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Reggie Middleton

Reggie Middleton

Who am I? Well, I fancy myself the personification of the free thinking maverick, the ultimate non-conformist as it applies to investment and analysis. I…

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The Worst is Behind Us, Unless Massive Bank Failure is Considered a Bad Thing

I hear many bank CEOs saying they believe the worst is behind us. I am not a banking exec, and I am not on the street, but I definitely disagree. Bank of America has missed estimates by about 44%, and has increased credit loss reserves by 500% to over $6 billion dollars, net income drops 77% amid write-downs, and it is forecasting a best case scenario of minimal GDP growth for the balance of 2008. 2007 was the year these same execs were forecasting no recession and a pick up in the following year. This is the same company that says it will buy Countrywide, which has a severe credit and NPA problem - and has nearly as many assets in REOs and repossessions as it had in actual performing mortgages. Does this sound like the worst is behind us? Let's take a look at some more banks.

The Bank of England has decided to just go forward and bailout its banks, "American Style": BOE Aims to Jump-Start Lending - The Bank of England launched a plan to allow banks to temporarily swap $100 billion of mortgage-backed and other securities for U.K. Treasury bills, in a bid to ease the current credit crunch. (Statement) Of course, I query (like the bloke I've been known to be), why dump a $100 billion into the market where the worst is behind us? That's a lot of money, considering they've probably pumped much more than that into the market for liquidity's sake over the last few months.

Of course, NatCity is raising money for the hell of it: NatCity Close to Cash Infusion - National City was closing in on a $6 billion capital infusion from a buyout firm and other investors. The parties were aiming to seal the deal by Monday.

The Wall Street Journal is jumping on my bandwagon, saying "Smaller Banks Begin to Suffer".

Capital One ramped up production of commercial real estate loans at the very tippy top of the real estate bubble. Capital One is (now, or at least was) a very prolific commercial lender, and you know how I feel about the commercial real estate market. I ride around Manhattan and downtown Brooklyn (alleged luxury condo hi-rise mecca) and see "Financed by Capital One" signs all over the place. These are projects that are either just breaking ground or have yet to be completed in an area with at least a 2 year supply of condos going up and in the pipeline, and rising - as the condo market collapses.

Their loan delinquency rate spikes up sharply at the exact apex of the commercial rent bubble.

Now, look at where and when the rent spread in retail real estate inverted. What a coincidence! What timing on the part of Capital One. Not to pick on this bank, most banks ramped up mortgage and consumer finance lending at the very top of the bubble, and actually accelerated as the bubble popped and credit losses were apparent.

Core Capital (Tier 1) Ratios follow my favorite CRE chart as well.

Tier 1 capital (from Wikipedia), the more important of the banking finance ratios, consists largely of shareholders' equity. This is the amount paid up to originally purchase the stock (or shares) of the Bank (not the amount those shares are currently trading for on the stock exchange), retained profits and subtracting accumulated losses. In simple terms, if the original stockholders contributed $100 to buy their stock and the Bank has made $10 in profits each year since, paid out no dividends and made no losses, after 10 years the Bank's tier one capital would be $200. Regulators have since allowed several other instruments, other than common stock, to count in tier one capital. These instruments are unique to each national regulator, but are always close in nature to common stock. These are commonly referred to as upper tier one capital.

Well, take a look at this sampling of regional banks core capital trends, and compare it to the commercial graph above. It is amazing how correlated all of this actually is to the commercial real estate market.

The loans to deposit ratio shows significant risk inherent in internal funding for these banks. They, in general, have an unprecedented amount of their assets tied up in mortgages at a time when real estate is tanking at an unprecedented level. This is a bad combination. Remember, just 20 or so year ago more then 3,000 banks and lending institutions failed due to unsound real estate lending practices. This time around, it is about as unsound as it gets.

So, what do banks do when they get themselves in trouble lending long on bad real estate deals while borrowing short in fickle markets while they are in need of capital? They arbitrage thier implicit backing by our government by offering higher than market rates for savings and CDs that are FDIC insured. One way to find a "who's who list on Reggie's prospective short candidates" is to surf over to Bankrate.com and searchg for the highest yielding CD rates.

  Date Rate   APR Minimum
Capital One NA
McLean, VA
4/16 4.40 D 4.50 5000 Lock in a 5.50% APY* on 7 year CDs
Countrywide Bank, FSB
Thousand Oaks, CA
4/18 4.25 D 4.35 10000 Online CD's @$10k; APY: 4.10% 12 mo.; 4.25% 24 mo.; 4.50% 36 mo.
Advanta Bank Corp.
Salt Lake City, UT
4/18 4.16 D 4.25 10000  
Discover Bank
New Castle, DE
4/18 4.10 D 4.18 2500 FDIC insured offering competitive rates and convenient access.
Fort Washington, PA
4/18 4.07 D 4.15 500 Convenience & flexibility from the bank of great interest.
M&T Bank, NA
Oakfield, NY
4/18 4.02 D 4.10 5000  

As a point of reference, the Fed Funds rates is 2.23%. Capital One and Countrywide have a plethora of credit loss woes, GMAC is dragging down GM, one of the largest companies in the world, and M&T Bank has one of the lowest core capital ratios out of over 330 banks that I have screened, ex. it is walking on paper thin capitalization.

Do you remember when I said 3,000+ banks failed the last time we binged on band real estate loans? Well, they tried to increase their deposit base through deposit brokers and offering yields that where way above what was prudent, and way above the market rates. Well, as the monolines can attest, when you try to offer deals that are artificially outside of what the market charges, you will run into trouble - big trouble. These banks push rates to up to attract deposit capital, their NPA and defaults put so much pressure on them that they fold under the expense of offering all of this rich money, and then our government comes in to bail them out - with a dollar that is beat to death, inflation beating at the door (citizens rioting and killing over unaffordable food prices, oil at a record $118 and rising), and funding two simultaneuos wars courtesy of Mr. Bush, et. al. Let's not forget all of the investment banks that we are bailing out ala Bear Stearns, and even a few dozen billion here and there to bail out the homebuilders via engorged tax refunds. Bailout, Bailout, B-A-I-L-O-U-T!!!

As you can see here, these guys have a signifcant portion of their loans as non-peforming. In addition, if you were to look at the trend of 30, 60 and 90 days delinquencies, you will notice a big disconnect between those trends and the NPAs. The banks are actually allowing people to stay in their homes way past the 90 day delinquency mark without aggressively pushing for foreclosures, most likely to minimize the NPA numbers on their books. The truth of the matter is, if you have a loan on your books that is not being paid, it is non-performing, regardless of what label you put on it. It is my belief that the financial stress that these banks are going through is not being reliably reported on their financial statements. I have just heard from a reliable source that Wachovia has 120B of Neg Am IO that is presently estimated by an "open source" to be bid at $60. Lets say its $70. That is a loss of $36 B and they paid $28B for it. So, they are down $64B in less than 24 months. The market cap is $58B.

Well, after reading through my digital tirade, do you think that I think that CEOs really think that the worst is truly behind them? There will be a lot of capital raising going on according to the chart above. BASEL II, the Fed, the BOE and practically everybody else who oversees or had anything to do with the banking industry were way off in how much capital these banks need to remain firm in a risky environment. Even after capital raising, both I and the FDIC feel that we have a lot of failures coming down the pike. This will push down RE values. Remember the problems GGP is having? They can't even go to the banks for liquidity anymore.


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