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Thomas Tan, CFA
Thomas Tan, CFA

High Leverage Has Brought Down the Whole Banking Industry

July 17, 2008 | About:

On Tuesday, as S&P briefly touched $1,200, banking sector represented by KBW Bank Index (BKX) (or other similar indices) went down to $47 (which had been range bound and traded around $75-90 early this year), and VIX reached $30, it seemed that stock market capitulation has materialized like the March plummet. The dropping of BKX index was very severe that it broke my technical target of $55 by $8 points. Now we may see a bear market rally lasting for a few months, similar to post-March capitulation.

I still think Jeremy Grantham's target of $1,100 will be reached sooner than 2010, probably later this year or early next year. I also doubt funds which have withdrawn from the market during the last half year, especially in last several weeks, will re-enter the market anytime soon. The worst case scenario is that they may never re-enter the market at all, especially if they are funds for baby boomers.

There is an interesting book "Bringing Down the House", which turned into a movie called "21". It is about a group of MIT students who were trained as card counters to play blackjack in casinos at Las Vegas. They acted as a group, and played small when the odds were not clear or not at their favor but one of them acting as a super rich person would enter into the table and play huge stake when the odds were at their favor. It is a typical example of using leverage against casinos.

It turns out to be that this highly leveraged technique is also used by banks, especially investment banks. No one is trying to bring them down like in the case of "Bringing Down the House". All the current troubles for this industry are their own making. They can't blame anyone else but themselves. However, now they argue that they need unlimited funding protection and bailout from the government, or more accurately, the taxpayers. Did we ask them to use high leverage? Did they ever share the profit with the public before?

To understand leverage, just look at this WSJ's article yesterday (7/16), LEH market cap of $9B is only 40% of their book value of $23B, and it sounds very cheap. But then look at their assets, they have $160B hard-to-value Level 2 assets and $41B impossible-to-value Level 3 assets. WSJ article applies a 5% haircut on Level 2 and 25% on Level 3 to come up with a $19B future write-offs. However, based on analysis from many other public sources, most of the Level 3 assets are MBS CDOs, even if they are AAA rated, the recovery rate is only about 50%. For Level 2 assets, 10% haircut is actually a conservative estimate. The combination of both will result $36B additional losses, which would more than wipe out their book value of $23B plus their market cap of $9B. This is leverage in the working, unfortunately at the down side.

Let us also look at Fannie Mae and see what the level of leverage they are using. FNM has long term liabilities of about $580B, according to Yahoo Finance. It has a negative duration mis-match of 14 months between its assets and its liabilities. Due to this mis-match, An 1% drop in interest rate will cause roughly 14/12 or 1.17% loss in value, or $7B (1.17% x $580B). And their market cap is only $10B. We are only talking about pure interest rate risk, not even the losses of credit risk from lending practice, delinquency, foreclosure, etc. from the deterioration of the real estate market, which would be much larger than interest rate risk.

People have drawn parallel between the current failure of IndyMac and the failure of Continental Illinois Bank in 1984, with the expectation that IndyMac will cost FDIC about $4B to $8B, when FDIC has only $52B in its insurance funds. But this comparison has missed the whole S&L crisis which losses were much larger than one commercial bank and FDIC was actually not quite involved. For S&L, the Federal Savings & Loan Insurance Corporation (FSLIC) was the show, and it had $5.6B in 1984 to pay claims, by 1989 its balance had turned into an $87B deficit. The total number of failed S&L institutions are estimated to be around 1,000, and GAO (US General Accounting Office) has estimated the total losses for S&L to be $166B for taxpayers.

Today people are trying to estimate how many banks will fail this time. The number probably won't get to the 1,000 mark as in the S&L case, and the figure of a few hundred banks has commonly been quoted. At the end of this crisis, FDIC will be most likely in the red as in the FSLIC situation.

A week ago, Bridgewater Associates has issued a report saying the banking system losses likely to hit $1.6 trillion, but didn't give any breakdowns. This is more than the $1 trillion estimate in my article "Will CDS Replace Subprime To Cause $1 Trillion Total Loss For This Credit Crisis?" in January this year. I actually tried to give a breakdown as follows: $500B for over the counter credit default swaps (CDS), $250B for subprime, and $250B for everything else such as commercial real estate, leveraged loans, credit card losses, auto loans, etc. Due to the deterioration of real estate market and continued losses, I think I underestimated the subprime by about $150B, also I should include some losses for Alt-A and prime mortgages since the losses have already cut into them, especially Alt-A. In addition, CDS has become a larger, deeper and wilder threat to the whole banking system day by day, maybe $1 trillion is a better estimate now. Overall, $2 trillion losses are really not stretching.

So far this year, some financial institutions have touched the single digit territory, such as Fannie Mae, Freddie Mac, Wachovia, Bear Stearns. After the current bear market rally for the banking sector, who would be the next round of candidates to touch and maybe even stay at single digit? It seems that investment banks are still the usual suspects, such as Lehman, UBS, and possibly even Merrill Lynch and Citigroup too.

In order to avoid the domino effect of the current credit crisis to ripple through the whole banking industry, the Fed is currently holding the bag by bailing everyone in trouble out. And so far we are only talking about residential mortgages and their CDO derivatives. If the next wave of credit default swap crisis hits, it would be much wider than LTCM, much worse than S&L, and much deeper than subprime. With raising capital becoming difficult these days, banks have to rely more and more on the Fed with balance sheet of only $800B.


Source: By Thomas Tan, CFA : See his profile at Vestopia

About the author:

Thomas Tan, CFA
Charlie Tian, Ph.D., is the founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

Rating: 3.6/5 (7 votes)


Singleralan - 11 years ago    Report SPAM
Mr. Tan, a certificed financial analyst, has painted an accurate and bleak picture for some of our banks and financial institutions. This is indeed scary because sub-prime and leveraging was a worldwide phenomenon & we the taxpayers and our children are going to have pay for this mismanagement & crap!
Buffetteer17 premium member - 11 years ago
In these electronic banking days, the govt can come up with $800B in a matter of minutes. It's not like they have to crank up the printing presses at the mint. All it takes nowadays is a few keystrokes at a computer and viola, $1000B of fresh new cash. Its magic.
John Krantz
John Krantz - 11 years ago    Report SPAM
buffetteer17 Wrote:


> In these electronic banking days, the govt can

> come up with $800B in a matter of minutes. It's

> not like they have to crank up the printing

> presses at the mint. All it takes nowadays is a

> few keystrokes at a computer and viola, $1000B of

> fresh new cash. Its magic.

We have found the Philosopher's Stone, fiat money. Faust, Part 2, Act 1, Scene 4 (scenes 2 - 4 for proper context). Technology is wonderful.

Sivaram - 11 years ago    Report SPAM
Some of these loss estimates make no sense. One thing people need to keep in mind is that some of the quoted losses include price losses by those who plan to hold the asset. For example, if house prices drop $1000, the loss would translate to billions in losses across every single household in America (including those who have no intention of selling their house.)

In any case, the author says he is estimating $500 billion in CDS losses. Does that make sense to anyone? CDS are zero-sum game so any non-zero loss will have to come from counterparty defaults (i.e. people can't pay what they owe). Does anyone else seriously think we will have $500b losses in CDS?
Commodity - 11 years ago    Report SPAM
I predicted the Debt Bubble one year before it poped.

It was a no brainer .

It was obvious that the lenders had no lending standards.

That leverage was insane .
Kfh227 - 11 years ago    Report SPAM
commodity Wrote:


> I predicted the Debt Bubble one year before it

> poped.


> It was a no brainer .


> It was obvious that the lenders had no lending

> standards.


> That leverage was insane .

I was thinking this about 3 years ago ever since I heard that hte average credit card debt of someone in Boston is $8K. No, I have no source other than my mind, however I would love to re-research this.

Roke6362 - 11 years ago    Report SPAM
Commodity: You certainly did predict it.
Sabonis premium member - 11 years ago
One of our "guru's" Arnold Van Den Berg wrote about the debt bubble back in 2004. Its all on his web site.

I think the debt bubble became common knowledge a couple years ago. The issue was how to invest in stocks that would be immune to the debt bubble/credit crisis.

Alot of people thought they could tap-dance around it and got burned.
John Krantz
John Krantz - 11 years ago    Report SPAM
commodity Wrote:


> I predicted the Debt Bubble one year before it

> poped.


> It was a no brainer .


> It was obvious that the lenders had no lending

> standards.


> That leverage was insane .

Interesting...you might enjoy these quotes from a former commodity trader I have been talking to:

"Before long I was making and losing more money in a day than I had ever made in a year before that. I was hooked."

"..the leverage available is astounding..."

"It's the only game in town where you can walk in with a toothpick and come out with a lumberyard."

"..and you can leverage the hell out of owning the commodity itself if you choose to do so... "

"I wouldn't be tempted to get back into the business in any serious way other than to manage a hedging program for a producer or consumer of agricultural commodities, or some entity that is exposed to risk of interest rate or currency fluctuations. I'm pretty much done being a bookie for speculators."

Wiglebot - 11 years ago    Report SPAM
Here is a short update in Market Watch (see URL below)

"...That left the firms leveraged more than 30 times at the end of 2007, a record, analyst Michael Hecht noted."

the investment banks balance sheets are so complex. Through their complexity theories they helped to figure out how to sell houses to people with no money......but the people with no money never figured out to pay for the houses!

So now they will need to de-leverage in an environment that will have new regulations and where they are not trusted. That's a tall order.

http://www.marketwatch.com/news/story/de-leveraging-slice-investment-bank-profitability/story.aspx?guid={4D1ABFD6-ACDA-4CDF-82EB-BA72F3FAFB41} (too long to tag)

Alanb9 premium member - 11 years ago
wiglebot Wrote:



> long to tag)


go to www.tinyurl.com and give us the results.

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