Here is Housing Doom’s fifth installment of our unauthorized annotated transcript of the American Enterprise Institute’s October 30, 2008 seminar "The Deflating Mortgage and Housing Bubble, Part IV: Where Is the Bottom?"  This is the presentation by Chris Whalen. He makes use of a slide deck. Here is the official transcript. There is a video and an audio-only recording of the event at the event site.
- "I mean, imagine we are in the kitchen with a big knife and we were just chopping fingers off one after the other and laughing about it. That’s what fair value accounting is."
- "… a 3rd phase in this crisis, … the off-balance-sheet derivative contracts that are quote-unquote ‘notional’ now, but as consumer defaults and commercial defaults rise they become real."
- "What it tells you is that the entire industry today is at levels of stress … that we haven’t seen in 20 years."
- "That means 5, 5 1/2 percent for Citigroup, OK? That means the government ends up owning that bank." 
- "… But I do think that if my friends are right about the severity and the duration of a recession, you could see the government controlling some of the larger banks in the US."
- "The model we’ve had over the last few years, in addition to being ill-advised and reckless, basically makes a mockery of the whole Basel process, …"
I’m going to focus my remarks on the banking industry, which has been my role in these conversations we’ve had over the last 2 years. And I’m hopefully going to give you some reason for optimism, but unfortunately banks are lagging indicators, so bear with me.
Where are we in the process? If you look at the banking industry, we would tell you we are about half way through the adjustment process. [slide 2] And you might think — Well gee, Chris, we’ve been at this for 2 years — but unfortunately that’s just the way banks are. If you take the collapse of New Century Financial — you remember that one? … as kind of the starting point when everyone was forewarned in a very public and visible way, we’re two years into this.
But really, New Century was kind of unusual for the last couple of years because it was real losses … it was a real bankruptcy. Most of what we’ve been reading about, and what the public has been reacting to, had been the headlines associated with the economic recognition of losses. That is to say, fair value accounting. In fact, I found a banker the other day who told me that she has had to start fair valuing her loan portfolio because of this lunacy — this absolute insanity.
I mean, imagine we are in the kitchen with a big knife and we were just chopping fingers off one after the other and laughing about it. That’s what fair value accounting is. OK? [laughter] Well I can’t put it any more bluntly than that without offending somebody. [laughter]
Now where are we going. [slide 3] Well, we’re kind of in the next phase of the crisis, which is much more basic and much more old fashioned. You all have seen the Jimmy Stewart movie "It’s a Wonderful Life," well what we’re talking about here is lose realization. That is to say old fashioned change-offs, sales of assets, and the actual realization of a lose by investors who buy financial institutions.
Now as of where we are today in Q3 2008, we are continuing to see change-off rates rise, so as I said banks are a lagging indicator.
And based on where we are, in other words looking at banks, looking at their ratios, looking at where they are compared to where they were even a year or a year and a half ago — which, let us remember, were fairly low loss rates … actually historically low loss rates — we’re still looking for the peak that some of my colleagues have referred to next year at 2 times 1990.
Now those of you who are old enough to remember the 1990s and the S&L Crisis know that at that time the US banking industry reached a charge-off rate of 2 percent across the board, and people like CitiBank NA reached 3.5 percent. That institution almost went bankrupt.
Imagine what the industry looks like at 2 times those loss rates [1:00:00] next year. And in particular if you listen to Tom and the other speakers, imagine what happens if we get to those loss rates and we stay there for a while. In other words it’s not just a peak and we come off, but imagine if the recession is extended, we get the banking industry up to historic loss rates, and then we hang out at those loss levels for a while.
Now why do I give you all this cheerful preparatory commentary? It’s because I don’t think that the 2nd phase, the realization, is the last phase. I think we’re going to see a 3rd phase in this crisis, [slide 4] where the losses, not only from financial assets that we can see on the balance sheets of financial institutions, but in particular the off-balance-sheet derivative contracts that are quote-unquote "notional" now, but as consumer defaults and commercial defaults rise they become real.
What do I mean? We wrote about this on Monday. We put out a piece called: "In the Fog of Volatility, the Notional becomes Payable."  And what I meant by that is that if you’re a German bank, and you took a punt two years ago on Leaman Brothers failing, and you wrote a Credit Default Swap that said, "I will indemnify you, the holder of Lehman Brothers bonds," and you paid me — let’s say — 150 basis points.
2 years go by and Lehman Brothers files bankruptcy. You, German Landesbank, have to come up with 9,700 basis points [97 percent] of cash.
OK? You got paid a couple hundred basis points each year for that insurance contract you wrote. You just had to come up with 9,700 basis points worth of cash to perform on that contract. That’s a liquidity black hole.
I don’t think our policy makers realize what’s it’s going to cost our economy and the global economy in terms of liquidity as many of the speakers were talking about before to make these contracts good. [slide 5] In fact I think when the politicians really get to understand that the bailout of AIG, and the bailout of other firms on Wall Street is not to help Mom and Dad, and not to get lending restarted in this country, but to bail out the credit default swap market, I think there is going to be a political reaction in this country that’s going to burn the sides of people’s heads off, I really do. So nice happy thought, right?
(… we’ve covered that …) Now let me show you a little picture. [slide 6] This is the credit index that we launched a couple of months ago. What is this? Well as you can see the current value at the end of the 2nd quarter’s a little over 1.4. The base year, which is 1995, is 1. This is an explicit census of the entire US banking industry. In other words we calculate the index value for every FDIC insured bank and then we roll them up into a single index like this.
What it tells you is that the entire industry today is at levels of stress based on things like charge-offs, capital, return on equity, efficiency — all the basic factors you look at when you are assessing a bank — that we haven’t seen in 20 years.
And we’re going higher. In fact my guess is from the 1.43 at the end of the 2nd quarter this index is probably going to get up to 1 1/2, maybe 1.6 by the end of the year.
Now the good news is that of the 8,400 FDIC insured banks in this country, the vast majority of them are fine. Not only are the vast majority of them below 1.4, but the vast majority of them are below 1. They haven’t even gotten up to the 1995 levels of stress, because they are by and large very conservative banks. This is your typical community bank — under-leveraged, under-risked, and very happy. They go home and have dinner with their families at night.
Unfortunately, the thing that’s dragging up this index — and I’m going to show you the picture now [slide 7] — if you take a look at that green line, what is that thing that’s at the very top there? That’s return on equity — mark-to-market losses. That hits income, hits equity returns.
Now you’ll notice the next line — it’s visible there — the red line line is your return on equity — the green one’s your defaults, which is really leading the parade. But if you take a look, the third line, capital adequacy’s, barely moved. Why?
Capital’s a lagging [corrected via e-mail note — thanks! jm] indicator. We haven’t started chewing into that capital yet, that’s where it’s going to be …
Alex Pollock: Chris … excuse me. Just a minute.
Chris Whalen: … yeah, go ahead.
Alex Pollock: … the return on equity must be an inverse measure, right?
Chris Whalen: Yes.
Alex Pollock: … if that line’s going up it means return on equity’s going down …
Chris Whalen: … up is bad, that’s right …
Alex Pollock: … yeah, thanks …
Chris Whelan: … each of these is evidence of stress. The higher the number goes, the worse it gets.
Let me put that copy on out there. My friends in California did this. They’re all geeks. They all come out of the aerospace business. [laughter]
But what I’m trying to say to you is that normally when you see banks reacting to a severe economic downturn, you’re going to see return on equity affected. You’re going to see efficiency affected. That’s all to come. We haven’t seen it yet, and when I said that we’re still early in the adjustment process, that’s what this chart evidences. It’s really saying to you — when we start [1:05:00] seeing equity, capital adequecy affected, when you start seeing efficiency in particular going higher than it ordinarily is — efficiency by the way is how much money does it cost a bank to generate revenue — So the whole industry was about 60 cents on the dollar a year ago. They’re now all up to 80. Why?
Because they are all spending money on advertising. They’re trying to keep deposits, customer service. They’re pushing it as hard as they can because they are all trying to hold their position in the marketplace. That’s what efficiency really measures.
So the point of all this is that the industry’s got at least another year, maybe longer, before it gets — in terms of the internal ratios of banks — to the point where you say, "ah, we’re at the peak."
So what does this suggest to us? [slide 8] Well, as I said before, we could see peak charge-offs next year getting up to 2 times 1990. That means 5, 5 1/2 percent for Citigroup, OK? That means the government ends up owning that bank. Sorry to say.
We could see the industry up to 3, 3 1/2 percent charge-offs across the board. That’s serious. The little banks will still be fine, but they won’t be reporting dividends for quite a while.
Now let me show you what I’m talking about. [slide 9] This is Citi versus the large bank peers through the 3rd quarter of this year. Now as you can see Citi is the blue line, and they’re up a little over 200 basis points of default. That’s 2 percent charge-offs against total loans and leases.
Now, is that unusual territory for Citi? No. Absolutely not. Citi normally has a much higher loss rate than other banks. More consumer.
If you look at somebody like JP Morgan, who’s included in this peer group, by the way, they’re not going to show the same kind of loss behavior because they’re much more commercial. Even though they have a really big retail book at that bank they have a very large business lending operation. So you’re going to see the pain hitting them next year … year after. Whereas in HBC or Citi with the consumer exposure you can see it now.
This line’s going to go higher. We could take some comfort from the fact that 2nd quarter to 3rd quarter the line flattered down a bit. Maybe everything’s fine, right? No, I don’t think so. I think the hockey stick continues after that.
So as I said before, the 2×90, 91 range [in other words losses about twice those in 1990 & 1991] … I think implies that Citi, JP Morgan at least are going to have to get additional injections of capital. [slide 10] I don’t think there’s any question in my mind that they’re going to have at least as much capital injected in those banks as they already have.
Now I don’t think all large banks are going to have to do that. But I do think that if my friends are right about the severity and the duration of a recession, you could see the government controlling some of the larger banks in the US.
And I think we’re going to have a very interesting public policy debate, perhaps right here, about what the government ought to do. My personal belief is that if we do have to see the Treasury take explicit control of Citi and JP they ought to break them up. They ought to sell every one of those branches at auction, because the result would be a more healthy, better capitalized, broader banking industry.
And I’m not just talking about Wells Fargo and US Bancorp. There’s probably 40 or 50 institutions who would happily bid for those assets — with private investmentors helping them. That’s the good news. There’s tons of capital out there that want to get involved.
But until — going back to this chart [back to slide 6] — until we can figure out where the peak loss rate is, it’s very hard for investors to kind-of jump in with both feet, because you can’t come up with a number.
A classic example is the acquisition of Nat City. In that case you have a bank that’s been above-peer-losses for 4 years? Where’s it going to end? I don’t know. The guys at Corsair Capital put equity into Nat City earlier this year and — brave souls — I just don’t know where the end is for that bank. Given it’s geography, given its other attributes. And yet the Treasury seems to think they can get past this crisis by just merging banks together, and unfortunately I think they’re wrong.
So let me just add up and end with a question that I’m going to be trying to answer over the next couple of months. I think we’ve got to have a discussion in this country not only about how to stabilize and rebuild the banking system and what it’s going to look like, but particularly what the business model is. [slide 11]
The model we’ve had over the last few years, in addition to being ill-advised and reckless, basically makes a mockery of the whole Basel process, 8 percent capital of total assets. Clearly, the activities we were all engaged in over the last few years probably needed more than 8 percent capital to support them prudently. If we’re going to now bring banks back to a model that’s less risky, more prudent, more stable, I have a feeling the returns on that model are going to be much lower than people think. Banks aren’t going to make 20 percent return on equity. They’ll be lucky to make half that. They’ll be utilities. And in that kind of a business model, I think the regulatory issues, the social issues, everything else are going to come to the fore because there’s no free lunch here.
Whether you’re talking about Community Reinvestment Act, if you’re talking about broad based programs for loan modification, this is going to cost a lot of money.
And I think once politicians [1:10:00] realize just how much of a subsidy is not going to helping consumers, businesses, the real economy, and how much of it is really going to the virtual, speculative economy, we’re going to have a very interesting political debate in this country.
Alex Pollock: Thanks Chris. I guess we could note that some of those 20 percent returns which were booked were actually never profit. It should have been booked as loan loss reserves. And the profits weren’t real, but of course they were booked as profit, they generated dividends [laughter] bonuses and taxes.
Chris Whalen: Let me mention just quickly. This last chart at the end of our deck. [slide 12] This is a study we did with Deloitte earlier this year. And this is real Risk-Adjusted Return On Capital [= RAROC] for the top 20 banks going 20 years. What do you see? You see that not only were their returns much lower than they were 15 or 20 years ago, but the variance among the group is declining. Everybody’s converging on the same business model. And I suspect this is going to change rather radically going forward. But this is where the industry is today.
Alex Pollock: Thanks, Chris. [1:11:05]
Notes and References
: "The Deflating Mortgage and Housing Bubble, Part IV: Where Is the Bottom?", AEI Event Homepage, October 30, 2008.
: "The Deflating Mortgage and Housing Bubble, Part IV: Where Is the Bottom? (PDF slide deck)", by Christopher Whalen, Institutional Risk Analytics / American Enterprise Institute, October 30, 2008.
- Title Slide
- Where Are We in the Credit Adjustment?
- Where Are We in the Credit Adjustment? (2)
- Where Are We in the Credit Adjustment? (3)
- Where Are We in the Credit Adjustment? (4)
- Credit Crisis Index
- Banking Stress Indices
- Outlook for 2009
- Gross Defaults: Citi vs. Peers (bp)
- Outlook for 2009
- What is the Business Model?
- RAROC (%) — Top 100 Banks [RAROC = Risk Adjusted Return On Capital]
- Contact Information
: "Stocks Rebound but Credit Markets Show No Signs of Improvement", by Eric Ross, Seeking Alpha, November 30, 2008. [I’d say Chris pretty well nailed that one …]
On November 25th, the U.S. government unveiled a series of programs to buy mortgages, agency debt and asset-backed securities (ABS). In addition to the $700 billion of the TARP funds, the Federal Reserve and Treasury will spend $800 billion more in non-TARP funds. The government also propped the falling Citigroup (C) by guaranteeing $306 billion in toxic assets on the bank’s balance sheet.
:"In the Fog of Volatility, the Notional Becomes Payable", by Christopher Whalen, Seeking Alpha, October 27, 2008.
: "Germany’s BayernLB gets 30 bln eur lifeline", Reuters, December 1, 2008. [Chris wins again — LB = Landesbank]
Germany is mounting a 30 billion euro ($39 billion) rescue of stricken state lender BayernLB in one of the biggest emergency packages in Europe since the global financial crisis began.
The country has been one of the worst affected by the storm, which started when poor U.S. home owners could not pay their mortgages before it snowballed into an interbank lending freeze that is sucking the global economy into recession.
On Monday, the state of Bavaria said it would inject 10 billion euros into BayernLB, the lender it partly owns. BayernLB will get a further 20 billion euros of state guarantees that will make it easier for the bank to borrow money.