After a huge fall off in credit consistent with the fall in nominal GDP, we are seeing credit stabilise at a lower level. Debt to GDP ratios may not be lower, but as GDP is lower, so too is credit in the system.  Yet there is a large difference between the haves and the have-nots, largely due to a difference in which banks received government largesse and which did not.

Bank analyst Don Coxe puts this in perspective for us:

A sustained U.S. economic recovery is unlikely until all banks, and not just the big institutions bailed out with government funds, start to recover from the effects of the financial crisis, according to longtime investment strategist Don Coxe.

Many banks that got funding from the government have seen their shares soar, while smaller, regional banks have not.

That’s a sign that investors believe the smaller banks are less well placed to participate in, and contribute to, the economic recovery, said the chairman of Coxe Advisors LLC in Chicago, who advises clients of the BMO Financial Group.

Think big banks – big business, small banks-smaller business.  In effect, the credit flow for large multinationals is now back to normal.  However, like consumers, small and medium-sized enterprises (SMEs) are finding a tougher reception. Revolving credit lines are being cut and loans are harder to come by (one reason Warren Buffett and Goldman Sachs are stepping into this space in this crucial holiday season).

This is a case of supply and demand constraints. One the one hand, credit supply is constrained because regional financials are loaded down with bad debts and have not received the same measure of bailout money that big banks have.  On the other hand, SMEs are having to downsize and are demanding less credit.

"The thousands of regional U.S. banks on which an economic recovery depends have not participated in the sudden explosion of trading profits" of the biggest five U.S. banks, he said.

The state aid granted to large banks during the financial crisis has convinced investors the government will step in again in future to save the behemoths if needed. That has helped pull share prices back up from the 12-year lows hit in March.

By contrast, as more commercial real estate loans turn bad in the still-feeble economy, regional and community banks are struggling.

A key gauge of the gulf between big banks and smaller lenders is the KBW Regional Bank Index exchange traded fund (KRE.P). The ETF’s recovery has lagged the rebound in shares of the biggest five U.S. banks, said Coxe.

"There will not be the kind of sustained U.S. economic recovery that will drive a sustained U.S. bull market until the shares of the Main Street (KRE) banks begin to outperform" both those of the biggest five banks and the S&P 500 index .SPX, he said.

Small bank index suggests recovery is elusive – Reuters

Related posts:

• More warnings on regional banks
• Regionals are exposed to credit crisis
• Michael Panzner: regional banks in trouble
• Relative value in financial services
• Fifth Third takes on assets of Freedom Bank

This is just in from the FDIC (emphasis added below). It should make clear that the banking system is still weak:

Credit quality declined sharply for loan commitments of $20 million or more held by multiple federally supervised institutions, according to the 32nd annual review of Shared National Credits (SNC).

The credit risk of these large loan commitments was shared among U.S. bank organizations, foreign bank organizations (FBO), and nonbanks such as securitization pools, hedge funds, insurance companies, and pension funds. Credit quality deteriorated across all entities, but nonbanks held 47 percent of classified assets in the SNC portfolio, despite making up only 21.2 percent of the SNC portfolio. U.S. bank organizations held 30.2 percent of the classified assets and made up 40.8 percent of the SNC portfolio.

The 2009 review covered 8,955 credits totaling $2.9 trillion extended to approximately 5,900 borrowers. Loans were reviewed and categorized by the severity of their risk—special mention, substandard, doubtful, or loss—in order of increasing severity. The lowest risk loans, special mention, had potential weaknesses that deserve management attention to prevent further deterioration at the time of review. The most severe category of loans, loss, includes loans that were considered uncollectible.

Key findings were:

• Criticized assets, which included SNCs classified as special mention, substandard, doubtful, or loss, reached $642 billion, up from $373 billion last year, and represented 22.3 percent of the SNC portfolio compared with 13.4 percent in 2008.
• SNC commitment volume increased $92 billion, or 3.3 percent, while the number of credits remained virtually unchanged.
• Classified assets, which included SNCs classified as substandard, doubtful, or loss, rose to $447 billion from $163 billion and represented 15.5 percent of the SNC portfolio, compared with 5.8 percent in 2008. Classified dollar volume increased 174 percent from a year ago.
• Special mention assets, which exhibited potential weakness and could result in further deterioration if uncorrected, declined to $195 billion from $210 billion and represented 6.8 percent of the SNC portfolio, compared with 7.5 percent in 2008.
• The severity of criticism increased with the volume of SNCs classified as doubtful and loss rising to $110 billion, up from $8 billion in 2008. Loans in nonaccrual status also increased nearly eight times to $172 billion from $22 billion. Nonaccrual loans included $32 billion in credits classified as loss and $56 billion classified doubtful…
• The review identified significant deterioration in credit quality of leveraged finance credits, with these loans representing more than 40 percent of the dollar volume of total criticized assets. About 72 percent of the dollar volume of the 50 largest leveraged finance SNCs were criticized, which represents one-third of all criticized assets.
• Underwriting standards in 2008 improved from prior years, with examiners identifying fewer loans with structurally weak underwriting characteristics compared to credits written in 2007 and 2006. However, the SNC portfolio contained loans with structurally weak underwriting characteristics that were committed before mid-2007 that contributed significantly to the increase in criticized assets.

New credit standards are improving. But, due to old loans, credit quality is not increasing. It is decreasing.

Related posts:

• UBS to write down but has massive Tier 1 capital
• Moody’s anticipates huge increase in leveraged loan defaults
• Credit in the US is collapsing
• UBS is sitting on billions in bad student loans
• Quality financials are out there

Last week, I highlighted some of the ideas of Australian economist Steve Keen in my post, “Politics and reform: Say I’m a politician….”  Keen is of the Minsky camp and he believes that an unsustainable debt bubble has build up in the industrialized world which can only be brought to heel through a ‘debt jubilee.’

Below is a video clip of Keen telling Max Keiser a bit more about how he sees things.  Central to his ideas is the concept that demand for credit creates loans which create reserves, which is the opposite causality of what one sees in neoclassical economics.  This would mean that, absent a pickup in demand for credit, inflation is unlikely to reappear – irrespective of what central banks do. I will have more on this subject in later posts.

Related posts:

• Chart of the day: Excess Reserves
• Steve Keen and the spectre of terminal debt
• Steve Keen: Debt and the economy – how do we pay for all of this?
• Is quantitative easing really inflationary?
• Connecting Fed cuts with credit writedowns and quantitative easing

In late June, I posted two items China’s present growth story is built on malinvestment and Chinese stock market bubble inflating, on the building bubble in Chinese lending and asset markets.  The crux of the pots was that China, in its efforts to reflate the economy to meet very high growth short-term targets and start a new domestic demand dynamic, was creating a credit bubble. Much of the lending mandated by Chinese authorities was finding its way into housing and shares, inflating those markets in an unsustainable way.

Chinese authorities are onto this and have decided to act.  The Financial Times reports.

Chinese regulators on Monday ordered banks to ensure unprecedented volumes of new loans are channelled into the real economy and not diverted into equity or real estate markets where officials say fresh asset bubbles are forming.

The new policy requires banks to monitor how their loans are spent and comes amid warnings that banks ignored basic lending standards in the first half of this year as they rushed to extend Rmb7,370bn in new loans, more than twice the amount lent in the same period a year earlier.

Beijing’s concerns are echoed in other countries across the region, most notably South Korea, where the government says it is taking steps to cool a real estate bubble, and Vietnam, where the government has ordered state banks to cap new lending to head off inflation.

The situation in much of Asia is very different from most Western economies, where governments have flooded the financial system with liquidity to encourage unwilling banks to lend more.

In China, regulators are now concerned that too much money is being lent by the state-controlled banks and the country’s tentative economic rebound could come at the cost of a stable financial system…

The flood of new lending also has implications for the quality of bank loans and the country’s overall growth.

“China’s economic recovery is being constructed on the back of a savaged banking system,” said Derek Scissors, a research fellow at the Heritage Foundation in Washington. “Tens of billions – and perhaps hundreds of billions – of dollars of loans will not be repaid.”

He points out that in recent years total loan growth of around 15 per cent has supported gross domestic product growth of higher than 10 per cent but in the first half of this year total loan growth of around 33 per cent supported GDP expansion of only 7 per cent.

“China’s economic policies have shifted from being unsustainable over the very long term to being unsustainable for any more than one year,” Mr Scissors said.

These accounts are not intended to malign the Chinese in any way.  After all, the US led the way in the last decade in regards to reckless lending and unsustainable growth. And the Chinese have much greater savings with which to cushion a fall i assets prices. What’s more, whether we like it or not, an authoritarian central government in China is better able to handle economic shocks simply through coercion.

But these accounts should cause you some concern if you are invested in China’s asset markets and think the uptrend there  can last indefinitely.  To be sure, we should take heart that Chinese authorities are looking to step in and reduce the excess liquidity.  Nevertheless, it sounds a lot more like jawboning than true regulation of the excesses.  In my view, animal spirits are too high for this to have much effect.  Authorities will have to take more draconian action.

The real question is whether the Chinese can foster more domestic demand before any ill effects from the present malinvestment become manifest.  If so, we should expect growth to continue with only a little hiccup.  My worry is that we are seeing the makings of a bust which could have wide-reaching consequences for China and the global economy.

Source

China warns banks over asset bubbles – FT

Related posts:

• Chinese stock market bubble inflating
• Stephen Roach sees a W-shaped recovery for China
• The world’s biggest bank is Chinese
• Marc Faber: China’s numbers are fake
• China: Growth on track but at what cost?

Credit is still tight despite the low Libor rates and other signs that market stress has died down. Case and point is an item I ran across on the Norwegian site E24. Apparently, Amsterdam is losing revenue as its prostitutes in the red light district cannot get credit.  Here is my translation of the story:

The City Council in Amsterdam is turning its attention to a pressing problem. One of the city’s key industries is struggling to obtain credit and banking. And it will now take elected officials to clear things up, reports Reuters.

The city’s red light district is known for women which lure customers through tiny windows with even tinier clothing. But despite the activities being completely legal, many banks do not want these women as customers.

The City Council will put an end to this. As part of a facelift for the De Wallen neighborhood, which also includes the red light district, the City Council has been asked to help bordello owners and employees to make banking connections more accessible.

Over the course of two months, a solution will be put in place that can help the industry. But the City Council will not establish or sponsor a separate sex bank, as reported by a local newspaper.

It’s a somewhat amusing little story, but the overall point is clear.  Credit is still restrictive the world over and that means deleveraging is still continuing apace.

Bankkrise for prostituerte – E24

Related posts:

• Bank of Canada blames Geithner for financial mess
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• Bloomberg wins Freedom of Information lawsuit against Fed
• Bloomberg News vs. Fed: Judgment against Fed attached
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Credit in Spain is contracting at an unprecedented rate, down 33% in the first quarter as Spain faces a housing bust and near 20% unemployment. Below is my translation of part of a Spanish-language article explaining the situation.

Consumer credit fell by 33.7% in the first quarter, to €5.796 billion, and late payments rose to 17.54%, according to the National Association of Financial Institutions Credit (Asnef).

Of this total, 4.254 billion euros corresponded to consumer goods, which fell by 23.9% and 1542.3 million euros to the automotive sector, which fell by 51%.

Asnef stressed that the fall in the consumer sector has been mainly due to losses on personal loans, due to the sharp decline in the credit available for consumer goods and by the contraction of revolving credit associated with credit card usage.

Specifically, consumer goods fell by 30% to 882.9 million, revolving credit card loans by 14.5% to 3.142 billion, and personal loans by 65% to 227.9 million euros.

With regard to late payments, the financial institutions put their rate at 8.03% and by activity, consumer credit stood at 17.54%, while in the automotive sector, it stood at 13.70%.

The total number of contracts signed during this first quarter was 1.64 million, representing a 27.6% lower over the same period last year, of which 1.5 million were for consumers, at an average 2,720 euros, 5.7% less, and 119,822 automotive contracts, at an average of 12,870 euros, 45.7% less.

Clearly, these are disastrous numbers.  This is one reason that ratings agencies have been downgrading Spanish banks.  I expect more bank failures or bailouts in Spain in the coming months.

Source

La morosidad se eleva hasta el 17% en los créditos al consumo – Finanzas

Related posts:

• Credit in the US is collapsing
• Chart of the day: consumer credit growth
• Spain: savings banks suffer while BBVA and Santander expand
• Spanish local governments struggling with bust
• Spain intervenes to save Caja Castilla La Mancha

FT Alphaville is reporting that the credit rating agency Fitch puts credit card losses at 10.4% of outstanding loans.  This is a record.  Bad news if you are a credit card company.  So, what does one do in that situation?  You raise rates on customers that are paying, silly.

Citi’s rate increases emerged on the day the government proposed legislation to create a new regulator with sweeping powers on consumer protection and a week after the bank was attacked by some politicians for raising employees’ salaries.

Holders of co-branded cards who failed to pay their balance in full at the end of the month saw their rates rise by an average 24 per cent – or nearly 3 percentage points – between January and April, according to a Credit Suisse analysis of data from the consultancy Lightspeed Research.

Now, remember, insurance companies do the same thing- jack up rates for those that can pay to make up for the losses on those that can’t pay.  But, the optics here are not good – with Citi being bailed out by government and Obama calling for consumer protection at the same time as Citi is piling on interest.  It should be interesting to see if the Obama people have anything to say about this.

The Alphaville post by Stacy-Marie Ishmael is interesting because it does suggest that off-balance sheet losses are going to be an issue here.

I have two thoughts on the larger issue of credit cards.

1. The banks to watch are Citi, JPM and BofA, and Capital One as they all have huge credit card outfits.  My eyes are on JPM because they are the bellwether of the industry now.  Back in November, I warned that they were highly leveraged to the real economy. So, while they have escaped fairly well to date, let’s see what kind of beating they take going forward.  This will be instructive to the health of U.S.banking.
2. One would normally expect a slew of writedowns.  After all, it was writedowns on marketable securities which blew up the credit crisis in 2007 and 2008.  But FASB has fixed this problem.  So, let’s see how many writedowns result.  In truth, credit card debt used to be discharged in consumer bankruptcy.  But, the credit card lobby fixed that problem in 2005.  Now, the credit card companies may still be able to get their pound of flesh even if one files for bankruptcy. The key is whether you have a job or not due to a new bankruptcy means test.  The long and short for me is this: in the real world, since a high percentage of people defaulting on credit cards have lost jobs, we should expect the recovery rate to be much lower due to debt discharge in bankruptcy.  This should lead to a lot of writedowns at the likes of Citi, PM and BofA.  But, given recent FASB guidance on accounting for mark-to-market, it is anyone’s guess at this point.

Any way you look at it, though, higher loan losses mean less revenue.  How this gets reported over the near term is another matter altogether.

Related posts:

• Consumer loan delinquencies paint bleak picture
• More credit card writedowns are coming
• Amex: paying cardholders to close accounts
• Citi close to selling German unit
• $35 billion in missing writedowns

Late last year, I predicted that China, as a major exporter to the West, would feel a huge impact from the meltdown in the global economy, taking it’s growth rate down to 2% (See Top ten predictions for the 2009 global economy). Forgetting about the fact that data are highly suspect in China, I see that prediction as very unlikely to come true due to huge fiscal stimulus in China. The Chinese government is very much wedded to its 8% growth target and will do whatever it takes to come close to that target – including flooding the domestic banks with a wall of money to lend.

However, preventing a downturn with easy money is a dangerous way to reflate the economy. The likely malinvestment will be large, something about which Andy Xie has recently warned.  Moreover, despite the implosion in house prices and shares in the Chinese market during the acute phases through to November 2008, a bubble has re-asserted itself there.  In a recent post, “Does Ben Bernanke blow bubbles too?,” I referred to research by James Montier, now at GMO, which indicated that large increases in liquidity can and will reinflate bubbles even in the face of investors who feel chastened by a previous downturn.  This seems very much to the point in China, where equity prices have risen some 60-odd percent since the trough in November.

Of course, all of this can continue for quite some time. And the Chinese are pulling out all the stops as the recent note by Marc Chandler, Chief Currency Strategist at Brown Brothers Harriman, attests.

There are several developments to note in China.

First, with deflationary forces still gripping the economy (year-over-year CPI has been negative by more than 1% since Feb), weakness in exports, Chinese officials are unlikely to allow the yuan to appreciate very much during the second half of the calendar year.  The pricing of the non-deliverable forward implies expectation for less than 1% appreciation against the dollar over the next 12-months, the smallest expected gain in a couple of months.  Next month will be the one year anniversary of the Chinese decision that in essence appears largely tantamount to re-pegging the yuan to the greenback.  It has been confined to a little more than a 1% range since.  Recall that under the fixed exchange rate regime of Bretton Woods, currencies were allowed to move in 1% bands.  Last July the pricing of the 1-yr yuan NDF implied a 6% appreciation.

Second, the 63% rise in the Shanghai Composite Index has been among the world’s top equity markets in H1 09.  The story is often told is that the large fiscal stimulus efforts has ensured that the economy will gain new traction.  Yet the stimulative measures are impacting perhaps in a way different from the conventional narrative.  Part of the stimulative measures, included removing curbs on bank loans.  Bank loans in China have surged by CNY5.8 trillion.  The rating agency Fitch warned earlier today of the dangers of the massive rise in lending.  Part of the lending–some reports suggest as much as 20% or some $170 bln–has found its way into the equity market.
Third, China and Hong Kong are expected to sign an accord shortly that will allow the settlement of bilateral trade to be conducted in yuan.  Back in April the PBOC announced it would let Shanghai and 4 other cities in the Gungdong province to begin settled traded in yuan.  China subsequently announced CNY650 bln (~$95 bln) in swap lines with a handful of countries, including Argentina, Belarus, Hong Kong, Malaysia and South Korea.  Since Hong Kong is a special administration region for China that a greater share of its bilateral trade is settle in yuan is hardly earth-shattering, but there may be some interesting implications.  Often Hong Kong is used by China and its trading partners to conceal trade as goods often get re-exported from HK.  China and its trading partners often disagree on how such trade should be counted.  More importantly, it takes more than diktat to determine an invoicing currency.  As the SAFE (the State Administration of Foreign Exchange) made clear today, China recognizes that the US dollar will continue to dominate global trade.  China’s desire for the yuan to be more of an international currency and invoicing currency is not greater than its desire to maintain firm control of the currency.   This is to say, China’s ambitions are continue to hemmed in by the realities of a currency that is still not convertible.

The Chinese government is committed to 8% growth for 2009. Hence the massive stimulus and bank lending. But, as Chandler notes, it is doing its best to transition away from an export-led dynamic over the longer-term. Hence, the numerous reports of China doing trade in Yuan and buying up commodities with its U.S. dollar stash.

So, where does that leave us over the medium-term?  In my view, it leaves us in a situation in which the Chinese economic policy is supportive of commodity prices and economic growth worldwide.  To the degree that medium-term economic recovery in the West is dependent on Chinese stimulus, we should feel confident that things are looking good.

The longer-term is quite a bit more murky and here I want to transit to a rather more sinister outlook as established by Ambrose Evans-Pritchard in the Telegraph at the weekend.  Evans-Pritchard sees malinvestment as a worry and quotes from a Fitch rating agency report which says an enormous spike in non-performing loans at Chinese banks is likely.

China’s banks are veering out of control. The half-reformed economy of the People’s Republic cannot absorb the $1,000bn (£600bn) blitz of new lending issued since December.

Money is leaking instead into Shanghai’s stock casino, or being used to keep bankrupt builders on life support. It is doing very little to help lift the world economy out of slump.

Fitch Ratings has been warning for some time that China’s lenders are wading into dangerous waters, but its latest report is even grimmer than bears had suspected.

“With much of the world immersed in crisis, China appears to be one of the few countries where the financial system continues to function largely without a glitch, but Fitch is growing increasingly wary,” it said.

“Future losses on stimulus could turn out to be larger than expected, and it is unclear what share the central and/or local governments ultimately will be willing or able to bear.”

Evans-Pritchard also quotes from Andy Xie who sees the massive over-stocking of commodity inventories in China as an accident waiting to happen, one which will precipitate a double-dip downturn.  While this makes good copy for bearish doom and gloom forecasts, it is a scenario about which we should be worried.

In reality, this crash scenario is pure but not idle speculation.  What seems clear is that the medium-term is looking more positive due to the huge surge in liquidity in China’s domestic economy.  This seems to be a gambit by the Chinese to spur enough domestic demand over the medium-term such that when the next global downturn hits, the Chinese will be insulated from U.S. dollar and America-related events. But, the Chinese are blowing serious bubbles, expanding excessive amounts of credit, and creating serious malinvestments.  In short, the Chinese are playing a dangerous game. If they lose, everyone in the global economy will lose with them.

Related posts:

• China issues bonds to “promote the RMB in neighbouring countries”
• Chinese to start settling trade in Yuan
• China: Growth on track but at what cost?
• Mea culpa on the need for a new currency
• China “serious about the plan to internationalise” Yuan

This is a very good explanatory piece from CNBC on how counterparty credit risk makes the credit default swap market a financial weapon of mass destruction.  Note they are not talking about eliminating the CDS market, but merely regulating and standardizing it to prevent a potentially catastrophic domino effect.

Related posts:

• Lehman Brothers: a primer on Credit Default Swaps
• Definition of the day: the law of unintended consequences
• Treasury credit default swaps rise dramatically
• Glencore: credit default swaps suggest something amiss
• CDS Market: Did Fannie and Freddie Default?

Reuters is reporting that the dissident Chrysler lender group has disbanded. Apparently, the lenders have finally figured out that they have zero chance of getting what they want as I have been saying all along (see posts here and here).  Let’s see what is in store at General Motors now.

A group of Chrysler LLC’s dissident lenders disbanded, representatives said on Friday, removing the last legal hurdle to the embattled automaker’s quest to complete a merger with Italy’s Fiat SpA with U.S. government backing.

"After a great deal of soul-searching and quite frankly agony, Chrysler’s Non-TARP lenders concluded they just don’t have the critical mass to withstand the enormous pressure and machinery of the US government," said Tom Lauria, the White & Case attorney representing the group.

But Lauria said the group did not intend to agree to the proposal to exchange their debt for 29 cents on the dollar.

Good luck with that.

Source

Chrysler dissident lender group disbands – Reuters

Related posts:

• The case of the dissident Chrysler bondholders
• A Case Of Gangster Government?
• Opel and Fiat spells bankruptcy for Chrysler and GM
• Lawsuit: steering mortgage applicants could mean more writedowns
• Wow, judges now nixing lenders’ foreclosure claims entirely in court

Of course you know I think credit cards are going to produce a tsunami of writedowns, right? Things are looking more and more like that tsunami is right around the corner:

Credit card writedowns soared to record levels in February, representing an all-time high in the 20-year history of the Moody’s Credit Card Index, as job losses mounted, the rating agency said Wednesday.

Credit card charge-offs, the writedown of uncollectable debt, advanced decisively to 8.82% in February, marking the sixth consecutive month of increases. The level, is more than 300 basis points higher than a year ago.

Sharp increases were experienced across several large issuers and have closely followed the surges in unemployment occurring over recent months, the rating agency said.

“We expect that the charge-off index will threaten double digits by the end of the year, in light of our expectation that the economy will worsen throughout the remainder of the year,” Moody’s said.

It predicts the charge-off rate index will peak at about 10.5% in the first half of 2010, assuming a coincident unemployment rate peak at 10%.

Certainly, I have said the Geithner plan, increasingly dubious as more details emerge, COULD actually work at restoring banks to health. But, if we do get the writedowns I anticipate, the banks will be right back where they started and Plan B will be necessary.

Source
Credit card writedowns hit record high: Moody’s – Financial Post

Related posts:

• AMEX credit card trouble deepens bank worries
• What’s in your wallet? Probably higher interest rates.
• Connecting Fed cuts with credit writedowns and quantitative easing
• Auto Loan ABS market best of the bunch
• Consumer credit down a massive 33% in Spain

Recently, I posted a Wall Street Journal article that suggested smaller banks and new banking enterprise can supply the lion’s share of additional credit needed for the U.S. banking system. While President Obama is off meeting the heads of the big banks, we should keep in mind that there are other institutions out there that can bring the U.S. credit markets back to life.

I am not the only one making this case. Meredith Whitney has also been vocal about the need to start focusing on community and regional banks.

Below is a CNBC video with Frank Sorrentino, the North Jersey Community Bank chairman/CEO lamenting the lack of attention they are getting.

Also see this video of Meredith Whitney talking about her view of the future of the banking industry, the demise of big banks and the rise of small banks. Great stuff. (PS. – the associated article also quotes me, so, of course I like it!).

Related posts:

• Meredith Whitney seems onboard with the fake recovery
• Bill Miller and Meredith Whitney: The Bull and the Bear
• Meredith Whitney says nationalization is wrong and banks will lose money
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This comes via Angus Robertson at Research Recap. Just as the RMBS post yesterday confirmed, moe writedowns are coming in other credit classes:

In a trend likely to accelerate in 2009, the default rate on bank loans to speculative-grade corporations rose sharply in 2008 and recovery rates on leveraged loans dropped over the same period, according to a new study from Moody’s Investors Service.

“Given tight credit markets, a worldwide economic slump, and a deteriorating issuer ratings mix, we expect default rates on leveraged loans will continue to climb in 2009, while recovery rates are expected to fall further,” said Sharon Ou, Assistant Vice President in Moody’s Credit Policy Default Research Group.

Moody’s U.S. leveraged loan default rate ended 2008 at 3.5%, up from the 0.3% recorded in 2007.

The ratings agency forecasts that 11.1% of U.S. leveraged loan issuers will default by the end of 2009.

First-lien loan recovery rates fell to 63.4% at the end of 2008, down from 68.6% at the beginning of the year. By comparison, senior unsecured bond recovery rates dropped from 61.8% to 33.0% during the same period.

Across industries, the Hotel, Gaming, & Leisure sector together with the Construction & Building sector accounted for almost one fourth of the loan defaulters in 2008. Measured by default volume, the most troubled sectors were Construction & Building with 21% of total volume and Diversified Media with 19% of total volume.

Related posts:

• Auto Loan ABS market best of the bunch
• JPMorgan Chase: Large exposure to real economy downturn
• Consumer loan delinquencies paint bleak picture
• New Writedown Risk: Alt-A
• Credit quality deteriorates in 2009

With the shadow banking system of hedge funds and non-bank financial institutions in shambles and the banking system’s credit shrinking, U.S. government officials are desperate to get credit into the system any way they can.  A key part of that is the TALF, which is a back-door recapitalization of the shadow banking system, albeit not yet with the necessary regulatory oversight to prevent future excess leverage.  

One often overlooked piece to this puzzle is fresh capital injecting into brand new lending institutions.  The Wall Street Journal has a good article today demonstrating banks are still opening. (Hat tip Judith) And depositors are rushing in.

In late January, as U.S. bank stocks tanked on nationalization fears, tiny Hanover Community Bank on Long Island opened for business.

The Garden City Park, N.Y., bank was swamped with customers, and a push to lure $20 million in cash by selling certificates of deposit attracted $43 million. As investors fled the stock market, some brought Hanover as much as $1 million at a time according to bank officials.

While the U.S. financial system is going through its worst crisis since the Great Depression, it is a great time to start a bank, some observers say. Former Federal Reserve Chairman Alan Greenspan recently claimed he would open one himself if he were 50 years younger. The return on capital could be impressive, the 83-year-old Mr. Greenspan said in an interview.

In the past year, 78 banks have opened their doors in the U.S., according to the Federal Deposit Insurance Corp. That is down from 173 that opened in the previous 12 months and 184 a year before that.

One big reason for the slowdown in bank start-ups is the typical battery of tests of a new financial institution’s capital, earnings prospects, management and risk profile. The recession is making it much tougher for some fledgling banks to clear all those hurdles, which is required in order to get FDIC backing on customers’ deposits. Luring investors is also tough.

“We had a couple of applications that we approved and the applicants couldn’t raise the necessary capital,” said David Barr, an FDIC spokesman.

Still, it is significant that any new banks are opening in the U.S. given the industry’s woes, including the fourth-quarter net loss of $26.2 billion by federally insured commercial banks and savings institutions. Nearly a third of financial institutions reported a loss for the quarter, according to the FDIC.

Start-up banks lack name recognition and customers. These days, though, they have one important advantage over just about every established rival: no crummy loans.

“We have that clean slate,” said Robert Long, co-chairman and founder of Hanover.

Meanwhile, generally tight credit conditions are helping the upstarts be especially persnickety about choosing who gets their loans. And the gap between the cost of funds and the money that can be made on loans is widening, meaning the likelihood of good profit margins.

An uptick in bank openings could help the economy as their start-up capital is converted into loans to businesses and consumers, said Christopher Marinac, a managing principal and research director at FIG Partners LLC, a bank-research firm in Atlanta. While banks of all sizes have said they are making every good loan they can, some are weighed down by all the bad loans made when times were good.

With no black eyes yet, start-up banks also look appealing to depositors who are looking for a safe place to park their cash — or are just tired of seeing their bank in somber headlines. A survey of 743 small banks released last week by the Independent Community Bankers of America found that more than half had seen deposits increase due to new customers, even after the financial crisis got much worse in September.

Hanover executives, who plan to target the Indian community around the bank’s hometown, started raising capital in 2007. “We wanted to sort of go back to the old days” of small banks with close relationships with their customers, Mr. Long said.

Mr. Long and Geevarghese Mathai, another mortgage banker who helped launch the bank, thought it would take just 30 days to get FDIC clearance. Instead, it took nearly a year, and Hanover’s organizers had to reformulate their plans a couple of times along the way.

“People would say to us: ‘Why should I invest in your bank when I can invest in Citibank?”‘ Mr. Long recalled.

At the end of the day, getting the economy re-started is all about freeing up credit to credit-worthy borrowers, so this account is a very heartening tale. Signs of renewed life in credit flow will be a key signal that the economy is about to rebound. I will be looking for those signs and post when information becomes available.

Below is the link to the full WSJ post including pictures and charts.

Source
It’s a Great Time to Start a Bank – WSJ

Related posts:

• FDIC moves in at Great Basin Bank
• Citizens Community Bank goes under
• Westsound Bank seized by FDIC
• Bank seizures 35 and 36 by the FDIC
• Fifth Third takes on assets of Freedom Bank

Below is an interview with an expert on the issue of mortgage cramdowns.  Basically, this issue is all about debt forgiveness for borrowers and writedowns for lenders.  Lenders do not like cramdowns for that reason.  See below for a view on cramdowns from Paul Van Valkenburg of the Mortgage Industry Advisory Corp.

Warning: you should expect him to have a negative bias given who he works for. I actually like cramdowns. Van Valkenburg is looking at this from an investor’s perspective and wants senior creditors not to be negatively impacted by the coming cramdown legislation. Nevertheless, I am posting this video because it is informative as to the impacts on mortgage-backed securities, mortgage servicing and housing.

Related articles
Cram down – Wikipedia

Related posts:

• On BBC World Service talking autos at 2PM Eastern
• Bank failures to surge in coming years
• Quote of the day: Wells and BofA are choking on acquisitions
• Cramdowns and refis won’t need appraisals
• Bloomberg is coming down hard on Goldman

The following article comes from Absolute Return Partners’ Niels Jensen. Absolute Return Partners LLP is a London based private partnership which provides independent asset management and investment advisory services globally to institutional as well as private investors, charities, foundations and trusts. Visit www.arpllp.com to learn more about them.  You can reach them by email at info@arpllp.com.

Update 05 Mar 2009: I should note that Niels makes mention of edits to an article in the Telegraph about European toxic asset exposure which I also spotted in my post “Are European banks sitting on 16.3 trillion in toxic assets?”

Now, Niels Jensen:

The Absolute Return Letter March 2009

“Many of today’s policy proposals start from the view that “greed” and “incompetence” and “poor risk assessment” are the ultimate source of what went wrong. In fact, they were not the true cause at all. Moreover, even if they had been, it is fatuous to think that we will now create a post-crash generation of bankers and traders who are not greedy, much less a new generation of quants who will be able to assess and manage risks much better than “the idiots” who have brought us to the current abyss. Greed cannot be exorcised. Nor can the inherent inability of any quants to determine the “true” probability distributions of all-important events whose true probabilities of occurrence can never be assessed in the first place.”

Woody Brock, SED Profile, December 2008

Policy mistakes ‘en masse’

The last few weeks have had a profound effect on my view of politicians (as if it wasn’t already dented). All this talk about capping salaries for senior bank executives is quite frankly ridiculous. It is Neanderthal politics performed by populist leaders. That Gordon Brown has fallen for it is hardly surprising but I am disappointed to see that Barack Obama couldn’t resist the temptation. The mob wants blood and our leaders are delivering in spades. The stark reality is that we are all guilty of the mess we are now in. For a while we were allowed to live out our dreams and who was there to stop us? Policy mistakes – very grave mistakes – permitted the situation to spin out of control. From the U.S. Federal Reserve Bank under the stewardship of Alan Greenspan being far too generous on interest rates to the British Chancellor of the Exchequer -who now happens to be our Prime Minister – advocating ‘Regulation Light’.

Policing must improve

If you really want to prevent a banking crisis of this magnitude from ever happening again, the focus should be on the way banks operate and not on how much they pay their staff. And, within that context, any discussion must start and end with how much leverage should be permitted. The French have actually caught onto that, but their narrow-mindedness has driven them to focus on hedge funds’ use of leverage which is only a tiny part of the problem. It is the gung ho strategy of banks which brought us down and which must be better policed. And guess what; if banks were better policed – and leverage restricted – then profits, even at the best of times, would be much smaller and there would be no need to regulate bankers’ compensation packages.

It is pathetic to watch our prime minister attacking the bonus arrangements of our banks when the UK Treasury, on his watch, spent £27 million pounds on bonuses last year as reward for delivering a public spending deficit of 4.5% of GDP at the peak of the economic cycle. Even my old mother understands that governments must deliver budget surpluses in good times, allowing them more flexibility to stimulate when the economy hits the wall. What Gordon Brown has done to UK public finances in recent years is nothing short of criminal.

So, with that in mind, let’s take a closer look at the European banking industry. The following is not pretty reading. I have rarely, if ever, felt this apprehensive about the outlook. So, if the crisis has made you depressed already, don’t read any further. What is about to come, will make your heart sink.

More leverage in Europe

Let’s begin our journey by pointing out a regulatory ‘anomaly’ which has allowed European banks to take on much more leverage than their American colleagues and which now makes them far more vulnerable. In Europe, unlike in the US, it is only risk-weighted assets which matter to the regulators, not the total leverage ratio. European banks can therefore apply a lot more leverage than their US counterparties, provided they load their balance sheets with higher rated assets, and that is precisely what they have been doing.

That is fine as long as you buy what it says on the tin. But AAA is not always AAA as we have learned over the past 18 months. Asset securitisations such as CLOs proved very popular amongst European banks, partly because they offered very attractive returns and partly because Standard & Poors and Moodys were kind enough to rate many of them AAA despite the questionable quality of the underlying assets.

Now, as long as the economy chugs along, everything is dandy and the AAA-rated assets turn out to be precisely that. But we are not in dandy territory. Many asset securitisation programmes are in horse manure to their necks, so don’t be at all surprised if European banks have to swallow further losses once the full effect of the recession is felt across Europe. The two largest sources of asset securitisation programmes are corporate loans and credit cards. Senior secured loans are still marked at or close to par on many balance sheets despite the fact they trade around 70 in the markets. The credit card cycle is only beginning to turn now with significant losses expected later this year and in 2010-11.

Not much of a cushion left

Citibank has calculated that it would only take a cumulative increase in bad debts of 3.8% in 2009-10 to take the core equity tier 1 ratio of the European banking industry down to the bare minimum of 4.5%¹. By comparison, bad debts rose by a cumulative 7% in Japan in 1997-98. One can only conclude that European banks are very poorly equipped to withstand a severe recession. Seeing the writing on the wall, they are left with no option but to shrink their balance sheets. Despite talking the talk, banks will use every trick at their disposal to reduce the loan book. No prize for guessing what that will do to economic activity.

The wheels are coming off

But that is not the whole story. It is not even the most worrying part of the story. For the true horror to emerge, we need to turn to Eastern Europe for a minute or two. Nowhere has the credit boom been more pronounced than in Eastern Europe. And nowhere is the pain felt more now that credit has all but dried up. One measure of the credit fuelled bonanza is the deterioration of the current account across the region. Credit Suisse has calculated that in four short years, from 2004 to 2008, Eastern Europe’s current account went from +6% to -6% of GDP². That is a frightening development and is likely to cause all sorts of problems over the next few years.

Meanwhile Western European banks, eager to milk the opportunities in the East after the iron curtain came down, have acquired many of the region’s banks (see chart 1). Now, with many Eastern European countries in free fall, ownership could prove disastrous for an already weakened banking industry in the West.

The problem is widespread

To make matters worse, the problems in the East are beginning to look systemic. Credit Suisse has produced an interesting scorecard where they rank a number of countries around the world on factors usually taken into consideration when assessing the credit quality of sovereign debt (see chart 2). At the top of the tree (i.e. the worst credit score) you find Iceland – hardly surprising considering their current predicament. More importantly though, of the next 14 countries on the list, 8 are Eastern European – not what you want to hear if you are an already undercapitalised European bank with huge exposure to Eastern Europe.

Swedish banks are already reeling from their exposure to the Baltic countries. Austrian banks are in even worse shape, having been the most acquisitive of any European banks. Some Italian banks could be dragged under by their Eastern European exposure and even the conservative banking sector in Switzerland doesn’t look like it can escape the mayhem.

Worst of all, the problems in the East are just about to unfold at a point in time where the European banking industry is bleeding heavily from massive losses already incurred in other areas. With no access to private funding, banks find it virtually impossible to re-build their capital base with anything but tax payers’ money.

US banks are better off

US banks are in less of a pickle. Unlike the subprime debacle which hit both the US and the European banks hard, US banks have little exposure to Eastern Europe. To prove my point, according to the IMF, European banks have 75% as much exposure to US toxic debt as American banks, but 90% of all cross border loans to Eastern Europe originate from Western European banks. And, to add insult to injury, European banks have been much slower than US banks in terms of recognising their losses. Write-offs now total about $750 billion in the US and only about $325 billion in Europe.

The great mortgage show

The problems in Eastern Europe begin and end with their large external debts. In recent years, ordinary people all over the region have converted their traditional mortgages to EUR- or CHF-denominated mortgages. Some have even switched to JPY mortgages. Who can possibly resist 3% mortgages? Didn’t anyone inform them of the risk? As currencies across the region have fallen out of bed in recent months, these mortgages have suddenly become 30-50% more expensive. No wonder the local economy is suddenly tanking.

Credit Suisse has calculated that net foreign liabilities (as a % of GDP) have risen from 47% to 65% in recent months as a direct result of the loss of local currency values (see chart 3 – and don’t ask me why Credit Suisse has included South Africa in Eastern Europe!).

Chart 4: Eastern European vs. Asian Crisis

Source: Wall Street Journal

Back in 1997-98 Asia went through a similar currency crisis. However, as you can see from chart 4, Asian current account deficits were much smaller than Eastern European deficits are now. So were debt levels. Despite that, the Asian crisis did enormous damage to the local economy. Eventually Asia came good, primarily because the devalued currencies allowed the Asian countries to export more. Eastern Europe does not share this luxury. With over 90% of the world’s GDP in recession, who are they going to export to anytime soon?

Austria is in greatest trouble

According to the latest estimates from BIS, Eastern European countries currently borrow $1,656 billion from abroad, three times more than in 2005 and mostly denominated in foreign currencies (ouch!). 90% of that can be traced to Western European banks. About $350 billion must be repaid or rolled over this year. Not an easy task in these markets. Austrian banks alone have lent about $300 billion to the region, equivalent to 68% of its GDP according to the Financial Times. A default rate of 10% on its Eastern European loans is considered enough to wipe out the entire Austrian banking system. EBRD has gone on record stating that defaults in Eastern Europe could end up as high as 20%³.

An extra $250bn to the IMF

Hungary, Latvia and Ukraine have already received emergency loans from the IMF and both Serbia and Romania are reportedly considering asking for help. Meanwhile the IMF’s coffers are draining quickly and it has asked leading industrial nations for new funding. At their summit a week ago, EU leaders coughed up an extra $250 billion but nobody said where the money is going to come from. Even if they find the money, it is likely to prove hopelessly inadequate. Our leaders must grow up. Measuring everything in billions is so yesterday. Trillions are the new billions, like it or not.

Conspiracy or…?

On the 11th February the Daily Telegraph’s Brussels correspondent Bruno Waterfield wrote an article under the header: “European banks may need £16.3 trillion bail out, EC document warns.” In the article, the reporter revealed that he has seen a secret document produced by the EU Commission which briefed the union’s finance ministers on the true extent of the banking crisis. Less than 24 hours later, the article’s header was changed to “European bank bail-out could push EU into crisis” and two paragraphs had mysteriously disappeared. Here they are:

“European Commission officials have estimated that “impaired assets” may amount to 44pc of EU bank balance sheets. The Commission estimates that so-called financial instruments in the ‘trading book’ total £12.3 trillion (13.7 trillion euros), equivalent to about 33pc of EU bank balance sheets.

In addition, so-called ‘available for sale instruments’ worth £4trillion (4.5 trillion euros), or 11pc of balance sheets, are also added by the Commission to arrive at the headline figure of £16.3 trillion.”

Do yourself a favour – read those two paragraphs again. Newspaper editors do not change content light-heartedly. Did the Telegraph editor receive a call from Downing Street? Or Brussels? Did he have second thoughts about the avalanche that he could possibly instigate? I don’t know and I probably never will. But one thing is certain. If the EU Commission’s estimate of £16.3 trillion of impaired assets is correct, then the crisis is far worse than any of us could ever imagine. Not only would we have to get used to the prospects of a systemic meltdown of our banking system, but entire nations may go down as well.

Public debt to rise and rise

Even if actual losses prove to be much, much smaller (and I sincerely hope so), the banking sector cannot, in the current environment at least, raise sufficient capital to stay afloat, so more, possibly a lot more, tax payers’ money will have to be put forward. This can only mean one thing. Public debt will rise and rise. The official estimate for the UK for next year is already approaching 10% of GDP, an estimate which will almost certainly rise further. We probably have to get used to running 10-15% deficits for a few years, a fact which seriously undermines the notion of government bonds being next to risk-free.

BCA Research has calculated the effect on public debt in a number of countries, as a result of further bank losses being underwritten by tax payers. Obviously, those countries with the largest banking industries (as a % of GDP) will be hit the hardest (see charts 5a and 5b).

For that very reason, and as pointed out in last month’s Absolute Return Letter, there is a real risk that investors will demand much higher risk premiums on government debt. Only a few days ago, Ireland issued 3-year bonds at almost 250 basis points over corresponding Bunds. As more and more debt is transferred to sovereign balance sheets, we will likely see the spreads between good and bad paper rise further but we will also witness increasingly desperate measures being applied by the men in power. If they could prohibit short-selling of banks on the stock exchange (which didn’t work), why wouldn’t they consider prohibiting short-selling of government bonds? Not that it would necessarily work any better, but desperate people do desperate things.

Can Germany rescue us?

Most investors remain convinced that Germany will come to the rescue – in my opinion not as simple a solution as widely perceived given the enormity of the crisis. One possible solution which has been mentioned frequently in recent weeks is for all the eurozone nations to get together and start issuing joint bonds. This would undoubtedly help the weaker nations, but the idea was shot down by the German Finance Minister only a few days ago when he said that closer economic harmony across the eurozone would be needed before Germany would be prepared to entertain such an idea.

The most obvious trick left in the book, therefore, is to inflate us out of this mess. With the enormous amounts of public debt being created at the moment, years of deflation a la Japan would be catastrophic. You will never get a central banker to admit to it, but a healthy dose of inflation is probably our best prospect of surviving this crisis.

Given this outlook, do you really want to be long euros?

Niels C. Jensen 

Related posts:

• EU planning 200 billion euro package for Eastern Europe
• UBS does not see the need for panic over Eastern Europe
• Bloomberg talks Eastern Europe as Latvia downgraded
• EU: Banks ask for a bailout for poor lending in Eastern Europe
• European banks: still undercapitalised

This news comes via Reuters:

Bank of America Corp is carrying loans on its balance sheet marked at more than $44 billion above their fair value, the company said in its annual report filed with U.S. regulators on Friday.

The bank said it ended 2008 with $886.2 billion in loans, but estimated the fair value — or market price — for these loans as $841.6 billion.

In a related Bloomberg article, an analyst from Friedman, Billings & Ramsey gets right to the point:

“That’s the heart of why these companies are trading where they are,” Friedman Billings Ramsey & Co. analyst Scott Valentin said in an interview. “Technically, if you mark-to- market the entire balance sheet, most of these banks are insolvent.”

Sources
Bank of America SEC Filings
Bank of America Loans Valued at $44 Billion Less Than Books Say – Bloomberg.com
BofA carries loans $44 billion above market value – Reuters

Related posts:

• FASB: Mark all financial assets at fair value
• $35 billion in missing writedowns
• Fannie reports $171 billion in non-performing loans
• JPMorgan’s $29 Billion windfall
• BofA, Citi, Wells and GMAC biggest losers in stress test leaks

From the Financial Post:

American Express Co., the largest U.S. credit-card company by purchases, is paying some cardholders US$300 each to close accounts so the lender can reduce the risk of defaults as the recession deepens.

People who got the offer to “simplify” their finances must pay off their entire credit-card balance by April 30, according to New York-based American Express. Enrolling in the program cancels a customer’s account and may lead to forfeiture of reward points or rebates, the company said on its Web site.

Chief executive Kenneth Chenault is shedding customers as rivals reduce credit lines, raise interest rates and cut back on mail solicitations to brace for future losses. The industry’s defaults are set to break records and may reach as high as 11% by year-end in a stress scenario, reducing American Express’s annual profit by about 40%, according to Brian Foran, an analyst at Goldman Sachs Group Inc.

“This is an offer we made to select cardmembers to incent them to help pay down their balance,” said Molly Faust, an American Express spokeswoman, in a telephone interview Monday.

Related posts:

• Citi close to selling German unit
• AMEX credit card trouble deepens bank worries
• What’s in your wallet? Probably higher interest rates.
• Citigroup gets $7.8 Billion for Japanese unit
• The Citigroup Bailout: a blogosphere post-mortem

This comes from the Danish daily Berlingske Tidene. It suggests that Citibank is cutting back all international lending. Citigroup has sold its German operations to a French bank and I understand they are cutting credit lines in the UK as well. In seeing all these stories together, one gets a full view of the kind of cutbacks now ongoing at troubled banks like Citigroup.

Update: 20 Feb 2009 1552EST: I have yet to see confirmation as to whether ‘cutting’ credit lines means reducing or stopping new credit availability. It is also unclear whether this is credit under the ‘quick and easy loan’ programme or under all Citibank activities. I will update the post accordingly when that information is available.

Citibank has stopped lending

- We are not offering loans at the moment because of the economic situation.
That is the message when you call to get a Citibank Denmark ‘quick and easy loan.’

The Bank has just closed itself for what banks are best: lending money. And it is still uncertain when Citibank will start lending money again, writes Ekstra Bladet Netsite, eb.dk.

Finn Ostrup who is a professor of Finance at Copenhagen Business School, believes that Citibank Denmark’s American owner, Citigroup, is about to go bankrupt.

“Citigroup would have gone bankrupt in December, unless they had been helped by the U.S. Government.

“They are still threatened with bankruptcy, and I think that is why they will not lend more money,” says Finn Ostrup to Ekstra Bladet.

For Danish Citibank customers bankruptcy could be a hard blow.

“If Citibank terminates loans, they might not be paid back right away,” says Finn Ostrup.

“If that happens, customers may try to obtain money elsewhere. But if Citibank does not have the option of canceling loans, customers will have no problems,” he says.

Ekstra Bladet tried all day to get a comment from the responsible representatives from Citibank, but failed.

Source
Citibank har stoppet udlån – Berlingske Tidene

Related posts:

• Citibank Belgium to pay ‘duped’ savers 128mn for bad Lehman deal
• Bankrupt Danish Bank Roskilde sold
• The Roskilde Bank problem
• Denmark bails out Roskilde Bank
• Chart of the Day: Citigroup

Related posts:

• Swine Flu video primer from the Wall Street Journal
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Below is my translation from an excerpt in the Swiss newspaper NZZ:

In 2008, the lucrative business with loans to U.S. students came to an abrupt end. Today, UBS sits on paper that could still be worth $8.4 billion – or less. The collapse of the market for student loanshas increased the barrier to a good education for young Americans.

Sebastian Bräuer, New York
Chris Croteau knows UBS only by hearsay. He has no account with the Swiss bank. Nevertheless, there is a fatal connection between the derivatives operations of UBS and the fact that the young man from New Hampshire was on the verge of interrupting his studies.

In the autumn of 2006, the now 20-year old, began to study Business. In order to pay the usual high tuition fees, he took out a loan. A foundation of his state (NHHEAF) awarded favorable loans to students…..

In February 2008 something happened, which UBS later sheepishly described as a “surprising and unexpected result of the U.S. subprime crisis”: Auctions [for student-loan backed securities] were no longer established. There were no more investors. That has not changed: The ABS market is frozen.

For the students in New Hampshire, this had a direct effect: One month later, the NHHEAF stopped awarding new loans. In the previous year the Foundation had funded $67 million in grants that supported 6000 students. “In 2008, demand would have been just great,” said NHHEAF spokeswoman Tara Paine. Thousands of students have had to seek private loans.

The result of the credit crisis has been two-fold:

1. Students have bee cut off from funds that were previously available.  This makes college unffordable for some. 
2. Banks like UBS are sitting on massive losses in student loans as a result of the downturn in this market and in the economy. Whether these writedowns are excessive because of mark-to-market accounting is hotly contested – hence the abuse of reclassification of assets as Level 3 assets.

I mention this story because it gives one a real understanding of what happens when the credit markets seize up. I first highlighted the implosion of thestudent loan market in May and then again in October. It is not just about over-leveraged subprime borrowers. There are other very real consequences. I think it is tragic that many young people might be denied an education because of this situation.

Moreover, this story highlights the degree to which there are many more credit writedowns which still need to be taken. For a troubled institution like UBS, taking these writedowns here and now could be fatal. In my view, this is yet another concrete example of the fragility of European and global banking.

At the end of December UBS had Asset-backed securities with a market value of $12.9 billion, of which $8.4 billion were based on student loans. The sum is only a vague estimate, because there is currently no demand. What the paper is really worth, is controversial. “The asset-backed securities could be worth 20 to 30% more in value,” says Sean Egan of the independent rating agency Egan-Jones. That does not benefit UBS, however, long as they cannot find buyers. Egan believes interest by private investors will likely return in one to two years at the earliest.

Until then, the ABS’s are a ticking time bomb. In the worst case, they must be written down. How much and how fast is a matter of accounting rules. In the last quarter, UBS reported a writedown of $ 1.2 billion – without a refined reclassification of assets, the bank would have had to report a trading loss of $4.2 billion.

Source
Die UBS sitzt auf Milliarden geplatzter Studentenkredite – NZZ

Related posts:

• Student Loans: New Credit Crunch Casualty
• What is a credit writedown?
• What Home-Loan Banks reveal about the effects of mark-to-market
• Deutsche Bank and HBOS hit by writedowns
• New Writedown Risk: Alt-A

In November, the U.S. federal agencies which oversee the banking system proposed new guidelines for real estate appraisals.  One would imagine that these guidelines would be in keeping with the new more stringent regulatory frame of mind the financial services sector.  This is not the case.

In fact, the new proposal appears to entirely eliminate mandated written appraisals in connection with cramdowns, refis, and Fannie/Freddie loans.  The key verbiage is on pages 45-48 of the guidelines:

In general, renewals, refinancing, and other subsequent transactions may be supported by evaluations rather than appraisals….

An institution may modify the terms of an existing credit without obtaining a new appraisal or evaluation. Such modifications should not involve any advancement of new funds, any material change in the borrower’s creditworthiness, any change to the borrower’s or guarantor’s obligation on the credit, or any changes to the collateral pool or deterioration in collateral protection…..

This exemption applies to transactions that are wholly or partially insured or guaranteed by a U.S. government agency or U.S. government-sponsored agency. The Agencies expect these transactions to meet all the underwriting requirements of the federal insurer or guarantor, including its appraisal requirements, in order to receive the insurance or guarantee.

As you may recall, inflated appraisals were at the center of much of the recent house price inflation in the United States. Many appraisers complained that mortgage brokers and loan officers steered business to appraisers who inflated appraisals to meet mortgage loans. In some cases, there was outright appraisal fraud.

As a result, many in the housing industry are looking to Washington for leadership in creating a more robust regulatory framework to eliminate wrongdoing in housing and bring confidence back to the market. They are waiting in vain.

The American Society of Appraisers (ASA) has had a look at the new guidelines and is coming out against them in the most categorical way (Hat tip, Scott). If this issue is any reflection of Washington’s will to eliminate incentives for mischief, we are likely to be disappointed.

First, the guidelines came out in November with a statement that they were beefing up and clarifying guidelines in appraisals (see press release here). They requested comments on those guidelines.

Then, the ASA, having looked over the guidelines, released a statement on the 20th which roundly condemned the new guidelines. Their statement is below. Feel free to skim through this -  I have highlighted the salient points.

Our organizations have strong objections to what appears to be the dominant feature of the Guidelines – the exemption of more than a dozen categories of real estate related financial transactions from the professional appraisal requirements of Title XI of FIRREA. Although the November 19, 2008, Federal Register request for comment on the Guidelines states that they “are intended to clarify the Agencies’ real estate appraisal regulations and promote a safe and sound real estate collateral valuation program,” we have reluctantly concluded that they do neither.

We believe the approach to valuation issues reflected in the Guidelines is fundamentally flawed; and is inconsistent with the safety and soundness of bank regulatory reforms promised by the incoming Administration. As a consequence, we are unable to support them and respectfully urge that they be withdrawn and reconsidered so that our recommendations and the recommendations of other stakeholders can be carefully studied and significant revisions made to the current draft.

The Guidelines Fail To Promote Safety and Soundness:

Instead of promoting safety and soundness by increasing reliance on professional appraisals of real property collateralizing mortgages and mortgage-backed securities, the Guidelines have the unmistakable effect of sanctioning wholesale avoidance of such reliance. They do so in two ways: First, by directly and indirectly exempting multiple categories of transactions from the requirements for professional appraisals; and, Second, by explicitly sanctioning the use of automated valuation models (AVMs), broker price opinions (BPOs) and tax assessment valuations (TAVs) as acceptable “evaluation” substitutes for the fair market value opinions of professional appraisers. They are not.

For the reasons discussed later in this comment letter, these alternative valuation tools, by themselves, are too often unreliable indicators of the fair market value of property collateralizing loans made by federally insured financial institutions. We fail to understand why the bank regulatory Agencies, which are responsible for assuring the safety and soundness of our financial system and the integrity of the mortgage credit markets, have devoted so much time and attention to allowing regulated institutions to avoid the use of certified, licensed, tested and accountable valuation professionals for so many categories of mortgage-related transactions.

As a consequence of the many exceptions to and exemptions from reliance on appraisals, our organizations have concluded that the proposed 2008 Guidelines represent a step backwards; and that they erode, rather than strengthen, the public policy purpose of Title XI of FIRREA – which is to protect the safety and soundness of the deposit insurance funds and the mortgage markets by ensuring that real property collateral is reliably valued by individuals who are regulated by and accountable to, state appraiser licensing authorities and who have demonstrated a high degree of valuation competency by meeting or exceeding the education, training, experience and testing requirements established by the Qualifications Board of the nonprofit Appraisal Foundation.

The Guidelines Obscure Rather Than Clarify Supervisory Expectations:

Rather than clarifying the collateral valuation responsibilities of regulated institutions, the Guidelines actually raise as many questions as they answer. In large measure, this is because the lengthy narrative and extensive details necessary to describe and explain the numerous exemptions from Title XI’s professional appraisal requirements – and the occasional exceptions to the exemptions – create confusion and not clarity about the Agencies supervisory intentions. As a consequence, we do not believe that financial institutions, appraisers and other stakeholders will easily be able to determine when an appraisal is or is not actually required for a given transaction.

The Guidelines Ignore The Current Distress Of The Banking System And The Mortgage Markets; And The Importance of Reliable Valuations To The Government’s Mortgage Relief Programs :

Because we believe the proposed Guidelines minimize the relevancy of professional appraisers and professional appraisals to safe and sound mortgage loan underwriting, we would oppose them even during “normal” times. But, given the current stress on our mortgage credit markets, the large and increasing number of foreclosed or troubled mortgages, the rapid changes in the values of residential properties throughout the country and the many governmental programs designed to assist homeowners by modifying their mortgages, we find the Agencies’ preoccupation with authorizing exemptions from professional appraisals, particularly troubling

As a specific example, we believe the Guidelines are entirely out-of-sync with the government’s many programs to assist distressed homeowners. Our organizations enthusiastically support these programs but also recognize that their success is dependent, in some important ways, on accurate appraisals of the fair market value of collateral property (e.g., for loan-to-value purposes; to gauge the extent of possible losses to taxpayers if modified mortgages default; and to establish accurate current market value when a reduction in loan principal is part of the relief package). Yet, the Guidelines move in precisely the opposite direction. We address this point in some greater detail in the “Discussion” portion of our letter.

While We Generally Support Improvements Made By The Guidelines To The Performance Of Appraisals, We Urge The Banking Agencies To Recognize That The Improvements Could Cause Some Regulated Institutions To Rely Increasingly On Valuation Approaches Whose Requirements Are Far Less Rigorous – But Also Far Less Reliable:

While our organizations do not believe the Guidelines foster safety and soundness, we do generally support those provisions which address who can perform “appraisals”, the contents of appraisals and the independence of the appraiser. Regrettably, the improvements to the details of the Agencies’ Title XI appraisal requirements are greatly outweighed by the fact that far too many transactions are exempted from those requirements in favor of evaluations.

Moreover, we hope the Agencies recognize that the enhanced requirements pertaining to appraisals, while desirable, can have the perverse effect of causing regulated institutions to opt for far less rigorous valuation approaches, such as evaluations and evaluation alternatives (i.e., AVMs, BPOs and TAVs). It is our view that this potentially adverse consequence serves as a secondary, but still important, reason for the Agencies to severely restrict the categories of transactions that are exempted from appraisal requirements.

The Wide Latitude Provided Regulated Institutions With Respect To How Collateral Property Should Be Valued, Not Only Jeopardizes Safety and Soundness, It Also Represents A Highly Inefficient And Ineffective Way For The Agencies To Perform Their Regulatory Functions:

Because the Guidelines provide regulated institutions with so much discretion and so many options for determining how collateral property should be valued, regulatory efficiency will be an inevitable casualty. Although the Guidelines reflect a policy of providing regulated institutions with maximum flexibility on the tools available to them to perform collateral valuations, the Agencies also recognize that this almost limitless flexibility brings safety and soundness dangers. As a consequence, instead of adopting a policy which requires institutions to rely on professional appraisals as the preferred approach most likely to produce reliable fair market values, the Guidelines adopt a permissive approach, but simultaneously promise robust examiner oversight of the institutions’ valuation decisions; and task the institutions with establishing elaborate internal controls over their valuation policies. Apart from what we believe are the obvious safety and soundness advantages of relying on valuations by professionally credentialed and state supervised individuals, our organizations are convinced that reliance on state licensed and supervised individuals produces a far more effective and even cost-efficient federal regulatory scheme than one which permits financial institutions almost limitless discretion but which in turn produces a need for extensive banking agency supervision and expensive internal controls…..

We do not believe such scenarios lead to regulation which is either effective or cost-efficient;

The Guidelines Fail To Address The Responsibilities Of Appraisal Management Companies (AMCs) Relative To The Agencies’ Appraisal

Requirements: Requests by banks for appraisal services are increasingly being funneled through Appraisal Management Companies; yet, the Guidelines do not address whether or how the AMCs are responsible for assuring compliance with the Agencies’ appraisal requirements. This gap must be closed. We discuss this issue in somewhat more detail in the “Discussion and Questions” section of our comment letter.

There is much more to this story in the links below. However, the long an short of it is that the U.S. government is changing appraisal standards in a way that makes appraisers themselves uneasy.

This is not a good sign. Is the U.S. Federal Government trying to relax appraisal standards?

Sources
Agencies Seek Comment on Proposed Interagency Appraisal and Evaluation Guidelines – Federal Reserve Board website
Proposed Interagency Appraisal and Evaluation Guidelines (PDF) – FRB website
Memo: Proposed 2008 Interagency Appraisal and Evaluation Guidelines (PDF) – ASA Website

Related posts:

• Case-Shiller: Across the board deterioration in every market
• Cramdowns are coming your way
• UK: House price fall moderates, prices still down 13.9% in year
• Nationwide: UK house prices down 15.9% from last year
• Citi agrees to do cramdowns

After meetings with lawmakers, Citigroup has agreed to back legislation that would allow bankruptcy judges to alter the amount due on mortgage principal, so called cram downs.

As it stands today, all other debtors including corporations have the cram down option available in bankruptcy court.  However, changes to bankruptcy law have eliminated this option for mortgages, creating an impasse as house prices have dropped.

This is how Reuters describes the Citi agreement:

Financial giant Citigroup Inc has agreed to support a controversial rewrite of U.S. bankruptcy law aimed at helping troubled mortgage borrowers, three Democratic senators said on Thursday.

Senators Richard Durbin of Illinois, Charles Schumer of New York and Christopher Dodd of Connecticut said the legal reform would help “millions of families save their homes.”

Citigroup has agreed to support, under certain conditions, a rewrite of bankruptcy law. Under the change, known as “cramdown,” bankruptcy courts could alter the terms of mortgages, subject to certain conditions, the senators said.

Citigroup had no immediate comment.

Only mortgages entered into prior to the date of enactment of the bill would be eligible for the treatment, they said.

Homeowners would have to certify that they have tried to contact their lender before filing for bankruptcy, they said.

Only major violations of the “Truth in Lending Act” would invalidate creditor claims on bankruptcy, they said.

I am all in favour of cram downs. They represent an effective and speedy way to move house prices down to a stable equilibrium level. And I would much rather recapitalize a bank doing cram downs, to the degree cram downs cause distress in the financial sector, than just handing free money to the financial services sector.

Tanta of Calculated Risk was also in favour of cram downs and indicated so in several posts there. CR recently mentioned the issue and has several links to her posts in their recent post. See the link below for links to her insightful commentary.

Sources
Citi backs mortgage bankruptcy reform: Senators – Reuters
House Considers Cram Downs – Calculated Risk

Related posts:

• Cramdowns are coming your way
• Merrill and Citi are the big losers this season
• Does Obama have the legal authority to take over Citi?
• Are Citi and BofA gaming the Geithner Plan already?
• Nationalized Citi Mexicana Redux

This is a thought experiment.

Imagine it’s the year 2003 and I am a senior credit card company executive. I have grown bored with my job and want to venture out on my own and start up a new company. With my industry connections, I am able to raise 400 million in capital. I soon start ABCD Card Financial and we are ready to start issuing cards.

Now, it just so happens, I am a fairly prudent fellow and I lend cautiously to creditworthy borrowers. But, unbeknownst to me, ABCD’s CFO invests our hard earned capital in Credit Card Asset-Backed Securities. Mind you, this is AAA-rated stuff, so to most observers, this looks like a prudent use of money.

Anyway, business goes well and we take the company public in 2006, raising $1.4 billion for 65% of the company. That’s a nice return for three years work. We are now flush with capital, $2 billion worth including retained earnings. We leverage this up 20 times committing to $40 billion in loans. Much of the capital is invested in more Asset Backed Securities.

Fast forward to 2009. We are now experiencing a deep recession and people are defaulting left and right on their credit cards. Suddenly, those AAA Asset-Backed Securities aren’t looking like a good call after all. ABCD is forced to announce credit writedowns of $300 million. But, luckily for us, our overall lending has been prudent and while charge-offs are high we will survive.

Now, think about it for a second. We just wrote off $300 million of capital. That means we have $6 billion less to lend. So everything else being equal, this credit writedown just vaporized $6 billion. Poof, gone.

What’s my point? Well, globally, financial institutions have written down almost $1 trillion. That is an enormous amount of credit that vanished in the stroke of a pen. Do you think that lowering interest rates 75 basis points more to 0.25% as the Federal Reserve did today is going to get ABCD to lend as much as it did before the writedowns? Maybe, if only we can leverage to 30 times capital and lend to riskier borrowers and that is not in our best interest.

When the Fed lowered interest rates to 0.25% today, the lowest since record keeping began in 1954, it influenced the price of credit lower, but not necessarily the quantity of credit. Low interest rates — what I call easy money — are not going to get the job done. What financial institutions need is more reserves and more capital.

So, what if the Fed came to my CFO and said we’ll trade you some of the Treasurys you own in your short-term investments for dollars? For the right price, we would say yes. Where do the dollars come from? Out of thin air of course. The Fed creates them in order to buy my assets. This is called quantitative easing. It’s basically inflating the money supply plain and simple. The difference between quantitative easing and low interest rates is that easing actually increases my reserves, giving me more money to lend. Whether I choose to lend is another question.

To my mind, lowering interest rates in the aftermath of an enormous credit bubble where institutions have just destroyed $1 trillion in capital is wrong. It distorts lending decisions such that yet more money will eventually be lent out imprudently. The only way to increase credit availability is by getting reserves into the system. And normally you do that by making a profit. However, profits are hard to come by for financial institutions right now. So the Fed can step into the breach adding reserves by purchasing assets with money that the central banks creates. Mind you, this is inflation. Even so, this money inflation won’t necessarily get financial institutions to increase lending.

On the other hand, lowering interest rates just won’t work.

Related posts:

• Is quantitative easing really inflationary?
• Quantitative easing: printing money like mad to ward off deflation
• Quantitative easing everywhere?
• What’s different about 2008?
• Chart of the day: Excess Reserves

Recently I wrote a post which claimed that Keynesian stimulus is what we need in the global economy right now. These ideas are considered heresy in Austrian School circles because trying to stimulate the economy out of recession only puts off the day of reckoning and often worsens that day of reckoning. This is exactly what we saw when Alan Greenspan lowered interest rates to 1% after the last recession.

So what exactly does Ludwig von Mises, the most revered Austrian School economist, say about this? The short answer is that he would say stimulus is only going to make matters worse.  He has written on this very subject in his essay “The ‘Austrian’ Theory of the Trade Cycle.” Let me provide you with some of the text from that essay and an explanation of why I believe stimulus is necessary despite what he warns. And remember, his essay was written in 1936, the same year Keynes released his seminal work so that everyone forgot about the Austrians.

In issuing fiduciary media, by which I mean bank notes without gold backing or current accounts which are not entirely backed by gold reserves, the banks are in a position to expand credit considerably. The creation of these additional fiduciary media permits them to extend credit well beyond the limit set by their own assets and by the funds entrusted to them by their clients. They intervene on the market in this case as “suppliers” of additional created, created by themselves, and they thus produce a lowering of the rate of interest, which falls below the level at which it would have been without their intervention. The lowering of the rate of interest stimulates economic activity. Projects which would not have been thought “profitable” if the rate of interest had not been influenced by the manipulations of the banks, and which, therefore, would not have been undertaken, are nevertheless found “profitable” and can be initiated. The more active state of business leads to increased demand for production and the wages of labor rise, and the increase in wages leads, in turn, to an increase in prices of consumption goods. If the banks were to refrain from any further extension of credit and limited themselves to what they had already done, the boom wold rapidly halt. But the banks do not deflect from their course of action; they continue to expand credit on a larger and larger scale, and prices and wages correspondingly continue to rise.

This upward movement could not, however, continue indefinitely. The material means of production and the labor available have not increased; all that has increased is the quantity of the fiduciary media which can play the same role as money in the circulation of goods. The means of production and labor which have been diverted to the new enterprises have had to be taken away from other enterprises. Society is not sufficiently rich to permit the creation of new enterprises without taking anything away from other enterprises. As long as the expansion of credit is continued this will not be noticed, but this extension cannot be pushed indefinitely. For if an attempt were made to prevent the sudden halt of the upward movement (and the collapse of prices which would result) by creating more and more credit, a continuous and even more rapid increase of prices would result. But the inflation and the boom can continue smoothly only as long as the public thinks that the upward movement of prices will stop in the near future. As soon as public opinion becomes aware that there is no reason to expect an end to the inflation, and that prices will continue to rise, panic sets in. No one wants to keep his money, because its possession implies greater and greater losses from one day to the next; everyone rushes to exchange money for goods, people buy things they have no considerable use for without even considering the price, just in order to get rid of the money. Such is the phenomenon that occurred in Germany and in other countries that followed a policy of prolonged inflation and that was known as the “flight into real values.” Commodity prices rise enormously as do foreign exchange rates, while the price of the domestic money falls almost to zero. The value of the currency collapses, as was the case in Germany in 1923.

Basically Mises has laid out very concisely the fact that the business cycle is due to the extension and over-extension of credit. Trying to continue to expand credit eventually ends in a hyper-inflationary scenario as it did in Weimar Germany in 1923. As a result, most countries are forced to stop.

If, on the contrary, the banks decided to halt the expansion of credit in time to prevent the collapse of the currency and if a brake is thus put on the boom, it will quickly be seen that the false impression of “profitability” created by the credit expansion has led to unjustified investments. Many enterprises or business endeavors which had been launched thanks to artificial lowering of the interest rate, and which had been sustained thanks to the equaly artificial increase in prices, no longer appear profitable.

If you read this and think about the Technology Bubble or the Housing Bubble, these are textbook cases. Investment money was diverted from other more useful sectors to fund over-investment in technology and telecom in the 1990s and to fund overbuilding in residential property this last decade. Both of these episodes were a direct result of low interest rates. And when Mises speaks of an “artificial increase of prices”, he means asset prices.

Some enterprises cut back their scale of operation, others close down or fail. Prices collapse;crisis and depression follow the boom. The crisis and ensuing period of depression are the culmination of the period of unjustified investment brought about by the extension of credit. The projects which owe their existence to the fact that they once appeared “profitable” in the artificial conditions created on the market by the extension of credit and the increase in prices which resulted from it, have ceased to be “profitable.” The capital invested in these enterprises is lost to the extent that it is locked in. The economy must adapt itself to these losses and to the situation that they bring about. In is case the thing to do, first of all, is to curtail consumption and, by economizing, to build up new capital funds in order to make the productive apparatus conform to the actual wants a not to artificial wants which could never be manifested and considered real except as a consequence of the false calculation of “profitability” based on the extension of credit.

Later, in the same essay Mises gets to the point about stimulus:

It has often been suggested to “stimulate” economic activity and to “prime the pump” by recourse to a new extension of credit which would allow the depression to be ended and bring about a recovery or at least a return to normal conditions; the advocates of this method forget, however, that even though it might overcome the difficulties of the moment, it will certainly produce a worse situation in a not too distant future.

Essentially, over-extension of credit is the problem. It is not the solution. One could say credit is a drug to which we have become addicted. So, how can giving more of that drug help us kick the habit? Why am I proposing more stimulus?

Using the drug analogy, I would say I am proposing “government stimulus” as methadone for addiction treatment to help with the heroin-like credit addiction. It is only a stop-gap. Going cold turkey is likely to lead to unpredictable — or even dangerous — results.

I do like to use the Weimar example to make this point. I lived and worked in Germany for quite a while and am very familiar with German history as a result. The Weimar Republic was Germany’s first attempt at democracy from 1919-1933. It was widely considered a failure and led to fascism and the Nazis as a result.

In assessing Weimar’s failures, most focus on the war reparations from the Treaty of Versailles that ended World War I as a principle reason for hyperinflation in 1923 and Weimar’s ultimate failure. In fact, the hyperinflation episode of 1923 is one reason the ECB and the Bundesbank before it had been noted for having a tight money policy.  Germans fear 1923 the way Americans fear 1929.

However, the severity of Depression of 1921 was a significant contributing factor to both Mussolini’s political success and Hitler’s initial political success in the early 1920s and the rise of fascism. Ultimately, economic depression again in the early 1930s created the pre-conditions for World War II and the breeding ground for despots.

So, my thinking is fairly simple: cushioning the fall with government stimulus will prevent worst-case outcomes — nothing more. It will not prevent depression.

Update: I have added an addendum to this article in my post “A brief philosophical argument about the role of government, stimulus and recession.” I wrote the second post to talk more about the efficacy of stimulus in hastening recovery. Please read that post in conjunction with this one.

Source
The Austrian Theory of the Trade Cycle, Ludwig von Mises, Gottfried Haberler, Murray Rothbard, Friedrich Hayek

Related posts:

• A brief philosophical argument about the role of government, stimulus and recession
• Liquidity trap of a different sort
• Why should central banks cut interest rates?
• Peter Schiff: “Government is a burden on the economy”
• Confessions of an Austrian economist