More on the Banking Backdrop, They Have Never Had So Many Loans

By: Reggie Middleton | Tue, May 20, 2008
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This is another installment of my series on the US banking system and the Asset Securitization Crisis. As a recap, let's draw a map to where we are currently.

Sections 1 through 5 are background material that is probably known to the professional in this arena, but will make good reading for the lay person. I used it to make sure I made judgments based on observable facts vs. media representation and/or personal bias. I feel the section on counterparty risk should be required reading for everybody, though. The report on PNC basically outlines, in full detail, why I chose that bank out of 329 others, to initiate my short foray into the regionals. Part 2 of the municpal report will be coming soon.

  1. Intro: The great housing bull run - creation of asset bubble, Declining lending standards, lax underwriting activities increased the bubble - A comparison with the same during the S&L crisis
  2. Securitization - dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble - declining home prices and rising foreclosure
  3. Counterparty risk analyses - counterparty failure will open up another Pandora's box
  4. The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue
  5. Municipal bond market and the securitization crisis - part I
  6. An overview of my personal Regional Bank short prospects Part I: PNC Bank - risky loans skating on razor thin capital, PNC addendum Posts One and Two
  7. Reggie Middleton says don't believe Paulson: S&L crisis 2.0, bank failure redux

In the graph below, you will see that commercial banks have gorged themselves on consumer finance risk over the last 20 years. It is not just the investment banks that took chances with leverage and concentration.

The primary benefit of securitization was the virtualization of the bank's balance sheet. Through securitization, banks were able to underwrite a vast amount of risk relative to their balance sheet capacity, by selling off the risk to the open markets. Despite this, banks have steadily increased the amount of risk kept on (and off, through SPEs) their books over the last 20 years, with a forced increase of this concentration in 2007 when the securitization market simply shut down - cutting off the liquidity spigot for these assets. Starting at about 2004 near the height of the securitization bubble , banks increased the pace of securitized asset retention.

At the same time the banks increased the pace of asset retention, the debt service ratio of the lending products backing the securities started climbing very quickly. Thus, not only were the banks increasing risk from a concentration perspective, they were increasing risk from a credit quality perspective simultaneously. This was all occurring during the near peak of a bubble. Unfortunately, for most of those involved in bubbles, it is nigh impossible to see the bubble until after it is too late! With debt service ratios so high, levels will trend down to the mean, either through increased income or decreased debts (charge offs).

My bet is on charge offs leading to the way. Charge offs have more than tripled in the last 7 quarters. The last two recessions have seen charge offs average 1-2% of total loans outstanding. I believe that that macro environment, fundamentals and general weakness of the consumer will cause an even higher level of charge offs this time around.

What most pundits who don't follow the fail to realize is that despite all of the fear, loathing and hoopla regarding mortgages, foreclosures and declining home values (most of which is quite justified, may I add), consumer loans have higher charge off rates than mortgages. That means those credit cards and auto loans are to cause the banks more stress, at least for now. In addition, the recoveries for these products are bound to be lower. Real estate charge offs are increasing faster, and will probably catch up, but if they do the combination is bound to put pressure on the businesses through slowed consumer spending in combination with the lax debt that was consumed by those very same businesses and cause the business loans delinquencies to spike as well. I have been predicting a spike in business delinquincies for the last two quarters to take effect right about now.

Loan charge offs, in aggregate, have spiked significantly during the last two recessions and I expect them to spike even higher this time around.

Now, what do yout think all of this adds up to? Well, looking at these top commercial banks and thrifts against the backdrop of the info just gleaned... Delinquincies are spiking, just as I anticipated, in the risky 2nd lien product class where high LTVs and decreasing home values portend 100% losses and zero recoveries in many cases. In order for this to happen, though, the delinquincies must become actual charge offs.

Well, guess what... Delinquincies are quickly becoming net charge offs!

As part of the next few posts, I will be offering part of my 2nd lien concentration studies that I used to find even more shorts in the banking sector. I will also review how muni losses will put the I banks at even more risk and potentially kick off a meltdown in the CDS markets. Stay tuned...



Reggie Middleton

Author: Reggie Middleton

Reggie Middleton

Reggie Middleton

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