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EJ
04-03-07, 05:27 PM
http://www.itulip.com/images/reserves.gifAre Loss Reserves Adequate in Light of Rising Delinquencies?
April 3, 2007 (A.M. Best Banking Report)

A prominent feature of the U.S. banking industry’s fourth quarter 2006 results were noticeable increases in other real estate owned (OREO) and real estate charge-offs of 9% and 33%, respectively, and in emerging past due real estate loans, which increased by 21%. This leads to the question of whether loan loss reserves are sufficient for the industry. The question is even more pertinent for the smaller banks, which exhibit concentrations in higher risk commercial real estate and construction loans: 25% and 14% of total loan and leases, respectively.

While the banking industry’s absolute capital levels are high, and improvements have been seen in credit card portfolios and fixed rate mortgages, these positive developments have been more than offset by sharply declining quality in adjustable-rate mortgages and other real estate loan classes, such as commercial real estate. The low delinquency and charge-off rates of the past several years may have encouraged the assumption of additional risks without additional loss provisions. Of note, loan loss reserves are down to levels not seen since 1985, while past dues are ticking upward. The historical context of past downturns in the economic cycle, as well as the forward looking credit quality indicator of 30- to 89-day past due loans for the industry, provide an interesting perspective on the adequacy of current reserve levels.

Looking back historically, the last time loan loss reserves declined to these levels was 1985. Interestingly, that time period preceded a real estate downturn for which banks were not prepared. The confluence of the industry’s low reserves in the mid-1980s and the onslaught of one of the most severe real estate market corrections had all the ingredients of a perfect storm that wreaked havoc on U.S. banks for more than a decade later. Whether or not higher reserve levels back in 1985 might have made any difference in the state of the U.S. banking industry during the real estate market correction is another matter. The historical context of cyclical patterns for real estate loans and the industry’s exposures to this asset class is seen by the peaks of noncurrent loan rates at the time of or shortly following the 1985/1986 slowdown, the 1990/1991 recession and the 2000 recession as seen in the graph. Indications that the economy may be slowing, once again, beg the question of how adequate are current levels of bank loss reserves.

As yet another indicator of the potential for the U.S. banking industry’s 2006 year-end reserve levels to prove inadequate for deteriorating credit risk profiles, the fourth-quarter rise in delinquencies included a troubling increase in the emerging 30- to 89-day past-due category. Historically, these delinquencies are a precursor to more serious delinquencies, which ultimately may lead to loan losses. Another way of stating it: Regard the 30- to 89-day past dues as the pipeline that ultimately feeds into the 90+ past dues and the non-accruals (albeit perhaps not dollar for dollar). With a groundswell of the 30- to 89-day past dues underpinning the 90+ day past dues and non-accruals, the industry reasonably can be expected to face ever-rising delinquencies in the latter category in the coming months and quarters.

The trends of rising delinquencies and deteriorating asset quality in all asset-quality indicators, including OREO, charge-offs, 90+ past dues and non-accruals, and the 30- to 89-day past-due increases, lends further credence to the troubling aspect of the reserve levels being the lowest since 1985. In the fourth quarter, the more advanced stage 90+ non-accrual category already had increased by 14% for all real estate projects and a whopping 31% for the highest risk construction and development loans. If even half of the emerging 30- to 89-day delinquencies were to move through the pipeline to be included with these loans, the result would be 90+ days non-accrual loans of $92.7 billion, overwhelming an industry loan loss reserve of $77.6 billion.

This study is available electronically from the A.M. Best Co. Web site at www.ambest.com (http://www.ambest.com).

AntiSpin: We asked last week, Can the U.S. economy digest the trillion dollar ARMs egg? (http://www.itulip.com/forums/showthread.php?t=1101) In the event, it appears that it's the U.S. banking system is likely to get indigestion.

Don't recall what happened to the banking system in the 1990s? Top three events were:

1) More than 1,600 banks failed.


http://www.itulip.com/images/bankfailures.gif


2) Banks went to the "discount window" to borrow from the Fed often during the period.


http://www.itulip.com/images/discountwindow.gif


3) The banking system for a six month period in late 1994 virtually stopped lending.


http://www.itulip.com/images/nolending1994.gif


This led to the reserve and account sweeps rule changes that iTulip's Aaron Krowne (now of Mortgage Lender Implode (http://ml-implode.com) fame) wrote about for iTulip in What (Really) Happened in 1995? (http://www.itulip.com/forums/showthread.php?t=292)

What led up to this crisis? According to the June 2000 FDIC report, An Examination of the Banking Crises of the 1980s and Early 1990s (http://www.fdic.gov/bank/historical/history/vol1.html):
During most of the 1980s, the performance of the national economy, as measured by broad economic aggregates, seemed favorable for banking. After the 1980–82 recession the national economy continued to grow, the rate of inflation slowed, and unemployment and interest rates declined. However, in the 1970s a number of factors, both national and international, had injected greater instability into the environment for banking, and these earlier developments were directly or indirectly generating challenges to which not all banks would be able to adapt successfully. In the 1970s, exchange rates among the world's major currencies became volatile after they were allowed to float; price levels underwent major increases in response to oil embargoes and other external shocks; and interest rates varied widely in response to inflation, inflationary expectations, and anti-inflationary Federal Reserve monetary policy actions.

Developments in the financial markets in the late 1970s and 1980s also tested the banking industry. Intrastate banking restrictions were lifted, allowing new players to enter once-sheltered markets; regional banking compacts were established; and direct credit markets expanded. In an environment of high market rates, the development of money market funds and the deregulation of deposit interest rates exerted upward pressures on interest expenses–particularly
for smaller institutions that were heavily dependent on deposit funding.

Competition increased from several directions: within the U.S. banking industry itself and from thrift institutions, foreign banks, and the commercial paper and junk bond markets. The banking industry's share of the market for loans to large business borrowers declined, partly because of technological innovations and innovations in financial products. As a result, many banks shifted funds to commercial real estate lending–an area involving greater risk. Some large banks also shifted funds to less-developed countries and leveraged buyouts, and increased their off-balance-sheet activities.
To answer the FDIC's 2000 question, Lessons Learned? Not many. Low loan loss reserves? Check. Competition from credit markets? Check. Avoiding competition and increasing profits by shifting funds to high risk real estate lending, junk bonds, LBOs, and emerging markets? Check, check, check, and check.

Appears that all we need to get a repeat show on the road is exchange rate volatility and higher interest rates. And that can't happen again, can it?

(See iTulip Select interview of Jim Rogers today (http://www.itulip.com/forums/showthread.php?t=1130).)

p.s. You won't see the A.M. Best story or the FDIC study on other sites as of 5:24PM ET today, but you will soon!

Finster
04-03-07, 09:13 PM
One might wonder in these days of vanishing to negative bank reserve requirements, printing presses and helicopters, what point there is to even having FDIC coverage. Bank insolvent? We can fix that. A few keystrokes can send a flurry of ones and zeros surging through the financial system in the twinkling of an eye. After all, debts owed the bank aren't anything tangible. Deposits are nothing more than evanescent blips on a disk. A bureaucracy dedicated solely to restoration of one institution's deficit of binary code through manipulations of its own binary code seems obsolete. Money is now nothing but electronic bookkeeping.

The Fed has legal authority to monetize just about any institution's debt. Since it already performs this service for the US Treasury, why can’t it do the same for any US bank?

Heck, why can’t we all be rich? Just dispatch an electronic edict across the land. Every account in the country is to be summarily be multiplied by ten. Just add a zero at the end. With a mere shift of a decimal point, GDP can grow 900%, the Dow Jones Industrials can soar past 100,000. Within days, no one need work any more. Close the factories, restaurants, schools, hospitals, mines, wells … all we really need is banks full of blips.

It might sound a bit far-fetched, but after all, we're already doing it. And if a little is making us better off, then why stop there? Economic nirvana is within our grasp!

GiM
04-03-07, 09:32 PM
...the result would be 90+ days non-accrual loans of $92.7 billion, overwhelming an industry loan loss reserve of $77.6 billion.

This isn't a 1-to-1 relationship though is it?
Defaulted RE loans still have some value from the collateral. Maybe less value than accounted for at closing. But on average, would a defaulted loan really cause more than a 80% real loss?
Eyeballing Exhibit 2 in the A.M. report it looks like charge-offs to non-current loans can be 40%-80% and are at around 60% right now (if I'm reading it right).

Anyone know what an appropriate or average reserves to loan value?
I've been looking at some of the "Alt-A" banks balance sheets and they are around 1%.
Non-current loans look to be at 1% as well.
Assuming a conservative 60% loss on non-current loans, we only need a 70% jump to eat through the reserves.

The highest non-current loan ratio in the '80s(eyeballing from exhibit 3) is around 4%. If the capital to loan of the average bank is 11% as A.M. states, that would mean a 20%-30% haircut off the banking industry.
Quite a correction indeed.

And Exhibit 4 is pretty scary. Showing a revision of the coverage ratio from 140% to 60%. I wish they had explained what that was all about.

Disclaimer: Of course I don't really know what I'm talking about and I don't understand how these numbers are generated (at what rate do non-performing loans drop off from foreclosure? etc...).

EJ
04-03-07, 09:39 PM
One might wonder in these days of vanishing to negative bank reserve requirements, printing presses and helicopters, what point there is to even having FDIC coverage. Bank insolvent? We can fix that. A few keystrokes can send a flurry of ones and zeros surging through the financial system in the twinkling of an eye. After all, debts owed the bank aren't anything tangible. Deposits are nothing more than evanescent blips on a disk. A bureaucracy dedicated solely to restoration of one institution's deficit of binary code through manipulations of its own binary code seems obsolete. Money is now nothing but electronic bookkeeping.

The Fed has legal authority to monetize just about any institution's debt. Since it already performs this service for the US Treasury, why can’t it do the same for any US bank?

Heck, why can’t we all be rich? Just dispatch an electronic edict across the land. Every account in the country is to be summarily be multiplied by ten. Just add a zero at the end. With a mere shift of a decimal point, GDP can grow 900%, the Dow Jones Industrials can soar past 100,000. Within days, no one need work any more. Close the factories, restaurants, schools, hospitals, mines, wells … all we really need is banks full of blips.

It might sound a bit far-fetched, but after all, we're already doing it. And if a little is making us better off, then why stop there? Economic nirvana is within our grasp!
We can print our way to freedom and prosperity, Pilgrim! How could we have been so wrong for so long!

The right idea all along, but off by a single, solitary, lonely little word, set in the wrong place, else the right idea entirely!


http://www.itulip.com/images/waytogo.gif

Can you believe that in the less enlightened olden days, the misguided souls believed this?


http://www.itulip.com/images/waytogoOriginal.gif

Editor's note: In case anyone missed the sardonic humor intended here: he's kidding. Changing the location of that one word certainly has a profound impact on the meaning of the cartoon, no? And brings it "up to date."
-Ed

DemonD
04-04-07, 05:10 AM
EJ, understand your point, but in all generations there have been "investments du jour." Bubbles, booms/crashes, etc. Whether it was tulips in holland in the 1600s, the south seas, gold in california in 1848, real estate many times in this country's history - it's always there. Whether it's a "carpetbagger" in the reconstruction era, a snake-oil salesman, or Robert Kiyosaki and all the MLM scams that are out there now, it's been going on for at least 500 years. And my bet is that it has been going on for thousands of years, we just didn't have fancy macroeconomics back then. (The smart people were trying to figure out how to, you know, not die by the age of 40.)

Ah, actually i do remember a story. Socrates was known for living in poverty. Some one (or a group of people) who were wealthy scoffed at Socrates' lifestyle, basically challenging him: he's a broke-ass philosopher, why would they take him seriously? They didn't think he was poor because he chose it, but rather because he was foolish and/or lazy or stupid or just an out and out nutjob.

So Socrates took their challenge, and proved to them that he could be monetarily rich if he chose to. He scrounged what little money he had and, after having studied weather patterns, decided to invest in a grove of olive trees. After a bumper crop, Socrates made a killing in the olive-selling produce market. (Maybe the tulips of his time?)

This showed the doubters who were skeptical of his wisdom that he did not have to live in poverty but did indeed choose it.

Incidentally, a cursory google search did not find any resources to back up this story, I recalled it from an intro philosophy class I took once. Also olive trees take a long time to cultivate and finally since Socrates never wrote anything down himself, difficult to say how true the story is, but the point is in terms of economics, it appears that booms and busts have been going on for at least 2500 years, and popular investments almost must be a part of the history of these countries.

BTW I see the word "implode" everywhere talking about mortgages. Since I was never around for previous bubbles/bursts, was that word used a lot? It seems like Aaron can take credit for creating/popularizing that word. And I'm sure every article that mentions mortgage companies going out of business is using the implode-o-meter as a resource.

miju
04-04-07, 05:19 AM
As usual people do not talk exactly about the same things, hence the confusion on figures. Truly the reserve ratios are very low in the industry. but can you ask a bank manager to create reserves when the business look good ? would the shareholder happy to see earnings lower due to provisions for potential problems ? do auditors and the IRS would accept to see undue provisions ? NO ! So don't blame for the low reserves ratio. but blame on the loose lending processes, YES ! having said that , previous banking crisis in the US or elsewhere showed that loan losses ratio can rise to 1.5 to 2 % and that would represent a good 50 % of the 2006 banking profits (130 bn for the commercial banks) . Beware of the impact on banks stock prices . but not on their balance sheet (equity base is above 1 trillion)
miju

DemonD
04-04-07, 05:23 AM
http://www.itulip.com/images/reserves.gifAre Loss Reserves Adequate in Light of Rising Delinquencies?


If you were to pour gas on fire like that, the fire would likely travel up the gas can and get into the gas can igniting the fuel inside it, and it would blow up in your hand. (Explosion as opposed to implosion.) Explosion probably might be a better term for mortgage companies because implosions are usually self-contained, where with explosions there is almost always collateral damage that can reverberate throughout an area, or if it is a big explosion, a more regional or national and potentially international effect. (Exploding volcanoes can cause global weather pattern changes. Krakatau in 1883 caused global weather pattern changes that affected the Earth for 5 years.)

Anyway as someone who dabbles in fire-type hobbies, I find that image particularly amusing and accurate.

FRED
04-04-07, 09:20 AM
If you were to pour gas on fire like that, the fire would likely travel up the gas can and get into the gas can igniting the fuel inside it, and it would blow up in your hand. (Explosion as opposed to implosion.) Explosion probably might be a better term for mortgage companies because implosions are usually self-contained, where with explosions there is almost always collateral damage that can reverberate throughout an area, or if it is a big explosion, a more regional or national and potentially international effect. (Exploding volcanoes can cause global weather pattern changes. Krakatau in 1883 caused global weather pattern changes that affected the Earth for 5 years.)

Anyway as someone who dabbles in fire-type hobbies, I find that image particularly amusing and accurate.

Good eye. We created the picture this way on purpose. "Fire type hobbies"? Hmmm!

bart
04-04-07, 01:11 PM
Oh ye of little faith... the Fed has things well in hand in reserves land. Just look at how wonderfully what they call excess reserves at depository institutions have been going up for decades, and how helpful that has been to stock markets.

http://www.nowandfutures.com/images/fed_excess_total_reserves_long_term.png



And besides, reserves aren't that important anyhow:


"The Chairman noted that the President had recently signed the Financial Services Regulatory Relief Act of 2006, which among its provisions gave the Federal Reserve discretion, beginning October 2011, both to pay interest on reserve balances and to reduce further or eliminate reserve requirements. The Act potentially has important implications for many aspects of the Federal Reserve's operations"
-- Source: Fed minutes from Oct 2006



Relief is on the way... plop. plop. fizz. fizz.

http://www.youtube.com/watch?v=qsFClz9Xkv0


A pen warmed in Hell (http://www.amazon.com/Warmed-Up-Hell-Mark-Twain-Protest/dp/0060906782/ref=sr_1_1/002-7040697-7243209?ie=UTF8&s=books&qid=1175706621&sr=8-1)

DemonD
04-04-07, 11:08 PM
Good eye. We created the picture this way on purpose. "Fire type hobbies"? Hmmm!

You didn't think I took my "fire flower" avatar as a stock photo from some random website or Google image search did you?

ablevin
04-05-07, 11:56 AM
EJ, any thoughts on the Euro? Do you still prefer the Euro to the Yen at these levels?