A brief review of the last 18 months in Banking, and what it means
Last night the news emerged that the US Government intends to somehow remove bad loans from Banks balance sheets, in what sounded like a bailout. Thought I’d give it a bit before wading in. Lots of hyperbole out there caught up in the stock market jump, that is cloaking the real story here. We also have the Republican Presidential candidate noting that the focus is wrong here. Thats for the political blogs.
US Republican presidential candidate John McCain has said he is against the state bailing out struggling banks and financial companies.
Mr McCain said the US Federal Reserve should get back to its core business of managing money supply and protecting the strength of the US dollar.
Lets reflect on what has happened, over the last few months, and couple of years beyond the short focus of this week or today.
- Banks around the world experience losses as a result of investment in commercial paper backed or partially backed by US sub-prime mortgages. This follows the dramatic impact from the large scheduled interest rate increases contained in the small print of Adjustable Rate Mortgages in the US. In simple terms these mortgages were designed to be affordable for a few months, but when the higher rate kicked in after say 6 months, the mortgage became unaffordable. The origination of those mortgages used debt service ratio’s based on the opening payments, not the eventual higher payments.
- The opening trickle of write-offs leads Banks’ and investors to realise that they actually have no idea of the scale of the problem. This realisation brings banks to the key realisation that they have no idea of the value of the asset backed commercial paper (ABCP) that is traditionally freely traded amongst them. Confidence dries up, and Banks refuse to trade with each other.
- Governments and Central Banks realise the cascading problem has issues for consumer costs, confidence, and the holy grail, gross domestic product (GDP). So massive credit is granted to Banks, and liquidity injected into the financial system. Sometimes known as printing money.
- Inflation becomes the next worry, which is obvious after 3. The worry is supplemented by dramatic escalations in price of food and oil.
- But then the unthinkable begins with the fall of Bear Stearns. After that its just a matter of time that highly levered Banks fall prey to the double hit from lack of liquidity and confidence. The Banks’ who rode short term financing for long term investment (mortgages) go first. Northern Rock, and HBOS are two examples. Following the collapse of Fannie/ Freddie (US Mortgage lenders), Central Banks pick their winners amongst the larger, better capitalised, and well run Banks (Lloyds, Bank of America) to takeover the weaker Banks. This in an attempt to stave of a complete collapse of the financial system. The Fannie Freddie situation alone doubled the US national debt adding another 4 trillion dollars. The US Government also effectively took over AIG Financial Group, although paradoxically they allowed Lehman Brothers to go bankrupt.
- interbank confidence reduced to such a level that on Sept 17th they refused to trade with each other at all, and bid Government Paper up to par, ie interest rate of virtually zero.
- US Government develops a plan similar to the 1980’s Savings and Loan crisis, designed to takeover bad mortgage loans from the Banks, and nationalise those loans. [Update: Rescue Plan Seeks $700 Billion to Buy Bad Mortgages - that's 3/4 of a trillion dollars]
This brief synopsis brings us up to date. So what’s next and what are the implications for financial services, and more importantly, customers of financial services.
Some themes for Banks that have developed throughout are:
- greater regulation of financial services
- dramatic inward looking focus by Banks, regrouping, absorbing takeovers
- lack of trust and failure of interbank trading
- significant pressure on expenses resulting from bad debts, ie higher expenses
Relevance to Bankwatch:
This is not a situation in which I would expect increased innovation from Banks. They are all running scared, worried about their leverage, their capital, their liquidity, and new failures that will hit their balance sheet.
On the other hand it would be a good time for new ideas and companies in financial services, but the increased regulation theme makes it tough there too.
Interesting but tough times ahead. Which Bank(s) will take advantage and break out of the pack with some innovations?