Wednesday, March 21, 2007

Can Banks Weather the Real Estate Storm?

Next in my series of posts on the potential impact that the housing downturn might have on the health of the US banking sector (see here and here for previous entries on this theme), I'd like to take a look at the question of how well banks are equipped to handle losses due to mortgage defaults.

Banks constantly face the possibilities that the loans they've made might not be repaid by borrowers. That's part of the risk of being a bank, and loan defaults happen to some degree even in the best of economic times. As a result, banks need to have sufficient capital to be able to weather those losses, honor their own committments (the most important of which is to repay people who've deposited their money), and still have something left over to lend out to future borrowers.

At first glance, it looks like banks are in excellent financial shape right now. Due to a series of regulatory and financial changes over the past two decades, banks have substantially increased the amount of capital supporting their activites.

The most recent data (from the Federal Financial Institutions Examination Council, via the excellent St. Louis Fed data site) shows that the US banking system has close to $1 trillion in equity capital to support their activities. Everyone (including me) would agree that banks seem to be very well capitalized right now.

(By the way: does anyone have an explanation for the seemingly discontinuous jump in bank capital between Q2 and Q3 of 2004? I'd be curious to learn the explanation, if there is any.)

The problem is that the amount of money that banks have loaned out for the purposes of buying houses has also risen dramatically in recent years. When we look at the ratio of bank capital to the real estate loans that banks have made (including both direct loans to borrowers, as well as indirect lending through the purchases of mortgage-backed securities), the amount of capital that banks have stockpiled in recent years doesn't look quite as unassailable.

This picture does not make the banking sector look weak, but it does remind us that the huge amounts of capital that banks have at their disposal right now are not that huge compared to their real estate exposure. Furthermore, the ratio has been creeping down in recent years. Banks have less capital supporting the loans they've made for real estate than they have at any time since the early 1990s.

One last point to consider is how many losses it might take to put a real scare into banks, causing them to curtail their lending. It turns out that, based on past experience, those losses may not have to be all that big before banks change their behavior.

The last chart shows that the financial losses (i.e. loan write-offs) suffered by the banking sector during the 1990 housing bust and subsequent credit crunch were only on the order of $10-$15 billion per quarter above and beyond the usual rate of loan write-offs. Yet those losses were enough to trigger a well-documented credit crunch that contributed substantially toward the recession of the early 1990s.

Similar write-offs today (relative to the banking sector's available capital) would be on the order of about $50 billion in extra losses per quarter (pushing total loan write-offs to maybe $70 bn per quarter). That's a lot of money, and would only happen with a truly massive wave of mortgage defaults -- something that may or may not happen, but unfortunately is certainly much more possible than I would like.

The more likely (and dangerous) problem would be if the economy turns sour more generally, so that banks have to absorb losses due to recession (like they did in the early 2000s) on top of a wave of mortgage defaults. Those two forces together could easily push quarterly loan write-offs well into the danger zone. That to me seems to be the biggest potential danger.

My conclusion is this: banks are reasonably healthy, though perhaps not as healthy as you might think; it will take a really big wave of mortgage defaults to hurt them significantly, though, unfortunately, not one that is beyond the realm of possibility given the current state of the housing market and household finances; and if the economy slows down more generally at the same time that the mortgage default rates climb significantly, it seems very possible that banks could be in for a rather rocky period.

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