Last week I took a look at why consumers were so depressed. In short, my conclusion was that consumers were finally coming to terms with their balance sheets and this wakeup call: that you can’t borrow your way indefinitely to maintain one's standard of living. Consumers will be forced to save and consume less as the liquidity trough of cheap credit has been removed. As Warren Buffet said, “Only when the tide goes out do you discover who’s been swimming naked.” The U.S. consumer has been swimming naked for several decades and is now scrambling for cover; so too our financial institutions that also leveraged up as risk management became a word lost in their vocabulary. The markets are down between 15% and 20% and I believe there is more to come, with reasons highlighted below.
Credit Crisis Continues
Chief among the reasons why the markets are heading lower is that housing has not bottomed and credit continues to be scarce. Financial losses will plague the market as long as housing prices continue to decline. Housing prices are not likely to stabilize until greater credit availability increases the pool of marginal buyers. Right now commercial banks are raising standards on both prime and subprime mortgages, effectively squeezing out buyers of lower creditworthiness, and so goes the vicious feedback loop. Falling home prices lead to greater bank losses who then tap the financial markets and Federal Reserve for capital to replace their losses rather than using the capital for issuing new loans. A reduction in credit for loans and higher credit standards reduces available demand for homes and contributes to further home price declines. We have witnessed a rapid decline in bank credit growth as well as credit tightening across all loan types to levels not seen since the last consumer-led recession of 1991 as shown in the figures below.
Figure 1
Source: Federal Reserve Board
Figure 2
Source: Federal Reserve Board
While many in the press are trying to call for a bottom in financial stocks, the bottom is nowhere in sight. We are in the process of unraveling a generational credit bubble that took flight nearly three decades ago with the peak in inflation and yields in the early 1980s. Since 1981 bank credit as a percent of GDP has risen from 40% to 65.6% currently, an increase of 64% in the relation of credit relative to the size of our economy. Most of the credit growth was seen this decade as a result of loose lending as banks made loans to anything that had a pulse. Teenagers were getting bombarded with credit card pre-approvals as they made their first steps on college campuses, enticed with free t-shirts for filling out applications as credit card companies exposed upcoming consumers to the drug of easy credit.
Figure 3
Source: Federal Reserve Board/BEA
The banks are now paying for their complete lapse in lending standards as financial losses continue to mount. Total commercial bank delinquent loans and leases have surpassed levels seen in the prior recession. Moreover, the rate of growth in noncurrent loans and leases is one for the record books as current deterioration in bank loans surpasses the rates seen in the prior two recessions.
Figure 4
Source: FDIC Quarterly Statistics on Banking
The FDIC Q2 2008 Quarterly Banking Profile attests to the current financial turmoil seen by commercial banks, with some of the headlines from the report given below.
FDIC Quarterly Banking Profile (Q2 2008)
- Second-Quarter Earnings Are 87 Percent Below Year-Earlier Level
- Noncurrent Loan Rate Rises Above 2 Percent for the First Time Since 1993
- Capital Growth Slows Despite Cutbacks in Dividends
- Net Charge-Off Rate Rises to Highest Level Since 1991
- Growth in Small Business Loans Slowed in the Last 12 Months
- Deposits Decline in Domestic Offices
- Two More Banks Fail in the Second Quarter
What was truly alarming in the report was the rate of deterioration in net charge-off rates. The rate of change in net charge-offs by category is given below, with the greatest deterioration seen in residential and nonresidential loans.
- Real Estate Construction & Land Development Loans: Increased by 1,226.6%
- 1-4 Family Residential Mortgage Loans: Increased by 821.9%
- Home Equity Loans: Increased by 632.7%
- Commercial & Industrial Loans (C&I): Increased by 127.5%
- Other Consumer Loans: Increased by 70.3%
- Credit Cards: Increased by 47.4
Also of note is that consumers have become aware of the risk of bank failures and are acting accordingly as domestic deposits declined due to a drop in uninsured domestic deposits. Domestic deposits fell by .8 billion, the largest one-quarter decrease in nine years. The decline was primarily due to a decrease in domestic time deposits greater than 0 thousand, which decreased by 5.1% (.9 billion) as deposits less than 0 thousand increased by 1.0% (.3 billion). Consumers are scared about losing their money, and those with accounts larger than the FDIC insurance limit of 0K are pulling their money out and spreading it around to other banks in account sizes less than 0K, as well as parking it in other places.
Consumer fears are likely to pick up even more as the FDIC problem list of banks continues to rise. The FDIC list of problem banks rose 30% in the second quarter to include 117 banks, the highest number in over five years. So far this year nine banks have failed, with two in the recent quarter. A Bloomberg article noted that the failure of IndyMac will cost the FDIC’s Deposit Insurance Fund (DIF) .9 billion alone, exceeding the billion to billion estimate (click for link). The FDIC’s DIF took a .6 billion haircut in the recent quarter as primarily the result of .2 billion in additional provisions for insurance losses, including provisions for failures that have occurred in the current quarter. The decline in the DIF has brought its reserve ratio down to 1.01%, the lowest reserve ratio seen since March 31, 1995.
The rising problem list of banks and falling DIF no doubt has the FDIC concerned, concerned enough to look to the U.S. Treasury. Excerpts from a Wall Street Journal article are given below.
FDIC Weighs Tapping Treasury as Funds Run Low
Federal Deposit Insurance Corp. Chairman Sheila Bair said Tuesday her agency might have to borrow money from the Treasury Department to see it through an expected wave of bank failures.
Ms. Bair said the borrowing could be needed to cover short-term cash-flow pressures caused by reimbursing depositors immediately after the failure of a bank. The borrowed money would be repaid once the assets of that failed bank are sold.
The last time the FDIC borrowed funds from Treasury came at the tail end of the savings-and-loan crisis in the early 1990s after thousands of banks were shuttered. That the agency is considering the option again, after the collapse of just nine banks this year, illustrates the concern among Washington regulators about the weakness of the U.S. banking system in the wake of the credit crisis.
"I would not rule out the possibility that at some point we may need to tap into [short-term] lines of credit with the Treasury for working capital, not to cover our losses, but just for short-term liquidity purposes," Ms. Bair said in an interview. Ms. Bair said such a scenario was unlikely in the "near term."
She said she did not expect the FDIC to take the more dramatic step of tapping a separate billion credit line with Treasury, which has never been used.
The FDIC said Tuesday its "problem" list of banks at risk of failure had grown to 117 at the end of June, compared with 90 at the end of March.
Comparisons to the savings-and-loan (S&L) crisis are appropriate as commercial bank losses increase, driving the number of unprofitable FDIC commercial banks to levels seen during the S&L crisis that witnessed the failure of 747 savings and loan institutions.
Figure 5
Source: FDIC Quarterly Statistics on Banking
It’s no wonder with such a major deterioration in financial institutions that a former International Monetary Fund (IMF) economist is predicting the failure of a big bank. Former chief economist Kenneth Rogoff made some dire comments at a financial conference as highlighted in the following article.
Former I.M.F. Economist Predicts Big Bank Failure
The worst of the global financial crisis is yet to come and a large U.S. bank will fail in the next few months as the world’s biggest economy hits further troubles, a former chief economist of the International Monetary Fund, Kenneth Rogoff, said on Tuesday.
“The U.S. is not out of the woods. I think the financial crisis is at the halfway point, perhaps. I would even go further to say ‘the worst is to come’,” Mr. Rogoff told a financial conference.
“We’re not just going to see mid-sized banks go under in the next few months, we’re going to see a whopper, we’re going to see a big one, one of the big investment banks or big banks,” Mr. Rogoff, who is an economics professor at Harvard University and was the I.M.F.’s chief economist from 2001 to 2004.“We have to see more consolidation in the financial sector before this is over,” he said, when asked for early signs of an end to the crisis. “Probably Fannie Mae and Freddie Mac — despite what U.S. Treasury Secretary Hank Paulson said — these giant mortgage guarantee agencies are not going to exist in their present form in a few years.”
Falling Earnings & Profit Margins = Falling Markets
Mr. Rogoff is probably correct that we aren’t even halfway through the credit crisis, and I would also add that we are not even halfway through the market correction, nor what will undoubtedly be declared a recession that began in either December of last year or January of this year. I agree 100% with the analysis of David Rosenberg, North American Economist for Merrill Lynch, presented in his article, “The Elusive Bottom.” Mr. Rosenberg doesn’t see the recession ending until mid-2009 and says that we could see S&P 500 operating earnings below , and also a price-to-earnings (P/E) multiple of 12.
We could get below on operating earnings
Even the economists who are predicting a recession are going say, "Playing in a little recession, on average, troughs go down 25%." The problem this time is that we have to overlay the revenue decline that actually comes from a recession with a much more significant margin, considering the levels from which we headed into this bear market and recession. So when I'm talking about that historically, what's normal in a recession is that this profit share equals to 7% and we started at 14%, we are talking about a 25% decline in earnings. We can be talking about something closer to 50% peak to trough. The peak is on a full-quarter trailing basis. It's not beyond the realm of possibilities that we get below in operating earnings. The first call consensus numbers is 5 earnings for next year. I give the odds of that happening at exactly 0.0%.
There is a good chance we test the 2002 lows
Now, I'm not at for next year. We're at for operating EPS, but that means that the answer is no, I don't feel that we're too low on earnings. Usually you slap a historical trough multiple on in a recession. But typically, during a recession coupled with a credit crunch, the multiple bottoms at 12. You're at a 12 multiple with in earnings and you're going to ask the question, "Are you talking about the possibility that we can actually test the ... 2002 lows?" And the answer is that it is certainly not outside the realm of the possible. I'm not making that forecast, but what I am telling you is that there is a good chance that that could happen.
As Mr. Rosenberg points out corporate profit margins are going to contract as they do during recessions and with it will be corporate earnings. Corporate profits relative to nominal GDP are already coming off their highs of 13% made in 2006 and still have a ways to go.
Figure 6
Source: BEA
As profit margins contract P/E ratios will rise and stocks will not seem as cheap as pundits would have you believe. Vitality N. Katsenelson, the author of Active Value Investing, does a beautiful job in illustrating this point in his article, “Down to the Last Drop of Profit Growth.” The figure in the article was recreated which shows corporate profits are indeed well above normalized levels and reversion to the mean, in this instance, normalized corporate profits, is likely underway.
Figure 7
Source: BEA
Actual corporate profits relative to normalized profits reached a peak of 52.2% in the third quarter of 2006 and are now 32.5% above normalized levels. Actual corporate profits tend to revert to normalized profits in economic downturns, meaning we could be in store for some serious earnings disappointments ahead as analyst estimates remain quite rosy.
Figure 8
Source: BEA
Analysts' estimates are far too optimistic and are likely to be proven wrong as their accuracy in predicting S&P 500 earnings has fallen to a 16 year low, as highlighted in a Bloomberg article.
Analysts’ Accuracy on U.S. Profits Worst in 16 Years
Analysts' accuracy in predicting U.S. profits dropped to the lowest level in at least 16 years last quarter, adding to a worsening track record since regulators forced companies to stop leaking information to Wall Street.
Earnings estimates from analysts matched results for 6.7 percent of companies in the Standard & Poor's 500 Index that reported second-quarter profit, the fewest since Bloomberg began compiling the data in 1992. Accuracy peaked at 30 percent in the fourth quarter of 2000, the year Regulation Fair Disclosure, known as Reg FD, was adopted, and has fallen for six of the seven years since.
"They're winging it,'' said John Kornitzer, who oversees billion as chief investment officer of Kornitzer Capital Management in Shawnee Mission, Kansas."They can't find out the stuff they want to find out, and they've got so much to do because there have been so many cuts.''
Commenting on current analyst estimates and how they have faired this year is analysis coming from Brian Pretti at ContraryInvestor.com.
Market Observations (08/26/2008)
All we can say is WOW! For a period where the year over year change in corporate earnings has decelerated even less than was the case during the 2001 recession, analysts are expecting an earnings growth rate turnaround for 2009 that makes the earnings recovery post the 2001 recession look like a picnic. Analysts are expecting an earnings blast off, unlike anything we've seen this decade to date. Is sub prime lending and credit cycle acceleration about to make a miraculous comeback, and someone forgot to tell us?
Well, we need to remember that analysts are quite the excitable bunch, virtually never pessimistic...until they are forced. Here's an example for you. At the beginning of 2008, analyst expectations for S&P earnings growth in 2Q was 0%. As of the last time we covered this subject about three months ago, they then expected a year over year decline of (8)% for 2Q. With 96% of the precincts counted, so to speak, as of now, the number for 2Q reality is a decline of (29)%. Seems the analysts missed by just a bit, no? And so we are to believe current analyst earnings growth expectations for 2009 are on the mark, or even close? Depending on whether and to what extent investors are relying on analyst earnings expectations for 2009, there may indeed be some serious disappointments ahead.
So, with the credit crisis still in full swing and analyst estimates way behind the curve, the markets are likely to go through some serious disappointments ahead, disappointments that are not likely priced into the market currently. Thus, the markets will likely be much lower by year end and any positive strength should be used to increase defensive positions. The worst is likely to come, at least that’s what the credit markets seem to be pricing in. Take a look at the CDS spread on Washington Mutual (WM), WOW!
Figure 9. Lenders
Source: Bloomberg
Figure 10. Brokers
Source: Bloomberg
Figure 11. Banks
Source: Bloomberg
