Exposure at Default: As Banks Shrink, So Does the Economy
September 16, 2009
"I was just reading your testimony on subjectivity and risk in models. I agree, though isn't the contrast between objectivity and subjectivity more of a continuum? Think about banks. Only 100% reserves makes a bank objectively safe from runs. Once you move to fractional reserve banking you have to accept some subjectivity and make assumptions to model the right level of reserves in order to assess risk. To me, the interesting point is the trade-off between that subjectivity (systemic risk) and economic efficiency. We can't have zero systemic risk, or perfect objectivity in models without an unacceptable loss in economic efficiency. But how much subjectivity is too much? That's one of the big challenges for financial economics right now, and until we get some sort of answer I don't see how we can make the right decisions in designing appropriate regulations."
An IRA Reader
This week in the IRA Advisory Service, we provided our institutional clients our estimate for the size of the deficit in the FDIC deposit insurance fund ("DIF") through the current economic "cycle" and what it may imply for future bank earnings. If you have not already done so, read the Picking Nits comment posted last month by IRA CEO Dennis Santiago.
Stare at the second table in the Picking Nits post showing the assets of the various banks in the different ratings strata from A+ through F as of Q2 2009. What does the $4 trillion or so in "F" rated banks suggest about losses to the DIF? Contact us if you want information about the IRA Advisory Service.
Suffice to say that before Treasury Secretary Tim Geithner and the other G-20 finance ministers set about to raise capital levels, they need to understand that the earnings of the banking industry are going to be impaired for years as the cost of resolving failed banks is repaid. Restoring solvency is the first issue for many banks, then we can talk about increased capital and restrictions on risk taking equally. And as the banking industry shrinks defensively in order to conserve capital and fund liabilities impaired by realized losses, the credit available to the US economy also shrinks. You can't have economic growth without credit growth.
Looking at the banking industry, it is really remarkable that Fed Chairman Ben Bernanke has decided that the recession is over - but not surprising. After the past decade or more of credit fueled exuberance, no surprise that the maddening crowd wants to go back to the way it was. Many of the bankers and Buy Side investors with whom we speak feel that the worst of the economic crisis is behind us. And we do see increase activity in the secondary markets for loans and failed properties, an encouraging sign that may - emphasis may - push down the ultimate cost of cleaning up the mess in the banking industry. There are many other indicators that suggest consumers and business are rebounding from the summer of dread.
But while we all do hope for better times ahead, the fact remains that the supply of credit available to the global economy continues to shrink with the balance sheets of banks around the world. Forbearance and flexibility are the order of the day for most lenders. The impact of this credit shrinkage on asset prices is decidedly negative, but in many cases, investments in residential and commercial real estate made over the past five years are so far under water that the owners are simply walking away. And when we say owners, we are not just talking about residential home owners, but some of the most respected institutional players in the worlds of Wall Street and commercial real estate as well.
Our fellow scribes at National Real Estate Investor, for example, report that last month, "Tishman Speyer Properties defaulted on loans associated with the acquisition of 28 Washington, D.C.-area office buildings for $2.8 billion from the Blackstone Group in 2006. Blackstone sold the portfolio to Tishman at the height of the market, the same month it purchased CarrAmerica, the portfolio's previous owner. Tishman also owns Rockefeller Center and the Chrysler Building in New York and controls assets worth an estimated $35 billion."
We hear in the channel that another market peak investment made
by Tishman, namely the $5.4 billion buyout of Stuyvesant Town and Peter Cooper
Village on Manhattan's East Side, could be going pear shaped in the not too
distant future. One of our colleagues in the ratings community who lives
in Stuyvesant Town and participated in an effort by fellow residents to make a
competing offer for a buyout, says that the closest that the banks advising
their group could get to the valuation agreed by Tishman was $3.5 billion,
suggesting that the deal could now be close to 50% under water.
The same source tells The IRA that Tishman apparently thought they could force rent stabilized tenants out of this unique community on Manhattan's Lower East Side much faster than has been the case. The idea was eject the current tenant, upgrade the apartment and remove it from rent stabilization, then lease at $2,000 and more to make the $5.4 billion valuation work. Well, not. The tenants, being New Yorkers, sued and Tishman lost a ruling in a lawsuit in New York Supreme Court accusing the landlords of illegally raising rents and deregulating rent-controlled apartments. "It could ultimately cost them up to $200 million that they don't have," reported The New York Times. The matter is still before the NY courts on appeal.
The funniest part of this sad tale is that because the City of New York decades ago gave the land for Stuyvesant Town and Peter Cooper Village to Met Life in return for building affordable housing, the ultimate motive of the new investors to upgrade the apartments and end the rent controls on same is probably not even possible under New York law. This is the key issue now before the New York State Court of Appeals, which is the state's highest court, by the way. And the lawsuit would effect all rent controlled apartments in New York City.
Somehow the army of investment bankers and lawyers representing Tishman, BlackRock (NYSE:BLK), SL Green and the Government of Singapore et al missed this little detail during their diligence. It would be kind of hard for us to believe that a bunch of smart people like Tishman and our friends at BlackRock would overpay by $2 billion for Stuyvesant Town and Peter Cooper Village just so they could gamble on a high-profile litigation on one of the most politically charged issues in New York City, namely rent controlled apartments. News reports say that the massive housing project could be in a restructuring by early in 2010, meaning that the equity is gone as even some of the debt holders also will get crew cuts.
Also of note is the fact that the TARP for Main Street
explicitly allows Treasury and HUD to use
public funds to bail out multi-family housing projects that are "at risk" or in
default. A cynic might argue that the Tishman Speyer et al, aided by good
friends like Reps. Barney Frank (D-MA) and Nita M. Lowey (D-NY) and Senator
Chuck Schumer (D-NY), will eventually approach Secretary Geithner for a
public bailout of their ridiculous investment -- this in the name of protecting
the rent stabilized tenants of Stuyvesant Town and Peter Cooper Village.
Even had Tishman paid a more reasonable price for Stuyvesant Town and Peter Cooper Village, the fact is that it would be virtually impossible to refinance the deal in the current market. Like many commercial and residential projects around the country, whether the deal makes sense or not, there is just no financing to be found. The continuing reduction in bank credit is entirely visible, yet somehow the inhabitants of Washington and Wall Street continue to pretend that it just ain't so.
Lending by the largest banks that received government bailout support declined for the sixth consecutive month in July, the Treasury Department said in its monthly report. Average loan balances at the top 22 recipients of government bailout support dropped by 1 percent in July. Average loan balances had also fallen by 1 percent in June, reports the AP.
But the reduction in available credit is not just reflected in loan balances. More important to many industries and investors is the huge reduction in unused credit lines, what we call Exposure at Default or "EAD" in the IRA Bank Monitor. We calculate unused lines as a percentage of existing loans for all FDIC bank units and then roll up this key metric into a bank only profile of the consolidated institution.
Click on the link below to see a chart showing the EAD for Bank of America (NYSE:BAC), JPMorgan Chase (NYSE:JPM), Citigroup (NYSE:C), Wells Fargo (NYSE:WFC and the large bank peer group of some 70 institutions above $10 billion in total assets.
The chart confirms the statistics from the Treasury showing that the unused lines for the top four banks have fallen dramatically over the past year. But there are a couple of interesting subplots in the FDIC data.
Perhaps most remarkable is the fact that crippled Citigroup remains the most aggressive of the top-four money centers in terms of EAD, in large part due to the large credit card and unsecured consumer lending operations. The ratio of unused lines to existing loans for all of Citrigroup is 2:1 or 200% as we express it in the Bank Monitor. The ratio of the credit card unit alone is 15:1 or 1,500%, but that is "normal" in a consumer lending operation.
Next in the group is JPMorgan, which has reduced EAD from over 200% to just 135% at the end of the Q2 2009. Given the institutional and commercial focus of JPMorgan, the change is remarkable for both consumers and business customers of the bank. Notice that in terms of percentage change, JPMorgan CEO Jaime Dimon has taken the most dramatic steps to protect his banks from defaults. Guess all of that PR fluff Dimon's lobbyists in Washington are giving to members of Congress and the Obama Administration about supporting the recovery with new credit is a little exaggerated. Just a little.
Bank of America is next on the list, in part due to the de-leveraging following the abortive acquisitions of Countrywide and Merrill Lynch. Note the huge skew in the data series at the end of 2005, when Bank America closed the acquisition of MBNA. Even with the large credit card portfolio, the combined EAD for the group is just over 100%. Again, those TV ads about providing new credit to the US economy seem wide of the market looking at the FDIC data.
Wells Fargo is the least at risk of the large bank peers with an EAD of just 50% as of the end of June 2009. Wells Fargo has always been conservative when it comes to unused lines, but notice that the bank continue to push down EAD even after the close of the merger with Wachovia. We would not be surprised to see this key metric fall further as Wells Fargo struggles to deal with the issues from the Wachovia transaction as well as its own legacy portfolio.
Finally, look at the data series for the large bank peer group, which actually managed to go against the negative trend of the top four banks until Q2 2009. Now it appears that the entire large bank peer group, roughly the same institutions in the Treasury lending survey, are all trying to reduce EAD as the banking industry heads into the worst part of the credit crunch in 2010. This, by the way, is why Citigroup, Bank America and other happy campers like SunTrust (NYSE:STI) are making all of this noise about repaying the TARP, hoping against hope that they can raise more common equity before those Form 13s starting appearing on EDGAR, showing that the smart money is running away from financials at flank speed. More on this next week.
Bottom line is that deflation is still the chief threat to the US economy, driven by a relentless contraction in bank and nonbank credit. Until we see a restoration of the market for nonbank finance and a sustained turn in the EAD of the large bank peer group, which accounts for almost 70% of the entire US industry balance sheet, we do not believe that any economic recovery will be meaningful in terms of jobs or asset prices. Indeed, we have to wonder whether the FDIC should even try to impose another assessment on the banking industry to fund failed bank resolutions when the effect of this action is to remove capital from the system and thereby accelerate the shrinkage of the collective balance sheet of US banks.
Before Secretary Geithner and the G-20 talk further about raising bank capital levels, we first need to find a way - and fast - to stabilize the existing capital base of the banking industry. Failure to do so, in our view, could be catastrophic for the global economy and could also further radicalize the political situation in the US, where many Americans are starting to realize that the party is well and truly over. As we said on CNBC on Monday, talking about raising bank capital at the present time is the functional equivalent of the imposition of the Smoot-Hawley Tariff Act of 1930. We desperately need a different approach.Questions? Comments? email@example.com
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