This is a guest commentary by Christopher Whalen. It was originally posted on Institutional Risk Analyst.
Source: Michael Sonnabend
New York --- Mohamed A. El-Erian’s day job is Chief Economic Adviser at Allianz, but he is also a key indicator – a canary – for the financial establishment. In his latest post on Project Syndicate, “America’s Confidence Economy,” El-Erian states the obvious, namely that the financial bubble created by the election of Donald Trump is deflating.
“[S]entiment is not always an accurate gauge of actual economic developments and prospects,” he says with considerable understatement. This is a nice way of stating that the Trump bubble in US stocks is an anomaly and that markets will soon reflect the underlying fundamentals. In his public pronouncements, Mohamed El-Erian is a polite but powerful indicator of directional change in the global political economy.
That said, the near-term surge in prices for stocks and corporate bonds since last October is modest compared with the vast asset bubble encouraged by the Federal Open Market Committee (FOMC) under the Chairmanship of Janet Yellen. Going back to the turn of the 21st Century, the US economy has been lifted and nearly ruined by a series of Fed-induced financial bubbles, manic events encouraged and driven by policy actions in and omissions by our platonic guardians in Washington. Because of what policy makers have done, and what they have failed to do, to paraphrase the Penitential Act, markets have soared and plummeted, but with little or no value in economic terms resulting.
The dot.com mania was followed by the Y2K hype fest, each of which encouraged short-term investments that temporarily boosted growth, followed by a sharp decline in demand and asset valuations. Later, in the 2000s, a vast credit bubble was created in residential real estate, encouraged by the earlier acts and omissions of the Clinton White House and Congress, and fueled by hyper-low interest rates c/o the FOMC. Since 2010, a similar sized bubble has grown in commercial real estate, commodities and consumer lending, in particular auto loans, that now threatens investors, auto makers and banks with significant losses over the next several years.
Let’s recall the mini-dip recession that began at the start of 2001, when GDP change slipped into negative territory and credit losses for major US banks began to rise. By the time of the September 11, 2001 terrorist attack, the US economy was already well on its way to recession. The Federal Open Market Committee took the effective federal funds from 6% at the start of 2001 to 1.8% by the end of that terrible year.
Spurred by the 9/11 attacks, the FOMC under Ben Bernanke put the proverbial pedal to the metal. The Fed kept the effective fed funds rate below 2% until the summer of 2004, by which time the residential real estate boom and related Wall Street machinations were running wild. The fed funds rate rose to 5% by June of 2006, but not in time to prevent names like Countrywide Financial, Washington Mutual, Wachovia, Citigroup (C) and the GSEs from failing 18 months later.
As readers of this blog will recall, in 2005 we noted that both Countrywide and WaMu were reporting negative default rates, this just as the FOMC began to try to throttle down the economic reactor. When a large bank tells you that extending credit has no or even negative cost, you know that bad things are about to happen.
Big Credit Canary: Citigroup
Among large cap financials, the key crisis bellwether for those of you who read The Institutional Risk Analyst a decade ago was Citigroup. Citi is the outlier among large banks. It saw credit losses almost double during 2001 even as the rest of the large bank peer group remained relatively normal. This idiosyncratic skew in the gross credit losses of one of the largest US banks presaged the bank’s failure just six years later. The chart below illustrates that period and also suggests just how much more risky is the credit profile of Citi compared with other large banks.
Source: FDIC
Even today, the relatively elevated credit profile of Citi’s customer base is reflected in a gross loan charge-off profile that at 126bp at the end of 2016 is more than a standard deviation higher than the average for the large bank peer group. Loss given default (LGD) for Citi is almost 80%, again far higher than large cap asset peers like JPMorgan (JPM) and Bank of America (BAC). Indeed, Citi in credit terms is really more comparable to below-prime lenders such as CapitalOne (COF) and HSBC (HSBC).
The 126bp of default reported by Citi in 2016 maps out to roughly a “BB” credit profile for its portfolio, again reflecting a deliberate business model choice that has selected a below-prime business as the bank’s model. COF, by comparison, reported 265bp of gross defaults at year-end 2016, roughly a “B” credit profile. COF’s loan loss rate is more than three standard deviations above the large bank peer group with an LGD of 77%, according to the TBS Bank Monitor.
Of note, COF showed a risk-adjusted return on capital of just 1.6% at year end ‘16 while Citi reported a RAROC of 3.8%. Since the nominal cost of capital for most large banks is well into double digits, you may be wondering why these banks are still here. Indeed, most large banks don’t earn their cost of capital, either in nominal or risk adjusted terms. But it is only when you look at these banks based on RAROC that you understand that the big zombie banks are perennial value destroyers. Smaller regional and community banks, by comparison, routinely earn double digit real, risk-adjusted returns on capital.
As in the early 2000s, today the relatively higher risk credit profile of Citi is an important indicator for what is happening in and around the US economy. Press reports regarding the rising level of defaults in the auto loan sector, for example, suggest that both gross losses and LGDs for all US banks are likely to rise over the next several years.
But for Citi, due to its higher internal targets for credit loss rates, the bank is likely to feel the pain of a deteriorating economy earlier and to a far larger extent than its peers. Have a look at Page 12 of Citi’s most recent Y-9 performance report published by the Federal Financial Institutions Examination Council (FFIEC) to get a real sense of just how different this bank is from the other members of Peer Group 1.
U.S. Banks: "The Dramatic Shift to Real Estate Risk"
Citi is particularly exposed to a downturn in corporate credits in the commercial and industrial (C&I) sector, not only because the bank has a relatively high LGD rate (60bp) on its loans but also because of the large amounts of unused credit available to the bank’s customers (50bp).
The classical Basel measure for “exposure at default” (EAD) for Citi is the highest in the large bank peer group at almost 200%, meaning that on average C’s customers can access another $2 in credit for every dollar of loans currently drawn. Today Citi’s credit exposure in the event of customer defaults is two standard deviations above its peers, but to be fair the bank’s EAD was even higher – nearly 300% – before Citi failed in 2008.
The key credit issue facing many US banks in 2017 and beyond is commercial loans and related commercial real estate credits. At present, one quarter of Citi’s loan book is in C&I credits with a gross spread of just 160bp vs almost 300bp for its real estate loans. By comparison, Bank of America has a cross spread on its C&I portfolio of 227bp, JPMorgan is 264bp, US Bancorp (USB) is 260bp and Wells Fargo (WFC) is at 380bp, a stark illustration of just how aggressive Citi has been in pricing its business loans.
Citi’s equally large credit card book – in nominal terms the most profitable part of the business – has a gross spread of almost 1,100bp, but also reported over 300bp in defaults in 2016. Still, with a 800bp net margin before SG&A, credit cards are Citi’s best business. Indeed, Citi’s payment processing and credit card business are the crown jewels of the franchise. If there were some way to sell the rest of the Citi operations, the payments processing and credit card business could be worth a multiple of Citi’s current equity market valuation.
The trouble with Citi and many other US banks is that their business are dominated by consumer credit and real estate exposures, with little in the way of pure C&I loans. When you look at most US banks, the vast majority of the exposures are related to real estate, directly or indirectly. Thus when the Fed manipulates asset prices in a desperate effort to fuel economic growth, they create future credit problems for banks. As our friend Alex Pollock of R Street Institute wrote in American Banker last year:
“[T]he biggest banking change during the last 60 years is… the dramatic shift to real estate finance and thus real estate risk, as the dominant factor in the balance sheet of the entire banking system. It is the evolution of the banking system from being principally business banks to being principally real estate banks.”
So whether a bank calls the exposure C&I or commercial real estate, at the end of the day most of the loans on the books of US banks have a large degree of correlation to the US real estate market. And thanks to Janet Yellen and the folks at the FOMC, the US market is now poised for a substantial credit correction as inflated prices for commercial real estate and related C&I exposures come back into alignment with the underlying economics of the properties. Net charge offs for the $1.9 trillion in C&I loans held by all US banks reached 0.5% at the end of 2016, the highest rate since 2012.
In New York City, for example, the term “overbuilt” does not begin to describe the situation in the commercial real estate sector. Rental rates for residential and commercial properties are falling. And more capacity in multifamily, office space and even hotels is coming to market in New York over the next several years.
Jonathan Miller of Miller Samuel has been chronicling the travails of the high end condo market in New York, where only sharp price cuts and incentives have been successful in moving the rising amounts of inventory. He writes about the iconic One57 West 57th Street skyscraper:
“When we talk about super luxury condos in Manhattan, One57 is top of mind. After years of slow sales, and no sales in the first half of 2016, they saw a surge in activity at the end of 2016. This bump was likely not related to improving market conditions but rather the introduction of their lower priced former rental units priced closer to current market conditions.”
So if you want a good bellwether for what is going on in the world of large C&I and commercial real estate loans, keep a close eye on Citi – the clear outlier among the large US money center banks. In terms of the pricing of its loans, its loan default rates and key operational credit metrics such as loss given default and exposure at default, Citi is easily one of the most aggressive banks in the top 10 US banking institutions by assets.
When the impact of the deflating Trump bubble, rising interest rates and ebbing exuberance among investors starts to really bite on US lenders this year and next, the pain will be visible earlier and in larger proportion at Citi than at its large cap peers. Citi is, as it has always been, the proverbial canary in the coal mine of finance.
EDITOR'S NOTE
This Hedgeye Guest Contributor piece was written by Christopher Whalen, author of the new book Ford Men Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington. This piece does not necessarily reflect the opinion of Hedgeye.
