Capital Markets

Tread Carefully

A credit downturn should be familiar territory for banks. Think again.
Economist StaffJune 27, 2008

The credit crunch has been an alien landscape for many banks. Exotic products, new accounting rules and an unprecedented liquidity freeze have left them groping for handholds. The terrain is gradually changing, as attention switches away from falls in the market value of securities and towards actual credit losses. Citigroup expects to see lower write-downs, but higher credit losses, when it announces its second-quarter results in July.

Industry-watchers see some relief in this. “We will all feel more like we are in our comfort zones after a six-month period of firefighting on structured-credit blow-ups,” analysts at Merrill Lynch sighed in a recent note. Not so fast. In Britain and America, the countries with the biggest headaches, the credit downturn has plenty of unfamiliar features.

The scale of the boom that came before it is the most obvious one. Anglo-Saxon consumers are famously carrying record amounts of debt. Exposure to commercial property has also reached disturbing proportions at many banks. The picture is grimmer in America, where concerns about unemployment are greater and consumer confidence is badly dented, but the economic environment is worsening fast in Britain too. “People have to start rebuilding their own balance-sheets,” says Adrian Cattley, an analyst at Citigroup.

Banks are also dealing with new types of borrowing. In Britain untested areas of specialist lending, such as buy-to-let and self-certification mortgages, are coming under stress for the first time. HBOS, the country’s biggest lender, revealed in June that arrears in these asset classes had risen much faster during the first five months of the year than among prime borrowers.

In America worries are focused on home-equity lending, an asset class with more than $1 trillion of outstanding balances. As homeowners fall into negative equity, these loans are the first to suffer, turning from secured to unsecured borrowing. Unlike subprime mortgages, which were sold on to other unfortunates, banks tended to keep home-equity loans on their books. And to get at the collateral, they have to buy out the lenders of the primary mortgage first, an expensive and risky process. Write-offs on home-equity loans are either zero or 100%, says Michael Zeltkevic of Oliver Wyman, a consultancy.

In theory, none of this should change the map that bankers usually follow when the credit cycle turns: tighten lending criteria, make provision for losses and try to stop struggling borrowers from defaulting. In practice, things are now much more finely balanced.

Start with lending criteria. According to the Office of the Comptroller of the Currency, large American banks tightened credit standards for the first time in four years in 2007-08. But tighter credit is making life harder for existing borrowers.

This problem is more widespread in Britain, where variable-rate mortgages have always been more common than in America (even if fixed-rate mortgages have made up ground since the last big property slump in the early 1990s). Analysts at Morgan Stanley reckon that 23% of the total stock of British mortgages by value is due to reset in 2008, against a mere 4% of stock in America last year. But the effects are more acute in America, where higher rates have savaged risky borrowers, who make up more of the market than ever before.

It does not help matters that record fuel costs are also guzzling more of consumers’ disposable income—some think that car-loan defaults may grow as drivers decide to throw their car keys in the same dustbin as their house keys. Inflationary worries are expected to send interest rates higher again (which has also muted hopes of an earnings boost from a steeper yield curve, the difference between long- and short-term interest rates).

It is not in banks’ interests to send their borrowers to the wall, of course, but their ability to be flexible is more limited because of the credit crunch. Higher financing costs on the interbank market make it harder for them to be accommodating to customers. And untapped loan commitments to corporate customers continue to crowd out space on banks’ balance-sheets. Analysts at Citigroup reckon that there is a $6 trillion overhang of committed lending facilities to be drawn down, most of it at more generous terms than borrowers could get now. Bankers report that corporate customers, who know a good thing when they see it, are not interested in refinancing. Lenient loan terms will soften default rates among companies, which are nevertheless expected to rise sharply, but the cost may well be even more abrupt tightening in consumer lending.

Blame the beancounters

Just as mark-to-market valuations fuelled write-downs on securities, so new accounting practices are adding to the pressure on banks’ loan books. In the past, banks used to plump up their loan-loss reserves when times were good, but worries about earnings manipulation in the wake of the Enron and WorldCom scandals put a stop to that. Provisions now have to be inflated in a hurry, which adds to the drag on earnings. In America commercial banks set aside $37.1 billion in reserves in the first quarter of 2008, more than four times the amount tucked away in the same period of 2007. Yet still more needs to be done: the “coverage” ratio of reserves to delinquent loans dropped last quarter, as credit conditions worsened. Procyclical provisioning is the second chapter in the mark-to-market story, says Mark Rennison, the finance chief of Nationwide, Britain’s second-bigger mortgage lender.

It is not all bad news. In both Britain and America the real problems are in the specialist businesses; prime borrowers face headwinds rather than tornadoes. British homebuyers do not face the same steep rises in interest rates that they did during the 1990s downturn. The American housing market is less bad in some places than in others. Banks have been successful at raising capital so far, although that will get harder the more often the begging bowl comes around. But for the first time since the crunch began, you might just prefer to be the boss of an investment bank rather than a commercial one.