My Diary 431 --- Liquidity Triggers Credit Crisis?

Liquidity Triggers Credit Crisis?

Robert Reoch is one of the original credit-bubble doomsayers. Here I summarize my note for your reference.

General Views:

ü In general he thinks that the deleveraging process at commercial/investment banks and with securities valued at US$50tn will be devastating, especially when including on- and off-balance sheet items.

ü It was also painfully interesting to hear the high level of real-estate exposure at small US regional banks - accounting for 50% of loans.

ü The impact of deleveraging from large banks to “just” 20x asset-to-equity would mean a US$5tn reduction in bank assets.

Overleveraged System and Funding Difficulty

ü The top structured-financed banks have seen leverage as measured by asset-to-equity, rising from 18x to 22x from 2000-07.

ü For investment banks, the increase is greater - from 20x to 29x. No wonder what appears to be slight writedowns on assets can destroy capital so easily.

ü It too remains a concern that the US$361bn of global capital raised does not quite match the US$507bn of writedowns, which is why it is unsurprising that banks will not wish to provide lending.

ü But with bond issuances down from US$100bn a month in early 2008 to essentially zero in September, the impact on funding for companies will be severe.

Off-balance sheet assets and Balance sheet tightening

ü We saw General Motors draw down on a US$4-5bn loan commitment this week, that is, it moved an off-balance-sheet item on to its balance sheet.

ü This leads to exponentially higher capital requirements on these assets, which means that further loans become less easy to make.

ü It can be worse, where banks are forced to cut lending altogether to make room for these new contingent liabilities to move on balance sheet.

ü Reoch shows that US$6tn is outstanding in such commitments and, thus, even if a fraction became bank loans, the impact would be meaningful.

ü Of course, this best explains the US bank-system loan growth during 2H07 (as well as in Australia), which was largely unwanted off-balance-sheet lending.

ü However, the refinancing of these facilities is being done at more economic pricing, based on credit-default-spread (CDS) rates at the time of drawdown.

Regulatory reaction: focuses on Liquidity not Credit Crisis

ü Fed reaction has thus far focused on liquidity & on confidence building.

ü But, if anything, the change in CDS of US Treasuries is suggesting a far greater perception risk of government paper default, which spiked on the news of the US$700bn proposed bailout package.

ü From a more normal 8bps, the five-year US government CDS has risen to 21bps.

ü It remains unclear what the clearing price will be on assets sold from banks and others to the Treasury, or how those values will be justified.

ü But on most measures of clearly visible risk, the US$700bn figure seems woefully inadequate, due primarily to factors of leverage.

ü Improving liquidity, removing uncertainty over distressed asset valuations and bank recapitalisation, are the steps to recovery, but in no way are these painless efforts.

The failure of US regional banks: another –Ve factor

 

ü A potential new negative factor, as if we needed more, is the large holdings of preferred Fannie Mae and Freddie Mac shares by US regional banks, which Reoch puts at US$36bn.

ü Since these banks are heavily exposed to the real-estate market - with 50% of loans for the smaller banks - the hit on capital can be significant.

ü Past-due loans have also moved from 1.7% to 4.3% in just two years.

ü Recall that even with the two small bank failures this week, we are still at less than 15 failures year-to-date, which is incomparable with the early 1990s.