FYI | Jun 04 2008
By Greg Peel
On Monday the president of the Atlanta Federal Reserve told the Jacksonville Regional Chamber of Commerce, “I would characterise the current position of the overall [US] economy as growing slowly, poised for gradual recovery, but carrying real risks that could subvert the story”. Those risks are an ongoing and self-feeding downward spiral in house prices, an oil price shock, and renewed financial instability.
Ever since America’s fifth largest investment bank – Bear Stearns – went under there has been speculation and rumour-mongering in financial markets that America’s fourth biggest investment bank – Lehman Bros – will be next. On the weekend that the Fed “saved” Bear Stearns the governors also rang around the other banks and major players and specifically asked them not to say anything negative to any of their counterparties about Lehman Bros. The reason was the Fed’s appreciation that Bear Stearns had been solvent one minute and liquidated the next because panicked counterparties withdrew funds in fear of just such a collapse. That’s the problem with “runs” on banks – they create their own result.
The share price of Lehman Bros has undertaken a rollercoaster ride ever since the Fed’s actions in March. Initial strength was encouraged by the Fed’s opening of the discount window to investment banks, the implication of which is that no other bank could now go under. Further strength was provided when Lehman announced a first quarter loss that wasn’t nearly as bad as everyone was expecting.
But still the rumours have persisted, and last night Lehman shares hit another slippery slope which suddenly had the market wondering whether it was a case of “here we go again”. The shares fell to below the level they had dropped to in March. On this basis alone, one must assume Wall Street is no longer confident that another Bear Stearns could not happen. The fall was sparked yet again by rumours – firstly that the bank was about to report its first ever quarterly loss, in the order of US$300m, secondly that it was about to go to the market for US$4bn of fresh capital (a Wall Street Journal report), and finally that the bank had actually been forced to go to the Fed for funds, under the new post-Bear Stearns arrangement (simply a rumour).
At that point Lehman was forced to come out and deny at least the last rumour. The bank has not approached the Fed since April. But it does say a lot about this supposedly financial-market-saving Fed facility. If a bank is spotted as much as loitering near the window, word gets out. And that word is “get your money out now, this bank’s in trouble”. It seems a bit self-defeating really. By the time a bank has gone to the window the stock market could well have wiped off as much in capital value as the loan the bank is needing to take out. Or worse still, that bank could already be insolvent.
Part of the problem has been that despite massive valuation write-downs of distressed credit securities by all the banks, no one is yet convinced we have seen the end of it. Bank analysts, led by Oppenheimer’s Meredith Whitney, have continually revised down their earnings forecasts for the US banking sector, suggested further write-downs are needed, and suggested that more capital will also be needed and dividends will be cut. The banks in question have denied, denied, denied, but then they have been denying since about August last year.
Lehman Bros is one bank (as explained in Part I of this series) which has left the market suspicious of seemingly minor write-downs to date by comparison to its peers. Its well known high-leverage business model would tend to suggest a greater exposure. Thus when rumours emerge of more capital being suddenly sought (and let’s face it, the Wall Street Journal is no gossip rag) doubt quickly escalates.
The reality is that despite the Bear Stearns action little much has changed for the US financial sector, and indeed the world financial market. On Monday British regional lender Bradford & Bingley saw its shares plummet 30% when it was forced to scrap a rights issue given its share price had fallen below the price of the new capital. This sparked a 10% fall in the shares of Halifax Bank of Scotland given that bank is also in the process of trying to put away a rights issue. While HBOS was quick to suggest that issue would proceed, the rumour in Australia today is that HBOS is looking for a buyer for its local subsidiary BankWest. HBOS bought the WA-based BankWest in 2003 and has most recently been trying to shoulder into the east coast mortgage market by undercutting the incumbents. Now it is believed HBOS needs to raise even more capital and it might be time to abandon the attack in Australia and withdraw the forces back to Scotland.
Outside of the resources sector, the Australian banking sector is the only other to see significant price action since the March market bottom. Most recently a lot of the enthusiasm has centred around the Westpac bid for St George, the potential for another bank to make a play, and the potential for the other banks to buy up smaller banks in retaliation. Now we have HBOS looking to go the other way and divest, speculation has already begun as to which of the locals will snap up the pesky BankWest.
What has been largely forgotten in all the brouhaha is whether or not Australian banks are properly valued given the growing indications of not only a weakening Australian economy (although the first quarter GDP result might suggest that weakening is not so severe, but don’t forget the first quarter ended three months ago) but also a threat of yet another rate rise. It wasn’t that long ago that bank stocks were weakening as one by one each announced significant increases in bad loan reserves.
It is bad loan reserves that have become the new focus amongst those Wall Street players who have not been totally distracted this last month by the price of oil.
John P. Hussman (PhD) of Hussman Funds was very interested to read the latest US Federal Deposit Insurance Corporation Banking Profile. This document, released last week, noted that the annualized net charge-off rate rose to 0.99% in the first quarter – more than doubling the 0.45% rate of the fourth quarter 07. What does this mean? It means that US banks doubled their bad loan write-offs in the space of three months. A rate of 0.99% may not seem like much, but it is the highest since the fourth quarter of 2001 and comes at a time when US banks are short on capital.
Moreover, the FDIC report noted that the amount of loans and leases that were non-current (more than 90 days past due) rose by US$26bn, or 23.6%, in the first quarter.
It could be argued that these figures should not signal danger, given US banks have been furiously writing down the value of their loan books (just as Australian banks have done) and as such are already covered, perhaps more than covered, for what might eventuate as the US economy slows. But unfortunately this is not the case.
The graph above shows that the US banking industry’s “coverage ratio” of potentially bad loans has actually fallen steadily for the last eight quarters. In the third quater last year the amount of non-current loans began to exceed reserves, and in the first quarter 08 that ratio fell to 89c in the dollar from 93c at the end of 2007. This is the lowest coverage ratio since the first quarter of 1993.
Hussman warns as follows, “Look carefully at the slopes of the lines on the chart above. Given that mortgage resets remain heavy and will continue well into 2010, is it really reasonable to assume that the increase in non-current loans will subside?” Indeed, Hussman believes banks will be forced to raise loan-loss reserves sharply just to keep up, and to raise the coverage ratio more “massive” write-downs must follow.
Hussman’s warnings are consistent with the theme now emerging across the globe – that the credit crisis is not yet over but entering Phase II. The first phase was highlighted by a crisis in the interbank market and write-downs of complex and spurious credit securities. The second phase will be highlighted by write-downs across the wider economy, and will feature everything from mortgages to car loans, small business loans and credit card debt. The fist phase hit the financial sector itself. The second will hit the consumer.
Phase II could potentially be avoided if the US housing market were to recover, but there are no signs of that happening anytime soon. Not even US Treasury secretary Hank Paulson can put a positive spin on the housing slump. Hussman notes that at the peak of the housing boom in the US, house prices overshot the relative cost of building a house and the relative cost of renting a house by 60%. The nature of any market is that it will always overshoot to the upside, and then overshoot to the downside. So far average house prices in the US have fallen around 14% over 12 months.
“The evidence suggests,” says Hussman, “that the worst of the credit problems are still well ahead”. He goes on to say:
“It would be naïve to accept that the amount of write-offs taken to-date is anything close to what will be required – they are not even keeping pace with the accelerating pace of non-current loans. Financial companies should, and most probably will, get to the task of preserving capital, cutting dividends further, and raising new funds in the not-distant future. The markets probably will not like this, because it will be an admission that credit conditions are still deteriorating.”
And already we have the rumours emerging. Is Lehman about to try to raise more capital? Does HBOS need to sell BankWest in order to preserve its own capital?
In the case of Lehman, whether or not the rumours are true, the situation has seemingly become more dire since the Fed governor Ben Bernanke had his little outburst in Barcelona last night. His diatribe about saving the US dollar from speculative weakness was a bombshell for long-time Fed watchers – not because of the not-so-subtle indication that the Fed’s focus has now switched from saving the economy to fighting inflation, but because “saving” the US dollar is the preserve of the US Treasury and not the central bank. Fed governors are not supposed to cross over this line.
The implication is that there will be no more rate cuts. Indeed, if the US dollar keeps falling and food and energy prices keep rising the Fed is more likely to raise the cash rate. If we are truly entering credit crisis Phase II where does this leave the banks? In theory it has been the rate cut from 5.25% to 2% and the subsequent massive injections of liquidity which have prevented the financial system from completely melting down. If the Fed raises the cash rate it will, in theory, need to take liquidity back out of the system.
It is no wonder the president of the Atlanta Fed cites “renewed financial instability” as a risk to the recovery of the US economy.
