Whenever there’s a banking crisis, there seems to be a very good chance that preceding it came some kind of property bubble. Banks have a habit of assuming that secured loans are secure loans, and loaning out enormous chunks of their balance sheets to property owners — if the property market crashes, banks can be left in a world of pain.
The problem is that banks never want to turn down large quantities of profitable business, and during a housing boom, mortgages are both profitable and very numerous. If they’re not careful, banks end up with an uncomfortably large proportion of their assets in real-estate loans.
Kash Mansori put a very good post up yesterday entitled “Can Banks Weather the Real Estate Storm?”. He’s relatively sanguine about their financial strength: here’s his conclusion.
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.
I look at the same data as Kash and am actually even more constructive. For one thing, Kash includes about $1 trillion of mortgage-backed securities among banks’ real-estate assets. That’s fair enough, but he doesn’t make allowances for the fact that most of those bonds are issued by Fannie and Freddie, and therefore very, very safe; a lot of the rest are likely to be AAA-rated too. So the risky part of banks’ real-estate exposure is certainly smaller than Kash lets on.
Kash also uses a chart of bank equity divided by banks’ total real-estate exposure — a ratio currently standing at about 23% — to conclude that “the huge amounts of capital that banks have at their disposal right now are not that huge compared to their real estate exposure”. I don’t know how he comes to that conclusion, however: the 23% figure seems pretty large to me. I have a feeling he’s looking not at the number, however, but at its first derivative: back in the late 90s, the number was almost 26%. But if the number’s high, it doesn’t really matter if it’s falling, and the propensity of banks to lend to businesses rather than into real-estate in the late-90s shouldn’t be held up as some kind of really great idea. After all, the very next chart from Kash shows banks’ loan write-offs soaring a couple of years later when all those non-real-estate loans went bad — and remember that recovery values on unsecured loans are always much lower than recovery values on secured loans.
Kash reckons that real-estate-related write-offs in a housing downturn could reach $50 billion per quarter, or $200 billion per year. Let’s look at Kash’s own numbers: total residential real-estate exposure is $1.89 trillion. Let’s call it a round $2 trillion if you include risky MBSs. Let’s say that overall delinquency rates reach 10%, and that 30% of delinquent loans go into foreclosure. Let’s further say that the bank takes a loss of 10% on non-foreclosed delinquent loans, and a loss of 50% on foreclosed delinquent loans. (I’m taking all these numbers from the top of my head, so do feel free to offer something more realistic.) Then you have $200 billion of delinquent loans, which suffer a total of $30 billion of losses on the foreclosed loans, and another $14 billion in losses on the non-foreclosed loans, for a total of $44 billion. How Kash gets to $200 billion, I have no idea.
In other words, the banks are fine. And we don’t need to worry about a credit crunch.