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March 20, 2007
Where The Risk Is
And so it appears that the moment of truth is near, when we will finally see beyond the immediate fate of the housing market and determine the magnitude of the collateral damage (no pun intended). I think that there is a consensus that, if the worst is to come, some sort of substantial disruption to financial markets will be in the middle of it all. Nouriel Roubini covers about every inch of territory you can on this theme, even managing to juxtapose Alan Greenspan and Ben Bernanke with foreign-policy neo-conservatives. In somewhat more measured tones, Kash Mansori and Calculated Risk have begun to fret about the potential for spillover into the commercial banking sector. Says Kash:
In my previous post I explained why I think that the quantity of bad mortgages in the US economy may actually be enough to significantly affect the non-performance and write-off rates for the US banking system as a whole. Yesterday, Calculated Risk followed this up with a discussion of why he thinks that the health of commercial real estate loan portfolios may soon suffer the same fate that residential loan portfolios are currently experiencing.
Some of that is not speculation, as this story from own neck of the woods so clearly shows:
The quaking U.S. market for subprime mortgage loans is rattling National City Corp. too.
The parent of National City Bank of Pennsylvania has decided it won't try to sell $1.6 billion in subprime loans after all, due to "adverse market conditions," National City said in a securities filing Thursday. The loans "are currently not saleable at what management considers an acceptable price," the bank said.
Instead, Cleveland-based National City took a write-down of $11 million in February, and sometime this month will return to its portfolio the loans it had intended to sell. "A further write-down is likely," the filing said. Spokeswoman Kristen Adams would not elaborate...
Additionally, National City expects to add "on the order of $50 million" to its reserves for possible loan losses, the filing said.
But here's how the story ends:
National City shares closed yesterday at $35.99, up 30 cents.
Hmm. Frankly, I just don't think the traditional banking sector is where be the dragons. Instead, I worry about the answers to three questions: 1. Will a growing perception of risk begin to choke off lending to investment projects that are otherwise economically viable? 2. Will a growing perception of risk cause businesses to forgo or defer an increasingly large quantity of investment projects? 3. Have hedge funds, private equity funds, and specialty financial corporations become such important parts of the credit channel that there is scant relief to be found from a relatively unscathed traditional banking sector?
To question 1, we have this, from Bloomberg:
Risk premiums on investment-grade corporate bonds are at their highest level in more than three months on concern rising delinquencies by subprime borrowers will slow the U.S. economy...
"This period of volatility is likely to continue as long as there is divided opinion about the magnitude and resulting financial impact of the subprime problem,'' said Edward Marrinan, head of North American credit strategy at JPMorgan Chase & Co. in New York. "Subprime risks and accompanying fears of a spillover into the broader consumer sector are the catalysts for the heightened volatility currently exhibited by all risky asset classes,'' he said in an interview...
The 7-basis-point increase in investment-grade spreads is the index's worst three-week performance since the period ending May 20, 2005, Merrill data show. The increase means a company would pay $70,000 more in annual interest for every $100 million borrowed.
We might hold on to the belief that firms are partially insulated from rising borrowing costs (or restrictions on loan availability) due to the fact the corporate cash-flow to investment ratio remains relatively high...
... but there are two problems with seeking shelter in that picture. First, we have data only through the third quarter of 2006, which is pretty stale information at this point. Second, and more importantly, a high cash-flow to investment ratio may itself be a symptom of business's unwillingness to commit to fixed investment spending.
To question number 3, I have no idea what the answer is. And I wish I did.
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