Let’s
take a look at banks, balance sheets credit card growth and other things
through the eyes of Minyan Peter, who “helped build and ultimately ran
a Wall Street asset-backed securities business and was treasurer of a
top credit card company and treasurer of one of the largest banks in
the Midwest.” Many snips of wisdom from Peter follow.


A Bird’s-Eye View of the Credit Conundrum

First,
having been there at the beginning, the genesis of the asset-backed
commercial conduits was regulatory capital arbitrage. Through the
conduits convoluted structures, banks were able to “lend” huge amounts
off-balance sheet and collect fees on no-capital-required lines of
credit. No one - and I mean no one - ever expected these conduits to
move from off-balance sheet back on-balance sheet and I don’t think the
market yet understands the earnings, capital and liquidity impact of
this migration. If you figure you need anywhere from 6-8% capital per
dollar of loans, then a move of $1.0 trln from off-balance sheet to on
requires $60-80 bln in additional equity capital. I don’t know about
you, but I don’t see this kind of free capital sitting around.


…


The
last consumer led recession was around 1990. Since then, the SEC has
placed enormous pressure on the banks to minimize their loan loss
reserves. The SEC hates earnings management and the loan loss provision
has historically been a key way for banks to “save for a rainy day.” I
don’t think the market yet appreciates the fact that banks are
currently provisioned for the top of the market.


….


Finally,
no one is talking about it yet, but I think the market will soon begin
to realize that the credit card lenders have in essence become the
consumer lenders of last resort. As consumers have been shut out of the
mortgage and home equity world, the last available credit is plastic.
One statistic that I have found very troubling is the degree to which
credit card balance growth is running ahead of retail sales growth - a
key sign that the consumer is stretched.


…


Digging even
deeper, you come away with more unanswered questions. First, annualized
net write-offs for the quarter were up 17% - 5.4% of loans versus 4.6%
during the year ago quarter. But behind that, masked by 14% balance
growth, there is a 32% increase in the dollars charged off. Further,
and to me more troubling, Target dropped its loan loss allowance from
8.3% of loans at the end of July 2006 ($501 mln) to 7.4% at the end of
July 2007 ($509 mln). Had Target kept its provision at 8.3% of loans,
the incremental cost would have been over $64 mln or almost 40% of the
pre-tax quarterly earnings of Targets credit card business.
Alternatively, had Target kept its provision at the same 1.8 times net
charge-offs as last year (an 8.3% allowance on 4.6% in net write-offs),
the required ending provision would have been over 9.7% of loans - at
an incremental cost to the company of almost $144 mln all but
eliminating earnings from the credit card operation for the quarter.
Put simply, when measured in dollars (rather than percentages of
balances) Targets nearly flat year-on-year loan loss allowance does
not synch with the increase in loan balances, delinquencies,
charge-offs, and late fees.


And while I have used Target as an
example, I dont think Target is alone. As we have seen already in
other parts of the credit markets, many banks and finance companies are
managing their businesses as if todays increases in credit
deterioration are merely a blip, rather than the beginning of a
broader, potentially more serious, decline. From where I sit, it looks
like it is only going to get worse, and its already in the cards.


-Minyan Peter

Bank Earnings 101

From
experience, I have found that most people are surprised to learn that
banks net income is generally only between 1 and 2% on assets. And
many people are also unaware that banks are generally leveraged 10:1.


So why are these points important?


First,
small changes in interest rates and loan losses have a big effect on
bank earnings. For example, in 2006, BofA had 70 basis points of loan
losses, but in 2002 that figure was 110 basis points a 40 bps
difference. All things being equal, (and ignoring income taxes for
simplicity) if we applied BofAs 2002 level rate to its 2006 results,
earnings would have been 28% lower.


…


Now while it
takes time for higher losses and funding costs to flow all the way
through to the bottom line (not all debt rolls over at once; nor do all
bad credits charge off at once), I hope you can see by this example why
the financial services community is so fixated on Federal Reserve
interest rate cuts. By dropping short term interest rates, the Federal
Reserve helps to offset the impact of higher borrowing spreads and loan
losses. The difference between and a 25 and 50 basis point cut may not
feel like much to you, but when all you’re earning at best is 1-2% on
assets, it is a huge deal.


-Minyan Peter

Bank Earnings 102: The Best of Times, The Worst of Times

As
much attention as they will get, in the bigger scheme of things, their
[the banks’] net incomes this quarter dont matter. And they dont
matter because of one simple rule for financial services firms:


The income statement is the past. The balance sheet is the future.


Let me repeat it again. The income statement is the past and the balance sheet is the future, especially now.


At
the top of a credit cycle, the income statement for a financial
institution shows the best of times, but buried in the balance sheet
is the worst of times to come.


…


History repeatedly
reveals the ability of highly profitable banks to go down in flames.
How many of you remember Texas Commerce Bank AAA at the top, but gone
at the bottom of a severe credit cycle?


Second, one quarter does
not complete a credit cycle. We are at the beginning of a material
economic change. Remember, we have only just seen the first month of
employment decline. Loan loss provisions are predicated on the present
economy, not on possibly better or worse future economies. This
quarters provisions are likely to be relatively light based on the
strength of our current economy. Similarly, any funding cost increases
are just beginning to impact net interest margin.


Go back and
read the 3Q ‘05 financial results for a few homebuilders and you will
get my point. Few reveal any clues to their future demise particularly
the potential for balance sheet writedowns. And I expect the same this
quarter for many banks.


But in much the same way as the housing
industry has taken one-time write down after one-time write down for
land values, I anticipate that we will see increasing loan loss
provisioning by banks as the economy continues to weaken. Remember, the
loans have been made. The only questions now are how severe the
downturn will be and how many borrowers will be affected. If the
housing industrys forecasting prowess is any indicator, I would
suggest we have a long way to go before we see the bottom of this cycle.


…


-Minyan Peter

Bank Earnings 103: Reading Bank Balance Sheets

While
I anticipate that most of Wall Streets attention at the end of the
third quarter will be on bank earnings, for reasons I outlined in
Banking 102, I strongly recommend that you focus on bank balance
sheets. From experience, changes in bank balance sheet composition are
much better predictors of future earnings than current period income
statements.


So where do you start?


First, I would look at changes across the four different major investment/loan categories.


In
investments held for trading, I would look for a significant overall
balance reduction and an upgrading in quality. Both would be
indications of a reduction in overall market risk appetite and a
willingness to allocate capital to volatile capital markets and
related businesses.


In investments held for sale, I would also look for a reduction in balances. As I mentioned in Whispers from the Confessional,
I expect that you will see many financial institutions reducing their
available for sale assets given the decline in secondary market
liquidity. Watch as to where the assets went. There should be
associated disclosure if the assets were moved into portfolio. And
remember that once in portfolio, the accountants make it very difficult
to move them back out to held for sale. So these moved assets will
have to be funded through to maturity.


Associated
with the loan portfolio, I would also review the loan loss allowance.
Material changes in the allowance ratios (provision to charge-offs and
provision to loan balances) are warning signs. So too are increases in
loan portfolio delinquency statistics. Remember, credit cycles play out
over a long period of time.


-Minyan Peter

Coming Bank Themes: Whispers From the Confessional

Thanks
to the annual Lehman Brothers (LEH) Financial Services analyst meeting
this week we have some early clues on banking results for the quarter.
Based on the presentations I have read, as well as related press
releases, here are some themes that I think you will see at the end of
the quarter.

• First, expect a massive migration of held for
  sale assets, particularly non-conforming mortgage assets, into held
  for investment or loan categories. Some may even, as Washington
  Mutual (WM) did, try to portray it as opportunistic portfolio growth.
  But the reality is that the only way banks can avoid significant
  mark-to-market losses on mortgages they intended to sell, but cant, is
  to move them into portfolio. And, remember, once these loans are in
  portfolio, related loan loss provisions are required. So you should
  expect higher provisioning even without any deterioration in credit
  quality, just due to forced balance sheet growth.
• Second,
  expect fair value write-downs on assets held for sale. As I wrote in
  Banking 102: The Best of Times, The Worst of Times, please remember
  that these write downs wont flow through the income statement, but
  through Comprehensive Income. Look, too, for changes in the composition
  of banks investment portfolios. I expect that you will see highly
  liquid securities swapped for conforming mortgage securities. And with
  the run up in Treasury prices, I expect that banks with long maturity
  Treasuries in their investment portfolios have sold them wherever they
  can to book gains this quarter.
• …
• Finally, expect higher provision forecasts due to both forced balance sheet growth and deteriorating credit quality.

For
example, at the Lehman Conference, Washington Mutual announced that it
now expects a $2.2 bln provision for 2007. $2.2 bln is $500 mln more
than it forecast in July and well above the $1.3 -$1.5 bln it forecast
in April when it said that its provision forecast was our best
thinking regarding trends in loan delinquencies, foreclosures and
housing valuations at this time. WaMus latest forecast is also almost
2.5 times what it shared in its 2007 earnings outlook ($850 -950 mln)
in October 2006.


-Minyan Peter

Thanks Peter!


A differing opinion can be found in Financial Sector: The News vs. The Numbers

We see three factors that could make XLF a very attractive investment for the second half of the year:

• Earnings estimates are risingnot falling.
• Actual results are strong.
• XLF is cheap.

I
am betting on the comprehensive analysis of Peter vs. opinions that
earnings are going to rise. A focus on PEs ignores leverage, increasing
write-offs, and balance sheet conditions. A compelling case has been
made that we are at the top of the credit cycle which 100% of the time
has spelled problems for the financial sector and stocks in general.


It
is important to remember that the Financial sector is 20%+- of the
S&P by weight and and that does not even count quasi-financial
companies like GE and GM, heavily dependent on financing operations for
earnings.

Chris Puplava on Financial Sense is asking Will Financials Be to This Bull Market and Economy What Tech Was to the Last?

Secular
shifts in a sectors predominance in the S&P 500 can be seen in the
figure below that highlights three different sectors that have had
their period to shine.





Energy
was the top performing sector in the S&P 500 [in 1980] with the
sectors weighting increasing substantially as investors chased the
returns being made in the sector. However, as more energy supply came
onto the markets at a time of falling demand due to high oil prices,
the bull market in energy came to an end.


The next major bull
market in U.S. stocks was seen in the technology sector in the 1990s.
Near the start of that decade, technology represented roughly 6% of the
S&P 500 and vaulted to a zenith near 33% by the end of the century.
However, overcapacity and excesses in the industry ultimately deflated
the bubble in which the technology weighting in the S&P 500 fell in
half to roughly 15% seen at the bottom of the last bear market.


As
mentioned above, there are fundamental factors that often lead to
secular shifts in sectors, and the predominant factor that has led to
an increase in the weighting of the financial service sector is the
price of the commodity it sells — credit. Since 1980 there has been a
secular bull market in paper assets as interest rates and inflation
have fallen. As interest rates reflect the cost of credit, falling
interest rates have led to an increase in the demand for credit as it
has become cheaper to borrow, which has fueled the growth within the
financial sector.

Chris goes on to compare mass layoffs in
the technology sector in 2000 with mass layoffs in financial services
today. Here is an interesting chart from his article.





Chris has many other interesting charts in his article.

I encourage you to take a look.


The Quarterly Banking Profile Second Quarter 2007 shows that loan loss provisions are rising while higher expenses are holding down earnings.

Insured
commercial banks and savings institutions reported $36.7 billion in net
income for the quarter, a decline of $1.3 billion (3.4 percent) from
the second quarter of 2006, but $772 million (2.1 percent) more than
they earned in the first quarter of 2007. The decline in earnings
compared to a year ago was caused by higher provisions for loan losses,
particularly at larger institutions, and by increased noninterest
expenses.


Insured institutions added $11.4 billion in provisions
for loan losses to their reserves during the second quarter, the
largest quarterly loss provision for the industry since the fourth
quarter of 2002.


Net charge-offs totaled $9.2 billion in the
second quarter, the highest quarterly total since the fourth quarter of
2005, and $3.1 billion (51.2 percent) more than in the second quarter
of 2006. This was the second consecutive quarter that net

charge-offs have had a year-over-year increase.


The
amount of loans and leases that were noncurrent (loans 90 days or more
past due or in nonaccrual status) grew by $6.4 billion (10.6 percent)
during the quarter. This is the largest quarterly increase in
noncurrent loans since the fourth quarter of 1990, and marks the fifth
consecutive quarter that the industrys inventory of noncurrent loans
has grown. Almost half of the increase (48.1 percent) consisted of
residential mortgage loans.

The balance sheets and loan
loss provisions of large cap financials like Citigroup (c), JPMorgan
(JPM), Washington Mutual (WM) , Bank of America (BAC), and even smaller
banks like Corus (CORS) will be interesting to watch as the credit
bubble pops.


Most importantly, the answer to Chris Puplava’s
question is “Yes”. Many signs are in place for Financials to be to This
Bull Market What Tech Was to the Last.

Originaly from Source