Red Sky Mornings, Investor Take Warning: More Finance Industry
Recognize the old saying ? "Red sky at night, sailors delight. Red sky in the morning, sailor take warning" ? It's actually grounded in science....as well as centuries of experience. Where the winds tended to be Easterlies a red morning sky meant the sun was being reflected off heavy cloud cover, i.e. storms. We seem to be in the process of alternately re-discovering red skies in the Finance Industry and panicing and then thinking the storms have missed us.
The next step after the Economy post was going to be looking at the Int'l situation but we're coming back and jumping on the Finance Industry instead because of the weekend bailout of Fannie and Freddie and the FDIC taking control of a failed CA thrift, Indy-Mac. BtW - sorry for the brief hiatus. Another warning sign. Every time a window opened up in my schedule to post my ISP/Hosting provider was having problems. Guess who - Yahung, that's who. Another red sky we'll pick up later. The chart's a pretty good red sky warning - in fact we'd view it more as a collection of major storm clouds. The real thing to ponder here is not how bad the storms are, or are going to get, but why everyone was/is surprised. There are a couple of really key lessons to think about IOHO. Really...really think about. First off the sky's been read for a long-time. Jim Jubak had a major column on regional bank problems in Jan this year, CalculatedRisk has been warning about commercial real estate problems and regionals for a couple of years now. And of course we've been beating the drum for so long we ended up with a whole dedicated archive. Another thing at a deeper level in the surprise is the follow-on question - if everybody's this surprised what else aren't they thinking about it ? What's not priced into the sector and the markets ? Yet a third thing at yet a deeper level is the problem with business models - when we say we think the business models are broken that means many of the major financial institutions are going to go thru a lot of pain and will never come back as they were in terms of growth and profitability. Let's consider some graphics we've discussed before.
Bad Loan Tsunamis
We won't dig thru this in detail but do want to remind everybody of this on-going set of bad loan tsunamis that are still to come. First off we're a long way from done with the Housing downturn - that means more foreclosures, more losses and writeoffs and tighter credit. Even if the economy doesn't get any worse than it is - not likely btw - this anemic environment still means that a lot of auto, credit card and other consumer loans will deteriorate. And ditto on the business side. How this will work out with the screwy debt instruments, excess leverage, etc. we've gone over several places (Markets and Financials:4 Year Crunch, Broken BizzMods) but it ain't gonna be pretty by any means.
Business Model Breakage
Now let's stop and think about the basic banking business model a little. A bank accepts deposits so people won't have to carry around cash thereby lubricating the wheels of commerce and consumption. Further it then turns around and loans out those deposits to folks who plan on spending more then they've got handy - serving as the intermediary between folks with spare funds and those with shortages. The former get paid interest and the latter pay it and the bank's revenue stream comes from the difference. Now the real magic happens when leverage enters the picture because the banks assets (the loans) can be some larger multiple of its' liabilities (the deposits). All it needs to have on hand is enough ready liquidity to meet the normal demands for cash. Over literally centuries the rule-of-thumb has developed that a bank needs to have around 6-8% of it's "assets" on hand - this its' capital requirement. Unless there's a sudden surge in demand, like when there's a run. But now you can see where multiplying your assets by 10X or so generates a much larger revenue stream. The problems come when folks loose confidence in getting their money back and they're made worse when that leverage is 20X or 30X or 70X - enormously worse. And we're not making those numbers up the Investment Banks were running at 30X leverage and by the time all the shenanigans with off-balance sheeting financings, synthetic instruments, etc. were in place they represented big X's ! Unfortunately when the bigs drop in value by a few percentage points it chews up much bigger chunks of capital. And there you have the reverse of the virtuous leverage cycle used to generate profits. The vicious cycle of capital writedowns leading to insolvency and bankruptcy. Now here's the business model problem for the industry - the more profitable segments weren't based so much on innovations and value-add for customers. They were based on leverage. Which means all the previously high-profit and risky strategies are going to get squeezed bad. It put BSC and Indy-Mac out of business, threatens Lehman and has caused $Bs in writedowns worldwide. With more to come for the known and acknowledged problems.
What we're suggesting with our little graphic on future tsunamis that a whole slew of other problems is hiding in the wordwork and coming out like maggots in a carcass. Which sectors are carcasses, candidates or survivors is, IOHO and inexpert opinion, suggested by the color coding. After the break you'll find our most recent collection of readings backup up these arguments. Bon Appetit'.
Business
Fannie, Freddie Losses Make Them `Insolvent,' Ex-Fed President Poole Says Borrowing at Fannie Mae, the U.S. government-sponsored mortgage company, has never been so expensive and it may not get better any time soon.Fannie Mae paid a record yield relative to Treasuries on the sale of $3 billion in two-year notes yesterday amid concern the biggest provider of financing for U.S. home loans won't have enough capital to weather the worst housing slump since the Great Depression. The company's credit-default swaps show traders are treating the AAA rated debt as if it were five steps lower. Fannie Mae shares tumbled 13 percent yesterday in New York to the lowest level in almost 14 years.Chances are increasing that the U.S. may need to bail out Fannie Mae and the smaller Freddie Mac, former St. Louis Federal Reserve President William Poole said in an interview. Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair value accounting rules, he said. The fair value of Fannie Mae's assets fell 66 percent to $12.2 billion, data provided by the Washington-based company show, and may be negative next quarter, Poole said.
· Panic as Fannie Mae and Freddie Mac dive
· US Treasury rescue for Fannie Mae and Freddie Mac, U.S. Bolsters Fannie, Freddie
· Agencies' problems could deepen impact of credit woes in Asia
Seizure of IndyMac Deepens Fears The federal government's seizure of IndyMac Bank is deepening worries about the U.S. banking industry, which is in a tightening bind following a long run of prosperity. Banks and thrifts are struggling against a rising tide of bad loans, and it is becoming increasingly clear that some lenders won't be able to dig their way out.
The Coming Bank Failures There have now been 5 FDIC insured bank failures in 2008, the most since 2002 (11). But this is nothing compared to number of failures during the S&L crisis in the '80s and early '90s. Going forward, I expect many more bank failures, although probably far fewer than in the '80s and early '90s. Unlike IndyMac that failed mostly because of bad Alt-A mortgage loans, most of the coming bank failures will probably be small regional banks with too much exposure to Construction & Development (C&D) and Commercial Real Estate (CRE) loans. Clearly there is the possibility of a huge failure too. FDIC Chairman Sheila Bair told a Senate Banking Committee in early June: "There is also the possibility that future failures could include institutions of greater size than we have seen in the recent past." Maybe she was thinking of IndyMac. Past Crises Suggest More Waves of Pain, Analysts Say More Banks Will Fail
A fate worse than debt Banking-industry woes once again disrupt the credit markets. HOLLYWOOD may love to churn out sequels but markets do not think much of them. Almost four months after the rescue of Bear Stearns, investors are again grappling with worries about the health of the banking industry. The spreads, or excess interest rates, on the riskiest corporate bonds are almost back to the levels last seen in March. Each day brings new sources of alarm. On July 7th shares in Freddie Mac and Fannie Mae, the American housing-finance giants, were pummelled on account of a Lehman Brothers report which suggested, if accounting rules were strictly applied, that the government-backed firms would have to raise $75 billion between them. Although this week’s commitment by Ben Bernanke, chairman of the Federal Reserve, to extend the Fed’s lending window to investment banks into 2009 may offer some reassurance, investors still worry that medium-sized American banks may be allowed to go bust; after all, they are neither too big nor too complex to fail. For credit markets, these banking problems are doubly ominous. They will cause the industry to cast about for more capital, but there is no reliable source of supply. If Bradford & Bingley is any indication, investment banks will have grown more cautious about underwriting rights issues. Hedge funds, another potential source of capital, are funded by the banks themselves. Fund-management groups, according to a recent Merrill Lynch poll, mean to be underweight bank shares. That leaves the sovereign-wealth funds as the only investors with cash to spare. But such funds are still licking their wounds, having provided capital to banks last year at share prices well above today’s. The banks’ problems feed back into the credit markets. For if the banks cannot raise as much capital as they need, they may feel they have to sell assets. And that may mean off-loading corporate and asset-backed bonds, even if the banks must accept fire-sale prices. The ABX index of asset-backed bonds is below the level that it sank to in March.
Bank consolidation: Under the hammer A wave of M&A deals is expected to hit the industry—eventually. LIKE plane-crash survivors forced to eat their fellow passengers, investment bankers have found some sources of nourishment amid the wreckage of the banking industry. Helping weakened institutions to raise capital has produced a useful stream of fees. Goldman Sachs, a tediously successful investment bank, notched up a 72% increase in equity-underwriting revenues in the second quarter, much of it from other banks. But many have their eyes on an even bigger prize: the wave of M&A deals that is expected, eventually, to result from the credit crisis. That a big shake-out is coming is in little doubt. Weaknesses in funding and business models have been laid horribly bare. Some franchises were too focused on the wrong markets. Wachovia, America’s fourth-largest bank, has suffered from outsize exposure to California’s imploding housing market and is a potential takeover target. Others face regulations that threaten their profits. The Wall Street banks are bracing for tougher capital and liquidity requirements as the price for access to the balance sheet of the Federal Reserve. Others still are questioning whether they have the right mix of businesses. The integration of volatile investment banking and staid wealth management at UBS and Credit Suisse, two Swiss banks, is the subject of much alpine soul-searching. Allianz, a German insurer, has apparently lost patience with its foray into investment banking, and is restructuring its Dresdner Bank subsidiary. Rumours fly about the blockbuster deals that may soon be done.
Kekst, Go-To Publicist for Kravis, Weill, Sees `Frightening' Merger Market Gershon Kekst, who pioneered the field of public relations for dealmakers as an adviser to Henry Kravis and Sanford Weill, said the current credit-market contraction is the most ``frightening'' slump in four decades. ``This is more severe and more intense, and if I had to use one word to characterize it, in contrast to the 80's, it would probably be frightening,'' Kekst, 73, said in an interview. ``We just don't know what's going to happen. The economy is being tested in a bear market that could go for a long time.'' Kekst, who agreed to sell his firm to Publicis Groupe SA last week for an undisclosed price, has had a front-row seat in four M&A booms and the busts. He worked through the merger wave of the 1960's, led by conglomerates such as Textron and ITT; the 1980's takeovers fueled by high-yield, high-risk bonds from Drexel Burnham Lambert; the Internet and technology mergers of the 90's; and last year's record private-equity buyouts. The current credit crunch, triggered by defaults on U.S. subprime mortgages, is more severe than the slump that followed the savings and loan crisis and the collapse of Drexel, Kekst said in the interview. He said he once asked his friend Flom whether Kekst & Co. would be crippled if mergers and acquisitions dried up. ``You're not in the M&A business, you are in the `seykhl' business,'' Flom replied, using a Yiddish word meaning ``street smarts.'' ``Business leadership is going to find issues and problems to get themselves into long after the M&A business is gone.''
Citigroup's $1.1 Trillion of Mystery Assets Shadows Accounting of Earnings At an investor presentation in May, Citigroup Inc. Chief Executive Officer Vikram Pandit said shrinking the bank's $2.2 trillion balance sheet, the biggest in the U.S., was a cornerstone of his turnaround plan. Nowhere mentioned in the accompanying 66-page handout were the additional $1.1 trillion of assets that New York-based Citigroup keeps off its books: trusts to sell mortgage-backed securities, financing vehicles to issue short-term debt and collateralized debt obligations, or CDOs, to repackage bonds. Now, as Citigroup prepares to announce second-quarter results July 18, those off-balance-sheet assets, used by U.S. banks to expand lending without tying up capital, are casting a shadow over earnings. Since last September, at least $100 billion of assets have flooded back onto Citigroup's balance sheet, accompanied by more than $7 billion of losses.
``If you start adding up all the potential exposures, it's a huge number,'' said Sam Golden, a former ombudsman for the U.S. Office of the Comptroller of the Currency who now heads the financial-industry practice for restructuring adviser Alvarez & Marsal in Houston. ``The banks will say that it was disclosed. Investors are saying, `Yeah, but it was cryptic. We really didn't know what you were telling us.''' Seven of the biggest U.S. banks, including Citigroup, are on the hook for at least $300 billion of credit and liquidity guarantees for off-balance-sheet loans and bonds, according to a June 30 report from consulting firm RiskMetrics Group Inc. in Rockville, Maryland. Such guarantees seemed remote when pledged as an inducement to bond buyers. Now, the first year-over-year decline in housing prices since the Great Depression and rising home-loan, commercial-mortgage and credit-card delinquencies have begun to trigger them. ``You will rapidly realize what a farce these off-balance- sheet things are,'' said Ladenburg Thalmann & Co. analyst Richard X. Bove. ``You could pick up a lot of loan losses with the stuff you're putting back on.'' It's impossible to predict what the losses might be from off-the-books assets or liabilities because disclosures are thin relative to what is required for balance-sheet assets, said Neri Bukspan, chief accountant for Standard & Poor's in New York. ``A lot of information tends to disappear or becomes second or third class,'' Bukspan said. Citi's Off-Balance-Sheet Assets