Despite the market's two-day rally, don't be fooled into thinking that the pain of the summer credit crisis is behind us. Quite the contrary, it's really just picking up steam. The leverage taken on by both consumer and bank alike during the past several years in the housing boom is coming home to roost as both are paying the piper.
We have already heard over the past few months of rising delinquency and foreclosure rates and subprime losses by several brokerage houses, but it seems the banks have finally joined the party. We saw the opening inning to this trend in the banks with the release of the Federal Deposit Insurance Corporation's (FDIC) Quarterly Banking Profile for the second quarter, which was commented upon in a previous WrapUp (Subprime Flu Infecting Other Financial Industries). The period did not include the summer's credit crisis but still showed a deteriorating trend in the banking industry.
Many have been anxiously awaiting the release of the third quarter report which hit the streets this morning. The results of the report are fairly well summarized and instead of reinventing the wheel, highlights from the report will be provided below with commentary to follow (click here for full report). Notice within the highlights that levels have deteriorated in many categories to levels not seen in decades. Text underlined and in bold are for added emphasis.
Almost Half of All Institutions Report Lower Profits
Rising levels of troubled loans in all major loan categories, but most notably in residential mortgage portfolios, led to a steep jump in expenses for bad loans in the third quarter. These higher costs, combined with sharply lower trading revenue, caused industry earnings to fall 24.7 percent from a year ago to $28.7 billion--the lowest level for industry earnings since the fourth quarter of 2002.The year-over-year decline in industry net income was fairly widespread; almost half of all institutions (49 percent) reported lower quarterly earnings compared to the third quarter of 2006.Figure 1
Source: FDIC
Figure 2
Source: FDIC
Loss Provisions Surge to 20-Year High
Loan-loss provisions totaled .6 billion, more than double the .5 billion insured institutions set aside for credit losses in the third quarter of 2006 and the largest quarterly loss provision for the industry since the second quarter of 1987.Sales of loans yielded a net loss of 9 million, compared to .3 billion in gains a year ago. This is the first time the industry has reported a net loss on loan sales since institutions first began reporting these data seven years ago.Gains on sales of securities and other assets declined by 8 million (80.8 percent) from a year earlier, to 6 million, the lowest level in seven years. Extraordinary items, which added 1 million to earnings a year ago, produced a net loss of .1 billion in the quarter.The magnitude of these downward pressures dwarfed improvements in net interest income, trust income and service charges on deposit accounts (up .6 billion, .3 billion, and 1 million, respectively).Figure 3
Source: FDIC
Figure 4
Source: FDIC
Net Interest Income Registers Strong Growth
The 6.5-percent increase in net interest income was the best year-over-year growth rate in five years. Interest-earning assets were up 7.5 percent from a year ago, and net interest margins (NIMs) were modestly higher than in the second quarter, thanks in part to a slightly steeper yield curve.Loan Losses Are Higher in Most Loan Categories
Net charge-offs totaled .7 billion, the largest quarterly amount since the fourth quarter of 2002. Loan losses in the third quarter were .6 billion (49.9 percent) higher than a year earlier, rising year-over-year for the third quarter in a row. Losses were up in most of the major loan categories. The largest increase occurred in loans to commercial and industrial (C&I) borrowers, where charge-offs were 6 million (91.4 percent) higher than a year earlier. Charge-offs of consumer loans other than credit cards had the second-largest increase, rising by 2 million (46.1 percent). Net charge-offs of residential mortgage loans were up by 6 million (164.8 percent).Figure 5
Source: FDIC
Figure 6
Source: FDIC
Residential Real Estate Accounts for More than Half of the Increase in Noncurrent Loans
Noncurrent loans and leases registered their largest quarterly increase in 20 years during the third quarter, rising by .0 billion (23.8 percent). More than half of the increase consisted of residential real estate loans.At the end of September, the total amount of loans and leases that were noncurrent stood at .0 billion, the highest level since the third quarter of 1992.Figure 7
Source: FDIC
C&I Loan Growth Sets Another New Record
Total assets increased by a record 6.3 billion (3.6 percent), eclipsing the previous quarterly high of 1.6 billion set in the first quarter of 2006. Despite the slowdown in construction loan growth, the number of insured institutions with concentrations of construction loans continued to increase. At the end of September, more than one in four institutions (27.4 percent) reported construction loan portfolios that exceeded their total capital.What the above highlights show is that the banking industry is under severe distress with loan-loss provisions rising to 20 year highs amid rising defaults among all categories. What is troubling is that despite loan-loss provisions rising to 20 year highs, the coverage ratio (loan-loss reserves/noncurrent loans) fell to its lowest level since the third quarter of 1993 as noncurrent loans have risen at a faster pace than bank loan-loss reserves.
As seen in Figure 6, residential mortgage charge-offs have risen a steep 164.8% over last year's levels and are likely to continue to climb as housing inventories continue to sore. The existing home sales report came out today and showed that sales declined 21% from last year's levels and months of available inventory rose to 10.8 months. Both existing and new home months of supply are in recession territory right here, with existing home supply putting in an all-time record and eclipsing the last housing recession's mark at roughly 10 months. The rapid deterioration in housing does not bode well for the banking industry with its record level of exposure to residential real estate.
Figure 8
Source: Moody's Economy.com
Figure 9
Source: Moody's Economy.com
Another troubling development is the banking industry's exposure to commercial and industrial (C&I) loans. Even though C&I loan growth set another record, the concentration of construction loans on bank balances also grew with 27.4% reporting construction loan portfolios that exceed their total capital. This is occurring at a time that the noncurrent rate on construction loans is rising from historical levels. These banks face considerable risk due to their high exposure to construction loans if the noncurrent rate rises to anything seen back in the last housing led recession of 1991.
Figure 10
Source: FDIC
As of the third quarter, construction and development loans outstanding totaled 6.4 billion. If the noncurrent rate reaches 14% as it did in the last housing recession, the total noncurrent construction and development loans would be .3 billion. This indicates the potential for how bad things can get in the banking industry if housing, both residential and commercial, continues to deteriorate as the third quarter net charge-off due to C&I loans of 6 million may just be the tip of the iceberg.
As shown in figures 5 and 6, banks are writing off more and more loans on all categories as delinquency rates surge. The trend in delinquency rates is closely correlated to the federal funds rate with a lag of 1.5 years and the recent cutting in short rates by the Fed in September indicates that delinquency rates, and subsequently bank net charge-offs, will continue to rise before cresting in the first quarter of 2009.
Figure 11
Source: Moody's Economy.com
Figure 12
Source: Moody's Economy.com, DismalScientist
This timetable is quite plausible as adjustable rate mortgage resets will continue to remain elevated into next year, as are the ensuing defaults which are forecasted to remain elevated into 2009. Thus, despite the markets bounce from deeply oversold conditions, the proverbial fat lady has not sung regarding the credit crisis as banks will continue to remain under pressure through next year.
Today's Market
The markets continued yesterday's gains with the Dow soaring more than 300 points when investors grew optimistic for a holiday gift from the Fed in terms of a rate cut as Fed Vice Chairman Donald Kohn said that tight financial conditions may merit offsetting policy from the central bank.
Also aiding the market's rally was a sharp drop in crude prices on inventory data that showed a milder decline in inventories than expected as a result of surging imports. Crude oil inventories fell by 0.4 million barrels last week, less than the 0.9 million barrel draw down expected. Had crude imports remained steady, crude oil inventories would have fallen by 4.1 million barrels.
The Dow Jones Industrial Average rose 331.01 points to close at 13289.45 (+2.55%), the S&P 500 gained 40.79 points to close at 1469.02 (+2.86%), and the NASDAQ rose 82.11 points to close at 2662.91 (+3.18%).
Treasuries fell with the yield on the 10-year note rising 8.1 basis points to close at 4.025%. The dollar index was up on the day, rising 0.03 points to close at 75.13. Advancing issues represented 85% and 76% for the NYSE and NASDAQ respectively, reflecting a broad rally in the markets.
