Wave 2 of the credit collapse approaches
On June 1, I asked you if you were ready for Round II of the Mortgage Meltdown after data on renegotiated residential mortgages showed that 65% to 75% of subprime loans renegotiated by creditors to avoid default were headed toward default despite those efforts.
That data flew squarely in the fact of the (incredibly) still ongoing rally in related equities (financials as well as real estate), and became one of several reasons for my high degree of un-ease with the rally at large. Blogger GMX noted parallel reverberations through the MBS market.
Throughout 2008 you'll recall one of my primary focuses was on correcting the prevalent notion that critical losses would be contained to Subprime or even Alt-A mortgages. I blogged repeatedly about the series of dominoes that unfortunately had to fall in succession as a result of the broader deleveraging event... including commercial real estate, credit card debt, auto loans, student loans, and even state and municipal debt. Commercial real estate is now preparing to fall with a resounding thud, which is both indicative of severe corporate malaise in general (reduced demand) as well as a harbinger of renewed pain for the financials. The financials have originated tons of new derivatives on new debt issued over the past year, adding fuel to the next fire.
Round 2 of the financial crisis will be more damaging than round 1, in part due to the scale of the response initiated to combat round 1. Buckle-up and hunker down, Fools.... here we go again.
I posted an article to my blog last year (april 2008) which included RBC analyst Gerard Cassidy's then-dire forecast that 150 banks would fail by the end of the financial crisis. His recommendation then to "underweight" the banking sector on the expectation of rising loan losses and capital shortfalls certainly turned out to be a solid call, which is why I urge Fools to listen this time as well.
The same analyst has issued a new warnings: he now expects up to 1,000 banks to failover the next 3-5 years as the recession (depression ... get over it already) intensifies.
SAN FRANCISCO (MarketWatch) -- More than 1,000 banks may fail during the next three to five years as the recession intensifies and loan losses climb, an analyst at RBC Capital Markets estimated on Monday.
In 2008, analyst Gerard Cassidy forecast 200 to 300 bank failures, but now he says the environment has deteriorated since then. See 2008 story on bank failures.
"Residential mortgage delinquencies remain at record levels, home-equity loan defaults are steadily rising and residential construction and land loan non-performing assets are skyrocketing for lenders with excess exposure to the weakest housing markets in the U.S.," Cassidy wrote in a note to clients.
"In conjunction with the slowdown in the economy, credit deterioration has accelerated in the commercial and industrial and commercial real estate loan areas," he said.
Since the mortgage-fueled credit crunch erupted in 2007, 34 banks have failed in the U.S. While Washington Mutual /quotes/comstock/11i!wamuq (WAMUQ 0.08, +0.00, +2.44%) became the biggest bank failure in history last year, Cassidy expects most of the banks that collapse will be relatively small, with less than $2 billion in assets. See story on latest banks to fail.
Cassidy and his colleagues have developed an early-warning system for spotting future trouble at banks using a calculation known as the Texas Ratio. It measures credit problems as a percentage of the capital a lender has available to deal with them.
The formula divides the number of a bank's non-performing loans, including those 90 days delinquent, by its tangible equity capital plus money set aside for future loan losses.
Cassidy came up with the ratio after covering Texas banks in the 1980s. He noticed that when problem assets grew to more than 100% of capital, most of the Texas banks in that precarious position ended up failing.
Among the 50 largest U.S. commercial banks by assets, Sterling Financial /quotes/comstock/15*!stsa/quotes/nls/stsa (STSA 2.29, -0.10, -4.18%) of Spokane, Wash., had the highest Texas Ratio at the end of the fourth quarter. The ratio of 54% was up from 45.4% in the third quarter and 15.6% at the end of 2007, according to RBC data.
Colonial BancGroup /quotes/comstock/13*!cnb/quotes/nls/cnb (CNB 0.72, +0.06, +9.09%) of Montgomery, Ala., had a ratio of 53.4% at the end of 2008, ranking it second among the top 50 commercial banks. That was up from 44.6% in the third quarter and 11.2% at the end of 2007.
Popular Inc. /quotes/comstock/15*!bpop/quotes/nls/bpop (BPOP 1.28, +0.19, +17.43%) was third with a ratio of 37.4%. But that was down from the 40.1% that the Puerto Rico-based bank had during the third quarter.
Huntington Bancshares /quotes/comstock/15*!hban/quotes/nls/hban (HBAN 3.67, -0.06, -1.61%) of Columbus, Ohio, was fourth with a ratio of 36.4% at the end of the fourth quarter. That was up from 21.1% in the third quarter, RBC data show.
Banks have raised a lot of capital, both from the government and private investors, so Texas Ratios remain lower than may normally be the case at this point in the credit cycle, Cassidy explained.
Wells Fargo /quotes/comstock/13*!wfc/quotes/nls/wfc (WFC 23.47, -0.79, -3.26%) saw its Texas Ratio drop to 15.5% at the end of the fourth quarter, vs. 19.3% in the third quarter.
J.P. Morgan Chase /quotes/comstock/13*!jpm/quotes/nls/jpm (JPM 37.92, -0.23, -0.60%) had a Texas Ratio of 6.5% at the end of 2008, down from a ratio of 9.7% in the third quarter, Cassidy noted.
Still, other big banks, including Citigroup /quotes/comstock/13*!c/quotes/nls/c (C 2.80, +0.07, +2.56%) , U.S. Bancorp /quotes/comstock/13*!usb/quotes/nls/usb (USB 19.77, +0.35, +1.80%) and Bank of America /quotes/comstock/13*!bac/quotes/nls/bac (BAC 12.58, +0.07, +0.56%) saw their Texas Ratios climb during the fourth quarter, RBC data show.
In his research report, Cassidy bluntly calls on investors to "avoid the bank stocks" during this precarious climate and gloomy outlook hanging over the industry.
"We are nowhere near the end of this down leg in the current credit cycle," Cassidy said. "Bank stocks will likely remain under pressure as the industry confronts its credit problems, de-leverages and raises common equity over the next 12 months."
P.S. I have done something I hardly ever do. I've acquired some exposure to select short and ultrshort ETFs in real life. Although I detest the toxic derivatives upon which they are based,I could not pass up the opportunity for near-term gains here. I will not say which ones, since I am actively trading those positions.