Interest Rate Roundup

Friday, February 29, 2008

The risk of failure(s)

You don't need me to tell you the U.S. financial industry is facing unprecedented challenges. What I still think some underappreciate, however, is that this crisis is different from ones we've seen in the past. Many past crises tended to be isolated to one or two parts of the credit market. But this time around, we're seeing major credit problems popping up in everything from residential mortgages to commercial mortgages to leveraged buyout loans to credit cards to auto loans. (And I'm probably forgetting a few!)

Let me enter into evidence the the Federal Deposit Insurance Corp.'s latest Quarterly Banking Profile (Warning: Large PDF link) This report comes out every three months, and it always has a treasure trove of information on the banking industry. The headlines and subheads tell quite a story:

"Quarterly Net Income Declines to a 16-Year Low"

"Noncurrent Rate on Mortgage Loans Reaches New High"

"Net Charge-Off Rate Rises to Five-Year High"

"Three Failures in 2007 Is Most Since 2004"

And what about the details? They're pretty awful, too ...

* In the fourth quarter, aggregate profits at the 8,533 institutions the FDIC tracks slipped to $5.8 billion. That was a drop of more than 83% from a year earlier, and the lowest absolute level of net income since the fourth quarter of 1991.

* Return on assets — a key measure of how much profit banks are generating from their assets (loans, securities, etc.) — plunged to 0.18% in the quarter, driven by problems at a few of the nation's largest institutions. That was down from 1.2% a year earlier and the worst performance since 1990.

* Provisions for loan losses — money banks add to their loss reserves when they expect credit performance to sour — soared to $31.3 billion in the fourth quarter. That's the highest level in any quarter ... EVER ... and more than triple what we saw in the same period of 2006.

* Net charge-offs — the hit banks take when they determine that nonperforming loans are essentially a lost cause (adjusted for recoveries on previously charged off loans) — surged to $16.2 billion from $8.5 billion a year earlier.

And again, it wasn't just one category of loans. Charge-offs rose 33% in credit cards ... 58% in the other loans to individuals ... 105% in the commercial and industrial loan category ... and 144% in the residential mortgage business.

Now here's the thing: On my recent trip, I spent a lot of time reading up on the last major banking crisis -- the S&L meltdown. "The Savings and Loan Crisis: Lessons from a Regulatory Failure" isn't exactly beach reading, but it's definitely a useful historical tome. It lays out the general outline of what happened back then for those of you who may not be familiar. In a nutshell:

Interest rate gyrations in the late 1970s and early 80s greatly eroded the capital of the entire S&L industry. Lenders made long-term, fixed-rate mortgages and funded them with short-term borrowings.

When short-term rates rose, their funding costs increased, but they couldn't do anything about those long-term loans. They were stuck holding old mortgages that didn't yield as much as new mortgages ... and the value of those old mortgages plunged.

Legislation then allowed the S&Ls to aggressively expand into new markets, like commercial real estate, in the mid-1980s. The intent was to help the financial firms "earn their way out" of the interest rate problems.

But tax law changes and regional economic downturns struck later in the decade, dealing a death blow to the industry. Failures surged, and we as a country ultimately had to spend around $150 billion cleaning up the mess. You can read more at the FDIC web site if you're so inclined.

Today, the question that people are starting to ask is simple: Are we facing a new rash of failures? Fed Chairman Ben Bernanke was forced to address that question head on yesterday. His answer: "There will probably be some bank failures."

Banks are much better capitalized today than they were back in the S&L days. So I do NOT expect to see as many failures this time around as we saw back then. Yet the lending and capital market problems that financial institutions face today are also more widespread, in my judgment. The decline in home prices is unprecedented in modern history too, and that's driving mortgage delinquencies and losses into uncharted territory.

The number of "problem institutions" flagged by the FDIC is already on the rise. It climbed to 76 in the fourth quarter of 2007 from 65 a quarter earlier and just 50 at the end of 2006. Problem banks are those with "financial, operational, or managerial weaknesses that threaten their continued financial viability." That is still low by historical standards, mind you. But clearly the FDIC is concerned about the trend, as indicated by the recent Wall Street Journal story chronicling how the agency is staffing up.

That brings me to some news that just broke in the last 24 hours: Troubled California S&L Fremont General just warned of additional write downs and reserve additions. This language should have us all sitting up and taking notice:

"... the Bank may need to record additional asset write-downs and reserves, which could result in further losses or, alternatively, will require the Bank to adjust downward its regulatory capital. In either case, such potential adjustments will further erode the Bank's total equity capital of $448.6 million that was reported in the Bank's Call Report publicly filed with the FDIC on January 30, 2008 for the year ended December 31, 2007. In addition, if the possible adjustments are ultimately recorded by the Bank, such adjustments could have an adverse effect on the Company's financial condition, results of operations and business."


"Fremont General also has significant liquidity risk as a result of limited sources of cash available to satisfy its obligations. At December 31, 2007, Fremont General had $21.1 million in cash and cash equivalents for payment of ongoing operating expenses, debt service and inter-company settlements. Since March 2007 when the Company and the Bank first became subject to regulatory enforcement orders, the Company's traditional source of funding (dividends from the Bank) has been disrupted. Without the ability to rely on dividends from the Bank, the Company will require funds from other capital sources to meet its obligations."

Fremont then goes on to say it has retained Credit Suisse and Sandler O'Neill to help it fix its capital deficiency problem. A company sale, or the restructuring of Fremont's senior debt and preferred securities, are options on the table. It's suspending interest payments on certain subordinated debt immediately.

I am NOT suggesting Fremont will fail (even as the stock price was recently down 66% on the day). But this kind of news just underscores how some institutions are really hurting in a way we haven't seen in a long time. In sum, I believe outright failures will be making headlines over the coming 18 months, for the first time in a long time.


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