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Five Things You Need to Know: How the Mighty Have Risen


Financial institutions will be forced to update their models to account for shifting consumer behavior.


Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:

1. How the Mighty Have Risen

A little more than a year ago Citigroup (C) was the world's largest bank by market value, and Industrial & Commercial Bank of China was a newly-minted public company. How the mighty have fallen... or risen, as the case may be. Today, Beijing-based ICBC is the largest bank by market cap while Citigroup has fallen to seventh place, according to Bloomberg.

As recently as 2003, there were 13 American banks ranked in the top 20 and not a single Asian financial institution, according to Bloomberg. Now, there are four Asian banks and six U.S. institutions. Bank of America (BAC) is ranked number two in the list.

Top 10 Banks, by market cap

2. Bank of America
3. HSBC Holdings
4. China Construction
5. Bank of China
6. JPMorgan Chase
7. Citigroup
8. Wells Fargo
9. Banco Santander
10. Mitsubishi UFJ Financial

2. Et tu China?

Meanwhile, speaking of giant banks, no bank worth its salt would make the mistake of leaving significant exposure to subprime mortgages off the balance sheet, not even a bank based in China.

Industrial & Commercial Bank of China (yes, that very same number one by market cap bank!), said it has set aside reserves equal to 30% of its $1.2 billion in subprime holdings to cover possible losses, a state news agency reported according to the Associated Press.

ICBC isn't alone among its Chinese peers. China Construction Bank holds about $1 billion in subprime debt and has set aside reserves to cover a possible 40% loss, AP reported. And the number two largest Chinese bank, Bank of China, last month, disclosed nearly $8 billion in subprime backed securities.

3. The Sea Change in Social Mood the Models Failed to Predict

Over the weekend we ran across an interesting article in the Financial Times discussing how it is the ratings agencies failed to accurately predict the wave of foreclosures and loan defaults now spreading across the credit spectrum.

The problem lies, as do nearly all financial problems, with the models. It turns out the mathematical models used by the ratings agencies to predict future default rates simply failed to account for a profound shift in social attitudes.

As Bank of America (BAC) CEO Kenneth Lewis noted recently, "There's been a change in social attitudes toward default." People are walking away from their homes but keeping their credit cards and auto loans.

This is not what the models predicted. In previous decades households more readily defaulted on unsecured loans (credit cards and car loans) first, and stopped paying their mortgage only at the bitter end. Part of the explanation for this is related to the continuing shift in social mood toward debt repudiation and the relative attractiveness of scaled down living. And some of it is simply a rational response to deflation and negative home equity. Why fight to save something that is going down in value?

This, of course, is how a deflationary credit contraction feeds itself. Financial institutions will be forced to update their models to account for shifting consumer behavior. The net result: less credit available going forward. See, for example, today's Number Five...

4. But First... Increased Joblessness?

One key contention of the "We're out of the woods" crowd" is that the still-robust job market is too healthy for a recession. Looking backwards, perhaps. Looking ahead? We're not so sure.

Last Friday's weak non-farm payrolls report aside, we saw this morning that job cuts announced by U.S. employers jumped 19% in January compared to a year ago according to Challenger, Gray & Christmas.

Financials led the reductions last month, with 15,789 cuts, more than 20% of the total. Construction cuts accounted for 1,245 announcements and the automotive industry shed 7,142 jobs.

5. Kicking Out the Good With the Bad

Egg, the Internet bank that was acquired by Citigroup last May, last week sent out an unexpected warning to 161,000 card users saying that it will end their agreements in 35 days time because they have a "higher than acceptable risk profile." Another blow to subprime borrowers, right? Not exactly.

The Internet bank, which has 2.3 million card customers, is not just cutting back credit to "risky' borrowers, but to a large segment of borrowers with perfect credit history. Why? Because they are, well, too perfect. According to the Times (UK), in addition to the so--called risky borrowers customers who pay their balance in full each month have been targeted. In the world of banking and finance these customers are simply not profitable.

The move is also part of a shift by the bank away from unsecured lending. Expect more of this going forward. The net result is less credit availability, and consequently a slowing in the velocity of money.

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