Credit Losses Seen Doubling in 2009

To consider the current state of the banking industry is to consider a very sick patient: marks of improvement come in small doses.

There are no improvements, however.

In a sweeping assessment of the banking landscape last night, Christopher Whalen, director of sales and marketing at Institutional Risk Analytics (and my vote for Risk Rock Star of the Year), offered his diagnosis of the banking industry, and it was dour indeed.

It all boils down to credit losses. In Whalen’s view, “we are about halfway through” the credit loss cycle. Whalen breaks down the credit-loss cycle into three stages:

1) Recognition of Losses. In this stage, financial institutions recognize that they have losses in their credit portfolios, although they might not do anything about it. This stage began when the market realized that “securitization was broken” when New Century Financial Corp. failed in early 2007.

2) Realization of Losses. Realization takes place when financial institutions write down the losses they recognized. We’re hot into this phase of the cycle.

3) A Broadening of Losses. This is when it gets ugly. Losses move across the entire spectrum of assets. We’re just getting to this phase now as stress begins to appear in commercial real estate and credit card loans, to name just two. Whalen sees this third phase lasting into 2010.

He cited subprime losses as evidence of where we are in the credit cycle. According to Whalen, subprime credit losses won’t peak until next year.

“We are still early in how these losses will be manifest,” he said of credit losses generally.

So what’s the damage? How about 4% of total chargeoffs in 2009, up from the current 2% or so. And for Citigroup Inc., credit losses peaking at 5% or 6%, he said. Let’s think about this for a moment. Credit losses will go to 4% from 2% -- well, that means credit losses will double from where they are now. And you thought the third quarter was bad.

To put this in perspective, Whalen estimates that ALL current capital at banks will need to be replaced. All!

These loss scenarios point to a greater underlying problem, which has Whalen relatively flummoxed: What to do with all the credit default swaps? There are at least $32.5 trillion of CDS outstanding. It is clear that some of these CDS will be “in the money,” forcing the counterparty on the CDS to make the buyer of the credit protection whole. This is essentially what ruined AIG.

In fact, this is why Whalen sees AIG still going into bankruptcy, despite the government’s efforts. Whalen sees no alternative to the CDS problem but to “tear up” the contracts.

“If we don’t get this stuff out of the system, we can’t fix the problem,” he said.

I would venture to say that it is nearly impossible to consider the implications of the current dilemma we face. There are so many question marks. For example, I’ve been focused on the unemployment rate, which I see as being perhaps the greatest determinant of credit performance going forward. Where the unemployment rate ends up could be a result of what happens with the Big Three automakers and so on.

“People just don’t know, and ‘don’t know’ is not an acceptable answer,” Whalen said.

Tags: aig, cds, citigroup, credit-crisis, subprime, whalen

Comment by Tom Burke on November 21, 2008 at 2:57pm: At the risk of sounding like an ostrich with its head in the sand, or like Hayley Mills in "Pollyanna" - (aside - how many of our members actually saw that movie?) I find it hard to believe that the underlying economy is as bad as everyone fears. Fear is, I suspect, the biggest problem of all. Chris Whalen is right that people just don't know, but what is it that they don't know? They don't know many things, they fear that the situation could get worse because our eminent leaders in Congress haven't a clue but they still have the power to "do something." That prospect alone should inspire a tidal wave of fear. Businesses and consumers are sitting well back from the sidelines waiting until they can feel reasonably certain that they know which direction that Washington will take.

A few things that we don't know:
--the true extent of the credit losses. Really, how bad are these subprime loans? Have they all gone into default? Have the institutions that are booking losses or adding to reserves examined every loan in those bundles or mortgages, separated wheat from chaff, and re-rated the loans accurately? How well do they know what's been charged off? Or have they just been guessing, and is there a sizable potential for recoveries of those chargeoffs? If there is, will the government impede the work of recovery?
--who is actually responsible for performing that detailed grunt work?
--where are those loans anyway? Who has them on its books? Is ignorance about just who's holding the bag fueling the fear and uncertainty?
--what overall course the government will take, and what industries/groups will get the goodies while others get turned down. But we do know that a Democrat-dominated adminstration will be taking power in January, and that cannot be good for working, productive people and businesses. So why should anybody be taking any risks or expending and entrepreneurial energy right now?

There are many other unknowns, and I don't want to go on endlessly here. Let me say that I think that a sober, clear-eyed and nonpartisan evaluation of the economy, particularly of the banking industry, would show that things aren't all THAT bad. If Congress would just shut up and get out of the way, we'd snap out of it.

Don't think I'm optimistic, however. I'm not like Hayley Mills - there's no reason to feel glad. I don't trust that Barney Frank, Chris Dodd, Chuck Schumer, Henry Waxman, and that whole crowd in Washington would ever do the right thing. Especially at a time like this. They are going to make it worse, whatever they do, and I believe that the vast majority of Americans feel that in their bones.

One final prediction - some day we will hear, from someone who had been on the inside at Fannie and Freddie, that the crowd running those monstrosities knew exactly what they were doing as far back as four or five years ago. They knew that they were building an unsustainable castle of cards, and they did their best to hide what was going on by clever structuring of the loan packages, concealing crummy loans beneath piles of acceptable ones. That's one reason it will not be easy to find and dispose of the rotten loan, and it's probably also a reason that they were able to keep the music playing for as long as it did. Just an old loan-review guy's jaundiced view...

Comment by JJ Hornblass on November 21, 2008 at 3:37pm: Tom, you make great points and I appreciate each. Thanks.

On one level I agree with you that, in truth, "things aren't all that bad." Yet, the fact that we "don't know" where and what are all the problems (as you correctly spelled out) in and of itself creates a greater problem. The underlying situation matters less than the reality of the moment, and the reality of the moment can end up amplifying even the worse-case scenario.

This is what is going on with Citigroup this week: the knowledge of problems at Citi in and of itself makes Citi's situation worse. The stock gets bid down and Citi's bad situation gets amplified.

My point is, if the financial situation is this bad at 2% chargeoffs, how much worse will it be at 4% chargeoffs? Honestly, I don't what to know the answer.

Comment by Tom Burke on November 21, 2008 at 5:28pm: Could be that Chris's projections are too dire, and that the chargeoffs will not be so high. And even if they end up at that level, I suspect that recoveries will be somewhat better than usual - eventually.

There was a good WSJ op ed by Andy Kessler yesterday. He says we should ignore the stock market until February, that the problem is not so much fundamentals as forced selling. A lot of selling goes on at year-end, and nowadays there are a lot of margin calls too. An interesting article, not directly linked to the credit mess but all of a piece with the overall situation that is the product of ignorance, apprehension, and total lack of confidence in the political people.

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