Get ready for the next crisis in the banking industry. During the housing boom, banks underwrote over $2.1 trillion in subprime, alt-A and option-adjustable rate mortgages underwriting could have losses as high as $727 billion.
The problem is, they weren’t particularly careful in how they performed their duties.
Administrative and substantive errors, missing trust documents, misleading placement memorandums, all create a potential liability for the banks. The speed over quality underwriting procedures in securitizing and processing that $2 trillion in sketchy mortgages is well over $100 billion dollars. So the potnetial in banks stockes pull-back is inevitable.
Investors who bought this mostly AAA rated junk as mortgage-backed securities are not simply going to swallow the losses quietly. These investors –including Fannie Mae, Freddie Mac, Pacific Investment Management (PIMCO) and BlackRock (BLK) are seeking redress. Under certain circumstances, the terms of their purchase agreements allow them to put back the mortgages to the banks.
Bank of America, with its still awful Countrywide and Merrill acquisitions, has the greatest exposure, at over $35 billion. Citigroup somehow has a mere $8B in potential putback losses.
A Potentially Big Hit
Big banks could lose $134 billion if mortgage securities are put back to them, according to Compass Point Research & Trading.
Loss (bil) Per
Share* % Tangible
Bank of America /BAC
$35.2 $2.11 17%
JPMorgan Chase /JPM
23.9 3.59 13
Deutsche Bank /DB
14.1 12.56 21
Goldman Sachs /GS
11.2 12.43 11
RBS Greenwich /RBS
9.4 0.10 12
Credit Suisse /CS
8.9 4.50 22
8.4 1.32 15
Morgan Stanley /MS
7.9 3.37 14
7.8 0.16 4
3.6 0.18 3
3.5 0.22 2
** AFTER TAX.
Sources: Compass Point Research & Trading LLC; Bloomberg; Inside MBS & ABS Asset Backed Alert
How to prepare to avoid these crises?
Banking issues are clearly resurfacing in recent months as the sovereign debt crisis flares up again and the mortgage fiasco in the U.S. comes to light. In addition, there is a very serious risk that a housing double dip will exacerbate all of these problems. Several reports in recent weeks support my theory that housing prices are indeed set to decline further in 2011. There are additional risks, however, and many of these issues are in fact being exacerbated by the Federal Reserve itself. In my recent presentation on TV, I have clearly highlighted why I believe the next US banking crisis is right around the corner and why the Fed is in large part to thank:
Many on Wall Street believe that net interest margin or NIM among U.S. banks is at record levels. They are right, but not in the way that many investors and analysts expect.
Unfortunately, measured in dollars, gross interest revenue ofthe banking industry has been cut by a third over the past three years due to the Fed’s zero interest rate policy. Banks, savers are literally dying from lack of yield on assets due to QE/ZIRP. History is the guide to illustrate and validate my point which holds water.
In the post WWII period, Fed interest rate cuts resulted in significant reduction in average mortgage borrowing costs for households ‐‐ until 2008, when mortgage rates implied by the bond market fell significantly but households were not able to refinance.
Fees charged by Fannie Mae and Freddie Mac, and a mortgage origination cartel led by the big four banks (BAC, WFC, JPM, C), are now 4‐5 points on new origination loans vs. less than 1 point during housing boom. Huge subsidy for largest zombie banks effectively blocks refinancing by millions of households.
These fees, which can add up to 7 to 10% of the face value of the loan, raise mortgage rates to borrowers by hundreds of basis points. Banks and the housing GSEs, however, saw significant benefits in declines in funding costs thanks to low fed funds rates.
Opportunities in distressed state:
For banks and investors, one of the biggest opportunities for gain is to invest in the stronger regional banks that are acquiring troubled or failed institutions. Resolution results in losses, but also creates value for investors and society.
Acquiring failed banks from the FDIC is extremely attractive for existing banks, which tend to get preference from regulators in failed bank sales. Attractive pricing, lack of legacy liabilities key positives for investment thesis.
Another way for investors to exploit the bank restructuring process is to purchase troubled assets. So far, Fed QE and ZIRP are enabling banks to resist selling bad assets.
In addition, the FDIC, NCUA and other agencies are issuing RMBS and CMBS securities with government guarantees that offer attractive yields compared with Treasury debt.
The U.S. banking industry entering a new period of crisis where operating costs are rising dramatically due to foreclosures and loan repurchase expenses. We are less than ¼ of the way through foreclosures. The issue is recognizing existing losses ‐‐ not if a loss occurred.
Failure by the Bush/Obama to restructure the largest banks during 2008‐ 2009 period only means that this process is going to occur over next three to five years–whether we like it or not. Lower growth, employment are the cost of this lack of courage and vision. Deleveraging in consumers is on the rise.....
The largest U.S. banks remain insolvent and must continue to shrink until they are either restructured or the subsidies flowing from the Fed, Fannie Mae/Freddie Mac cover hidden losses. The latter course condemns Americans to years of economic malaise and further job losses.
Source: Institutional Risk Analytics
The new Basel III banking rules will leave the biggest U.S. banks short of between $100 billion and $150 billion in equity capital, with 90 percent of the shortfall concentrated in the top six banks.
Banks will need to hold top quality capital equal to 8 percent of their total assets — a one point cushion against falling below the effective global minimum of 7 percent set in September by the Basel Committee on Banking Supervision.
The regulations mean banks may need to increase their capital through
1. Retained earnings OR
2. Issuing equity OR
3. Banks need to cut their risk-weighted assets by selling off assets
and cutting back riskier business.
These shortfalls are entirely manageable. But the big and the more difficult question is what affect the new rules will have on the i) COST, ii) AVAILABILITY OF CREDIT & iii) BANKS PROFITABILITY. US banks can cut their equity needs by $10 billion with each $125 billion reduction in risk-weighted assets. Get ready for more headwinds and nosie coming out of the market. More Blood would be bleeding from the global financial system. Will PIIGS reduce some blood in the financial markets remain to be seen. Portugal and Spain are next in line of fire.
Disclaimer: This is just a research piece and not an investment advice. Investors and readers are encouraged to execute their own Due diligence for the strategic investment decision in the long run.