WHALEN: HOW TO PREPARE FOR THE NEXT BANKING CRISIS
12 November 2010 by Cullen Roche
12 Comments
Banking issues are clearly resurfacing in recent months as the sovereign debt crisis flares up again and the mortgage fiasco in the U.S. comes to light. In addition, there is a very serious risk that a housing double dip will exacerbate all of these problems. Several reports in recent weeks support my theory that housing prices are indeed set to decline further in 2011. There are additional risks, however, and Christopher Whalen believes that many of these issues are in fact being exacerbated by the Federal Reserve itself. In a recent presentation he highlighted why he believes the next US banking crisis is right around the corner and why the Fed is in large part to thank:
- Many on Wall Street believe that net interest margin or NIM among U.S. banks is at record levels. They are right, but not in the way that many investors and analysts expect.
- Unfortunately, measured in dollars, gross interest revenue ofthe banking industry has been cut by a third over the past three years due to the Fed’s zero interest rate policy. Banks, savers are literally dying from lack of yield on assets due to QE/ZIRP.
- In the post WWII period, Fed interest rate cuts resulted in significant reduction in average mortgage borrowing costs for households ‐‐ until 2008, when mortgage rates implied by the bond market fell significantly but households were not able to refinance.
- Fees charged by Fannie Mae and Freddie Mac, and a mortgage origination cartel led by the big four banks (BAC, WFC, JPM, C), are now 4‐5 points on new origination loans vs. less than 1 point during housing boom. Huge subsidy for largest zombie banks effectively blocks refinancing by millions of households.
- These fees, which can add up to 7 to 10% of the face value of the loan, raise mortgage rates to borrowers by hundreds of basis points. Banks and the housing GSEs, however, saw significant benefits in declines in funding costs thanks to low fed funds rates.
Opportunities:
- For banks and investors, one of the biggest opportunities for gain is to invest in the stronger regional banks that are acquiring troubled or failed institutions. Resolution results in losses, but also creates value for investors and society.
- Acquiring failed banks from the FDIC is extremely attractive for existing banks, which tend to get preference from regulators in failed bank sales. Attractive pricing, lack of legacy liabilities key positives for investment thesis.
- Another way for investors to exploit the bank restructuring process is to purchase troubled assets. So far, Fed QE and ZIRP are enabling banks to resist selling bad assets.
- In addition, the FDIC, NCUA and other agencies are issuing RMBS and CMBS securities with government guarantees that offer attractive yields compared with Treasury debt.
Conclusions
- The U.S. banking industry entering a new period of crisis where operating costs are rising dramatically due to foreclosures and loan repurchase expenses. We are less than ¼ of the way through foreclosures. The issue is recognizing existing losses ‐‐ not if a loss occurred.
- Failure by the Bush/Obama to restructure the largest banks during 2008‐ 2009 period only means that this process is going to occur over next three to five years–whether we like it or not. Lower growth, employment are the cost of this lack of courage and vision.
- The largest U.S. banks remain insolvent and must continue to shrink until they are either restructured or the subsidies flowing from the Fed, Fannie Mae/Freddie Mac cover hidden losses. The latter course condemns Americans to years of economic malaise and further job losses.
Source: Institutional Risk Analytics
Great Post…
Stop the insanity, put the insolvent big banks in receivership. Sell the assets to the surviving banks at market and put those who committed fraud in jail. Its really not that hard…yes, there will be massive losses to equity and bond holders at BAC, C, Ally, WFC, and JPM, but thats how the system works. The industry will be much stronger and if you eliminate the fraud the real estate market will clear. Its better to be at S&P 600 with a solvent banking system, then S&P 1200 with an insolvent banking system living off a govt put.
Do we really want to go the path of Ireland? At least the US isn’t stupid enough to try austerity and bailing out private banks at the same time, right?
“Finance Minister Brian Lenihan said in September that the final cost of rescuing the banking system may be close to 33 percent of the country’s gross domestic product.
Ireland now is preparing to cut its budget by 6 billion euros in 2011 and then by another 9 billion euros over the next three years, to narrow the deficit to 3 percent of GDP from 12 percent this year. The figure is 32 percent when bank rescue costs are included. Ireland has made 14.5 billion euros of cost savings since 2008, Cowen said Oct. 27.”
http://www.bloomberg.com/news/2010-11-12/shadow-of-imf-spooks-irish-taking-pay-cuts-to-avoid-greece-style-bailout.html
Why should the interest expense go up if interest rates do not ?
Yeah, I don’t really get it either. It seems like the two will always be highly correlated. What gives?
NIM is, in large part, the slope of the Yield Curve (“borrow short, lend long”). As such, a flattening curve will cut into NIM. (Further, “lending long” also means that these re-price at a lagging pace; 5-10yr loans made during the rise/peak of the bubble will “re-price” at a much lower interest rate when they ‘roll’, or are re-fi’ed. So even if the curve stays fixed from here, we should see more NIM compression this ‘lag’ catches up with the past years’ move down.)
the arrows Whalen uses I think just implies a normalization in the curve, or flattening by interest costs (short rates) going up, interest income (longer rates) going down, or both.
Chris,
being part of the euro, sadly and unfortunately, it has to do so…until europe realise that it will kill them all. Deficit criteria is of utter importance to them…they are still pursuing the utopic dreams of avoiding too much disparity between its members…Additionnally Germany, which has paid for reunification (huge cost !), does not want to pay for spain, ireland etc…i guess
IMF being IMF they will as always provide advices that will help lenders and kill the country (i remember them advising ethiopia to open its stock markets, cut spending etc…while there were still starving issues etc. blatant how emerging markets who did NOT follow their advices are now in better shape than those that did)..i mean they are a bunch of old farts triting the same old worthless if not dangerous recipes…
Whalen is too smart on banking to not listen to.
Agree with Boatman. Also don’t think gentle Ben will have as much freedom going forward to be creative in saving banks. The Fed is “independent” but still has to pay some attention to happenings around it The mood of the country has shifted. More people are aware of the Fed–not just economic nerds like most of us that visit here. Even Sara P has voiced her “wisdom” on the subject. Also see a video on QE that is making its way around the web–can be found at http://www.youtube.com/watch?v=PTUY16CkS-k really cute. Ron Paul will not be helpful to Ben (he might need a sleeping bag up on the hill to save time going back and forth to hearings). Eventually banks have to make a real mark to market profit and that could be very painful–maybe a 600 print on the market might be reasonable. Sure wish I could guess when.
An add to my last post– do not agree with the economics of the video– just pointed it out to show the headache that Ben may be facing. Agree with most of TPC on QE thought I better add this before I get a lot of flack/
The Govt. continues their long term bail out of the banks while the middle class lose their homes, jobs, and make zero interest on their savings. Then the Banks executives, the people that ran our economy into the ground with their greed, award themselves massive bonuses with tax payer infused earnings. If the other shoe does fall and America slips into a real Depression, possibly even hyper-inflation, I am afraid that there are people that will be looking for pay back. The Govt. has failed in holding the bankers accountable. The people may do so yet. If I were a Banker I would keep watch on the streets from my ivory tower, and be very familiar with the exits.
the govt wants consumers to spend but we are to deep in debt they should force the banks to dump all the houses on the market driving down the price so they are afordable people would then have money left over after there mtg payment to buy things then if we buy from made in north america jobs would be created if we let the gov keep printing money we will have hyper inflation and everybodys pension will be worthless
While I agree with the general tenor of this report, there are some errors. E.g. the claim of 4-5 points for FNMA/FHLMC is wrong; recently, borowers have been getting 30-year fixed loans at 3,875% for only 1-2 points.
While I suspect that the big banks may all be insolvent, the situation is different at each bank. Forexample, while Chase bought all the WaMu toxic sludge, it did so at a huge discount and also has the ability to put loans back to FDIC. Also FDIC retains any claims against WaMu, not Chase. So it is unclear whether WaMu will have a positive or negative impact on Chase’ income.
Wells and B of A each bought Wachovia and Countrywide, respectively. The net effect of those acquisitions will depend upon the prices paid, performance of theloan portfolio, and whether any losses were successfully isolated from the acquiring bank. Again, a big unknown.
Finally, a huge problem for all the big banks, to the extent they participated in the RMBS is the huge failure to do legal REMIC transfers and the resultant uncertainty this has created in the foreclosure arena. Note that these failures are triggering lawsuits by borrowers and investors alike. The exposure is a vast unknown, but probably beyond the ability of any of them to absorb.
So with huge potential risks and bailout again unlikely, the big 4 are looking great.
correction:, “… the big 4 are NOT looking great.”