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Minyan Peter: Bank Earnings Post Mortem


The secondary market for loan assets is either non-existent or extremely thin. The consequences are significant and multifold.


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

With substantially all of the major US financial services firms reporting third quarter earnings, I thought I would summarize some of the take-aways from the earnings releases.

First and foremost, the "originate for resale/securitization" business model in place for most US banks during this credit cycle is officially broken. With the exception of Freddie and Fannie conforming mortgages, the secondary market for loan assets is either non-existent or extremely thin. The consequences are significant and multifold:

  • Bank balance sheets are growing rapidly.
  • On-balance sheet loan growth is requiring unanticipated increases in loan loss provisions as previously "held for sale" assets are moved into portfolio.
  • Funding for balance sheet growth is coming through non-deposit sources.
  • Even without write-offs, leverage is increasing.
  • Stock buy-backs have stopped for all but a few banks.

Second, credit quality is deteriorating. And to be specific:

  • Substantially all banks reported deterioration across all consumer asset categories.
  • Many banks signaled deterioration in commercial real estate related portfolios.
  • Indirect loan portfolios (loans originated by third parties) are performing worse than bank originated loans.
  • Non-performing loans increased significantly year on year across the board.
  • Severity of loss, particularly in residential real estate loans (both first mortgages and home equity loans) is increasing dramatically.
  • Most banks reported an acceleration of the rate of deterioration in loan quality and all, but a few, suggested further deterioration in credit quality during the fourth quarter of 2007. A small number suggested further declines into 2008.

Third, loan loss provisioning was very uneven. Many banks, while reporting significantly higher delinquencies and loan losses, (and loan growth) did not increase their overall provisions (suggesting either over-provisioning for prior periods or denial). Others, particularly those with large indirect loan portfolios reported significant increases in net provisions.

Fourth, substantially all banks discussed some level of credit underwriting risk tightening. Some even hinted at limiting new credit availability to their "best customers."

Finally, most banks indicated that where possible they are re-pricing risk upwards. The best example I could find on this was in Capital One's earnings release in which the bank reported an increase in credit card gross margin from 16.39% in Q2 to 18.78% in Q3.

With this as background, let me share a few implications from these take-aways.

First, and as I wrote earlier this week, because of capital and leverage constraints, where it was once abundant, credit is becoming a scarce resource. Further as deterioration continues it will become available only to higher and higher tiers of credit.

Second, increases in charge-offs and provisions are likely to continue to for the foreseeable future. With the exception of the truly worst credits, we are in the early innings of this credit cycle. I for one, expect that we could easily see a 24-36 month time period for this to play out.

Third, because of the acceleration in credit quality deterioration, secondary loan pricing is likely to fall further resulting in series of one-time market value adjustments to bank "held for sale" and investment portfolios.

Finally, banks will need to move as quickly as possible to replace non-deposit funding with deposits in order to stabilize their liquidity profile. Deposit pricing will increase putting pressure on net interest margins, (although some of this will be offset by further Federal Reserve interest rate cuts).

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