Is The Worst of the Credit Crunch Behind Us?

One of the more common refrains we keep hearing is that the worst of the credit crisis is behind us. Not only that, but banks have written down so much bad debt, that there is an upside surprise ahead of us!

I’m not so sure about that. As to the first part, credit spreads, mortgage rates, and the actions of the Bank of England strongly imply we are still in the thick of it. As to the latter, I simply doubt management has been that forthcoming.

I am not the nly one with such doubts. The WSJ looks at the specific accounting quirks that allow banks to write down much less bad debt — about 20% less — than they actually have:

"Outsize losses reported last week by Citigroup Inc. and Merrill Lynch & Co. could have been a lot worse except for a quirk in the way companies account for different types of securities.

Citigroup took $15 billion in write-downs and credit
charges, leading the big bank to report a first-quarter loss of $5.1
billion. But $2.3 billion in other write-downs didn’t hit the company’s
income statement.

The same was true at Merrill. The broker had $6.6
billion in write-downs, leading to a loss of $1.9 billion. But Merrill
took at least $3.1 billion in other write-downs that didn’t count
toward its loss."

Best of all, its all legal according to the accounting rules:

"So, where did those other charges go? Into a special
bucket in shareholders’ equity called "other comprehensive income." The
beauty of this bucket is the charges land on the balance sheet, but
don’t dent the companies’ bottom line.

Heard_20080420182910It all gets down to how a company classifies a
security. A company can say it plans to hold a security until it
matures, that it is available for sale or that it is being actively
traded. Securities being held to maturity are held at their original
cost and their value is written down only if they are deemed to be
impaired. Securities that are traded are always marked to market, and
gains or losses immediately hit profit.

The
available-for-sale category is a middle ground in which the value of
the securities is written down or up depending on market prices, but
the loss or gain ends up in the "other comprehensive income" bucket. It
stays there until the change in value is considered more permanent. At
that point, a company finally takes the losses out of the bucket, and
they hit the bottom line.

How much worse the balance sheets of the major banks and brokerages will get before the credit crunch is fully behind us is still anyone’s guess. Those of you who have been trading the beaten up banks best be nimble enough to reverse course if another leg down starts.

As to BoE, their announcement today of a plan to swap about "50 billion pounds ($100 billion) of government
bonds for mortgage-backed securities to lower credit costs" shows the global impact of the credit crunch remains unabated:

The plan will "unfreeze the situation we’ve got at the moment,” Chancellor of the Exchequer Alistair Darling said yesterday in an interview with the BBC, without specifying how much would be made available. "What the Bank of England will do is, in effect, lend the banks that money. In the meantime, the Bank of England will take a security.”

Prime Minister Gordon Brown’s government is trying to encourage lending after a surge in borrowing costs prompted banks to withdraw their best mortgage offers, threatening to exacerbate the worst housing downturn since 1992. The plan is a change of approach by the Bank of England after three interest-rate cuts since December failed to ease the logjam."

Some people have been calling the banks an opportunity of a lifetime. I am far less sanguine about the sector over the intermediate and longer term. This remains a troubled sector, with its losses not fully realized  yet.

>


Related:
Credit crisis a "global calamity"–Kaufman
John Parry
Reuters, Fri Apr 18, 2008 11:40am EDT   http://www.reuters.com/article/ousiv/idUSN1845613820080418

Sources:
A Way Charges Stay Off Bottom Line
DAVID REILLY
WSJ, April 21, 2008; Page C1
http://online.wsj.com/article/SB120873768772029985.html

Bank of England Will Unveil Swap to Ease Home Lending
John Fraher and Gonzalo Vina
Bloomberg, April 21 2008
http://www.bloomberg.com/apps/news?pid=20601087&sid=a1Xcc.MQyy.g&

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What's been said:

Discussions found on the web:
  1. dblwyo commented on Apr 21

    They are the opportunity of a lifetime on traditional valuation and earnings analysis. I also think we’re looking at “Boiled Frog” syndrome. For the traditional view to be right the existing business models which shifted to trading on own account using leverage from the original get fees, provide services and make sound loans has to be sustainable, right and executable. If the Finance Industry as a whole fails any of those tests then the traditional analysis. Personally IMHO we’re facing a decade long worth of work to re-think the business models and improve the management systems. And the work hasn’t begun because there is general denial that it’s required. That’s hardly my sole opinion and several astute observers have made similar ones:
    http://tinyurl.com/4tytv2 or http://tinyurl.com/48ggwk for some readings on the subject including JPM’s that we’re facing a decade of turmoil.

  2. Wayne Mulligan commented on Apr 21

    Wow, great post! So there’s roughly $85 billion in write-downs that have yet to hit the bottom line. If we look at how stock prices have reacted to the current stream of write downs I think it becomes pretty clear that financials (and the rest of the market) still have a lot of downside risk in them.

  3. Philippe commented on Apr 21

    The lyric is cheerful but the numbers may disappoint
    Few figures
    The EURIBOR one year is at 4.8 % when the ECB rate at 4% and the ten years OAT at 4.34%
    Banks and financials have written off around 250 Billion USD out their backlog and have so far raised 100 billion USD in private placement (Data from Bloomberg)
    They have tier one ratio under the Basle agreement of 8% they are much below the 12%
    Their liquidity ratios are as reliable as their assets rated AAA
    The average gearing of the banking sector is 30/40
    They have been given until July (the usual time of bad debt discovery for the banking sector) to reveal their bad debts
    The financial sector loss estimates vary between 650 Billion USD (Pareto stats as applied to the housing sector only) and 1 Trillion USD for the new consensus IMF
    Few pockets of further ordeals may stem from derivatives and the default swaps « horror show »
    They are still making huge profits on their own bonds (please read that their bonds price is not reflecting interest from lenders)
    Lehman short interest on its share price is around three times its market capitalisation (the last time there was such a reading it was for Bear Stern) This is for the reading of the equities market.

  4. cinefoz commented on Apr 21

    I am currently in the middle of “Traders, Guns & Money: Knowns and unknowns in the dazzling world of derivatives” by Satyajit Das

    This is an amazing book. Mr Das is a world expert on derivatives. This book is more of a behind the scene look at traders, quants, management, greed, scams, screw ups, and phonies in the options markets. It indelicately removes the mystique about the people in the derivatives business.

    There is a small part in the book about how banks use FASB rules to move accounting balances around to hide losses. Good bonuses depend on good earnings. The one described above would be known to all 2nd year accounting students.

    It would be impossible for anyone to read this book and not consider the oil bubble that is now building to be a sucker market of titanic proportions. Undoubtedly, the FOMC is subsidizing it by implying that rates will continue to fall and the dollar will follow. Unfortunately, demand does not support the existing price. Neither does the rest of the economy.

    Excess revenues do not appear to be going to new capacity. These parasites are nothing but vacuum cleaners who suck cash from the pockets of everyone else, giving oil profits to OPEC and trading profits to those who exploit FOMC blindness.

    Lowered rates later this month will probably be used by sales staffs to encourage suckers to buy oil contracts, raising the price maybe another 10% or more if a feeding frenzy really builds. Other commodities are tagging along, I’m sure. Regardless, at some point the bubble will burst. Credit will dry up again for a while and we will probably have another significant stock downdraft.

    I don’t know who is financing the commodity frenzy. But it appears that stupid is an incurable condition. Maybe the TED spread is reflecting more idiot lending on another sure thing?

  5. Karl K commented on Apr 21

    Barry, when it comes to the banks, I think it’s a case by case basis.

    Citi is broken — their business model is such a wreck it may takes years to recover. But it will simply because the foreign investors have always loved it.

    Then you have JPM and Chase. When you buy any company, you buy leadership. And these companies have two pretty amazing CEOs.

    Is there any doubt Jamie Dimon is one of the sharpest shrewdest guys out there? He’s taken a pretty sleepy bank and made it one of the top players out there with good acquisitions and clever moves. And, unlike Bob Rubin, he knows what a liquidity put is.

    And there’s Ken Lewis, a maniac if there ever was one. He’s an entrepreneur in a pinstripe suit. He has has vision and nothing is going to stop him, not you, not the Fed, not subprime. He’s gonna grow this Bank and make it an absolute monster. Really what do you think the odds are that BAC will cut is dividend? I think you would have to cut off Lewis’ testicles first.

    I own both stocks. Not a lot. They are the only banks I own directly. I think they will both be winners when this all passes.

  6. stuart commented on Apr 21

    Not a chance

    1. The downturn in real estate is still accelerating with the overwhelming majority of Alt-A and options ARM resets in front of us. This “collateral” is on the bank’s balance sheet. IMO the downturn in real estate won’t stop until homes = 3x income and even then until inventory clears up… years away. Add CRE on top of that and banks are years away from reliably valuing their balance sheets. Ample documentation on this worsening trend everywhere.

    2. Banks have not taken accountability and write offs to date have only come with them kicking and screaming like a spoiled child. They have shuffled off anything to Level 3 asset categorization that they don’t like the markets valuation for. Until those gets significantly written off too, they’re no where near.

    The only element that’s even making some perceive this is a credible question is the fact the central banks are swapping treasuries for non-marketable MBS “crap”, alleviating some stress on the banks, yet, transferring crap is all they’re doing. Until this crap is fully realized and banks begin to take proper, proactive accountability and write it in off in full, any assertion that the worst is behind the banks is merely a self-incriminating admission of ignorance and individuals making making such assertion, henceforth, with merit, should be stripped all credibility with their absurd statements kept for public records.

  7. Francois commented on Apr 21

    May I ask a really dumb question?

    Here it is: Is there any valid* reason why what publicly traded corporations report to investors isn’t exactly what they report to the IRS?

    Thank you
    * By “valid” I mean a reason that obey the laws of common sense. I know, I know…the least common of the senses.

  8. dave commented on Apr 21

    The banks share prices look like a bargain compared to their tops, but dont forget the huge share dilution that has happened as they raised capital. Many of the preferred shares will be converted to common in the future as well. Thus their EPS will continue to fall and they may take many years to return to their previous tops.

  9. Rich Shinnick commented on Apr 21

    Unfortunately banks can’t “proactively” write off anything. They need to maintain capital ratios. So, here is the game: take a little write off (“little” being a relative term), raise a little capital, take a little write off, raise a little capital, etc. It is a game, banks are trying to outrun this thing and the only question is whether they can extend the losses over a long enough period of time to allow them to generate enough fees, cut enough jobs and float enough new debtequity and cut dividends fast enough to stay in business.

    Anyone who thinks this is not a total and complete disaster has their head in the sand. It will get worse, consumers are only just now running out of steam.

    Listen to the language being used, every CEO is hedging. Pay attention to what IS going on not what people (media) says is going on.

  10. larster commented on Apr 21

    It seems to be generally accepted that we overloaded on credit the past few years, not only on housing but cars, boats, toys,etc. If we take a deep breath, stop profligate purchasing, and begin to get our finances under control, how do the banks make money? Or should I say how do they make the money they made the past few years? Bank stocks may reflect diminished earning power and are close to fair value.

  11. HCF commented on Apr 21

    Great post Barry!

    Am I the only one who wants to strangle myself everytime someone comes on CNBC after negative econ. data, earnings misses, etc. and says “Oh, but if this had come out two months ago, we’d have been f****d and down 600 pts. But since the market is ‘shrugging’ it off, we MUST be past the worst of it.”

    I’m glad there are still a few bastions of relative objectivity (namely here) in the analysis…

  12. ECONOMISTA NON GRATA commented on Apr 21

    Just when you thought that it was safe to go back in the water, we get this headline from the Onion…..

    U.S. Blowjobless Rate At All-Time High

    “According to Labor Department statistics, the overall blowjobless rate swelled to 37.4 percent in July,”

    http://www.theonion.com/content/node/39680

    It must have something to do with all the hedge fund managers cutting back on the discretionary spending. I can’t see any other cause.

    I’ve already had to give up my pan seared, truffle encrusted Cheetah sweetbreads. I can see why this is happening.

    Best regards,

    Econolicious

  13. michael schumacher commented on Apr 21

    continuing to call it a “credit crunch” is equally as naive and stupid.

    Call it what it is: A serious solvency issue that is being passed off as a bump in the continual “up” road.

    But that would be too easy.

    Ciao
    MS

  14. SPECTRE of Deflation commented on Apr 21

    Only if they found Dorothy’s Ruby Slippers over the weekend. They are still playing hide the sausage.

  15. blin commented on Apr 21

    Phillipe,

    “Lehman short interest on its share price is around three times its market capitalisation (the last time there was such a reading it was for Bear Stern)”

    This is impossible. The maximum short interest can only be the market capitalization of LEH, since you must first borrow shares to short the stock. The short interest is currently just over 10% of its market cap.

    Also

    “They have been given until July (the usual time of bad debt discovery for the banking sector) to reveal their bad debts”

    Please explain yourself. Who has told the banks they have been given to july to reveal their bad debts?

  16. Karl K commented on Apr 21

    Dave wrote:
    The banks share prices look like a bargain compared to their tops, but dont forget the huge share dilution that has happened as they raised capital. Many of the preferred shares will be converted to common in the future as well. Thus their EPS will continue to fall and they may take many years to return to their previous tops.

    Alas, it’s not that simple.

    Of course, if preferred gets converted, guess what that means? Stock price has gone up.

    Guess what that also means? Company retains more earnings as its interest outlays decline. Dividends on stock require less cash relatively than interest on preferred.

    Finally, the raising of capital can be unwound by increasing dividends. Bank of America has continuously increased its dividend. I bet it does it again in the future.

  17. Philippe commented on Apr 21

    Blin

    The short interest as I read it is recorded at the following page http://www.bloomberg.com/apps/quote?ticker=LEH:US

    The dead line for reporting banks losses is the outcome of the G7 finance minister which took place this month (I did not record the exhaustive list of the recommendations among them a reference to the liquidity ratio of the Banks and a dead line for reporting their losses )
    Such a short time to compute the losses may be cause for embarrassment?

  18. blin commented on Apr 21

    Philippe,

    The Bloomberg post confirms my statement.

    Short interest: 56.6M shares
    Shares outstanding: 553M

    just over 10%… sometimes the numbers are confusing, but make sure that you dissect them accurately otherwise it can cost you a lot of $$

    ……..

    I guess the banks will continue to lie and ignore the requests of th G7. Hopefully the banks will comply, but if their survival is on the line, they WILL lie through their teeth.

  19. VennData commented on Apr 21

    Well so much for Larry Kudlow’s write ups bringing us a stock market nirvana in “the second half.” You can’t write up what was never written down in the first place.

    He’ll have to mine the Bush Boom book for another fanciful future (another war perhaps?)

    Would be interesting to see the other side of his coin if an Obama or Hillary Clinton became President.

  20. Philippe commented on Apr 21

    Blin

    Thanks for your input on my weak reading on the numbers of short interest in LEH equities.
    Not owning or trading shares my apologises should go to BP readers as I might have misled them.

  21. Cohen commented on Apr 21

    I fully agree with Barry that there are way more losses to come from the banks and that this isn’t over but I take some exception with that WSJ article. That acocunting policy isn’t a quirk. It is part of the move towards fair value accounting and less historical cost. The policy has been disclosed in 10-Qs and Ks for several years now. Also, OCI is fully disclosed and broken down in financial reports. WSJ, brush up on some basic accounting. If you take a loss on your I/S, it reduces your retained earnings, reducing your equity. If the bank takes it OCI, equity is still being reduced. So, lets say the writedown in OCI is $10B at the end of a reporting period, and then the available-for-sale asset is sold at loss of $12B in the subsequent period, there’s only an additional hit to equity of $2B. If one believes that the write-downs reported in OCI should be on the income statement, then its easy to adjust the numbers accordingly but it has no impact on the balance sheet.

  22. michael schumacher commented on Apr 21

    >>Finally, the raising of capital can be unwound by increasing dividends. Bank of America has continuously increased its dividend. I bet it does it again in the future.>>

    How much???

    Since everyone knows that these banks are just so flush with cash in order to pay out that dividend….oh yea that’s right they’ll just go get it from the FED.

    Still a circle jerk attempt at reasoning that destroying money in the pursuit of yield is just fine as long as we keep increasing the dividends.

    So really..I’ll bet..

    How much???

    (they will lower it but not eliminate it as dumping the div. means that alot of fund managers HAVE to sell the stock regardless of intent)

    Ciao
    MS

  23. Karl K commented on Apr 21

    How much Michael? Beats the heck out of me…I anticipate the future but don’t predict it…even though folks like you for some strange psychological reason think I should.

    You make yourself look foolish when you demand such silly things on a blog. Then again, that requires understanding what foolishness really is, which may be a challenge for you.

    I hold BAC and JPM for the long haul. Say, the next 10 years. I think the likelihood of BAC increasing it dividend over that period is quite high.

    Meanwhile, I’ll enjoy the fact that I put on my position when BAC was yielding 7%. LIke I said, I don’t own a lot but I know the company and at that price for the amount I invested, it was too good a bargain to pass up.

    Now I know that many on here, maybe even you, want to see the credit system collapse so they can caress their krueggerands and break open the canned goods in their basements. Or maybe they just wnat to laugh at folks at me.

    Either way, I could care less.

  24. michael schumacher commented on Apr 21

    Karl K-

    Before you vilify me for whatever reasons you can come up with….it was you who made the following statement:

    >>Finally, the raising of capital can be unwound by increasing dividends. Bank of America has continuously increased its dividend. I bet it does it again in the future>>

    or this one:
    >>Either way, I could care less.>>

    But you cared enough to bet with your previous post…

    Not so sure at this point now eh???

    Nice try

    Ciao
    MS

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