loan losses

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Voodoo Real Estate

Just a quick note: sometimes we need to remember that talk of ‘markets’ is a massive abstraction. A market is simply us. Or a collection of us. So when we speak of markets doing something or other we are really talking about us doing something or other. In this context a walk around my neighborhood here in Manhattan is quite illuminating. Clearly the next recessionary shoe has yet to drop.

Yes there are plenty of empty store fronts. Commercial rents are obviously not fully adjusted to the more limited cash flows that small businesses can generate from the spaces that, only a year or two ago, could have been much more lucrative.

But the big issue is commercial real estate. There are so many empty buildings within a short walk of here that I can only conclude that a race is on to garner the few remaining sales. Once those dry up completely – and who says they haven’t already? – and the entire financing arrangement of whatever is left surely crumbles. These are big ticket items. They have cost multiple millions to build and all are massively reflective of the gaudy days gone by. They appear doomed.

They are condominium buildings with all sorts of ‘amenities’. One has a fireplace in its ‘all season pool’ area. Others boast lavish lifestyles with pompous catchphrases supposed to reflect the upper echelon folks who were going to snap up the over-decorated and over priced ‘luxury residences’. The collapse of finance and its bonus structure, even though it may bounce back, has devastated this part of the market.

And because of the cash treasure trove these buildings once represented no other construction went on recently. Every corner seems to have a huge, and generally ugly, condominium building perched on it. They all have silly market researched names. All are pretension personified. And all are empty.

Rumor has it that at least one is approaching the end of its financiers patience. Another has been so incapable of selling its ‘starting at $4 million’ luxury spaces that it wants to cut prices. But, and here’s the real insight: the banks won’t let it do so. The problem is that the prices necessary to sell these ridiculously ill conceived places is below that needed to repay the loans. So a stand off has emerged.

The developer cannot sell at the listed price. The bank cannot afford to let the prices be cut. Why not? Because once the condos are sold for the lower market price the bank will be forced to recognize a loss. So, even though we all know that the market clearing price is much lower than the listed price, and even though there is ample evidence that the building as originally conceived is a hopeless money losing proposition, nothing happens. It sits. Ugly. And very overtly a loss.

On the bank’s balance sheets these buildings are still shown as good assets. Any casual observer walking by knows they are toxic. The bank’s regulators and auditors endorse the charade. The forlorn hope is that the market recovers. Or, more likely, each developer and its banks hope that their building is the lucky one to sop up the few remaining buyers leaving all those other buildings to take the loss.

So a race has begun. It is a war of nerves. The first building to blink loses. Its bankers have to write down the loan. The advertising against each other is insane. Do a Google search on one and the chances are another will pop up on the same page. Bottom fishing lawyers are in on the act. I came across one law firm advertising its prowess in getting people out from underneath the deposits they might have already made. These are fun times as we watch the inevitable losses mount amongst the developers who are responsible for the pandering to the well heeled ‘proper’ folks who they want to populate their buildings. The regular people of New York, the ones whose neighborhoods were torn down to make way for these ‘stylish’ behemoths, can savor this moment.

What goes around …

And think of the ‘knock on effects’. As each of these new buildings struggles to fill its street level commercial space it has the potential to rob tenants from existing buildings. If that happens the older building is left with a gaping income hole to fill. If it fails its occupants have to make up the loss. Simple finance tells me that those old condos are now worth less than they were. So the new buildings produce a glut of space that presses down on real estate values generally. It is the Manhattan version of the foreclosure blight Florida, Nevada and California have experienced. Even ‘good’ buildings can get dragged down when there is an excess of ‘bad’ buildings.

Meanwhile, the lesson to take away from a quick walk around this part of New York is that those bank balance sheets are full of assets that are already rotten. If only the banks were telling the truth.

That’s the emerging wave of commercial real estate losses I have warned about for months. That’s why I thought the stress tests were inadequate.

Maybe the next wave of losses is coming to a street corner near you.

Maybe its there already.

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Banks To Repay TARP Money

The Treasury Department has approved the plans of ten banks to repay the TARP money they received as part of last year’s bailout of the banking system. The total cash going back is $68 billion, which can either be lent out again if the need arises or simply be used to reduce the government’s need to borrow from somewhere else.

In one way this is a good sign. Obviously the administration has more confidence in the banks than it did even a month or so ago. The names of the banks has not been released officially but reports suggest that JP Morgan Chase, Goldman Sachs, American Express, and Morgan Stanley are among them. Citigroup, Wells Fargo and Bank of America are not.

The banks have wanted to repay the government since they all passed the stress tests performed a month or so ago. Continued use of TARP money meant that they were subject to restrictions on the way they conducted themselves. All the banks chaffed at the notion of government scrutiny of their activities, and in particular, at the limits placed on pay scales. Bankers like to pay themselves big bonuses, and while they were on the government dole political pressure and legal straight jackets stopped them from making significant payments to ‘key’ people.

“The cost in cash and human misery that the bankers created is epic. They should pay for it.”

The government was adamant that the banks demonstrate an ability to raise capital from private sources before it would allow repayment, hence the frenzy of debt and equity issuance by the healthier banks over the past month. Now that most have managed to restore their access to the capital markets the regulators are satisfied that this first group can be weaned off taxpayer assistance.

But is this a good thing?

I am not so sure.

The banks who are now allowed to repay TARP cash all passed the stress tests. As you know I thought the stress tests were none too stressful. In fact I thought them to be easy. Not only that, but the banks all indulged in a period of negotiation subsequent to the tests, so the image created was not one of severe oversight but of indulgent cooperation. The regulators simply didn’t have the stomach to impose strong standards, and so the banks were required to rebuild themselves only up to fairly lenient levels of capital. And the ‘worst case scenario’ they all supposedly passed looks a lot like the most likely outcome for this year’s economy rather than a severe further downturn.

Given this, I don’t think that we truly know just how healthy these supposedly healthy banks are. They are all still sitting on substantial portfolios of toxic assets of doubtful worth. They will no doubt need to keep raising capital just to offset future losses on those portfolios. Which means that the amount of capital available to be deployed as loans is still limited.

So the flow of credit into the economy is by no mean assured even though we now have a slew of ‘healthy’ banks.

Meanwhile we now have two types of banks: those who have repaid their TARP money, and those who are still tethered to the Treasury Department. Clearly the latter are now at a significant competitive disadvantage. The credit markets will differentiate even more strongly between the ‘strong’ banks and the ‘weak’ banks which implies higher interest rate costs for the weaker ones and possibly even more difficulty in their capital raising efforts. Private investors will take the repayment green light as a government ‘seal of approval’ and thus channel their investment into the strong banks and away from the weak ones. This will make it harder for the likes of Citi to rebuild itself to the point that it, too, can be allowed to repay TARP.

The market has, of course, been drawing its own conclusions as to relative bank strengths, so all of this may not change the environment for capital raising very much. But it cannot be welcome news for shareholders of Citi, Wells, B. of A. etc that their organizations are still considered too weak to come off life support.

In broader terms there are very clear signs that the credit markets have settled down from their crisis levels of last September and October. Risk spreads are much lower, funds are flowing, and investors are willing to lend to banks gain. So there is a semblance of normality slowly returning. The recent spate of better news in the ‘real’, i.e. non-financial, economy has helped lift the mood of investors too.

But we should take great care not to declare the crisis over. The banking system remains very fragile and large losses on commercial real estate and credit card portfolios loom in the near future. Plus the banks are as opaque as ever in their activities. Nothing substantial has changed in the system except for the reduction in competitors and the new two tier system of good and weak banks that results from this TARP repayment. The biggest of our banks remain ‘too big to fail’ and can thus indulge in extravagant risk taking for the benefit of their bonus payouts knowing full well that the taxpayers will pick up the pieces.

This privatization of profit and socialization of loss is an anathema to the long term health of the economy. It has to stop. Bankers have to be made accountable for the losses that their excessive risk taking produces. It was failed bank management, and, in particular, a cavalier approach to risk, that brought the nation’s economy to its knees. The cost in cash and human misery that the bankers created is epic. They should pay for it.

This means radical and structural reform of the banking system.

There are proposals already floating around as to how this should be done. So far none are adequate, although some regulators are agitating for strong action. The latest salvo to be fired came from Federal Reserve Board Governor Dan Tarullo just this week who focused especially hard on the banks considered to be ‘systemic risks’. He advocates a fairly hard line to restrict the damage that rotten bank management and failed bank business models can do to us in the future. As of now though the debate is only warming up, and time is slipping by.

But for now the big banks will remain ‘too big to fail’ and thus we can expect them to retain control over public policy. This is the most important point we must confront. The banks have ‘captured’ the legislative process and thus can ensure that legislation is always modified in their favor. Even in these times of evident failure they have been able to push back against bankruptcy law changes that would have allowed easier mortgage payment modifications for borrowers. I am thus not expecting the administration to introduce the kind of stringent re-regulation I see as needed to prevent further banking mischief.

The banks, even in their currently impoverished state, still flood the electoral system with cash and other forms of largesse. In any other nation on earth this flood would be called corruption. Here we call it free speech. It is the sort of free speech advocated by the Mafia. I doubt whether our doughty legislators will be able to resist the suggestions of their local bankers, let alone those of the big Wall Street banks and the various trade associations that inhabit the shadows of Washington.

So while we applaud the repayment of TARP money, we may regret the continued power of the banks. They are not fixed yet. And the odds of getting them fixed, as in becoming socially acceptable and reliable institutions, is waning. As the immediacy of the crisis fades and the attention span of Congress shifts its focus somewhere else our window of opportunity for reform diminishes.

I wonder whether we have lost the chance to restore balance to the economy even though the debate is only now beginning. I hope not.

Addendum:

Clearly the Congressional Oversight Panel [‘COP’], led by Elizabeth Warren of Harvard University, agrees with me about those stress tests. The panel’s June report contains a critique of the tests written by two Berkeley professors. They conclude that the tests are too lenient given where unemployment already is [the tests worst case assumed an unemployment rate of 8.9% as an average for 2009]; that they don’t extend far enough into the future, while much of the commercial loan losses will occur in 2011 and beyond; and that they have been deliberately obscured so that understanding how they were carried out is very difficult. The COP concludes that the stress tests should be run again to adjust for these problems.

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The Small Bank Crisis

Lost in all the hubbub about the losses and possible collapse of our largest banks – most of the fuss has been about only the 19 largest banks in the country – is the ongoing crisis that the small, local, banks are facing. So it is worth taking note of what’s going on at the lower levels of our financial system.

And the news is not good.

The latest FDIC report shows some very disturbing trends among our smallest banks. For instance over one fifth are not making any money: the figures for the first quarter include the fact that 22.5% of all banks with less than $100 million in assets are unprofitable. Not all of these will go out of business, but a large percentage will. The FDIC has been very busy so far this year winding up small banks, about 21 through March, and the likelihood is that many more will disappear as we go through the nest wave of loan losses.

Smaller banks are particularly prone to commercial real estate losses because those types of loans make up a much higher percentage of their total loan book. So with the oncoming rush of property developer defaults, which is typical at this time of any recession, the pressure on smaller banks will intensify.

Couple this with the alarming drop in profitability small banks have suffered over the past two to three years – returns on assets have dropped by almost two-thirds for the group of small banks as a whole – and the situation is even worse.

Finally there seems to have been a shift of deposits out of smaller banks towards larger ones. This deprives the smaller banks of their most reliable source of funding and reduces their ability to finance activities in their local communities. Since smaller banks play a pivotal role in many of America’s more rural areas their plight is especially relevant and should not be overlooked.

The administration has begun to shift its bailout attention towards the lower end of the banking market in anticipation of the difficulties that are now emerging there: there are now 305 banks officially listed as being ‘problematic’. The cost to the FDIC of winding up those 21 small banks led its reserves to drop from $17.3 billion to $13 billion in the first quarter alone. As a result it has levied new fees on the banks who benefit from its guarantees in order to raise almost $5.6 billion to create a war chest to deal with the problem banks on its list.

So, while our attention is inevitably focused on the ‘too big to fail’ banks like Citigroup and Bank of America, we should acknowledge the crisis brewing down below. One result of this recession will be a further reduction in the number of small banks scattered across the country. It is not just Wall Street that is being re-cast. Main Street is getting a make over too.

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The Results Are In!

And the winner is? Well that depends on your point of view. The early winners seem to be Goldman Sachs and JP Morgan Chase who flew through the tests with flying colors. The losers include Bank of America and Wells Fargo, the latter of whom must be particularly peeved having been lauded by no less an authority than Warren Buffet just a few days ago. Following up the rear is GMAC who seems to be the only tested bank who pulled the equivalent of an ‘F’.

So. Now what?

The banks that have been told to get capital have until June 8th to present a plan showing how they intend to do so. They then have until November 9th to raise the cash.

What if they don’t? We’ll see about that later.

Now that the whole charade is over and the dust settles what have we learned?

The tests indicate that the Treasury Department expects this group of banks to suffer a further $600 billion in loan losses through the rest of this credit cycle. Those losses are expected to stem from such things as the effects of rising unemployment and the ‘normal’ cycle in commercial real estate. This estimate is on the low side. Other organizations, most notably the IMF have forecast losses much worse than this.

In part the difference between the IMF and the Treasury may flow from the fact that the Treasury allowed the banks to do the predicting by using the banks own risk assessment models. This involvement of the banks would naturally skew the expected losses down. After all these are the same risk models that helped create the mess in the first place.

As you know I have been highly critical and skeptical of the entire testing process. I find it odd that the banks were involved so deeply in the process – it sounds more like a self-assessment than a rigorous audit. And the fact that they were negotiating the results seems just absurd. These two factors fed my naturally cynical nature, and resulted in my conclusion that the tests were run as a ‘misdirection’ play to make it seem as if we were facing the banking crisis rather than actually doing anything about it.

Be that as it may.

The tests are now done and we must all face the new reality.

So the discussion now shifts to the next few months and the consequences of the testing process.

Are the banks safer?

Well not yet. Some like Goldman and JP Morgan Chase are already chaffing at the bit to repay TARP money so that they can get on with their business without government interference. I don’t blame them. We should all recall that the banking landscape has been re-written over the past few months. There are far fewer major players and some of those left standing are ineffective players at the moment. I can imagine the guys at the healthy banks want to get stuck into the game: they will make hay over the near tern while their weak competitors do lazy eights as they raise capital. Expect profits to rise sharply among the healthy. Not only is the competitive landscape ripe for profit making, but loan spreads are high, the yield curve has been twisted in favor of lenders, and cheap government bailout money is lowering the cost of doing business. In short if you are a ‘healthy’ bank things are truly looking up. The government is doing all it can to give those banks a leg up.

Meanwhile: the weak banks will wallow around. Their spreads and so on will also improve. So their profits will be better. Loan losses will cripple any efforts to expand lending, but that has become secondary. Public policy, which at the start of this crisis was focused on getting lending going again, is now more focused on keeping the weak banks alive long enough that they can thrive on their own. The second objective is to keep the out of pocket cost to taxpayers as low as possible.

An interesting problem may emerge later in the year when, and if, one of the weak banks fails to raise the capital the government has ordered it to. Right now the Treasury Department is indicating that it will forcibly inject more capital at that point. I doubt it. One of the administration’s goals in the test process was to punt the problem forward. By November with banking conditions slightly improved and the economy gradually rising from recession, both of which are certainly possible, the politically smart move would be to punt again. Since the administration seems to have been driven by politics rather than economics so far I would bet on another punt.

Plus I expect lost of discussion to surround that part of a bank’s capital called Tangible Common Equity [‘TCE’]. As I have said here many times that ratio can be fixed more easily than broader measures of capital such as Tier 1 Capital. Geithner has been hugely successful in switching our attention to TCE so there is no reason to change now.

One of my yardsticks for the testing process would have been the level of howls from the industry. Normally a strict audit will elicit predictions of dire consequences and imminent disaster. So far the reaction has been more one of confusion. The stock market has bid up then bid down the stocks of the weak banks, largely due to the flood of rumors we have suffered through. Now that the facts are before us the market should settle down. I would expect banks that are deemed healthy to attract investors, while those who are weak will have a harder time raising private funds: who would want to invest in an organization that the government has on life support? So an outcome of the testing is that the weaker banks, who need to find capital, may find it harder to do just that. The best avenue for capital growth will then be from the sale of subsidiaries and lines of business. Look for hedge funds and private equity funds as well as the healthy banks to attempt to bulk up by acquiring bits of their weaker competitors.

This really is a case of the rich getting richer and the poor getting poorer.

In the end I am glad the process is over. I am sure you are too, given all my venting over it.

But the concerns remain. We should be leery of declarations of success. The second wave of losses is coming, and the structure of banking remains the same. If anything there are some too big to fail banks that will now be much bigger.

Saving banks is one thing. Fixing them so they can’t screw us all up again is another.

So I will leave you with this:

My concern has always been with the structure of the industry: it needs to be reined in so that we are not exposed to its excesses again. As I watched the administration deal with the immediate issue of saving the weaker banks I used it as an acid test of their ability or desire to take what I perceive to be tough action to downsize or limit the power of the industry. The stress test process leaves me highly skeptical. The government seems to be unable or unwilling to face the banks down. Whether that results from hard nosed political calculation or from simple cowardice I don’t care. The result remains the same. Until the banking industry is severely restricted and its major players reduced so that they can fail without destroying everything around them our economy remains at risk: from the undue influence of financiers and from the very high prospect of another asset bubble resulting from easy credit.

So my confidence is high that the banks will be saved. And it is low that they will be fixed.

Too bad.

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Sometimes the Truth Really Hurts

I have just managed to spend some time reading through the IMF’s recent Global Financial Stability Report. And yes it’s tedious at over 200 pages in length. Suffice to say that this is not the stuff young children should be allowed to read: the numbers are staggering.

Martin Wolf at the Financial Times offers a great summary of the report so I won’t repeat it. You all should add him to your regular list of reading: I think he is one of the best analysts on world affairs out there.

But, for those of you who want a sample here are some numbers to get your arms around:

  • $4.4 trillion. That’s the total of all global banking write-offs expected at the moment.
  • $2.7 trillion. That’s the write-offs in the US alone. Just to show how fluid the situation is: this level of write-offs compares with the last IMF estimate back in October of only $1.4 trillion.
  • 37 years. These write-offs represent 37 years worth of foreign development aid at 2008 levels.
  • 13%. The write-offs represent about 13% of the GDP of the countries involved.
  • $8.9 trillion. This is how much governments worldwide have spent so far in providing aid to the financial system. And that looks like just a beginning.
  • $500 billion. The amount of new capital US banks need to get back to a 17 to 1 capital ratio, which is barely adequate.
  • $25.6 trillion. The amount of bank assets that will mature and need to be replaced between now and 2011. Yes that’s $25.6 trillion!

As you can see these numbers are simply breathtaking. They tell a story of an industry not just run amok, but totally beyond control. Insane and totally self regarding the banking industry has brought the world to its knees.

Banking became a world unto itself. It created products and services that had no bearing to the ‘real’ economy, but represented fluff that trading desks could churn at lightening speed to earn fees that supported short term bonus structures. The actual contribution of banking to economic activity was hidden behind a veil of self gratification and greed that ended up destroying the world economy. The numbers do not lie: the business models providing the basis for banking over the past thirty years are a disaster.

The truth is that banking became a cancer. It is an illusion based upon a series of false premises and demonstratively incorrect economic theories. It is no accident that the derivatives business exploded right after the publication of the Black-Scholes-Merton financial economic theory. That theory is wrong at its core, but it gave legitimacy to what had previously been viewed as gambling. It took a phone call from Milton Friedman to the SEC to force them to allow the Chicago Exchange to trade derivatives. The rest is history. Finance became totally separate from all other economic activity. A world unto itself it has now ruined lives right across the globe.

There was no underlying purpose to most of what the big banks trading floors did other than to generate fees. It was perhaps the world’s most utterly pointless and useless utilization of resources ever.

And the IMF’s data highlight the incredible damage.

What the IMF also points out is that recessions following financial crises are particularly severe. So are recessions that spread out across the entire globe.

Presumably recessions like this one that are both global and originating within the financial sector are the worst possible kind.

Sorry folks, but this recovery may have to be long and slow in order to eliminate the excesses that the banks wrought.

In fact that’s a very good bet.

Which is why I beat the drum of banking reform. Never again must they do this to us.

Addendum:

For those of you who have no clue what the ‘Black-Scholes-Merton’ theory is: have no fear! It is one of the most significant economic theories of the last fifty years. It won the authors Nobel prizes and huge acclaim. It is taught at the most elite economics departments around the world – MIT seems to be at the fore. It anchored the whole explosion in derivatives trading. It gave intellectual plausibility to options trading.

And it is wrong. Totally.

It relies on core assumptions that collapse in the face of empirical analysis and, frankly, should be tossed aside along with stuff like the ‘efficient markets hypothesis’ and all the other equipment of the extreme neo-classical school of economics. Hiding behind all those Nobel prizes doesn’t make up for the damage their ideas have wrought.

One of my beefs with the economics profession is that it simply doesn’t want to admit its role in the current debacle. I suppose $4.4 trillion in write-offs isn’t enough to get their attention. This was their model. Their theory. They are just as culpable as the idiots on the trading desks, and the politicians of all political stripes who pressed for deregulation.

When I hear academic economists decrying their colleagues for teaching this rubbish I will start to listen to what else they have to say. Meanwhile I consider them more than a little ethically challenged.

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