We are entering the next stage of the credit crisis, and one which
is potentially more troubling than what we have seen over the past
year, absent some policy reactions by the central banks and governments
world wide. The crisis was started by an intense run-up in leverage by
financial institutions and investors world wide, investing in
increasingly risky assets such as subprime mortgages and then the
realization that leverage could hurt. The deleveraging process started
to intensify last year about this time. The easy part of that process
has been just about done. Now is the time for the really hard work. It
will not be pretty. In this week's letter, we look at the process and
think about its implications for the markets and the economy, and visit
some data on the housing market and unemployment.
And just for
the record, the problems I am describing in this letter are very real.
But we will get through them, as we have always done. This is not the
end of the world. There are a lot of very good things happening here
and there. As we will see, for most smaller banks, it is business as
usual. In general, in most places and for most people, life is going on
just fine. There are opportunities being created. The markets will find
new solutions. But there is some more short-term pain for many market
participants, and we need to be aware of the problems and see if we can
avoid them for ourselves.
But first, let me ask you for some
help. I get to travel a lot with my daughter and business partner
Tiffani (actually she runs the business) and meet new people. Over the
years, she has become as fascinated as I have with their individual
stories. Everyone has a story to tell or a lesson to teach. As I
announced a few months ago, we have decided to write a book (or series
of books) about those stories, looking at the differences in
perspective between old and young, retired and working, those who are
wealthy and those who aspire to wealth. What are the differences in
attitudes, in work habits, in how you manage money, in how you look at
the future, and a score of other items? How do all of these things
We have created a totally anonymous online survey
seeking answers to these questions and more. We have had more than
12,000 of my readers fill out the survey (thank you!!!) and we are
learning a lot. We are eager to see what we find as we pore over the
resulting data and engage in a lot of in-depth analysis. Are the rich
really different? Is there a difference in people from Europe, Asia,
Latin America, Africa, and the US? I think we will find some very
note: this is not just a survey for millionaires. We want everyone, of
all income levels and ages, to take the survey, so we can get a true
representative sample. We would especially like more ladies and
international individuals to take the survey.
You can get to the survey page by clicking here.
It will take about 10-15 minutes to complete, and I think that going
through the questions will make you think about your own situation.
Some have told us the survey is quite thought-provoking. If you have
attempted to take the survey and had problems, we think we have worked
out the bugs.
Thanks in advance. And now on to the letter.
Thoughts on the Continuing Crisis
start by explaining the process of de-leveraging in what I know are
VERY simplistic terms. On average today, FDIC insured banks have about
7.89% of capital for their outstanding assets (loans are generally
about 60% of assets), so they are roughly levered up by about 12.5
times. Some investment banks are leveraged up to 30 times. Fannie and
Freddie are leveraged 50 times their capital. But to make matters
simple, let's assume leverage of 10 times.
(For the record, to be
considered "well capitalized" you have to have at least 5% of capital
in Tier One assets, and 10% of what is considered risk based assets,
with anecdotal evidence that the regulators want to see 12%.)
means for every $1 million in capital you have, you can lend out $10
million. The profit you make is the difference in the cost of your
capital and money your borrow to lend and the interest rate you charge.
If your are paying 4% for your money and charging 8%, you would make 4%
times $10 million, or gross profits of $400,000. That is a return of
40% on invested capital, which is why so many small banks are being
started all over the country every year. Nice business if you can get
Of course, you have to be able to take some losses. If you
had a $500,000 loan go bad, you would have eaten up all your profits
and dipped into your capital. Now you would only have $900,000 in
capital. That means you could only make $9 million in loans. Either you
will have to raise more capital from investors or reduce your loan
portfolio, in addition to writing off the bad loan.
constitutes capital at real world banks is a very complex thing. How
much it costs to find money to lend can vary wildly. Many of us "lend"
money to our banks at zero cost to the bank in our checking accounts.
They pay more for savings accounts, borrowing from other banks, etc.
They charge different rates for different types of loans. It is a very
complicated business, and we will not go into any details. The basics
of my simple illustration will get us to where we need to go.
I want to find out something about US banks, I turn to my friends at PL
Capital. They run a fund which invests in smaller banks, and have been
consulting with banks for many, many years. They really know the
business. I caught up with Rich Lashley and asked him to give me his
thoughts. I am going to pass them on to you, as they are not as bad as
one would think.
In the US, and in much of the developed world,
there are two tiers of banking. There are about 8500 banks. The top 50
banks have more than 80% of the assets. The rest of the banks are
generally much smaller. Outside of five states hit particularly hard by
the housing crisis (see more below), for most of the under top 50
banks, it is business as usual.
There is money for most smaller
businesses and projects at the smaller banks except for residential
development. The true credit crunch is at the top for larger projects.
Want to do a $3 million deal? If you have a reasonable project, it can
get financed. Want to do a $300 million deal? Lot's of luck, for
reasons we note below.
Most of the smaller banks have plenty of
capital and are looking to put it too work. Rich guesses there are
about 4-500 banks (5% of the total, with concentrations in states with
bad housing markets) which are in some level of financial stress,
meaning they need to raise capital or reduce lending. His guess is that
we will see about 100-150 banks fail over this cycle. He would be
surprised if we saw more than 3 top 50 banks fail. Most of the larger
banks, if they get into trouble, would be absorbed by better
capitalized banks in search of market share.
In fact, Rich is
quite bullish on selected bank shares. 86% of the banks/thrifts in the
U.S. made money in Q1 2008 and almost 50% earned more in Q1 2008 than
they made in Q1 2007 (i.e. they made more money after the credit crunch
than before.) But nearly all banks stocks have declined in sympathy
with the problems brought on by the credit crunch. Over times, growing
earnings will make for a rebound.
So, middle America and middle
American business, except for construction, are not by and large
experiencing a credit crunch. The smaller banks are not cutting home
equity lines and Rich says they are not experiencing abnormal losses.
That is because they are local bankers who know their customers. It is
the banks which offer home equity loans and have brokers do the lending
without really having any incentive to make sure the loan will be good
which are the ones in trouble. Securitized home equity loans and second
mortgages are showing significant losses.
Fool Me Once, Shame on You
It is a different story at many of the larger banks. Let's look at two tables from my friend Gary Shilling's latest letter. (www.agaryshilling.com) It is well worth the $275 a year (the investment professional version is $1,000).
set up the tables, there have been writedowns and losses of about $501
billion in both investment and commercial banks. They have raised $353
billion in capital. As I have written repeatedly, it is likely that we
will see another $500 billion in losses. The IMF estimates total losses
of $1 trillion. Private estimates from credible sources can run as high
as $2 trillion.
As you would expect, the largest losses are
typically in the larger banks, with some exceptions. Goldman has only
written off $3.8 billion. Citigroup has written off $55 billion. The
table, if I am adding correctly, sums up the losses from 64 banks, and
adds in "other" banks losses from European, US, Asian and Canadian
banks. Outside of the top 64, there have only been writedowns of $16
billion. Again, that speaks to the phenomenon Rich alluded to earlier.
It seems that the bigger banks took the riskier bets, getting stuck
with the "Old Maid" of subprime and other mortgages and loans. Banks
that could not afford to get into the game did not have the losses. In
this case, being small was an advantage.
how did the investors who gave the various banks capital do on their
investment. Shilling shows us 9 deals done by sovereign wealth funds.
The best return was down a mere 26.6%. The worst was Singapore in UBS
for down 56% in less than nine months.
old line is "Fool me once, shame on you! Fool me twice, shame on me!"
How difficult do you think it is for any major bank to go back to
sovereign wealth funds and ask for more? If they got it, you can bet
the terms will not be favorable to current shareholders.
week I talked about how much it costs for many banks to raise money
today. For weaker banks, the cost of new capital is prohibitive.
going back to my simplistic illustration, regulatory requirements mean
that if you are deemed not to have adequate capital, you have to raise
money or reduce your loan portfolio. Raising money in today's
environment is going to be difficult for many banks. Lehman has been
shopping for capital for months. Merrill has had to sell some key
assets. It is a strange philosophy of selling the best and keeping the
rest, but that is what regulations require you to do. Merrill, for
instance, recently sold $30.6 billion of poorly performing mortgage
related assets for (which they valued at $11.1 billion) to a private
equity firm called Lone Star for $6.7 billion, which is a 78% discount
to the original face value. But Merrill had to finance 75% of the deal,
which means they may only get 5 cents on the dollar.
And while I
am picking on Merrill, let me quote this paragraph from Shilling's
latest letter to illustrate the problems the large banks have.
add insult to injury, Merrill Lynch recently announced plans to sell
$8.5 billion in new common stock, which will dilute shareholders by
38%. Previously, in response to writedowns, which totaled $46 billion
since June 2007, Merrill has raised $15 billion in common and preferred
stock. And this new common stock sale will be even more costly to
Merrill since earlier sales of $5 billion in stock at $48 per share to
Temasek, a Singapore state owned investment company, required
compensation for the difference if Merrill sold stock at a lower price
within 12 months. The stock is now $27 per share, which will cost
Merrill over $2 billion."
If there are in fact more large losses
coming in the next year, what will the banks do? Raising capital is
going to be tough and come at serious costs to current shareholders. We
will see some of that, and that is a reason I would be very cautious
about the stocks of large financial companies. The bulls would say that
the problems are already in the price. Of course, that is that they
said six months ago as well. Caution is to be taken.
thing they can do to repair their balance sheet is reduce their loan
books or sell off assets or loans. And that is happening. And it is
going to happen more and more. It is going to be increasingly difficult
to get large new loan deals done and that is going to put a damper on
the economy. 60% of banks report they are tightening their lending
standards. In the recent Beige Book, the Fed reported that all
districts have seen tightening standards, something that is unusual.
loan for mergers and buyouts have dropped 75% since last year. They
were only $50 billion in the first quarter, and it is almost certain to
have dropped to even lower levels this last quarter.
leverage that was so helpful as it rose? It is now going to have the
opposite effect. If you lose a billion and can't raise the capital, you
are going to have to reduce your loan book or sell off assets by (using
my analogy) $10 billion. If we have potential write-downs of several
hundred billion more, that pain is going to be felt in both the
corporate and individual worlds, as credit availability is going to
decrease and rates are going to go up.
And the pain may not be
abating. While some suggest that we have seen the bottom in housing and
the economy, the data out the last three days suggest that is not the
Delinquencies and Foreclosures Spike UP
Phillippa Dunne (The Liscio Report) sent me this note a few moments ago:
MBA delinquency numbers just came out. In Q2, foreclosures were started
on 1.19% of outstanding mortgages, up from 0.99% in Q1, and nearly
three times the pre-2000 record. The total stock in foreclosure was
2.75% of all mortgages, more than twice the pre-2000 record. Seriously
delinquent (90 days or more, plus those in foreclosure): 4.50%, also
more than twice the pre-2000 record. Most of the previous records were
set in the 1980s, when both unemployment and interest rates were
considerably higher than they are now."
If 4.5% are 90 days or
more behind, it is likely that foreclosures will rise precipitously. If
you think there is a crisis today, just wait six months. Mortgages past
due by 30 days are more are now at a nose bleed 6.35%
this. Freddie and Fannie guarantee 50 times their capital in mortgages.
What would a 2% default rate do to them? 8,000,000 homeowners now have
negative equity in their homes as of the end of the first quarter. That
number is rising as home values drop.
Some cheered the fact that
home sales rose last month, and that is a good thing. But the number of
homes for sale rose even more. There are now 11.4 months of inventory
in the existing home market. New homes show an inventory of over 8
months versus an industry norm of 4.3 months.
As I have been
saying for almost two years, the housing market will not normalize
until some time in 2010. It is going to take a long time for the
markets to work off the excess inventory.
Anecdotally, I have a
realtor friend in Dallas who is working with a number of investors
buying distressed homes (using some leverage) and condos and then
leasing them for returns of 8-10% or more. I am sure that is happening
in a lot of places. Such activity is needed to get excess inventory off
the "for sale" lists.
Unemployment Rises to 6.1%
is a reason that consumers are falling behind on their home loans (and
on credit cards, auto loans and student loans - you get the picture).
Over the last 8 months, unemployment has risen by 685,000. And that
assumes there are hundreds of thousands of jobs created in the
birth/death model. When the numbers are revised next year, I would be
willing to wager that job losses are closer to 1,000,000. That would be
consistent with an unemployment number of 6.1%, up from 5.7% last
month. That is the highest level in five years.
Greg Weldon provides us with the following thought (www.weldononline.com)
the top-down macro-perspective, there is NO denying that the US Labor
Market is in a RECESSION, as might be best evidenced via a perusal of
the chart on display below, in which we plot the monthly change in the
headline Non-Farm Payrolls, along with its 12-Month Exponential Moving
Average. Indeed, EVERY time the moving average falls below zero ... it
has indicated that the broader economy has dipped into a RECESSION, in
1973-74, 1980-81, 1990-91, 2000-01 ... and ... 2008 !!!!"
Action Is Needed Now
is unfortunate that the crisis in housing and the credit markets seems
to be coming to a head in the middle of a hotly contested election
cycle and a lame duck president. Matters are such that waiting until a
new president is in power and has his new appointees in place is a very
bad option. Things could spiral down very quickly without action by the
Treasury and the Fed and other regulators.
Lax regulation of both
the mortgage industry and the rating agencies allowed the current
crisis to develop. While new regulations will be helpful in the future,
we have to deal with the problems as they are today. As I noted above,
the credit crunch has the potential to get much worse in the coming
quarters. It is clear to a number of observers that Freddie and Fannie
are dead men walking. They are going to need capital from the Treasury.
Those with mortgages that have the ability to pay at some level should
be helped, and the rest need to be sold off at market clearing prices.
But that means mortgage debt must be available. Because of the problems
in the markets, mortgage rates are higher than they should be, making
the housing problems worse.
Since we are going to have to take
action sooner rather than later, we should do it sooner. One of the
main rules in investing is that "The first losses are the best losses."
The longer we wait, the more distress there will be in the housing
markets and the lower values will go. Putting off action until next
year will mean more losses for taxpayers and more pain in the markets
when action is finally taken.
It physically hurts me to write
those words. It is so against my free market economic beliefs. But a
slow implosion of Freddie and Fannie, and a non-existent jumbo loan
market, will mean a very serious recession if not checked soon. Art
Cashin sent me this note today: "Paul Volcker at Calgary Conf. says
financial crisis "most complicated" he's ever seen. Losses will clearly
exceed $500B and U.S. growth will be slowest since the Great
Those are not light words from a man who is one of
the better insights into the economy. I will leave it to wiser men than
I to figure out how to stabilize the housing market and Fannie and
Freddie. But it must be done.
Further, some thought should be
given to allow for slower writedowns of assets, giving troubled banks
with otherwise profitable businesses the time to heal. This should be
done in conjunction with better regulations and a requirement for
reduced leverage over time from investment banks that have access to
the Fed window would be helpful.
And while I am indulging myself
in wishful thinking, would someone please force Credit Default Swaps
onto a regulated derivative exchange like futures and options? This has
the potential to magnify the credit crisis into a real nightmare. Maybe
we can dodge that, but why risk it? I see no reason to do so, and about
$60 trillion (the value of the CDS markets) reasons to do so.
Annapolis, La Jolla and Wedding Videos
is a good thing I looked at the invitation a few days ago. I thought I
was going to Baltimore. As it turns out, I will be traveling to
Annapolis (not too far away) tomorrow morning with Tiffani to go to my
really good friend Bill Bonner's 60 birthday bash. We met 26 years ago.
How time has gone by. When I first went to his office in a very bad
part of Baltimore so long ago, I was seriously nervous about walking
two blocks from my car. Bill decided that low rents were worth it. And
as rich as he is, he is still frugal. He scraped and painted 100
shutters himself (with his kids) at his chateau in Ouzilly in the
country side in France.
We have some things in common. Both our
mother's are alive and served in the Women's Army Corps in WW2. He has
six kids and I have seven. We both have several New York Times Best
sellers. We have ridiculous travel schedules. And life has blessed us
immensely. We also have a lot of mutual friends, so this is going to be
a very fun weekend! Bill throws great parties.
Bill writes the
Daily Reckoning. He is one of the best pure writers I know. I sometimes
feel like a house painter looking at a Rembrandt when I read his
essays. You can read some of his essays and subscribe to the free Daily Reckoning (be warned: Bill is quite bearish) by clicking on this link: http://www.dailyreckoning.com/rpt/mauldin.html.
just sent me a link to this short version of what will be a major video
production of her wedding in a few months. If you have a bride coming
up in your family, you might view this to see what a non-traditional
wedding can look like. And she is a very beautiful bride. Pay attention
to the fireworks in the background as they kiss. You can see it at http://vimeo.com/1615007.
And yes, the strawberries on the treasure chest wedding cake are to
hide where I put my thumb through it, thinking it was a real chest.
Take some time this week to see families and call that old friend up and say hello.
Your really ready to party analyst,
Copyright 2008 John Mauldin. All Rights Reserved
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