>Banks (CLSA)

Seven deadly sins of banking

We are initiating on US banks with an Underweight sector rating given the ongoing consequences of increased risk taking by banks in seven different areas. A key implication is that loan losses (to total loans) should increase to levels that exceed the Great Depression. While certain mortgage problems are farther along, other areas are likely to accelerate, reflecting a rolling recession by asset class. New government actions might not help as much as expected, especially given that loans have been marked down to only 98 cents on the dollar, on average.

Greedy loan growth – once-in-a-generation excess
This decade, the pace of loan growth versus its natural rate (nominal GDP) was the widest in a generation. This type of excess seems to occur about once every 40 years, or enough time for those who made the prior mistakes to retire. The issue was less the reported pace of loan growth, which matched the average of the prior decade (8%), than the failure of bankers to realize that the natural rate declined given a decline in nominal GDP from an average of 8% during the prior three decades to 5% this decade. Loans overshot this decade and now will likely undershoot versus nominal GDP.

Gluttony of real estate – historic asset concentration
The fastest loan growth this decade has been in home equity and construction (20% annual), along with mortgages and other commercial real estate. Phase one of the problems reflected borrowers that probably should have never gotten the loans, especially at it relates to subprime mortgages. Phase two reflects the more credit-worthy borrowers that face issues given unemployment concerns. In addition to loans, banks increased their concentration in securities. The percentage of mortgage-backed securities (now $1 trillion) increased from 15% in 1982 to 40% in 1992 to 65% today, whereas Treasury holdings declined from over one-third to only 2%. Now, these securities will likely refinance at lower rates at a time when banks have limited to no capacity to add new MBS.

Lust for high yields – worse loan losses than the Depression
Banks’ greater risk-taking reflected not only faster loan growth and greater concentration but also a higher risk mix of loans. This improved loan yields, only to back-end loan losses. The result is that we expect loan losses to increase from 2% of loans to a peak of 3.5% by late 2010. If so, this would be higher than the peak of the Depression of 3.4% (1934). In particular, during the Depression, banks did not have home equity or credit card loans, and never
before had the record high percentage of construction loans. Relative to the Depression, these three areas alone add an estimated 100 basis points to our loss estimate.

Sloth-like risk management – highest consumer debt in history
Banks en masse lent to over-levered consumers. Consumer debt (to GDP) is the highest in history at 100% vs. 70% at the start of the decade, 50% in 1985, and only 37% in 1929. This leveraging reflected the US more generally, given an increase in US debt to 3.5 times GDP, higher than the Depression of 3.0. Going forward, this implies lower fees related to consumer borrowing (cards, mortgages, etc.) and fewer new loans given ongoing deleveraging, mitigated by better pricing on new loans and potential re-intermediation opportunities as business comes from nonbanks and capital markets.

Pride of low capital – highest leverage in 25 years
The industry increasingly and falsely felt comfortable with higher levels of leverage. The level of banks’ tangible common equity and reserves (to total assets) declined to the lowest level in 25 years as of a couple years ago and now is in the process of getting rebuilt. The brokerage industry, too, increased leverage from 20 in 1980 to 30 in 2000 to a peak of 50 late this decade and similarly faces deleveraging. The result partly stemmed from their acting like leveraged bond funds with more wholesale borrowings. Banks increased the percentage of wholesale funding from one-third to one-half since the early 1990s, reflecting the higher funding risk that helped to facilitate risk related to leverage.

Envy of exotic fees – exotic turns toxic
US financials will soon approach about $400 billion of capital market write-downs since 2007. While these write-downs seem in the later stages, there still is the chance for ongoing write-downs in areas such as leveraged loans, private equity, and other areas. All fee revenues are not created equally, given annuity-like service charges and low capital-intensive revenue related to insurance; however, these other fee areas are more volatile or lumpy, and these more volatile fees have come to represent a significant portion of fee revenues at banks, increasing from 20% of the total in 1980 to 30% in 1990 to 40% today. This is the first time that this level of fees has been subjected to a major downturn, creating uncertain fallout.

Anger of regulators
While regulators seemed to have insufficient authority over some of the worst nonbank offenders (mortgage brokers, insurers, etc.), in our opinion they nevertheless appeared to get too close to the industry that they regulated. Bank lobbying may have been too successful. Most banks paid zero deposit insurance premiums from 1996-2006 and now, as these rates increase we estimate they will cost a permanent 3% to EPS. The SEC’s decision in 1998 related to SunTrust made it more difficult for banks to reserve for problem loans, leading to uniquely low reserves going into this recession. Moreover, the budgets of all regulators were reduced at the wrong time, in our opinion. For instance, during the peak, Goldman Sachs generated the equivalent of the SEC’s annual budget every two weeks. The FDIC’s headcount got slashed by a whopping three-fourths since the early 1990s. An increase in regulatory oversight is a permanent change that can increase expenses, cause the largest banks to become more akin to public utilities, and create investing uncertainty until all the regulatory rules are known.


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