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Is Dilution Done?


Banks face immediate, long-term issues.

Another Minyan Peter asks a great question: "Is all of the dilution already priced into bank stocks?"

On the surface, I can appreciate why he and others would feel that all of the pain is priced in. Unfortunately, I think that there are both immediate credit issues and longer-term structural issues which will require far more additional capital than first meets the eye.

The immediate credit issues relate to delinquent consumer loans, which are currently moving through the charge-off pipeline. While a significant amount of consumer-related securities write downs have already been booked, non-Treasury and Agency securities represent less than 15% of bank assets, and, on a percentage basis, surprisingly few real consumer loan losses have been taken. Further, substantially none of what I think of as "second derivative" consumer credit losses – from commercial real estate and leveraged loans, have hit bank P&L's.

One other comment on consumer credit losses: None of the losses we have seen so far have occurred during a recession. As reported this morning, GDP growth for the first quarter was 0.6% and unemployment is still relatively mild. While I appreciate all of the Federal Reserve's attempts to stimulate the economy, it's difficult for me to see how, with consumer spending representing 70% of U.S. GDP, we avoid a recession. And I believe that with this recession will come far higher absolute loan losses than are currently forecast. As I wrote earlier this week, I believe we are at the beginning of what will be an extended "Consumer Consumption Crisis."

But even if financial services firms get through the daunting consumer credit loss issues I have just described, there are two other long-term structural capital issues which they face.

The first relates to the dislocation of the securitization markets and the impact this will have on most banks' "originate for resale" loan origination business models. Having been there at the beginning, I can assure you that one of the principal motivations for securitization was greater capital efficiency – and over the last 20 years, banks have stretched that efficiency about as far as it can be stretched. So even when the market for securitized debt recovers, which eventually it will, I firmly believe that the capital benefits of asset securitization will be significantly diminished, and significantly more on-balance sheet capital will be required for every off balance sheet dollar of assets.

Second, given the regulators' focus on "too interconnected to fail," I anticipate that we'll see a dramatic increase in the capital associated with off-balance sheet derivatives activity. This is the only way I can see the regulators creating a global financial system strong enough to absorb the loss of a major counterparty given the inbred web of derivative contracts among the world's largest financial institutions.

As a consequence of these three factors, I believe we have miles to go in capital raising – and not "hybrid" capital, but truly eviscerating recapitalization of many large financial institutions. And, particularly due to the derivatives issue, the capital raising process will likely require at least some period of nationalization for several major financial institutions – not just here in the U.S. but across the world.

And to give you some small sense for what I think is ahead, take a look at National City's (NCC) common stock issuance - $7.0 billion in new shares for a quarter in which the bank reported a $300 million loss. Clearly it sees more losses ahead – and, as much as it's paid the price, I would suggest that no other bank has taken the kind of dramatic recapitalization step that National City has.

While National City may have been laughed at for its actions, I believe that time will show that it was wise to obtain common stock while it was still available.
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