Financial Losses Continue to Mount with No Bottom in Sight

As we enter the second year of crisis within the credit markets all is not well now for banks and government-sponsored enterprises (GSEs), specifically Fannie Mae and Freddie Mac. Last month, the U.S. Treasury was granted the power to extend its credit lines to the GSEs

and to invest in their debt and equity if necessary. Amid many reports of the growing likelihood of a government bailout, which would wipe out the equity holders, the stocks have been at the mercy of unrelenting selling pressure and are both down more than 90% since their August 2007 highs.

Given current real estate values, Congressional oversight committees estimate the losses for Fannie and Freddie to be about $25 billion. That’s with a “B” for billions. But with those values continuing to sink, the loss estimates continue to rise. Adding fuel to the fire is an economy not recovering, leading to independent (from government) estimates that are double or more relative to those out of Congress. As noted by John Mauldin in his Thoughts from the Frontline newsletter, “There is $36 billion in preferred shares as of June 2007. Then there is $19 billion in subordinated debt. These firms back $5.2 trillion in mortgage securities. As an aside, that means even a 1% loss from foreclosures would mean a $50 billion portfolio loss.” And, none of this includes the estimated $62 trillion in credit default swaps written against Fannie and Freddie debt (12 times the actual debt), with nobody knowing who is on the hook for these derivatives.

Stanley Fischer, the governor of the Bank of Israel recently said, “There is enormous uncertainty about where we stand at the moment. We are in the midst of the worst financial crisis since World War II.” He added that the credit crisis is entering a “second round” in which economic and financial weakness could feed on each other.

Although successful capital-raising has so-far offset losses the financial institutions have incurred from write-downs (which now total more than $500 billion), that capital has largely been in the form of hybrid securities with both debt and equity characteristics. As a result, Standard & Poor’s notes that “the quality of banks’ capital has eroded somewhat.” And this says nothing about the regional banks, about which we’ve expressed concern during the past year. Their ability to raise capital is significantly constrained relative to the larger commercial banks.

Credit losses and their impact have migrated from subprime into nearly all segments of household finance (like credit cards, auto loans and even prime mortgages). Standard & Poor’s now expects losses on the books of U.S. banks to reach $285 billion a year for the next two to three years.

The Federal Deposit Insurance Corporation (FDIC) said recently that its list of “problem” banks at risk of failure had grown to 117 at the end of June, up from 90 at the end of March, with the troubled lenders having combined assets of about $78 billion. Indeed, there are more than 8,000 banks nationwide, so 117 is not a big number, but remember, IndyMac Bank (which failed a few months ago) had $32 billion in assets and cost the FDIC $4 billion to $8 billion, wasn’t on that list, highlighting that failures can happen quickly and without much warning. Industry-wide, bank earnings plunged 86% from April to June this year.

FDIC Chairwoman Sheila Bair said the agency might have to borrow funds from the Treasury Department to see it through an expected wave of bank failures. As many banks juggle to pay the floating-rate notes, profit margins are likely to continue to suffer as investors demand higher rates for new borrowings. Banks are becoming less and less willing to make new loans as a result, only aggravating the economic woes.

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