturn about the same as the 1990s even though economic conditions are not as bad this year, he said. Should the economy worsen, the housing problem could become much more severe, he said.”
-MarketWatch, 30 May 2008

See: Credit Crisis Timeline for a full list of writedowns and capital raising by institution and a timeline of the credit crunch.

See also: Other posts under the label ‘regional banks.’

Related posts:

• Regional banks: examples of risk from SoCal
• Wave of regional bank write-offs?
• Regionals are exposed to credit crisis
• Revisiting regional banks
• New Crisis Threatens Healthy Banks

I am wary of regional banks for good reason. KeyCorp came out with a disastrous earnings report yesterday and was promptly whacked by the market. The regionals have way to much exposure to commercial real estate (CRE) and construction loans. And in the next leg down of this downturn, that is where losses may be centered.

This past weekend, Barron’s published an interview with Hedge Fund manager Sy Jacobs about his thoughts on financial stocks. You will see, he also is skeptical of banking stocks and sees more trouble ahead. The article begins:

Three years ago, Hedge-Fund manager Sy Jacobs told Barron’s that serious trouble was brewing in the housing market, predicting that “the bursting of the housing bubble [would] be a dominant theme for investing in financial stocks in the next decade.” He was right. Jacobs, 47, is the founder of New York’s JAM Asset Management, which runs two funds, both focused on financial stocks and closed to new investors. The larger entity, JAM Partners, follows a market-neutral, long-short strategy and has close to $300 million in assets. As of May 21, the fund’s year-to-date total return, net of fees, was 9.6%, versus a 4.5% loss for the S&P 500. Its annualized return since inception in 1995 (through April 30) was 16.6%, compared with 9.9% for the S&P.

He talks specifically about the CRE and construction loan exposure, where I am worried.

In a recent letter to your investment partners, you noted that you were very concerned about the health of construction loans. Could you elaborate on that concern for us?

I spent a week recently in California, visiting some troubled, or soon-to-be-troubled, banks. With home sales down so much, construction lending is becoming a problem. You have a lot of developers and home builders stuck with homes that aren’t moving. And they are sitting on lots that have loans against them. Subprime is such a small piece of the banking industry, but construction lending is a core product. If the housing market stays weak for much longer — and it seems to be getting weaker — construction-loan losses are going to be a big problem.

After the brutal real-estate recession that occurred in the early 1990s, there was a sense that banks had finally learned their lesson and would be much better fortified for the next downturn. I take it you don’t think that’s true.

I take a pretty cynical view of whether bankers have gotten smarter. We’ve had a real-estate bull market ever since the early 1990s. I think you are going to see the same thing again. The number of banks that get taken over by the FDIC and disappear may not be as high as it was in the late-1980s and early 1990s because there is strength in the energy patch now. But real-estate lending institutions are the bulk of the community-bank world, and I think you are going to see a lot of banks disappear.

The article goes on to ask Jacobs about his picks in the financial sector (questions from Barron’s in italics, answers from Jacobs then follow):

You’re a fundamental stockpicker, but are there any interesting trends you see in the financials?

One of our themes on the long side is that local plain-vanilla, over-capitalized community banks, especially thrifts, are in a position to gain back market share in the lending business. And they have real deposit franchises that they can fund themselves with. They have been losing market share to the Countrywide Financials [CFC]of the world for a generation. Now, though, they are going to gain a lot of that market share back, because they suddenly have a funding advantage, relative to the larger financial firms that have been securitizing their loans. That market has been discredited. We’re long lots of micro-cap ways to play this, but they’re too illiquid to mention here.

How about a different short holding?

Hudson City Bancorp [HCBK], which is based in New Jersey. The shares have gained about 60% from their July ‘07 lows and now trade at 21 times ‘08 estimates and two times tangible book. They have a wholesale funding and asset-generation strategy, which allows them to keep expenses low.

Fair enough. Let’s discuss some of your holdings, starting on the short side.

The first one is Wells Fargo [WFC], trading at 12 times ‘08 estimates and 2.7 times tangible book; the group trades at less than two times book. The Wells Fargo name has a storied past and gets the Warren Buffett halo effect because he owns a lot of the shares. But if you look back at the last real-estate recession in the early 1990s, the Wells Fargo side, focused on California, had a lot of credit problems in the real-estate area, and the stock underperformed during that period. The Norwest side, which has more exposure to the Midwest, still has a lot of consumer-credit exposure. Of particular concern is the bank’s portfolio of home-equity loans.

What’s the big worry there?

Home-equity line of credit (HELOC] is 16% of their portfolio. More than a third of their HELOC exposure is in California, which is now developing very badly on the home-price and employment fronts. And delinquencies and losses are already rising pretty sharply. But they also have a big unfunded exposure to the undrawn lines of credit. Also, despite their reputation for being conservative, their loan-loss reserve at the end of March was lower than their annualized charge-off rate for the first quarter. Given the prospects for rising losses that we see, that’s not conservative. We think they will disappoint this year and next and, as a result, their premium multiple will go down.

Wells Fargo, however, is known a
s a well-run bank. One example of that is the company’s reputation for being very effective at cross-selling its products.

We’re most concerned with their exposure to home-equity loans at the top of a real-estate bubble. Remember that home-equity lines of credit sit on top of first mortgages. So if home prices depreciate, which is what is happening now, and a home goes into foreclosure, the home-equity line often gets wiped out. The first mortgage holder can get most of their money back, but the home-equity line absorbs all of the loss.

Let’s move on to another short position.

BB&T [BBT], which operates in the Southeast. The stock trades at 11 times ‘08 earnings and 2.5 times tangible book. It’s bounced about 30% off its lows in January. They’ve gotten a pass because, to some extent, their core Carolina and Virginia real-estate markets were among the last to roll into home-price depreciation. So their non-performing assets are still low. But we listened to the Toll Brothers [TOL] conference [call] recently. [Chairman and Chief Executive] Robert Toll graded the markets they operate in and he gave Charlotte an F-minus for current home-building conditions and Raleigh a C-minus. We’re also concerned that they have 4% of their portfolio in Alt-A mortgages, which are between prime and subprime, and 20% in construction loans.

Long story, short: financials are a place where fortunes will be made and lost in this market.

See also: Other posts under the label ‘regional banks.’

Related posts:

• JPMorgan Chase: Large exposure to real economy downturn
• Regionals are exposed to credit crisis
• More warnings on regional banks
• Wave of regional bank write-offs?
• What Home-Loan Banks reveal about the effects of mark-to-market

The U.S. regional banks are certainly the next set of financial institutions in the U.S. that are going to get hit by the credit crisis. While these banks did not have significant exposure to the CDOs and RMBSs and other types of derivative instruments that have caused the majority of writedowns to date, they do have large exposure to the housing and construction industry.

The regional banks have significant amounts of construction and commercial property loans on their books. When I talk about regional banks, I mean banks like Fifth Third, KeyCorp, AmTrust and others with strong regional franchises, but without a national presence like the banks which have written off large amounts in the subprime crisis to date.

KeyCorp is the canary in the coalmine as they have just announced large losses on their loan portfolios and have suffered their worst one-day decline since the Crash of 1987. As the subprime crisis morphs into a credit crisis and a recession, with increasing effects on the real economy, expect the regionals to become more severely burdened.

KeyCorp fell the most since the stock-market crash of 1987 after doubling its forecast for loans that won’t be repaid, prompting concern that regional banks have underestimated the cost of bad mortgages.

KeyCorp sank 10.6 percent in New York Stock Exchange trading after saying uncollectible debts may be as much as 1.3 percent of average total loans this year. The figure may rise even more, KeyCorp said, as the Cleveland-based company cuts holdings tied to homebuilders.

The revision by the Ohio bank, which last month quadrupled its provision for loan losses to $187 million, may foretell similar increases at U.S. commercial banks as home prices keep sliding, analysts said. The S&P/Case-Shiller home-price index fell 14.4 percent in March to the lowest since figures were first published in 2001, data released yesterday show.

“Things are getting significantly worse before they are going to get better for KeyCorp and the banking industry,” RBC Capital Markets analyst Gerard Cassidy said in a note to investors today. He rates KeyCorp “underperform.”
-Bloomberg, 28 May 2008

See also: Other posts under the label ‘regional banks.’

Related posts:

• KeyCorp craters after dividend cut
• New Crisis Threatens Healthy Banks
• More warnings on regional banks
• What if a large US regional bank goes to the wall?
• Commercial real estate is next