April 16, 2008 12:39PM
What Inning is the Great Credit Crunch In?
By Elizabeth MacDonald
Top executives of Goldman Sachs (GS) and Morgan Stanley (MS) now say respectively that the financials are in the fourth quarter or ninth inning of the credit mess.
Yes, and all of the financials’ profit reports are as sweetly fresh as lilacs after rain, and their stock prices are really not careening around worse than the Jamaican bobsled team.
An admitted accounting geek, I have reported on quality of earnings for more than a decade. No way, no how am I an expert, when I hear that, it feels like my brain is starting to run out of my ears. I am just a journalist. But having researched this and talked to the pros as much as I can, my thinking on this is clear as a cold country creek.
There is still plenty enough voltage and not enough shock absorbers in the financials’ balance sheets to leave any Wall Street executive feeling as withered as a salted snail.
Which is why you’ll see the more circumspect Wall Streeters like Richard Fuld, chief executive of Lehman Brothers (LEH), and his chief financial officer Erin Callan carefully couch what’s going on by saying that, while the current financial crisis may be past its nadir, problems remain.
And which is why it’s passing strange that John Thain, chief executive of Merrill Lynch (MER), has been saying his beleaguered brokerage doesn’t need more funds after raising nearly $12.8b, although the Wall Street Journal says you can expect to see $6b-$8b in writedowns when it reports earnings tomorrow.
I must get this out of the way first. What’s really intolerable is the combination of finger wagging brimstone behavior and self righteous piety on what the world needs to do to fix the credit crisis coming from the likes of George Soros, a billionaire who has built his fortune on the backs of past crises, and a certain high level central banker instrumental in helping create this one, you know who I mean, weighing in like a self-serving cuckoo clock as well (as Abe Lincoln once said, “he can compress the most words into the smallest number of ideas of any man I ever met.”)
We are not out of the woods just yet. Banks are rapidly recapitalizing with infusions from sovereign wealth funds (some SWFs have seen their stakes drop 20% or more), from private equity firms, and either by selling assets or issuing new shares. Suffice it to say investor pain remains. Not just pain in the form of shareholder dilution–the negative G-forces in the form of damaged credit on bank balance sheets have created a Black hole from which no dividend can (or should) escape.
Here are the statistics. Anywhere from $360b to $460b of adjustable-rate loans are scheduled to reset this year. About 9m borrowers are upside down in their mortgages. Auction notices rose 32% year over year, a sign that defaulting homeowners are just walking away, market watcher Richard Suttmeier says. A cold calculation–borrowers, even those with decent credit scores, find it easy to walk away from their houses when their loans are close to or surpass the market value of the property.
And as the value of securities tied to mortgages nosedives, banks and investment houses will face more writedowns, which so far have totaled at least $245b since the beginning of 2007. Some estimates put the eventual cost at $460b. The IMF puts the credit losses overall at $945b. It’s anyone’s guess now. UBS (UBS) still has ropey assets on its balance sheet, some $31b. Goldman Sachs (GS), $96.5b, Morgan Stanley (MS), $78.2b.
So no more talk of innings or basketball quarters. This feels more like a basketball game’s shot clock.
But here’s what should most concern you. Hedge fund Greenlight Capital’s David Einhorn, as sharp a pencil as any when it comes to reading the financial statements, says investors may choke when they take a closer look at what’s really sitting on the financials’ balance sheet.
Remember how in the past couple of months how Carlyle Capital was on the brink of collapse, he asks? It used its balance sheet assets to do more borrowing, levering itself 30 to one against its assets. Same leverage ratio for Merrill. Same for Bear Stearns.
But Carlyle’s portfolio had triple-A rated government securities, historically the safest paper around, Einhorn notes. Chilling.
What’s even more perilous is what Einhorn found out that’s really going on with a critically important valuation metric used to assess the health of banks and brokerages. It’s called return on equity, the equity portion similar to what is an individual’s net worth. Einhorn says that banks count things such as preferred stock and subordinated debt as equity when calculating their leverage ratios. That’s like adding in, instead of subtracting out, your mortgages and auto loans to arrive at your own net worth.
If those items are knocked out as they should be, then the financials’ leverage to common equity is even higher than thirty times, Einhorn says.
And the financials consciously levered themselves to eye-watering levels because that is what they were incentivized to do, to maximize executive compensation, Einhorn says. More leverage means more revenues which means more compensation, especially at investment banks which pay out 50% of their revenues as bonuses are backpay.
And Einhorn adds that the banks and brokerages’ levered balance sheets hold items much dicier than government securities. They have stocks, bonds, various loans waiting to be securitized, pieces of structured finance transactions, derivative exposures of staggering notional amounts and related counter party risk, they have real estate, private equity.
Back to the IMF’s $945b figure for expected losses. That’s vs $750b in losses fm Japanese economic crises of 1990s. That $945b breaks down as follows: $556b for US residential loans and securities; $240b on commercial real estate securities. Corporate loans including leveraged loans are expected to account for $120b in losses, consumers add another $29b.
That $945b is about 8% of the US’s GDP vs 15% of Japan’s GDP. But whereas Japan’s banks bore almost all the losses, now places as far afield as Norway, the Artic, and entities such as pension funds, insurance companies and hedge funds will bear most of the losses from the credit crunch. Spread the pain, right?
So how long will it take The Great Credit Crunch to unwind? One 2003 study of post war housing busts in rich countries indicates that housing crashes coupled with banking crises last about four years. The housing busts in Sweden and Norway in the early ‘90s acted like an anvil on their balance sheets for years.
A bright spot: the IMF expects global growth to slow to a 3.7% growth rate from 4.9% in 2007. Not so bad, given the five years of hectic growth the world has seen–and still coming off a huge base. Besides, any slowdown might be a good thing, as it would dampen inflation now coming a cropper (I like that term, coming a cropper) in emerging markets.
Comment by Chris Mikesell
Apr 16th, 2008 at 1:41 pm
First, welcome back Liz. I am beginning to feel like a bitter small town American after reading another depressing financial article. I used to be in the accounting profession. How could 30 to 1 debt ratio’s be good? The problem is that it is more than 30 to 1. It’s like the level 3 assests. The ratio should not even be 1 to 1. Always side with caution and assume the worst. At most the level 3 assets should be set at .1 to 1. We would never had a run at Bears with taht type of ratio. Here is a different idea on exeuctive pay. The compensation group shoul consist of employee’s not big shareholders and other CEO’s. The pay should be tied to profit not shareprice which can be abused like at Countrywide. I think if I looked at the financials like you did I would have a brain freeze!! Bring back common sense accounting and loan practices. For my mortage I had to show my latest pay check plus my tax returns from the last two years. That was before the subprime mess. Any way another great read.
Comment by john m
Apr 16th, 2008 at 2:55 pm
Great article about what’s really going. You could have titled it “Seduced by the dark side of the financial force”. God knows what shoe is going to fall next. Goldilocks is on life support. The financial talking heads would make Pearl Harbor into a victory celebration.
Comment by R B. Tonnesen CPA, ret.
Apr 16th, 2008 at 3:32 pm
Hi
You’re not even close as to the coming damage!! You havn’t figured in the effects of the changes in the bankruptcy laws that were made a couple of years ago. Those changes, where lenders were supposed to recover more because the borrower does not get a clean start but instead has to repay part of his debt had two significant side effects.
The first is the one you’re seeing now. Knowing that the borrower would have to pay if he had the means allowed banks and other lenders to be a bit more careless than they should have been, not just with the sub-prime housing market but with all credit.
The second shoe comes when these bankrupt borrowers are paying back loans that put them into a new kind of debter’s prison. The result is that, where under the old law they would have had a clean slate and could start spending again now they will have only survival rations to spend and this is not likely to spur any ecenomy!
They will certainly not lift ours to any new hights. This also explains why people will use their economic stimulant money to pay off debt rather than buying.
Another story for you: The Fed’s recent actions have driven down the interest that banks are paying on their savings and other accounts. How disasterous has this been for fixed income retirees who were depending on that income to survive??? Did the Fed bail out its frends in banking at the expense of the poor???
Comment by Don
Apr 16th, 2008 at 4:13 pm
LOOKS LIKE THE END OF THE WORLD,HUH?
Comment by Tom Richardson
Apr 16th, 2008 at 4:47 pm
There are a few companies run by people a lot smarter than I that are well positioned to take advantage of these severe dislocations. They include BRK,LUK and Y among others. Just the other day Warren Buffett mentioned to a group of students that he had bought a $4 billion slug of muni’s at a yield of more than 11%.
RBT-CPA above is absolutely on target regarding retiree savers being punished by the Fed. Talk to my father in law who, at age 90, thought he had the rest of his life figured out. Save and invest conservatively. (At age 90, bank CD’s) His anxiety level is through the roof. I listened in on the conference call of the company that manages his continuing care facility. They bragged about their ability to raise prices at a 10 percent per year. I haven’t mentioned that to my dad in law. He has enough anxiety with his income down to 2.3% from his CD’s.
Comment by Chris
Apr 16th, 2008 at 6:59 pm
I think we’re toast.
Comment by Vito Boscaino
Apr 17th, 2008 at 11:26 am
As a former corporate finance guy turned real estate business owner, I find myself constantly fending off real estate practitioners who have heavily consumed the National Association of Realtor kool-aid which says “Now is a great time to buy real estate” campaign. My personal belief is that we will not see the bottom of the real estate market in Ohio until at best the latter part of 2009, if not somewhere into 2010. Everyone is aware of the looming tsunami of foreclosures that are in the pipe-line. Pile on top of this the looming tsunami of adjustable rate mortgages which will be resetting this year, which will ultimately lead to more foreclosures in one to two years. Now throw in a healthy dollop of high energy prices along with reduced discretionary spending due to inflation and job losses and anyone can begin to understand just how dire this situation is.
As someone who is closer to the “man-on-the-street” as opposed to a Wall Street banker in the canyons of The Street, I just have to laugh when I see these Wall Street types trying to convince Mr. and Mrs. America that everything is working out fine and the crisis is over, just jump back in and start investing in stocks again. Seriously, how can these guys look anyone in the eye and keep a straight face when they start spouting this self-serving drivel. I mean they are all lined up at the Fed trough drinking as much of the low-cost borrowings as they can get, and for what? To keep their bonuses in the right place. So taxpayers are bailing out rich Wall Street bankers, who previously exercised extremely poor business judgement, and still continue to do so. Instead of being rewarded in a true capitalist fashion by getting their asses kicked, and their asses kicked out the door, they just jump on the Federal Reserve Welfare Program for Rich Wall Street Bankers.
So instead of representing everything that is good and noble about a capitalistic system, they actually portray just the opposite, steal from the blind, turn to the government for bailouts, lie to the public about the true nature of the situation, just so the cycle can start all over again.
Sure I think the financial institutions are misleading shareholders and the public about how they portray their assets and liabilities. But one has to ask - Where is the SEC? Where are the banking regulators? Where are the public auditors? What happened to Sarbanes-Oxley requirements? Where are the Attorneys General? Not only is the Fed duplicitous, but so are all the other authorities.
We hold ourselves out to be capitalists - If we truy believe this, then these financial institutions need to be held fully accountable for their poor judement and poor management teams and the market should step in and react in the same manner as they did with Bear Stearns - with one importnant difference, no backstopping from the Fed. Let the company go under, let the vultures pick up the pieces for pennies on the dollars, let the shareholders sue and hold management accountable. Gee, that kind of sounds like a homeowner that borrowed 100% on an option-ARM, no doc. loan going into foreclosure…..
Comment by Carla, Ballwin, MO
Apr 17th, 2008 at 12:34 pm
Interesting - “come a cropper” - I will be 50 in August, I have never heard that expression. Unfortunately, you could use that term in reference to the 2008 Clinton campaign! EMAC - the best in the blogosphere! Thanks, Carla Baynes
Comment by Aaron
Apr 17th, 2008 at 1:03 pm
Let’s just ask Oprah…she knows everything!