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July 02, 2008

Even the Most Bearish Fail to See the Risk that Stalks the Banking World
by Reggie Middleton

Nouriel Roubini, global macro Uber-Bear, has posted an interesting commentary on his blog - "The delusional complacency that the "worst is behind us" is rapidly melting away...and the risk of another run against systemically important broker dealers" which I am excerpting below with my comments in red:

The deleveraging process for the financial system has barely started as most of the writedowns have been for subprime mortgages; the writedowns and/or provisioning for the additional losses have barely started. Thus, hundreds of banks in the U.S. are at risk of collapse. The typical small U.S. Bank (with assets less of $4 billion has 67% of its assets related to real estate; for large banks the figure is 48%. Thus, hundreds of small banks will go belly up as the typical local bank financed the housing, the commercial real estate, the retail boom, the office building of communities where housing is now going bust. Even large regional banks massively exposed to real estate in California, Arizona, Nevada, Florida and other states with a housing boom and now bust will go belly up. This is true, and the risk is borne not only by the smaller and regional banks, but the big brokers and the entire US economy as well. This is a snapshot from the Asset Securitization Crisis Series - A very significant part of our GDP is now tied up in this mess! In the decade from 1988-1997, residential loans have expanded at a CAGR of 10.1% as compared to 3.5% for commercial loans. However, in the following decade i.e. 1998-2007, residential loans grew at a lower CAGR of 11.2% as compared to 12.4% for commercial loans, mainly because of small and mid-size banks lent more in commercial real estate during the period. Although commercial real estate loans were higher paying, they also bore higher risk in the form of liquidity, valuation, market risk - which affected the risk profile of these banks that were incapable of bearing such a level of complexity in risk in the first place.

Source: FDIC

Shift from traditional banking activities

With major opportunities of revenue generation being offered by trading and other investment activities, as well as the lifting of the Glass-Steagal Act in the US (which allowed commercial banks and investment banks to compete directely), banks across the globe shifted from traditional banking activities to other sources of income, leading to better revenue diversification. The ratio of non-interest income to a bank's total income has more than doubled from 20% in 1980 to approximately 44% in 2006.

Source: FDIC

Back to the Roubini Excerpt...

And even large banks and broker dealers are now at risk. After the bailout of Bear Stearns' creditor and the extension of lender of last resort liquidity support the tail risk of an immediate financial meltdown was reduced as that liquidity support stopped the run on the shadow banking system. Indeed in March we were an epsilon away from such meltdown as - without the Fed actions - you would have had a run not only on Bear but also on Lehman, JP Morgan, Merrill and most of the shadow banking system. This system of non-banks looked in most ways like banks (borrow short/liquid, leverage a lot and lend longer term and illiquid). So the risk of a bank-like run on non-bank (whose base of uninsured wholesale short term creditors/lenders is much more fickle and run trigger-happy - as the Bear episode showed - than the stable base of insured depositors of banks) became massive. Thus, the Fed made its most radical change of monetary policy since the Great Depression extending both lender of last resort support to non-bank systemically important broker dealers (via the PDCF) and becoming a market maker of last resort to banks and non-banks (via the TAF and the TSLF) to avoid a full scale sudden run on the shadow banking system and a sure meltdown of the financial system.

While the tail risk of such a meltdown has now been reduced the view that systemically important broker dealers - that have now access to the TSLF and the PDCF - now don't risk a panic-triggered run on their liabilities is false; several of them can still collapse and not be rescued. The reasons are as follows: liquidity support by the Fed is warranted for illiquid but solvent institutions but not for insolvent ones; and the risks that some of the major broker dealers may face is not just of illiquidity but also insolvency (Lehman had as much exposure to toxic MBS, CDOs and other risky assets as Bear did). The Fed already tested the limits of legality (as argued by Volcker) in its bailout of Bear's creditors.

I have a lot of respect of Professor Roubini's predictive success over the last few years, but he (like most) appear to have not taken a close look at these banker's books. Reference my original research on MS form December of last year. Once it comes to the truly illiquid stuff, Morgan has Bear beat by about 25% and Lehman beat by a large margin as well. As a matter of fact the only one's that come close are the media and Street's golden darling boys, Goldman Sachs. Surprise, Surprise!!! It always pays to go through the numbers. Is GS reyling on risky prop trading to keep up this pristine facade? Curious minds want to know.

The riskiest bank on Wall Street - High exposure to Level 3 assets despite significant write-downs

Unconsolidated VIEs could aggravate woes

VIEs have tormented most Wall Street financial majors -- several of them have had to consolidate their VIEs to increase liquidity and limit losses. These innovative, structured entities were introduced to boost earnings without transferring actual risk into the balance sheets of banks.

Morgan Stanley has significant exposure to VIEs, with the maximum loss ratio averaging roughly 50% in recent years. The large exposure ($37.7 billion in 4Q 07), high loss ratio and adverse market conditions could force the company out of business if its maximum loss assumptions become reality. Morgan Stanley's unconsolidated VIEs comprise the most troublesome asset categories - MBS & ABS portfolios (worth $6.3 billion), credit & real estate portfolios ($26.6 billion) and some structured finance products ($8.6 billion). Loss exposure in the credit & real estate portfolio is not expected to be lower than 70% considering the slump in housing demand, falling home prices and rising foreclosures. The growing housing inventory across the U.S. has also raised concerns about the disposal of these assets. Home prices across the U.S. declined 7% (on average), while foreclosures increased 20% during the past year alone. This scenario reflects the bleak prospects of the housing industry and the securities linked to it.

Unconsolidated VIEs, Exposure to loss (in $ mn) and loss ratio (in %)

Source: Company data

And back to Roubini...

Suppose that a run - triggered by concerns about illiquidity and solvency - occurs against a major broker dealer (say Lehman) would the Fed come to the rescue again? The answer is not sure: such broker dealer has access to the PDCF but sharply borrowing from this facility would signal that the institution may be bleeding liquidity and be in trouble; thus large access to the Fed facility may cause the run on the liabilities of such financial institutions to accelerate rather than ebb. The reason is as follows: if creditors of the broker dealers knew with certainty that the Fed liquidity tab is open and unlimited the existence of the facility would stop the run. But if there is any meaningful probability that the amount that the Fed would be willing to lend to an institutions using that facility is not unlimited and is not unconditional then use of the facility may accelerate the run - as those first in line would have access to the liquidity provided by the Fed lending to the broker dealer in trouble while those waiting may be stuck once the lending stops. This is akin to a currency crisis in a pegged exchange rate regime triggered by a run on the forex reserves of a central bank. Once the reserves are running down and investors expect that the central bank will run out of reserves the run accelerated and the collapse of the peg occurs faster.

I tend not to build too high a concentration in any one position (risk managment guidelines), but I have been allowing certain broker banks to tilt the scale a little. I hear whispers of potential runs, and the logic is there as Dr. Roubini has illustrated and as I have pointed out in earlier posts. This combined with the fact that a couple of these brokers are quite exposed to risk and the media/pundits haves not their homework in regards to exactly who is weak and why portends another Bear Stearns-like catastrophe/profit oppurtunity.

Reggie Middleton
http://boombustblog.com/

Reggie Middleton is the personification of the freethinking maverick--the penultimate nonconformist as it applies to macro strategies, investment, and analysis. He uses his background and knowledge in new media, distributed computing, risk management, insurance, financial engineering, real estate, corporate valuation, and financial analysis to pursue, analyze, and capitalize on global macroeconomic opportunities.

Finding most available research lacking, both in quality and quantity, Mr. Middleton assembled his own talented research staff. As forensic research is a lynchpin for his own investing, "to actually put food on the table," he stands behind it as doing what it is supposed to do - illustrate, elucidate and educate.

He does not sell advice or research. He is an entrepreneur who exists outside of mainstream corporate America and Wall Street. This allows him the freedom to do things that many cannot--perform without conflicts of interest and corporate politics. He prides himself on developing some of the highest quality, actionable research available - regardless of price. He welcomes any and all to peruse his blog of freely available analysis, opinion and participatory social media; use his custom tools, download files, interact with the community and make critical comparisons from a results orientated perspective. Reggie believes ideas and implementations are improved and fine-tuned when bounced off of the collective intellect of the many, in lieu of that of the few - in essence, a form of collaborative open source financial analysis.

Visit his blog Boom Bust Blog.

Copyright © 2007-2008 Reggie Middleton

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