How High Leverage Has Brought Down the Whole Banking Industry

On Tuesday, as the S&P 500 briefly touched 1,200, the banking sector represented by KBW Bank Index [$BKX] (or other similar indices) went down to 47 (which had been range bound and traded around 75-90 early this year), and VIX reached 30, it seemed that the stock market was under capitulation similar to the March plummet. The dropping of $BKX  was so severe that it broke my technical target of 55 by 8 points.

Now we may see a bear market rally lasting for a few months, similar to post-March capitulation. I still feel Jeremy Grantham's target of 1,100 will be reached sooner than 2010, probably later this year or early next year. I also doubt that funds which have withdrawn money from the market this year, especially in last several weeks, will re-enter the market anytime soon. The worst case scenario is that they may never re-enter the market at all, if these are funds for the baby boomers.

There is an interesting book "Bringing Down the House", which was turned into a movie called "21". It is about a group of MIT students who were trained as card counters to play blackjack at casinos in Las Vegas. They acted as a group, and played small when the odds were not clear or not in their favor. But after receiving a signal from his companion, one of them acting as a super-rich guy entered into the table and played huge stakes when the odds were in their favor. This is a typical example of using leverage against casinos.

It turns out to be that this highly leveraged technique is also used by banks, especially investment banks. No one is trying to bring them down as in the case of "Bringing Down the House". All the current troubles for this industry are of their own making. They are the ones who choose to gamble with their own capital, unlike the casinos. They can't blame anyone else but themselves. However, now with the help of their friends in the government, they are arguing that they need unlimited funding protection and bailout from the government, or more accurately, U.S. taxpayers.

To understand leverage, just look at this WSJ article from Wednesday. Lehman's (LEH) market cap of $9B is only 40% of their book value of $23B, and it sounds very cheap. But then look at their assets: They have $160B hard-to-value Level 2 assets and $41B impossible-to-value Level 3 assets. The WSJ article applies a 5% haircut on Level 2 and 25% on Level 3 to come up with  $19B future write-offs. However, based on analysis from many other public sources, most of the Level 3 assets are MBS CDOs, even if they are AAA rated, the recovery rate is only about 50%. For Level 2 assets, 10% haircut is actually a conservative estimate. The combination of both more realistic haircuts will result in $36B additional losses, which would more than wipe out their book value of $23B plus their market cap of $9B. This is leverage in the working, unfortunately at the down side.

Let us also look at Fannie Mae (FNM) and see what the level of leverage they are using. FNM has long-term liabilities of about $580B, according to Yahoo Finance. It has a negative duration mismatch of 14 months between its assets and its liabilities. Due to this mis-match, a 1% drop in interest rate will cause roughly 14/12 or 1.17% loss in value, or $7B (1.17% x $580B). And their market cap is only $10B. We are only talking about pure interest rate risk, not even losses of credit risk from lending practices, delinquency, foreclosure, etc., which will be much larger than the interest rate risk.

People have drawn parallels between the current failure of IndyMac and the failure of Continental Illinois Bank in 1984, with the expectation that IndyMac will cost FDIC about $4B to $8B, when FDIC has only $52B in its insurance funds. But this comparison has missed the whole S&L crisis, in which losses were much larger than one commercial bank, and FDIC was actually not quite involved. For S&L, the Federal Savings & Loan Insurance Corporation (FSLIC) was the show, and it had $5.6B in 1984 to pay claims; by 1989 its balance had turned into an $87B deficit. The total number of failed S&L institutions is estimated to be around 1,000, and GAO (US General Accounting Office) has estimated the total losses for S&L to be at $166B for taxpayers.

Today people are trying to estimate how many banks will fail this time. The number probably won't get to the 1,000 mark as in the S&L case, and the figure of a few hundred banks has often been mentioned. At the end of this crisis, FDIC will be most likely in the red, similar to FSLIC.

A week ago, Bridgewater Associates issued a report saying that the banking system losses will likely hit $1.6 trillion, but didn't give any breakdowns. This is more than the $1 trillion estimate in my previous article Will CDS Replace Subprime To Cause $1 Trillion Total Loss For This Credit Crisis? in January this year. I actually tried to give a breakdown at that time as follows: $500B for over the counter credit default swaps (CDS), $250B for subprime, and $250B for everything else such as commercial real estate, leveraged loans, credit card losses, auto loans, etc. Due to the further deterioration of the real estate market and continued losses, I think I underestimated the subprime by about $150B, also I should have included some losses for Alt-A and prime mortgages since the losses have already cut into them, especially Alt-A products. In addition, CDS has become a larger, deeper and wilder threat to the whole banking system day by day, maybe $1 trillion is a better estimate now. Overall, $2 trillion losses for this credit crisis are really not stretching at all.

So far this year, some financial institutions have touched the single-digit territory, such as Fannie Mae, Freddie Mac (FRE), Wachovia (WB) and Bear Stearns. After the current bear market rally for the banking sector, who will be the next round of candidates to join the single-digit club? Investment banks are still the usual suspects, such as Lehman, UBS (UBS), and possibly even Merrill Lynch (MER) and Citigroup (C) too.

In order to avoid the domino effect of the current credit crisis rippling through the whole banking industry, the Fed is currently holding the bag by bailing out everyone in trouble. And so far we are only talking about residential mortgages and their CDO derivatives. If the next wave of the credit default swap crisis hits, it will be much more complicated than LTCM, much worse than S&L, and much deeper than subprime. With raising capital becoming more difficult these days, banks have to rely more and more on the Fed with balance sheet of only $800B.

Can the Fed handle the worst monetary crisis in 60 years? Should taxpayers save and bail out the financial institutions in trouble? Did we ask them to use high leverage initially? Have they ever shared the profit with the public at the time when they were making tons of money by using leverage? Why should the whole society have to pay for the bad decision of a few banks at the down side, but  never be allowed to participate at the up side?

Comments

[Ishortyou]

well the same way the wrap those CDOs ABS then need to unwrap them to find out exactly what do they have inside.

[Raj Bapna]

Damn right. And, really scary.
Great article !

[bluecat]

Totally agree! It's ludicrous what the fed is doing with taxpayer money. They will continue to print money to try and get us out of this mess which will only continue to crush the dollar and stoke inflation. Gold and silver make a lot of sense in this environment!

[mkttrdr]

Good work guys-comments are right on.
Free markets work when others don't mess with or bailout companies that are mismanaged. The FED needs to Let it be-let the banks fail.
We need 100 National regulated banks not 12,000.
Leh,mer,bs,ubs,fnm and more will fold. "we can just resell these repackaged cdo's to somebody else". If the board and directors feel that way-let their ships sink. Their greed and ability to leverage 30 times over means the end to many investors.
Thanks guys- see you in the soup lines.

[User 228271]

The big question to me is why the Fed allowed banks to loan money to people who were securitizing mortgages. The whole point of securitizing the mortgage was to get the bank out of the transaction. These loans brought the banks right back into the equation. This was especially a problem since no one did a proper risk evaluation of these mortgages.

For the future, the system needs to be fixed so that this risk is more contained. To my mind, the simplest solution would be to ban banks from using funds from guaranteed deposits to loan to financial companies. There is a lower standard on stocks than on loans -- why then allow stocks to be used as an asset against loans? If mortgage securitization had been funded by equity funds, then at worst the fund would have gone bankrupt and lost investor money. We wouldn't have the domino effect of fractional reserve lending.

The Fed's current ability to loan money to investment banks is completely the wrong solution in my opinion. The problem was that investment banks were accessing guaranteed funds. We should fix that rather than offer new ways to bail out bad investor decisions. Perhaps these loans are necessary in the short term, but we need to move to a system where they aren't necessary.

The Fed's primary focus should be on price stability. Currently it's trying to handle both price stability and economic growth, which is causing it to fail at both (not as badly as in the '70s, but it's early yet). It needs to refocus on price stability and let other actors handle economic growth (possibly by going through a purging recession). Low interest rates should be a tool to avoid deflation, not to try to grow the economy.

[amm]

Intersting. regarding your paragraph on Lehman bros. why would you add the book value and mkt cap together. Doesnt book value incl mkt cap or whatever eqty they have?

[wyosteven]

I agree, with the utter lack of transparency, the valuation is completely "unknown" and therefore risk prone. Personally, I think the Fed ought pull back, let the banks collapse and restore this false sense of security the market has in them. That in turn will lead to regulation so we don't end up here again, and again, and again. I shouldn't have to pay for poor default risk, and next is credit risk, and then what?! *sigh* If Washington only had a clue... even a $.05 K-Mart clue...

[samuelc]

the government shouldn't be regulating at all. if no bank learns from its past mistakes and this happens again then they should be allowed to fail (again). the banks shouldn't be dealing with products incalculable (at least to them) risks. let the strongest entities survive. don't hurt them by bailing out the weak entities that made poor decisions and allowing the them to survive.

people won't learn anything if they're just going to get bailed out.

did anyone ever have that friend who drove a nicer (and possibly faster) car than everyone else that normally sped? when they received a ticket for speeding they were mad because it surely wasn't their fault. when their parents paid off that ticket they forget and started speeding again as if nothing happened? while obviously not entirely the same our current financial situation isn't that much different.

[iThinkBig]

I am with you Wyosteven. I would rather eat government cheese and wheat rations now for a year and start over. The problem of course, is that government officials will be named and blamed and removed by force if necessary by the public. This means they will socialize which in the short term prevents collapse. Then these leaders leave office so in 3-4 years time, that leader gets all the blame by the American people. The French Bastille comes to mind but the bummer is that unlike 1789, most of these guys truly responsible will be sipping on fine whiskeys in some other foreign nation (note recent government discussing massively taxing dual-citizenship) while the entire nation endures the pain and does the heavy lifting. Such is the way of governments for 10,000 years. In this case, let's hope it doesn't turn into a bloody revolution.

[ari5000]

Very good article.

[helplessobserver]

Thomas,
This post exceeds your normally high standards. Unfortunately the horse is out of the barn and we must resort to taxpayer unfriendly methods to keep the banking system functional. Once this short covering and "fools rush in" rally is over the SP will fall well below 1100.

[JasonC]

What do you mean, "never be allowed to participate in the upside"? If you think banks are a one way, can't fail bet, then buy lots of bank stock. Anybody can play. But pretending it isn't risky as heck is, well, pretending.

[fatcat]

I just went back to dec 27,07 and read mr. Tans predictions for 08...uncanny...

[The Jackal]

Tom Tan is the man.....he knows his Si*t.

[chrispycrunch]

What choice does the Fed have in restoring some kind of liquidity for the markets? The lending market is like a car brake that has seized up.

Main question remains: when will the housing prices stabilize? The Fed needs to restore confidence in the banks, long enough for housing prices, and therefore banking losses, to stabilize.

[PeterPrinciple]

Privatize the profits; socialize the losses.

Some things never change.

[User 228479]

Greed fosters the aggressive banks' downfall. Fed's fear & thus helicopter money will nearly impoverish the taxpayer & enrich the affected banks and funds. Letting the latter down their own medicine and risking a deflationary depression is the lesser of two great evils, the other being an inflationary or maybe a hyper-inflationary depression.

[Bob Gary]

What ever happened to free market capitalism? Why is the govt. jawboning and intervening. Don't we need some failures. A strong economy is formed by weeding out the weak links. It's like little league baseball when you had to play the fat kid for 3 innings! Let the market run operate freely please. This was a good piece on this topic i saw today.

www.greenfaucet.com/tr...

[glassbox]

The whole financial sector is going to get another huge leverage boost again if nothing is done to regulate short selling (or ban it). Short selling is another form of leverage - instead of borrowing money, you borrow shares. The difference is that you can probably multiply money easily but you certainly cannot multiply shares.

[CharlieStromeyer Jr]

Good piece, Thomas. Do you agree with an earlier Bloomberg article which implied that JP Morgan (JPM) has the greatest risk exposure ever to credit default swaps (CDS)?

[Pauly B]

Right on Mr Tan!. Just a great blog...

It would be nice for once to see some FED officials being hauled out in handcuffs for poor oversight of Investment, National and Regional banks. Where were the bank examiners? Do they exist? Did anyone walk into these banks and ask to and review just 25 loan applications?

Whats even worse are the credit rating agencies that where rating these banks that drove stock prices higher and higher.

[Stockguy456]

must see explains everything!
video.google.com/video...

[vaduz]

usd will go down, inflation up , s&p down and gold up.
the risks are high and i wouldnt like to be on a decision making desk either at the fed or in a private bank having to decide which bank to let fail resp. which bank to give my free money.

[AmesTiedeman]

Of course it was leverage. 30-1 in some cases. How stupid can one get? All the earnings were essentially a lie without the leverage working. When it stopped working they were wiped out. Total disgrace for America. Billion paid in bonuses, billions now needed to bail them out.

[pescayolas]

excellent commentary Thomas, how can we continue to ignore the hard and fast numbers clearly showing the collapse of our financial system. could you please shed some light on the numbers found on page 25 of the latest OCC report on bank trading and derivatives found at www.occ.treas.gov/ftp/...
jp morgan has 1.3trillion in assests v. 84trillion in derivatives? how about some info on the credit exposure to capital ratio? what do you think that 84trillion is comprised of?

[Kunst]

samuelc: "the government shouldn't be regulating at all. if no bank learns from its past mistakes and this happens again then they should be allowed to fail (again). ... people won't learn anything if they're just going to get bailed out. "

Two different issues here.

We wouldn't be in this mess if reasonable regulation had prevented what we now recognize as reckless and irresponsible lending, including unlimited securitization and a completely hidden derivatives market. These were huge departures from what has long been known about responsible finance.

What we needed was to PREVENT this mess. Then we wouldn't have to be arguing about how to clean it up. If you really mean banking shouldn't be regulated at all, how do you feel about traffic laws. They are meant to protect society as a whole, not the driver (bank) personally. If this mess brings down the whole country, do we just focus on the individual entities?

[lonie]

Once upon a time there was in American some criminals according to the law . Jesse James , Bonney and Clyde , Willie Sutton and others . I believe they robed banks .Their methods proved to be dangerous to life and limb.
Their progeny must have realized , we have to devise a less dangerous way, went to Harvard , Stanford and such to get MBAs so they could work their way into the finance system . Some have went so far as to work their way into government ,Treasury , Fed . Reserve and such to help less fortunate compatriots in their efforts to rob the whole damned populace.

[Kinabalu]

"most of the Level 3 assets are MBS CDOs, even if they are AAA rated, the recovery rate is only about 50%."

Level 3 assets and AAA is a contradiction of terms. I'm not sure what you mean by a 50% recovery rate, but these assets are carried by many institutions at less than 5% of face value.

[Kinabalu]

Sorry, also meant to comment on "Can the Fed handle the worst monetary crisis in 60 years?" you kind of lost me there. What happened in 1948?

[allerion]

Thank you stockguy456 for the link.

[CharlieStromeyer Jr]

Kinabalu, I also find it hard to believe that the recovery rate is about 50% at Lehman (LEH). For example, almost all of the $48 billion of CDOs underwritten by Merrill Lynch (MER) in 2007 are now in default or on the verge (according to BusinessWeek and other sources).

[pescayolas]

its funny, the process used to anticipate losses on these CDO's is called a Monte Carlo Simulation, and if losses are above 10% the entire pool is wrecked. The name should have been Las Vegas Gamble or even worse a Reno Reposition. please check out this link:
www.occ.treas.gov/ftp/...

[thomast2]

Thank you all for providing your wonderful comments here. I really appreciate your thoughts and your time.

Amm, book value and market cap are two different things. Market cap usually is higher than book value but not in LEH’s case here. I also used the same approach as used by the WSJ article that the potential future writeoff could wipe out both book value AND the market cap.

Helplessobserver, I also agree that S&P will fall below $1,100 which is only my intermediate target. See my previous article of seekingalpha.com/artic..., my ultimate target is actually $800, as indicated in my article.

Thanks to Bob Gary and stockguy456, those are good links, especially the video on Fed which I watched before and now watched again. It is a cartel of the banks, by the banks and for the banks.

Charlie, you can read my previous article of seekingalpha.com/artic..., which has a brief discussion on the CDS risk exposure to JP Morgan. This is also the 2nd most popular article I have written next to my 10 predictions for 2008. By the way, what is the link to the Bloomberg article you were referring to?

Pescayolas, this is a long report, let me read through it, especially the derivative portion. Thanks for the link.

Kinabalu and Charlie, what I meant was for those CDOs with AAA rating, which the recovery rate is around 50%. It is more conservative that way. I am aware that anything below AAA rating is pretty much all wiped out. But at the same time, LEH may have written some of them off already.

[CharlieStromeyer Jr]

Hi Thomas, here is the Bloomberg article about CDS exposure:

www.bloomberg.com/apps...

The article gets some of its info from the OCC report that pescayolas linked to.

[Stefan]

When banking gamble with their money an loose we are all affected in hte way of higher interest rates.