Wednesday, June 25, 2008

US Banks and the perfect storm

US Banks are in for the perfect storm ahead. Never mind the fact that the sluggish economy means there isn’t much new business going the way of banks. I say the prospect of credit defaults alone will cause much more pain for US banks in the months to come.

After the storm, who will disappear, who will be left standing? That’s an interesting question. But who does disappear depends on how heavily their asset base and financial performance are affected by the elements of this perfect storm. Here are those elements:

By now, everybody knows all about sub-prime. This was where the banks’ trouble started. At the beginning, the weakest link always breaks first. Banks who aggressively lent to sub-prime borrowers were the first to swallow asset write-downs and write-offs.

At the same time that US banks and consumers were reeling from the credit crunch brought about the by the sub-prime mess, along came inflation. Brought about by robust growth and infrastructure development in the developing world, basic commodities such as energy, minerals, and food suddenly became scarce.

With inflation, cost inputs rise. So along with the sub-prime sector, the next tier of borrowers will break. The small and medium scale businesses are the most affected by the spectre of inflation. They are the next likely candidates for credit default, if inflation continues inching upwards. Which banks are most exposed to this sector?

If and when more business fail because of inflation, we will see the effects of recession spread towards the greater economy. As more people lose their livelihoods, less consumer spending means less money pumping the general economy, the more businesses will be put at risk, and on back to consumer livelihood risk.

Banks heavily exposed to the consumer segment will suffer most in this stage.

As more borrowers default, credit providers will resort to ever tighter lending standards. Liquidity will further erode, and interest rates will rise. Rates could go so high that even the most credit-worthy borrowers will now feel the heat.

These credit-worthy borrowers are usually corporate and institutional borrowers allowed to borrow heavily on their balance sheet. These are the institutional investors, private equity and hedge funds, as well as the largest cash-generating companies.

Money lent out will be called by the lenders. What happens to money lent that had been re-lent? In these instances, will there be a multiplier effect on margin calls? After all, the beauty of the banking system is to grow the economy by making money available to a greater number of borrowers, right?

So if a margin call by a primary lender results in a call by sub-lenders down the line, will we see more calls than there is money available? What happens when the “coiled spring” of capital expansion ricochets backwards?

The spectre of inflation means that a Fed rate increase is always just around the corner. A rate increase just when liquidity is disappearing? Just when there are more calls than money available?

Also, some government policy advisers are advocating a tax on oil and gas consumption. Is this tax applicable to all users, including businesses already reeling the from already high oil cost? If this tax is indiscriminately applied to all users, prepare for business closures, and perhaps, even more bankruptcies.

Because banks trade with each other all the time, they have numerous ongoing financial contacts with one another. If a major financial counter-party fails, guess what happens to the entire financial system?

And yet with the current environment, a major bank failure seems just around the corner.

Lastly, it always helps if speculators hasten the inevitable by betting on the direction of the perceived inevitable. If enough hedge fund managers believe a bank is likely to fail, large bets that go against the open positions of the bank in question will always ensure that said bank ultimately fails. Remember Long Term Capital.

The hedge fund phenomenon is proof that while liquidity is getting dry in some parts of the market, there is still enough capital in the market flowing to those poised and well-positioned to profit the most from the depressed environment.

Update: Similar-themed post here.

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