Third in a series
Most of the losses at the large banking companies to this point in the current credit cycle can be traced to their investment banking units.
Unable to assess how deep credit losses are likely to run, investors have been refusing to engage at almost any level, and both the volume and price of bids have dropped. Those are market-related hits, spread by the psychology of fear.
But traditional credit losses are mounting, as the same factors that pressured lenders to ease financing in one sector begin to play out in other types of loans. Liquidity hits spread as a result of a systemic lack of confidence; credit hits naturally proliferate across the portfolio as a result of systemic underwriting failures.
And even though losses from investment banking are concentrated among the largest banking companies, credit losses are accelerating throughout the industry.
"It seems unlikely that whatever excesses there were on the borrower and lender side — both issuers and purchasers — were really constrained just to the residential market," said Jim Wilcox, a professor at the University of California-Berkeley's Haas School of Business. "What we're likely to discover is that wherever people will find excesses on the residential side, they are likely to be similar patterns on the business side. It seems unlikely that this is just about mortgages in Massachusetts. It is probably also corporate bonds and sovereign debt."
The shoe-drop watch has been heightened these days, but what happens next for banks is less about the past sins of loose underwriting and shaky structured transactions, and more about factors over which they have less control: house prices, inflation, unemployment reports, and gross domestic product growth. The National Bureau of Economic Research can take its time in declaring a recession; the consensus among economists is that it has already begun.
So far most of the credit losses have been in consumer products: mortgages, credit cards, and home equity loans. That should be comforting to bankers and their regulators, because even though deterioration is always painful, these credits are granular, not lumpy, and lethality risk to banking companies traditionally has been found in the corporate book.
The concern, of course, is that whatever loss patterns have emerged in consumer lending eventually will bleed to the corporate side.
"If the economy goes soft enough, those loose standards are going to be revealed in a way that is similar to what happened in the housing side," Prof. Wilcox said. "So far the default rates haven't shown it, and the delinquency rates haven't yet shown problems, but the operative word is 'yet.' "
The spread of losses from the consumer to the corporate side seems inevitable to some.
"From the corporate perspective, we're still on the way down," said Donald van Deventer, the chief executive of Kamakura & Co., a risk management consulting firm. "My guess is this time the corporate sector is probably going to trail the retail sector, because the lack of home equity is going to take a while to trickle through."
The incipient fear of spreading deterioration is already playing out in the corporate market. Credit spreads on corporate debt are extremely wide, even though defaults are still low by most historical measures. The phenomenon of fear running ahead of reality is typical of a liquidity crisis, and it is self-reinforcing.
"In terms of default incidence, I think it is still fair to call this a subprime crisis," said Darrell Duffie, a finance professor at Stanford University's Graduate School of Business. "But spreads are alarmingly high. … Senior tranches of corporate CDOs are way out of whack. The implied correlations are sky high."
The explanations are not particularly consoling.
It's possible that investors "don't know how to price the default correlation anymore and they have given up," Prof. Duffie said. "Either that, or they are extremely worried about a corporate meltdown, even though there is none on the horizon in terms of the regular numbers."
Some observers say the credit cycle is reaching a tipping point, at least in terms of income-statement geography. Most of the writedowns from residential mortgages and structured products have been felt, but the pain is far from over.
"At some point we'll switch from securities writedowns and loans marked to market to provisions as credit losses rise," said Toos Daruvala, who heads McKinsey & Co.'s banking and securities practice for North America. "Absent another seismic event, I think we've got another quarter or two of marks to come out, but there will be a steady rise in provisioning through the year."
Implied in that observation is the notion that losses are going to be distributed more widely throughout the industry; community and regional banks have less to fear from market-related valuation losses than they do from any toxic loans in their portfolios.
Perhaps one point lost in the rising tide of losses is just what is driving them. No doubt, popping a bubble hurts, but the decimation of consumer wealth caused by falling house prices is not just a cyclical phenomenon. Some of the losses are clearly a reckoning based on secular change in the American economy. Rising defaults and foreclosures in Orange County, Calif., and Dade County, Fla., have distinctly different reasons than those in Monroe County, Ohio.
"There are two things happening simultaneously. One is the normal cyclical thing, and the other is this economic, structural thing that is playing out as we deal with the globalization of manufacturing," said Nancy Wentzler, the chief economist at the Office of the Comptroller of the Currency. "What is happening in Florida and California is not what's going on in Detroit, and I think we have masked this all as the same subprime contagion."
Part Four: Regulators are a popular target in the blame game.
