Unfortunately for those policymakers hoping banks will now repay taxpayer support by lending to boost their national economies, a narrow escape is not the prelude to robust extension of new credit.
The patient may have been resuscitated but is still slumped on his bed in the emergency ward: he is not merrily jogging back to work.
The IMF’s global financial stability report has estimated that total writedowns from the sub-prime mortgage and structured credit disasters will reach $1.4 trillion before this is over, with banks on the hook for between $725 billion and $820 billion of that. By mid October, banks had written off $635 billion, putting maybe 80% of the problem behind them. But they had raised just $420 billion of capital.
That still leaves a gap for government capital to fill – and governments are the only source, with private equity and sovereign wealth funds nursing losses from rescue issues they began a year ago – just to deal with the old problem.
A new problem is looming: higher personal and corporate loan defaults in a global recession. The downturn in the credit cycle is only just upon us. Banks will consume even more capital in dealing with the losses yet to come. So the problems of high leverage, thin capital bases and excessive reliance on wholesale funding still remain almost as pressing for the banks – even after government injections of equity and guarantees of term funding.
Matt King and his fellow analysts at Citi say bank deleveraging has barely begun yet.
They offer a simple diagnosis for how different regulatory and investor pressures on both sides of the Atlantic led to similar outcomes for the global banking industry. In the expansion of the credit bubble, US banks strove to keep their tangible equity to total asset ratios in check by securitizing as much as they could. Unfortunately a big proportion of what they retained turned out to be highly toxic. European banks let their risk weighted assets balloon while trying to keep a better credit quality, though even that proved beyond them as many AAA rated assets turned out to be anything but.
The forecast is now the same in both cases: reduced lending. Statistics on monthly issuance of term and other drawn loans compiled by Dealogic and Citi show the run rate collapsing from a peak of $350 billion in the first half of 2007 to around $60 billion today.
While the financial and currency markets continued to convulse in late October, attention began to shift away from the banks and focus on forced selling by hedge funds where recent performance has been almost uniformly awful. Hedge funds will need to raise more cash to meet rising redemptions and margins. Remember that many banks are hedge funds in all but name.
Is there any type of borrower to which banks might increase lending? Developed world governments spring to mind. Banks’ holdings of government bonds declined markedly as a percentage of their total assets during the credit bubble. And of course government issuance is now set to increase. Already in October, five-year CDS spreads of European governments were showing some signs of the potential stresses of assuming banking system liabilities. Spreads on Germany climbed from 7bp in September to 27bp a month later and UK spreads from 18bp to 43bp. The IIF predicts that the US budget deficit is headed for 6% of GDP in 2009, including a second projected stimulus package. Looming behind all such calculations is the Japanese banking crisis and recession which saw public debt rise by 50 percentage points of GDP from 1997 to the present.
The prospect of banks lending money to governments to help fund their bailouts of banks looks horribly circular and reminiscent of the vehicular finance system that brought us to this point by which banks partially funded SPVs that bought both bank debt and the garbage CDOs of ABS the banks sold them.
On the outside looking in are me and you, the highly leveraged companies bought out by LBO shops in the boom that will soon turn into zombie companies and many large corporations, including car companies, energy and oil companies and retailers, with short-term debts coming due far in excess of their cash reserves.
Demand from borrowers for new loans will diminish sharply in the recession. The problem rests with those that need to refinance. Unless conditions soon change in the debt capital markets, those with undrawn revolving credits will resort to them soon, swelling banks’ balance sheets and further reducing their appetite to lend.
We may still be closer to the start of this problem than the end.