Doom Transcripts: Index & Guide

Housing Doom is pleased to present a third selection from our under-construction transcript of the American Enterprise Institute’s October 22, 2009 event "The Deflating Bubble, Part VI: The Lessons of the Bubble and Crisis".1

The event site has a number of resources, including an audio and video of the proceedings. There is as yet no official transcript.

This is the presentation by IRA co-founder Chris Whalen.  I see Nouriel on deck, but this one’s going to be a tough act to follow.

So this is what the commenters at Calculated Risk have been going on about …

Chris Whalen: [0:27:02] I’m going to talk a little bit about the industry because we’re in the middle of earnings season, and I apologize for not preparing something, but I’ve been reading bank earnings statements, so I will share some of my impressions of that. And then I want to talk a little bit about not only lessons, but some of the enduring trends that I see that have not been affected by the extensive bailout that the government has put together for our largest financial institutions.

In general, when you look at the industry you have to recall the words of Mr. Feinberg, and I don’t mean the guy who was in the newspaper today, I mean my friend Bob Feinberg in the back of the room, who predicted several years ago in an interview we published that the GSE would become the business model of choice for the United States.

And so we now have at least 4 GSEs, maybe 5: obviously Fannie, Freddie, Citigroup and AIG; I think you would also probably want to include BankAmerica and Wells Fargo in that fine association; and depending on your mood you might put JP Morgan in as well, but I generally have JP 4th on my list of worry for the top 4, OK, so you’re wondering what my order is.

When you look at the big banks, the first thing that jumps out at you, of course, is their marvelous earnings results. And when you dig into their financial statements what you find is that their net interest margin tends to be a good 50, sometimes 60, percent higher than it is for smaller banks. This is the subsidy that everyone in this room is providing to the equity- and bond-holders of these institutions.

Another way of looking at it is if you look at the Revenue Run Rate for Citi for the analyst community next year, their estimate, it’s $10 billion lower than the current revenue run rate for Citi. What’s wrong with this picture?

Well, what it is telling you is the Street doesn’t think that in a normalized scenario that bank can generate as much revenue as it is generating today with the various subsidies from the Fed and Treasury.

The other real eye-opener, of course, with Citi, is that we’re almost up to my prediction of a year ago of 6 percent charge-offs. This is inclusive of loss-sharing. This is inclusive of various other subsidies. So the question you should be asking yourself when … that is when Citi …

Alex Pollock: … Chris, when you say inclusive, do you mean "net of," "on top of," loss sharing?

Chris Whalen: … I mean that this is the number modified by the loss-sharing. So in other words the actual loss rate is higher.

In all of your minds you should be thinking to youselves, "Gee, Chris told us a couple of years ago that Citi peaked around 3 1/4 percent charge-offs in the early ’90s, so if they’re reporting almost 6 today, and the actual economic losses inside the enterprise are higher than that, then that tells you that a lot of what Tom was just saying about the environment is absolutely right. And that these banks are going through a terrible, terrible period of loss. But we have [0:30:00] nicely disguised it.

Now you see this, of course, because the top performing financials over the last 6 months in terms of equity markets were the GSEs — Fannie, Freddie, Citi. They were followed by the Life Insurance underwriters, who are as opaque as companies get, and also performed about 150 percent over a 6 month period.

But then when you get down into the rest of the banking industry, what you see is a fairly gruesome picture. We do a preliminary index / snapshot right before the FDIC press conference where we look at the industry ex- large bank. And our stress index right now is a little over 5. The benchmark year is 1995, which is equal to 1. So what we’re talking about is this sleepy, pedestrian industry known as commercial banking has moved almost a half an order of magnitude in terms of stress in a period of just a couple of years. They were down at the average 1 rate back in 2007 — lower than that, actually.

This is not normal for banks, and as my aircraft engineer partner Dennis Santiago remarked after we got the second quarter data, "Gee, Chris, some of these banks are moving too much. They are not going to recover, because their indices are moving far too rapidly for a bank."

Now the thing that really worries me, though, because obviously "extend and pretend" is the operative policy at the moment with respect to the financials, is when you look outside of housing, and when you look outside of banks, and you look at things like … commerce.

We all remember commerce, right? Before financial services became the main engine of growth in the US economy? Well I just did an interview with my very dear friend Jerry Flum. Jerry runs a tiny little publicly traded company called Credit Risk Monitor. Have about $5 million in revenue this year.

They serve corporate treasurers, and corporate credit people. Every month they gather accounts payable and accounts receivable data from the Fortune 1,000. What this data shows you is that a financing market that used to be 4 times the size of the banking industry’s lending book is now just about gone. And when I say gone, I mean vendor financing has been withdrawn from the commercial channel.

What does this mean? This means cash on delivery. This means you’re not getting 30 days anymore from whoever, who’s selling you a couple boxes of widgets that you need for your business. They want to be paid up front.

So what this means is that for all manner of small, medium, even relatively large companies out there, there’s no longer any free working capital coming from the vendors that serve them.

Many businesses, if they’re well run, will actually have negative net working capital, right? They make somebody else finance the business. That’s not the case anymore.

So as Jerry said to me, and we’ll be running this interview either tomorrow or early next week, there’s no oil in the machine. That worries me a lot, because the banks can’t pick up the slack. This is the world of the CITs and some of the other private factors, but they’re only a small part of this market. When you talk about commerce, you talk about vendors who are willing to finance everything from CISCO routers to tubs of chemicals or whatever it is. They all give their buyers 30, 60, 90 days, whatever the practice is, whether it’s retail, what have you. And that market is gone.

So we can sit here and pretend as much as we like that the economy’s good because the Fed has liquified the financial system and they are providing ample credit. They’re even trying to pump up housing. But the thing I worry about with my banks is if we don’t get a bounce in unemployment, if we don’t get a recovery in the real economy, then we’re not going to see changes in credit loss experience for banks, even after next year. It’ll just keep on going.

And this is why I’ve been telling my at times cranky clients who say, "Chris, they were up 150 percent, you’re bearish." I say, "Yeah, I’m bearish for the simple reason that there are so many people betting on the long side of these instruments, whether they’re stocks or bonds." The change in pricing, the change in market sentiment that could occur will be very rapid. It won’t be a nice change in direction. This will be a sudden shift that is going to catch everybody as flat-footed as we were caught last year about this time.

So when I take a step back and I think of lessons I say, well, the chief lesson I am drawing from all this, and I’ve talked a little bit about this in a session I was involved with Vince Reinhart here about a week ago, is that, you know, our country is more and more being governed by a group of leaders who are far more interested in the opinions of the international community, and particularly our creditors, than they are in the views of our citizens and really in the interests of our economy here in the United States.

I think [0:35:00] you see this in many of the policy prescriptions that our colleagues are going to describe in terms of monetary policy.

And the question is, what’s the cost? Well the cost to us is inflation. I hear constantly from people, in part thanks to my friend John here in the front, talking about how, "Oh, Chris, deficits don’t matter, the Fed can just print money and it’ll be OK, we don’t have to worry about this, it’s all just inflation." Yeah, well it’s all just inflation, but you know what? If we continue along this path, most families in this country are not going to be making it in 20 years. And we are going to see this society collectivize.

Because we’ll have no choice. As Bob Feinberg predicted, the GSE will rule, and private corporations will not be able to compete in that environment. In fact it’s very hard for private banks to compete with the larger GSE banks today.

I smiled when I saw the results from my friends at Hudson City Savings this week, because they hit one out of the park again. Very profitable. But that’s a little bank that actually lends money to real people for real purposes in the New York area. How can they compete with an entity like Ally Bank, that has the Treasury underwriting them, that has terms on their deposits that are clearly unsafe and unsound, and yet this entity is allowed to continue, including with these obnoxious television ads.

I’m going to write a little piece about Ally Bank next week. I may just do the hat dance on them on a regular basis, because I just find it obnoxious that we could allow an insolvent institution like this to go around advertising the fact that they don’t have to follow the same deposit rules as solvent institutions.

So there are many lessons I could draw, I think most of them are moral, however. When we allow our government to stop paying attention to our wants and needs, this is what happens. And I look forward to your questions.

Notes and References

[1]: "The Deflating Bubble, Part VI: The Lessons of the Bubble and Crisis", AEI event homepage, October 22, 2009.