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Credit Quality and the Suffering Banks


Given that human nature goes through all aspects of denial, fear, depression and panic, declines in credit quality take much longer to play out than most market participants anticipate.

The following is the latest missive from Minyan Peter, author of popular articles like the Bank Earnings series.

First, credit quality is getting worse, not better. In fact, one could easily argue that the pace of decline has accelerated during the third quarter. For example, in early September, Washington Mutual (WM) estimated that its full year credit loss provision would be $2.2 billion. As of last night's press release, that number is now estimated to be $2.7-$2.9 billion. (And again, as a point of perspective, WaMu forecast a $1.5-1.7 billion figure in July.)

Second, historical recovery assumptions on mortgages and home equity loans are now in question. With the accelerating decline in home prices, not only is the number of defaulting loans rising, but the severity of loan losses ($ loss per loan) is accelerating. This is likely to result is greater and greater provisioning for the same notional amount of non-performing loans.

Third, comments on indirect lending activities have been universally negative – whether mortgages, home equity loans or automobile loans. I raise this because, up until recently, most of these loans had been packaged by banks and resold into the secondary market. As the banks represent "deep pockets" we should expect to see more and more secondary market investors claiming foul and seeking recourse.

Fourth, in its prepared remarks last night, WaMu specifically added credit card loans to the list of deteriorating assets - suggesting both higher future delinquencies and lower recovery rates for these assets.

Finally, a word of caution. From my perspective, there are two distinct elements to a down hill credit cycle which I believe most people combine into one. The first is the repricing of risk. To me this best resembles a car being shifted from "drive" to "reverse" at 100 mph. This is what we saw in August, and arguably what we are seeing right now. Here, the market tends to extrapolate both down (August) and up (September) future credit quality; and, as a result, mark-to-market pricing moves wildly in both directions. It is also why financial stocks become such "value traps".

Under the surface, however, is a much more steady, albeit accelerating, decline in credit quality. Given that human nature goes through all aspects of denial, fear, depression and panic, declines in credit quality take much longer to play out than most market participants anticipate.

As a consequence, and as we have already seen to a limited extend, the collapsing of our credit balloon is much more likely to resemble a series of waterfalls, versus a one-time October 1987 like stock drop. (Remember too, that one of the critical roles of the Federal Reserve is to slow the pace of decline. And in fact, Mr. Bernanke all but admitted that in his most recent speech to the NY Economics Group.) Also, don't forget, that if you look at bank stocks they continued to drop from 1987 through 1990.

This is not to say that there won't be panics along the way. There will be. And many of them will be severe, particularly given the magnitude of the credit contraction underway. But I believe both traders and investors would be wise to ignore any notion of a "one and done" credit market correction.
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