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Analysis and Outlook
By Victor Valdivia, CPA, Ph.D., NYSSCPA Banking Committee Chair
Posted on 9/4/08
NEW YORK -- Credit crunch. Sub-prime. Foreclosure. These words have now become part of daily conversations. Hardly a day goes by without another headline on the financial crisis that started last August.
On the 1-year anniversary of this crisis, it is worthwhile to pause and ask: How did the crisis start? What else may occur as the crisis unravels? How long will it last?
To tackle these questions, the NYSSCPA Banking Committee invited Barry Korn, vice president of Webster Business Corporation, a division of Webster Bank; and Konstantinos Papakonstantinou, analyst with the hedge fund Locust Wood Capital, to share their views on the crisis.
The Makings of the Crisis
There has been a lot of finger-pointing towards the cause of the crisis. An oft-cited reason is that interest rates were too low for too long in the aftermath of the previous financial crisis -- the bursting of the dot com bubble. Although this could have contributed to the current situation, it is doubtful that this alone could have caused the crisis. Several other factors need to be looked at.
Securitization, the practice of bundling together loans and packaging them into securities sold to investors, certainly played a role. It did not help matters that this practice was misused and perhaps even misunderstood.
Lenders lowered lending standards as investors stood ready to buy even the lowest-quality loan packages. One of the drivers behind such strong investor demand for these securities was that they were perceived to carry low risk. However, these securities -- that go by names such as MBSs (mortgage-backed securities), CDOs (collateralized debt obligations), CDO-squared, and SIVs (structured investment vehicles) -- ended up carrying more risk and resulted in substantially higher losses than investors had previously anticipated.
Yet this strong demand by investors, even for low-quality loans, fueled the deterioration of loan quality, which is driving the higher loan defaults we are experiencing today.
Another factor behind today’s crisis is the high rating that many of these securities attained initially, as well as delays in their downgrades once it started to become evident that they carried more risk than initially thought.
“If rating agencies had not given many of these securities such a high rating initially, many institutional investors would not have purchased them,” said Howard Gluckman, former Banking Committee chair.
Once it became evident that many of these securities carried more risk than originally thought, buyers of the securities fled, and the markets in which such securities trade froze -- this is the “credit crunch.”
One of the features of the onset of the crisis was the lack of early warning signals. Barry Korn provided some explanations for this.
One reason is that many banks had eliminated their work out departments, because banks found ready buyers for even their weakest loans, he said. A second reason was the widespread use of covenant-lite loans, or loans with few or no covenants: “With no covenants, there would be no default triggers,” Korn said. A third reason was the “payment-in-kind” feature of many loans, which allowed borrowers to add to the principal due on a loan if they chose not a make an interest payment due. All these factors masked the underlying problems with many borrowers and contributed to the sudden market freezes.
What Is Still to Come
The credit crunch, or lack of liquidity in capital markets, was quickly felt by lending institutions, investment banks and private equity firms, as all these firms held assets that could not be re-sold. Many of these firms are now busy raising capital to replenish their equity.
Korn’s view is that “the credit crisis has only recently begun to trigger a deluge of negative consequences.”
One indication of this is the overall decline in credit available to all borrowers, not just to homeowners. Declines in credit available to students, car buyers and those who want to lease cars have been reported. Borrowers have also experienced cuts, or even eliminations, in their available lines of credit. Firms in distress are finding it particularly hard to obtain financing.
Along with the tightening of available credit, there is an increase in lending standards, or rather a return to the lending standards of the past that had been abandoned in the last several years. Lenders today are examining collateral more closely and are also re-introducing covenants. Overall there is evidence that loans are harder to get today.
This reduction in credit and increase in lending standards is also raising the cost of borrowing. Borrowers today have to undergo a deeper examination that they did in the last couple of years. Some firms are even resorting to hiring consultants to assist them through the process.
Clearly, the decline in available credit and the higher costs of borrowing, for all types of borrowers, will have a negative impact on the overall economy.
The Way Out
There are several things that need to occur as we work through this crisis.
Principally among these is the need for borrowers to cut back their debt. In addition, investors will need to recognize losses and lenders will have to return to solid lending practices. All this, Korn said, could take “a few years”.
A significant valuation gap also needs to be closed. Today there is significant disagreement on the valuation assigned to loans, securities backed by loans, and the shares of financial companies. Large discrepancies in valuations assigned by buyers and sellers to the same asset can lead to declines in trading volume and/or increases in price volatility when trading does take place.
Papakonstantinou presented the cases for the bulls and bears.
Bulls believe that accounting markdowns disproportionately penalize banks, as they believe that asset impairments are temporary and will be eventually reversed, that valuations already reflect worst case scenarios, and that there is an excess of short interest that will eventually have to be closed out, Papakonstantinou said.
Bears believe that house prices will drop further, said Papakonstantinou, perhaps to 40-50 percent from their peak, compared to the more common assumption of 20-25 percent. Loan default rates, foreclosure, and recovery assumptions will also need to be revised downward, he said, and homeownership will decline from 69 percent in 2006 to a mid-1990s level of about 64 percent.
Bulls and bears have a lot of conviction and there are well-known and well-respected investors on both sides. Such disparity of views drives the extreme volatility we observe in today’s stock markets. For example, in mid-July, shares of Washington Mutual dropped 35 percent in a single day and Bank of America shares increased 80 percent in one week.
Other things Papakonstantinou said to look out for as we emerge from this crisis include a decrease in housing inventories, an improvement of credit spreads, and the stabilization in foreclosures, delinquencies and net charge-offs. Overall, there is much damage to be undone from the factors that led us into this crisis. This will take time to work through.
The annual FAE Banking Conference on Sept. 25 will highlight key topics on credit markets, valuation, rating agencies, as well as other topics of interest to CPAs, controllers, CFOs, auditors, regulators, and bank and financial institution employees who want to keep up with the latest in bank accounting, auditing, and tax matters.
NYSSCPA Banking Committee Chair Victor Valdivia, CPA, Ph.D., is the CEO of Hudson River Analytics Inc. and can be reached at v.valdivia@gmail.com.
