Interest Rate Roundup

Monday, January 07, 2008

Paulson says subprime problem "well-contain" ... er ... sorry, wrong speech

Actually, what Treasury Secretary Henry Paulson is going to say in a speech today to the New York Society of Security Analysts is that "our financial institutions entered this period well-capitalized, and we expect them to remain so," according to Bloomberg. He will also reiterate the Bush administration's position that it will support increasing the size of mortgages that Fannie Mae and Freddie Mac can back if Congress tightens oversight of the two GSEs. And he made some comments about the government's program to freeze rates on select subprime loans.

My headline above is a tongue-in-cheek reference to several comments from Paulson and others in 2007 that the economy was fine and that the subprime mortgage mess was variously "well contained," "containable" and so on. Today, the question at hand is how severe the loan loss problem will be for the banking industry -- and whether we'll see a rash of actual bank failures.

Right now, the bad loan problem that was formerly "contained" to subprime -- and then Alt-A -- home mortgages , is spilling over (to a lesser degree) into the prime sector. Moreover, delinquency rates on home equity loans, HELOCs, and indirect auto loans are also climbing. As if that weren't enough, you've got a potential problem brewing in LBO financing and commercial real estate mortgages, given all the stupid lending that went on there.

I'll grant that banks entered this period of crisis in pretty good shape. The number of "problem institutions" identified by the FDIC fell substantially in the early 2000s. (Here's what that means, per the FDIC: "Federal regulators assign a composite rating to each financial institution, based upon an evaluation of financial and operational criteria. The rating is based on a scale of 1 to 5 in ascending order of supervisory concern. 'Problem' institutions are those institutions with financial, operational, or managerial weaknesses that threaten their continued financial viability. Depending upon the degree of risk and supervisory concern, they are rated either a '4' or '5'. For all insured commercial banks and for insured savings banks for which the FDIC is the primary federal regulator, FDIC composite ratings are used. For all institutions whose primary federal regulator is the OTS, the OTS composite rating is used.") And for a 10-quarter stretch between mid-2004 and early 2007, not one FDIC-backed institution failed, the longest such stretch on record.

But the PI list started to lengthen in 2007. This chart (incorporating Q3 2007 data from the FDIC) also shows that noncurrent loans are rising fast. The longer the housing slump persists, the more loan categories show signs of stress, and the more the U.S. economy slows, the higher that number of problematic banks will rise -- and the greater the risk of a noticeable uptick in bank failures. Let's hope Paulson is right about the prospect for banks to weather the storm fairly well.

UPDATE: Here is the text of Paulson's speech.


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