Posts tagged ‘subprime crisis’

Banking On It

With equity markets reaching ever dizzier heights this year, oil stable and government bonds serene it is difficult to think back to how the financial world felt about a year ago. Back then, an eye-watering collapse in risk pricing apparently presaged a rerun of the Great Recession. The clear catalyst was to be a systemic financial crisis just like that of 2007-9, though this time originating in a China riddled with insurmountable debt problems. Bank worries persisted into the summer, with the European Banking Authority’s July “stress test” widely expected to demonstrate the insolvency of many weak banks (and especially those in Italy).

These fears – intense as they had been – eventually dissipated. Since its post-referendum nadir the UK’s FTSE All Share Banks Index has risen by 51%, comfortably outpacing the broad market ex banks by more than 30%. Yet the G7 Finance Meeting summit on in Italy right now has continued to generate headlines about bank solvency in that country. So has the problem gone away? And should risk assets head south once more, would it be a financial collapse that Mr Market, once again, was banking on?

The numbers in Italy are indeed problematic – for Italy. But they are too manageable and too well-known to foment a systemic crisis more widely. To answer the question more broadly, however – which in times of panic is invariably how it is phrased – we can take a look at various data on bank solvency and non-performing loans across the world to see where it stands today, where it stood during the crisis years and what happened to it in the supposed nightmare period of 2016.

Let’s start with non-performing loans. This is the most obvious cause for concern in the banking system: when a bank lends money to a sufficiently large number of customers who default on their loans its income falls, its balance sheet weakens and it can in extremis go under.

In the UK, the combined value of reserves for loan losses at Barclays, Lloyds and RBS (including all their current subsidiaries) peaked at £51.4bn in 2011. By the end of 2015 this had fallen to £15.0bn, and it fell further last year to £11.4bn, which is below the pre-crisis levels of 2007. In the US, where the subprime debacle saw the most severe financial bloodletting anywhere, the figures for the Big Four (Bank of America, Citi, JP Morgan and Wells Fargo) have charted a similar trajectory. The peak was reached earlier, in 2010, at $158.8bn, had fallen to $49.9bn by 2015’s close and ended last year at $48.5bn.

Taking a more global view, the IMF collects data by country on actual non-performing loans after the event, and this naturally tells the same story as individual banks’ bad debt provisions. Starting again with the UK, the banking system in aggregate saw the proportion of non-performing loans to total gross lending peak at 4.0% in 2011, falling to 1.0% in 2015 (data for last year is not available yet). The US hit a more severe peak of 5.0% in 2009, which had run down to 1.5% by 2015. It also posted that level last year.

Turning to the market’s bogey men in this department: Euro area banks didn’t see their aggregate loss ratio peak until 2013 on the back of the double-dip recession there (at 7.9%). But this has since fallen, reaching 5.8% in 2015 and continuing to fall to 5.4% over last year. And in China, while the same ratio did actually increase in 2016 this was only by 0.07% (the figure was a stable 1.7% from 2015-16 at only one decimal place). Note, too, that the Chinese peak was all the way up at 29.8% back in 2001, which ought to put this squarely into context.

As well as the incidence of loan defaults, the resilience of balance sheets is another key moving part when it comes to assessing the vulnerability of a banking system. So we can also look at bank capital ratios to see just how much sleep we might expect to lose should those not-very-concerning loan loss numbers begin to tick up again.

Regulators tend to focus on “tier 1 capital”, which can be summarized as balance sheet equity plus whatever debt can be written down without putting a bank into distress. The EBA helpfully compiles data on this for the EU in aggregate. Before the financial crisis, the tier 1 capital ratio for EU banks was 8.0% (2006). With the assistance of vast sums in emergency state support and generous debt swaps this percentage actually rose slightly during the crisis itself before really taking off in subsequent years to hit 14.9% by the end of 2015 and 15.7% last year. In other words, just as loan losses have been falling, capital buffers have been increasing – to almost twice the strength they had a decade ago.

Turning to the IMF once again we can have a look at similar data for (balance sheet equity) capital ratios across the world. This rather more traditional measure of capital is narrower than tier 1 and so the numbers are smaller and not quite so illustrative. They do, however, tell a similar story: the euro area’s “pure” bank capital ratio increased from 8.0% to 8.5% in 2016, ahead both of its 2011 nadir (5.6%) and pre-crisis level of 6.6% (2006). The Chinese ratio has risen from 5% to 8% over the last ten years, in the US it grew slightly from 10.5% to 11.7% over the same period and here in the UK the increase was from 6.1% to 6.8%.

There have been some weaknesses visible in this data – in Russia, for example, and in Brazil, which both suffered so badly at the hands of weak commodity prices in recent years. Again, though, banking issues in these countries have neither the scale nor the surprise factor to cause a genuine, systemic upset elsewhere. And in most other places, including those over which the strongest concern has traditionally been expressed, we can see that banks, as a whole, are in rather better shape now than they were in 2015 – never mind during the subprime crisis and Great Recession.

“In times of crisis”, this blog wrote back in February last year, “it behoves us to seek refuge in facts.”  The view that last year’s funk was nonsense proved correct, and provided an opportunity. But it is not just when the market is in crisis that we need to mind our fundamentals. Greed is every bit as dangerous as fear. We might not have to fear for the banking system at present (especially in places where interest rates go up) – but just because Mr Market looks unlikely to stub his toe on the banking system in the near future that doesn’t make him immune to stumbling elsewhere.

 

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12/05/2017 at 3:01 pm

Credit Crunch: End Of The Beginning?

It is now seven years since the first signs of strain and balance sheet writedowns signalled trouble in the US subprime mortgage market. A few months later – in June 2007 – the first credit rating downgrades of securities backed by pools of these mortgages occurred. The collateralization and ownership restrictions placed on institutional investors in the vast “asset backed” market were superglued to these ratings. On the back of the downgrades, Bear Stearns put up $3.2bn of lending to prop up one of its two subprime hedge funds. Amid collateral calls the entire subprime mortgage market collapsed. In July Bear announced that both its funds were worthless, and for the next few months an explosion in downgrades (and underlying mortgage defaults) began to focus the financial world’s attention.

So it may seem surprising to say that we are only really at the end of the beginning of this crisis. Seven years is a long time. And yet …

Last week saw the release of Q4 mortgage delinquency data for the US. The headline number showed that delinquencies – loans at various stages of falling behind with payments up to and including foreclosure – as a proportion of the whole mortgage market fell again, to 6.4%, as they have done steadily since peaking at 10.1% in March 2010. But dig deeper and we find that the subprime delinquency rate ticked up. In fact it has been stuck in a 20-22% range for the last two calendar years, not far shy of its 27% peak in ’10. The overall improvement in delinquencies has been entirely due to improvements in the prime mortgage market over that period. Subprime foreclosures are running at over 10% of loans, still materially higher than at the peak of the previous default cycle in 2000. For that reason, there are still plenty of ratings downgrades on mortgage-backed securities working their way through the system.

At the same time it is right that the US mortgage market has lost its power to terrify. Overall, as we know, the real estate market has been picking up again (with a recent setback driven by the execrable weather). And bank balance sheets have improved steadily and considerably in line with the mortgage market overall. Reserves for losses on loans across the Big Four US banks – JP Morgan, Bank of America, Citigroup and Wells Fargo – peaked at $158.8bn in Q1 2010. The current reporting season showed that had fallen by almost 60% to $67.8bn in the quarter just gone. That’s some way north of the $42.2bn reported at the end of 2007, but still pretty impressive.

Perhaps this partly explains why it looks too cautious from a US perspective to say we are only at the end of the beginning of the credit crunch. From a more global perspective, however, the description fits more clearly.

Here in the UK our banks have not recovered so well. At Barclays, loan loss reserves only trickled slightly lower last year and are roughly 41% below their reported peak. For Lloyds the figure is 38% and at RBS of course reserves hit a new high of £25.2bn for Q4 – 39% higher than the amount provisioned for at the end of 2010.

Turning to Europe, where banks are at least as far adrift, we have another aspect of the crunch to contend with. In some cases (most notoriously perhaps in that of Iceland), bank distress led directly to a sovereign debt crisis. In most countries it played a significant role – as did the crunch’s recessionary effects on the wider economy, of course. And we should remember that the Cypriot banking system went down less than a year ago, all part of the same protracted drama of downgrade, writedown, bailout and default.

Symptoms of the sovereign crisis remain. The yield on ten year Greek government debt fell below 7% only today for instance, the first time since the country’s ignominious junking by S&P in April 2010.

Which brings us on to the next stage. Greek government debt to GDP for 2013 is forecast by the IMF to reach 175.7% – more than 5% above the peak reached prior to the debt restructuring of 2012. It is still not certain whether another restructuring of one kind or another will be needed to make this manageable on a 5-10 year view. Much will depend on how the economy performs this year. And it is still less certain when Greece will be able to consider re-entering the bond market, as some less severely crippled bailout economies have already done.

Once we know that the Greek debt position is settled it could be the beginning of the end of the credit crunch, and not before. Then Greece – as others, including the rest of the eurozone, UK and the US – will be set on the path of managing its economic affairs with a huge burden of borrowing round its neck that will mark fiscal planning with servicing costs for many years to come. That is the lasting legacy of the insane credit markets of the mid-2000s. Only when that borrowing, weighing down across most of the developed world, has been firmly established on a reducing path for some time – only then will we be able to say that the credit crunch is over.

In terms of what all this means for markets let me make one observation.

Risk markets became absurdly optimistic in a short period of time during the end of the Great Recession in 2009, not at all seeming to understand the scale or possible longevity of the problem. Then came the sovereign debt crisis and a period of complete panic in 2011, and then, pretty steadily since the most successful example of Open Mouth Operations in history (by the ECB in mid-2012), risk has come back into favour.

The key point is this: by backing fundamentals, and so being sceptical of risk in late 2009 and more constructive thereafter (and especially in the autumn of 2011), investors would have done pretty well.

The gargantuan upheaval of the credit crunch and the hysteria which followed have left their mark in different ways at different times. There are still plenty of anomalies out there both between and within asset classes. As and when (and if) the ripples from that giant explosion seven years ago continue to fade, there is every reason to continue to expect that backing the fundamentals will remain a profitable thing to do.

28/02/2014 at 6:07 pm

Watch Those Bonds

Europe was the main focus of investor attention this week. For once the latest proposals from the continent’s leaders received a warm reception from markets. The catastrophic failure of the eurozone is not being taken quite so much for granted.

Amid the avalanche of comment on the expansion of the EFSF, the 50% haircut on Greek debt, the financial strength of the zone’s banks and so on, it has been easy to lose sight of what went wrong for Greece, and what might still go wrong for Italy and the others. To assess the risk of full scale catastrophe it is necessary to look in one place only: the bond market.

It was not the banks alone, or the recession alone, or the burden of government debt alone that did for the Greeks. It was the cost of debt. This cannot be emphasised enough. The idea in some quarters that a debt-to-GDP ratio of 100%+ is automatically unsustainable is simply wrong – and not just wrong for giants like Japan, or the US, but for lowly-rated borrowers like Lebanon. Or like Greece, which enjoyed an interest rate on its ten year bonds only 0.27% above that of Germany as recently as 2007. Today that would mean paying 2.5%; at that rate, debt to GDP of 300% would be perfectly affordable.

It was the bond market that broke Greece. The last emergency summit in Europe, remember, was convened back in July to agree a revised bailout for Greece: the continued effective closure of debt markets to the country made the refinancing pathway envisaged under the terms of the original 2010 deal impossible.

At the same time, concerns about contagion through the banking system do not convince. Those expecting lightning to strike in the same place twice need to remind themselves of the scale of banking losses suffered on the back of the subprime crisis: Bloomberg gives a figure of over $2.1trn in writedowns worldwide, with over $1.6trn of capital needing to be raised. For Europe alone the losses were over $730bn. And that crisis took the world largely by surprise. The restructuring of Greek debt, as well as being a much smaller event, is hardly coming out of left field. It is frankly obtuse to expect a comparable degree of systemic dislocation to ensue.

But the bond market is a different matter.

Italy tapped the market for just under €8bn of 3-, 8- and 10-year money this morning, paying rates in the 5-6% range for the privilege. Demand for the new bonds was weak, and this has received a lot of attention, but a rate of 6% is far from disastrous. Italy has about €300bn of debt to refinance next year; at 6% this would cost €18bn in interest per year. If rates were to rise to 10%, however, the cost of servicing the debt would increase by €12bn, wiping out the whole benefit of the austerity budget agreed last month.

Still, the very fact that today’s auctions took place shows that the bond market is still open to Italy. The bear case that the expansion of the EFSF to a hypothetical €1trn is “too little, too late” rests its logic on the size of Spain and Italy’s financing requirements (between them they are likely to need to raise that amount between now and end-2013 or so). But so long as they are able to raise debt without any assistance from the EFSF this is not entirely relevant.

It was hugely significant during the recent crash that Italy’s bond yields did not rise to dangerous levels. If they continue to hold their ground – or better yet, if confidence improves and they fall – catastrophic contagion in the eurozone is unlikely to occur. Talk about the banks, and haircuts, and credit derivatives is all very interesting. But if you really want to know how afraid to feel, just keep an eye on those bonds.

28/10/2011 at 4:51 pm 5 comments


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