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From Lombard Street Research:

Banks are profit-maximising institutions that are the originators of liquidity through the expansion of their balance sheets. Two factors restrain their ability to expand: the need to hold some cash and the capital/asset constraint. A central bank influences the supply of money though its hold on the banks via the cash requirement, as at the end of the day only it can physically print money if there is a run on the banks. Central banks provide the banking system with liquidity at the rate of interest that they set. However, in normal circumstances the capital/asset constraint plays a more important role in banks’ decision to lend. Bear in mind that for banks, as profit-maximising institutions, lending at any rate is better than not lending at all if they have the capital. Of course they have to factor in risk.

After the introduction of Basel I in the late 80s banks are required to hold a minimum of 8% capital against their risk-weighted assets. Securitisation has allowed the banks to boost their income. They offload the loans from their balance sheet, releasing capital for making new loans, but as well as fees from the origination of the loans they continue to earn the fees from their servicing, and then from the next round of the same process. The more debt they securitise, the more profits they earn. Invariably lending standards fall as banks no longer hold the risk. Revenue is solely governed by volume. There is nothing bad in that as Mike Milken showed in the 80s when he invented junk bonds. Investors are prepared to hold more risk if the yield is sufficiently high. However, the buyers of collateralised debt have to rely on rating agencies to give them guidance as to the risk involved. Meanwhile, the Eurasian savings glut and the expansion of the hedge fund business have created huge demand for CDOs, leading to the mis-pricing of the risk.

Securitisation allowed leverage to increase fast at a time when the savings glut has pushed up asset prices, justifying the boom in leveraged buy-out deals. But the US sub-prime mortgage problem started the unravelling of this process. As the Bear Stearns story has unfolded, investors have become aware that they do not know the real value of these obligations, let alone where the risk lies. The past week has seen the bad news mount as IKB and Macquarie Bank announced difficulties as a result of exposure to US sub-prime loans. The situation is reminiscent of Japan in 2001, 2002 and early 2003. Japan’s banks were saddled with bad loans. The Japanese Financial Services Agency estimated them at ¥43,000bn, but privately they were believed to be around ¥150-250trn. The huge uncertainty caused the public’s liquidity preference to soar and negated the expansion of money. It then took decisive action on the part of Mr. Koizumi and Mr. Takenaka in 2003 to conduct special investigations at the banks and come up with the real estimate of bad loans. This was a lot more important than the plan to deal with the bad loans as it finally succeeded in convincing the market that the true size of the loans was indeed in the order of the ¥40,000bn. The removal of uncertainty was instrumental in the Japanese stock market recovery that followed.

But who is to remove the uncertainty this time around? Where central banks failed over the past few years is in not collecting the data that would have allowed them (and us) to keep up with the expansion of the global financial structure. We know that banks have exposure to CDOs, the defaulting mortgages themselves and the hedge funds that funded holdings of the “toxic waste” with debt. But as yet no one knows the true size of the problem. Such conditions are classic breeding ground for a further increase in risk aversion. The close integration of the global financial system must mean that these developments will be unfolding on the world stage. Anecdotal evidence and market jitters are building to suggest that the demand for securitised debt in any form is drying up.

But how is the supply of money affected? As noted, the losses that US banks will face are unclear. An article in Friday’s FT carried the same features as the Japanese story above. The author made reference to the $100bn estimated by the Fed to be the possible losses the financial system could face. But he continued to say, “One only need contemplate that subprime and Alt-A loans might in the end have to be written down on average by 10 per cent to arrive at a total cost of the crisis more in the order of $250bn”. Well, not all will be held within the money-making institutions, but the figure does give an indication that these losses could easily leave US commercial banks with a net overall loss for 2007.

The Fed reported income before tax at US commercial banks to be $189.3bn in 2006, up from $165.9bn in the year before. But it seems unrealistic to expect that the banking sector will perform as well in 2007 as last year. Faced with dwindling demand for CDOs, the banks are likely to have to keep loans that they previously expected to collateralise on their balance sheet. As it is the end of the cycle, these loans they probably made under relaxed lending standards. In any case, the banks’ response has been to tighten lending standards. Importantly, collateralisation is unlikely to be the same source of additional income given the size of their capital any more. The fee income they get for origination and servicing the loans will be confined to the balance sheet expansion that will be possible at the given capital. Non-interest income grew briskly in 2006 at the highest rate in seven years. Its subcomponent — other non-interest income, the bulk of which is income related to securitisation and investment banking activity — was 27% of revenues last year.

In terms of their capital ratios, US commercial banks appear to be on fine form. Their regulatory capital (Tier 1 and Tier 2) was around 12.5% in 2006, which is well-above the required 8% and still above the 10% which according to federal bank regulatory agency definitions denotes a “well-capitalised” bank. The current report on the state of the whole banking system only goes to Q2 2006, but also showed a strong ratio at 11.73%, although this is the lowest rate since 1999. Meanwhile, neither report provides the actual figure for regulatory capital but it could be inferred to be around $960bn. On the numbers for 2006 profit and the loss of $250bn, referred to above, capital could be undermined by 6%. But even if banks manage to come out in the black in 2007, the capital ratio could continue on its way down as banks are seeing almost no growth in mortgage lending, which enters risk weighted assets with a weight of 50%. The Q2/06 report also stated that, “Higher dividend payouts by larger companies and increases in unrealised losses in available-for-sale investment account securities that reduced the accumulated other comprehensive income component restrained equity growth for the quarter.” And this was well before the current worries surfaced.

The sub-prime/CDO debacle has a real potential to create major stress within the US banking system. It could well turn out that after frantic reassessment of the risk positions across financial institutions globally and further ructions, market players regain confidence of what the true size of the problem is. However, this is likely to take a while. In the meantime, it is reasonable to expect that the liquidity crunch will intensify as both supply and demand for credit suffer. Contagion across asset classes seems likely. Increased liquidity preference will cause the sale of assets, unlikely to be confined to one asset class.

Diana Choyleva