The Next Banking Crisis on the Way

Jim Jubak
MSN Money
January 21, 2008

Is this the quarter when banks finally admit all of their problems?

On Jan. 15, Citigroup (C, news, msgs) announced it would take an $18.1 billion write-down on its portfolio of subprime mortgages and other risky debt, and the bank cut its dividend 41%.

With other banks following suit — Merrill Lynch (MER, news, msgs) reported $16 billion in write-downs and other charges two days later, and Wells Fargo (WFC, news, msgs) delivered similarly huge losses — will they throw everything, including the kitchen sink, into their losses? That kind of quarter always marks the bottom in a crisis like this.

Nah. The banks and other financials have more losses from the subprime-mortgage mess on their books that they haven’t yet confessed. Worse, the mortgage debacle has spread to other types of debt, with banks and other financial companies reporting mounting losses in their credit card and auto loan portfolios. And worst of all, the next big leg of the crisis — the one I think will mark the true bottom — has just started.

As the economy slows, the default rate is rising for corporate debt, especially for the high-risk, high-yield corporate debt called "junk" by many of us. That’s opening a Pandora’s box of potential write-downs that could dwarf the losses in the mortgage market.

If that’s true, it would push off the kitchen-sink bottom until the second or third quarter of 2008, depending on how bad the economy gets and how long it stays in the dumps. (See my Dec. 28 column, "Don’t count on a ‘normal’ recession.")

A brief history of bubbles

It’s not surprising that it will take so long to work through this mess, if you remember how it all began. The current crisis is yet another in a string of financial bubbles — the tech bubble that burst in 2000, the housing bubble that burst in 2007 and the debt-market bubble that’s bursting now. Behind each bubble stands a global flood of cheap money created by:

• Central banks running their printing presses to fend off economic slowdowns or financial-market crashes.

• A weak yen that let traders and speculators borrow for almost nothing in Japan in order to buy stocks and bonds in other markets.

• A huge surge of exports from countries such as China determined to hold down domestic consumption.

• Soaring oil prices that gave oil producers billions of dollars to invest somewhere.

All of those dollars chased a limited supply of real assets and traditional stocks and bonds, bringing down returns just as a falling dollar and signs of inflation lowered real returns more. Everyone wanted something as safe as U.S. Treasurys that paid more than Treasurys.

Everyone wants to believe in magic

Wall Street obliged by packaging and then slicing debt backed by mortgages, so that even the riskiest mortgages could earn a safe AA or AAA rating from Standard & Poor’s, Moody’s (MCO, news, msgs) or Fitch. It performed the same magic with credit card debt, with auto loans and finally with corporate debt — even the riskiest kind, called high-yield because it pays out a higher dividend to compensate for its higher risk. It’s known as junk because in hard economic times it can become worthless. (See my Aug. 10 column, "How Wall Street got into this mess.")

Everyone wanted to believe that Wall Street’s magic worked. Investors from Citigroup to the Hillsborough County Public Schools in Florida (exposure: $573 million) bought in. The more investors who bought in, the more of these new products Wall Street could sell and the more money it was willing to lend to home builders, home mortgage lenders and credit card companies; to the savings and loans and banks that created the raw materials (mortgages, credit card debt, auto loans) that Wall Street needed to manufacture its products; and to the hedge funds and structured investment vehicles that bought what Wall Street produced.

It worked out just fine until reality stuck a pin in the bubble. It turns out that you can’t lend more and more money to less- and less-qualified home buyers without driving up the number of borrowers who pay late or can’t pay at all.

On Jan. 9, Countrywide Financial (CFC, news, msgs) reported that the foreclosure rate on its 9 million mortgages had climbed to 1.44% in December, double the 0.7% rate of December 2006. The delinquency rate had climbed to 7.2% of unpaid balances, up from 4.6% in December 2006. The rates were the highest ever for Countrywide, which entered the mortgage business in 2002.

Within a week, as bankruptcy rumors swirled around Countrywide, Bank of America (BAC, news, msgs) agreed to acquire the company for $4 billion.

Damage goes beyond mortgages

But the cause of this mess stretched far beyond any problems specific to the mortgage sector, so the damage wasn’t limited to that part of the debt markets. On Jan. 10, for example, American Express (AXP, news, msgs) announced that credit card debt at least 30 days past due had climbed to 3.2% of its portfolio from 2.9% in the third quarter, and write-offs of bad debt had climbed to 4.3% from 3.7% in the same period. In 2008, American Express expects write-offs to average 5.1% to 5.3%.

Continued: The real concern

How about auto loans? On Jan. 15, Sovereign Banc (SOV, news, msgs) said it would take $1.6 billion in charges for the fourth quarter of 2007, including a $600 million write-down on consumer and auto loans. The company had aggressively expanded its auto loan business in Arizona, California, Florida, Georgia and Nevada in 2006 and 2007 — just in time to get hit by the cooling of the hot real-estate market in those states. The company has pulled out of the auto loan market in Arizona, Florida, Georgia, Nevada, North Carolina, South Carolina and Utah because of rising default levels.

But it’s the emerging problems in the corporate-junk-bond market that really worry me. The sector and the problems are big enough to produce another big setback for financial companies and the economy as a whole.

The real concern: Credit-default swaps

Actually, I’m worried not so much about the junk-bond market itself as the huge market for a derivative called a credit-default swap, or CDS, built on top of that junk-bond market. Credit-default swaps are a kind of insurance against default, arranged between two parties. One party, the seller, agrees to pay the face value of the policy in case of a default by a specific company. The buyer pays a premium, a fee, to the seller for that protection.

• Talk back: Do you think we’ve seen the worst for financial stocks?

This has grown to be a huge market: The total value of all CDS contracts is something like $450 trillion. Because buyers and sellers of insurance usually create multiple "policies" as they attempt to control risk, that number includes a lot of duplication. Real exposure, says the Bank for International Settlements, may be only 20% of that, or $90 trillion. Some studies have put the real credit risk at just 6% of the total, or about $27 trillion. That puts the CDS market at somewhere between two and six times the size of the U.S. economy.

The CDS market has been a good place to make money in the past few years because default rates in the junk-bond market have been historically low. The default rate for all junk bonds declined to 1.7% in 2006. That’s the lowest rate since 1996. With defaults that low, sellers were paid insurance premiums but didn’t have to cough up much in return.

But that default rate started to rise in 2007, climbing to 2.6%. And Standard & Poor’s projects the rate will climb to 3.4% by October. At that rate, 56 bonds would go into default in 2008, compared with 14 in 2007.

That level of default isn’t likely to inflict too much damage on the CDS market. The historical rate for defaults by corporate junk bonds has averaged 5% a year since 1980. But the default rate has run as high as 12.7% in previous recessions.

Will investors walk or run for the exits?

The junk-bond market isn’t in a panic yet, but the fear is climbing. The spread between the yield on the safe U.S. Treasury bonds and comparably risky high-yield bonds climbed by 0.81 percentage point in the few trading days up to Jan. 9. That’s the biggest increase in the spread in the first days of January ever measured.

I’d say that junk-bond investors, taking a clue from the 30%-to-50% losses suffered in the subprime-mortgage market by investors who held on too long, are moving toward the exits with all due speed. They also know that in the CDS market it’s very hard to tell who is ultimately holding the long or short end of any deal. And it’s even harder to judge the financial strength of the ultimate holder of any individual insurance contract. If the mortgage crisis is a guide, some of that insurance may turn out to be worthless because it’s held by an investor without the ability to pay.

Whether that exit continues at a purposeful walk or turns into panicked flight largely depends on the speed with which the economy slows and on the duration of any slowdown. Wall Street continues to talk as if all we’re facing is a two-quarter downturn, although perhaps of some severity, but the early money is starting to behave as though things are likely to be worse than that.

On Wall Street, fears have a nasty tendency of becoming self-fulfilling prophecies.

All it takes is enough investors behaving as if the short-term, asset-backed commercial-paper market is risky for that market to freeze into immobility, which leaves companies with less-than-sterling credit ratings without a source of short-term working capital.

All it will take in the CDS market is enough buyers and sellers deciding they can’t rely on this insurance anymore for junk-bond prices to tumble and for companies to find it very expensive or impossible to raise money in this market.

And that would be enough to make any economic downturn both longer and deeper than stock prices yet reflect.