Mortgage Duration Risk: The Banks Are No Longer the Problem
“You think that’s air you’re breathing?”
Morpheus to Neo
We are gratified to see that Treasury Secretary Geithner and Fed Chairman Ben Bernanke take our suggestion of several weeks ago on CNBC not to allow the TARP banks to repay the government debt until they prove the ability to function in the debt markets without reliance upon a government guarantee.
Washington has indeed fixed the solvency problems of the large zombie banks — not with additional capital or stress tests, as many of us seem to think. Rather, the banks have been stabilized by turning them into GSEs via FDIC guarantees on their debt. Those banks which can end their dependence on federal guarantees will be the visible winners in the post stress test market, and valuations and spreads will reflect this divergence between zombies and viable private banks.
Seen from this perspective, Chrysler, General Motors (NYSE:GM) and the large banks are GSEs rather than private companies, parestatales as they know them in Mexico. To talk about a rally in the equity of large US financials seems truly ridiculous, at least to us, especially true when you look at how the public sector subsidies being applied to the banks have distorted their financial statements.
Maybe by the end of next year, when we know which banks can or cannot shed the need for government subsidies, then we can talk about investible equity in these GSEs. To that point, turning Bank of America (NYES:BAC), Wells Fargo (NYSE:WFC) and Citigroup (NYSE:C) into GSEs was just the first battle, Vol. II of the Lord of the Rings, to use another cinematic metaphor. Next comes dealing with the dysfunction in the non-bank market for securitization and financing, the real battle to save the US economy from a truly dreadful year-end 2009 and beyond.
By the way, is it not remarkable that the FDIC has run dozens of resolutions and bank sales processes over the past 18 months without a single leak or breach of confidentiality of these sensitive transactions, including both the WaMu and Wachovia transactions? Yet the Fed and Treasury run a confidential stress test process via overt leaks the press!
One thing we learned years ago working at the Fed of New York, the senior man never talks to the media and never goes to the meeting. Maybe our friend Nouriel Roubini could whisper this into Secretary Geithner’s ear next time they spend quality time. We hear from the Big Media, BTW, that Tim Geithner’s growing corps of handlers directs media inquiries to Roubini for “an objective view” of the Secretary’s handling of the financial crisis. One Democrat asks: Could it be Larry Summers to the Fed, Roubini to the White House?
And speaking of the fall of the elites, FRBNY Chairman Steve Friedman finally resigned yesterday, ending a scandalous period when the greater community of present and past employees of Goldman Sachs (NYSE:GS), JPMorgan Chase (NYSE:JPM) and other dealers was arguably in control of the most important arm of the US central bank.
The fact that the Board of Governors appointed former GS ibanker Freidman as a “C” class director, who are meant to represent the public interest and not be past officers of regulated banks, was scandal enough. But then, when GS formally became a bank holding company last year, the Board failed to remove Friedman when his conflict became acute. The Board also failed too to appoint another “C” class director, making it almost seem that the Board wanted to assist in the GS operation to influence the operations of a Federal Reserve Bank.
Remember that the board of directors of the FRBNY selected Tim Geithner as President, who then bailed out AIG to the benefit of GS and the other OTC derivatives dealers that were facing AIG. That is why a congressional inquiry is needed to understand just why the Fed Board and, in particular, Fed Vice Chairman Don Kohn, tolerated the Freidman conflict and arguably neglected their statutory duty to ensure the proper governance and operation of a Federal Reserve Bank.
But hold that thought.
Earlier this week, IRA released to subscribers to our Advisory Service preliminary Q1 ratings for the 7,000 or so banks that have submitted their call reports to the FDIC. Users of the IRA Bank Monitor professional edition may view the preliminary ratings for the units of their BHCs as the reports are released by the FDIC.
Once we are finished testing this preliminary dataset, we will also enable these displays in the consumer version of the IRA Bank Monitor. Click here to go to our Picking Nits blog where IRA CEO Dennis Santiago provides his take on the preliminary data from the FDIC and some observations about what the data suggests for 2009.
While the idea of public stress testing is a new concept in Washington, we’ve been conducting a census of all US banks for years, first via our public Basel II benchmarks and Economic Capital model, and more recently with the bank ratings from our Bank Stress Index. Each quarter, we ask two basic questions about all US banks:
Stressed View: First, how did you do this past quarter? Looking at factors such as capital, lending, realized losses, income and efficiency, we grade all US banks on a six notch scale, which forms the basis for our “A+” through “F” ratings.
Risk Adjusted View: Second, we calculate Economic Capital or “EC” factors for all US banks, and compare the “stressed,” maximum probable loss from trading, investing and lending to their current capital, from tangible common equity up through the various regulatory measures. By looking at EC, we provide users of the IRA Bank Monitor with a second, risk-adjusted perspective on the safety and soundness of the institution.
Based on the institutions for which data has been released by the FDIC, it is pretty clear in our latest stress test that the condition of the US banking industry is continuing to deteriorate and that we are still several quarters away from the peak in realized losses for most banks.
The key telltale in the Q1 FDIC data is that ROE degradation, not charge-offs, still leads the rising stress evidenced by the IRA Banking Stress Index. Remember that provisions are a leading indicator, while charge-offs lag the credit cycle. Once you see ROE performance improving, meaning a decline in the need to build loss reserves to buffer future losses, and charge-offs are the leading factor in our index, then you’ll be able to test the thesis that the worst is over for US banks and valuations are beginning to stabilize.
So based on what we see now, is it time to be being financials? One IRA reader in SF named Jonathan asks: “This market for financial stocks must have some of your clients scratching their heads. What do you make of things? Is this irrational exuberance or have we turned?” We’ll be addressing the Q1, post stress test valuations for the largest banks as the rest of the units in the bank universe fill in their FDIC CALL reports.
No, in our opinion we have not turned the corner in financials. The current FDIC data suggests that bank loss rates may not peak until next year. We are not yet even on the right block to make the turn, in our view.
Suffice to say that the composition of the Q1 loss data we see from the FDIC makes us believe that the peak in terms of losses for the US banking industry will be closer to Q4 2009 than our original target of Q2 2009. Given where large bank loss rates were in Q1 2009, just imagine where we’ll be by Q4. Or put another way, now you know why regulators are pushing BAC and WFC to raise additional capital.
The bank stress tests conducted by regulators are not so much about capital adequacy through the current economic cycle as identifying enough capital to get the large zombie banks through the end of the year. While Larry Summers and the other economic seers who populate the Obama Administration actually believe that we’ll see an economic bounce in Q3 2009 – a key assumption that also underlies the regulators’ approach to designing the bank stress tests – we see nothing in the credit channel that suggests improvement in the real economy. Both residential real estate or “RES” and commercial real estate or “CRE” markets in the NY area, for example, are starting to see an acceleration in price declines, this as the swelling population of frustrated sellers is starting to capitulate in the face of few or no buyers.
But the chief reason for this sad tale above is that there is no financing for jumbo loans in the RES market. Indeed, as one of the bankers who participated in the “Market & Liquidity Risk Management for Financial Institutions” conference sponsored by PRMIA at the FDIC University on Monday noted, banks are not originating any RES paper that cannot be sold to Fannie Mae or Freddie Mac, soon to be merged into “Frannie Mae,” as we noted earlier.
During a luncheon keynote address at that event, Josh Rosner of Graham Fisher & Co. noted much of the “growth” in non-conforming real estate markets during the final years of the boom was fueled by speculative buying and that the lack of financing in the jumbo, non-conforming RES markets is forcing price compression in markets like the urban RES and CRE markets of NY, CA, MA, etc.
“The lack of attention paid to the creation of industry wide standards and a more solid legal basis for securitzation has only hindered the recovery of a financial intermediation in a market that once funded about 50 percent of all consumer revolving and non-revolving credit,” Rosner told The IRA.
While regulators think that stabilizing the banks was the real battle, is it in fact the dysfunction of the non-bank securitization markets and the effect of this dysfunction on valuations in the RES and CRE real estate markets that is now driving the US economic meltdown? While the Fed as a good bit to the toxic securitizations in cold storage on its balance sheet, the central bank’s best efforts at adding liquidity facilities cannot replace this multi-trillion dollar market if banks won’t originate paper.
If you want to learn more about the problems in the non-bank sector and how products like ARMs are about to push the US economy into a meltdown, take a look at the presentation from the PRMIA event on Monday by Alan Boyce, the former CFC executive and now chief executive officer of Absalon, a joint venture between George Soros and the Danish financial system that is assisting in the organization of a standardized mortgage-backed securities market for Mexico.
Go to the last slide. This is an illustration of the Option Adjusted Duration (“OAD”) of the US mortgage markets. Notice that the OAD calculated by Boyce has grown from a low of $23 trillion in Sep 05, which just happens to be the nadir of loan defaults for the US mortgage market, to $45 trillion in Mar 09. The OAD is set to grow significantly as US interest rates rise or as the slope of the interest rate curve steepens.
OAD is essentially a way to measure the economic weight of debt, basically time x money or the price response for a given move in interest rates. Using existing data and some clever suppositions, Boyce constructed an alternate explanation of “the conundrum” of 2003 to 2006. This was driven by the Fed’s very predictable interest rate policy, which flattened the interest rate curve and compressed interest rate volatility.
Homeowners were encouraged to refinance into ARMs and there was significant cash out refinancing into premium fixed rate mortgages. Interest rate risk was transferred to US consumers and created a ticking time bomb for US markets in terms of the future duration of the total corpus of outstanding mortgage debt.
During the PRMIA conference, Boyce echoed the view of other participants that the failure to act on securitization ensures further RES and CRE price compression. In a rising rate environment the OAD of this RES exposure in particular will grow exponentially and dwarf the “weight” or OAD of the UST debt issuance. The US homeowner will be trapped in their homes, unable to sell as nominal mortgage debt exceeds house values.
Of note, in the Danish system, rising interest rates do not create negative equity for home owners, performing borrowers may redeem their mortgage by purchasing the associated bond at the prevailing market rate. Credit risk is kept out of the bond market, making the mortgage bonds a pure reflection of the associated interest rate risks. By efficiently splitting credit and interest rate risk, there are no surprises as each risk resides where it is best analyzed and hedged.
Bottom line is that securitization machine operated by Wall Street doubled the outstanding stock of mortgages during the last five years of the boom, but the falling OAD driven by Fed rate policy hid the growth.
Unfortunately, in their wisdom, federal regulators actually encouraged US mortgage originators to use ARMs and other products to push interest rate risk onto the backs of homeowners and bond market investors ill-equipped to understand let along manage such risks. Boyce and many others believe that without a complete refinancing for all performing mortgage borrowers, the US real estate markets – and thus the financial industry – will in trapped in a deflationary environment for years to come.
The only way to fix this mess, Boyce suggested at the conference, is to refinance the entire performing mortgage market into standardized, transparent, callable, fixed rate loans, which allow the homeowner to value his liability at the market price. The interest of the mortgage originator needs to closely aligned to that of the borrower via a minimum 10% first loss risk sharing.
Rosner told The IRA he doubts that America’s political and business sectors are ready or willing to embrace the transparency and consumer-friendliness of Denmark’s mortgage sector, but the fact that Boyce and George Soros are advancing this example as a solution may be significant – especially as the year-end deadline for resolving the conservatorships of Fannie Mae and Freddie Mac approaches. Rosner and Boyce believe that the restructuring of the housing GSEs presents an opportunity to set a new, consistent standard for securitization in the US.
More on this issue of “reformation” of the non-bank financial sector in a future issue of The IRA.
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