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Oxstones Food For Thought – October 2010

Why Bank Lending is Not Coming Back Anytime Soon

By Liu-Yue (Louie) Lam, Co-Founder, CEO, Oxstone Capital Management

The Great Recession has caused fiscal strains at all levels of government (local, state, and federal).  Due to low savings rate, the US is heavily dependent on foreign capital to finance its deficits.  However, many G-8 nations are currently exercising global competitive devaluations in a race to the bottom.  This will eventually lead to a period of anti-globalization.  With international investor appetite for more US debt waning, the US government will need domestic investors to buy an unprecedented amount of Treasuries in order to fund record budget deficits.  The Fed has created abnormally wide credit spreads with a very accommodative monetary policy.  In such an environment, banks are encouraged to purchase and hold government debt on their balance sheets, which limits the amount of credit available to the private sector.  This cozy relationship between the government and banks will persist for some time.  Banks do not need to lend.  It is more profitable and patriot for banks to lend to the government rather than to lend to private borrowers.  In addition, the stronger Banks are waiting to be appointed receivership by the FDIC in order to pick up market share simply by acquiring failed banks.  This is a time of – whoever has the most capital and can wait out the storm; will win the game.

Banks are slowly healing but this process will take another 3-5 years.  During this time Banks will continue to slow down lending because they need to reserve precious capital for expected future losses from legacy loans.  The commercial real estate sector is still a slow motion train wreck waiting to happen.  The current extend and pretend policies by banks are delaying the eventual defaults and price discovery necessary to cleanse out the system.  With roughly $1.4 trillion commercial real estate debt maturing in the next five years, and commercial banks accounting for 45% of the CRE market therefore it’s fair to assume the majority of these maturing loans are currently sitting on bank balance sheets.

Commercial real estate properties declined on average -42% from peak to bottom.  Healthy properties on average declined -33% and distressed properties declined on average -56%.  Even if you’re an extreme optimist and assume that all commercial real estate properties were conservatively underwritten at 70% LTV during the past four years, the majority would still be underwater if the average decline was -42%.  However, during the CRE peak from 2005-2007 many commercial real estate properties were aggressively underwritten with little or no equity.  With current interest rates at an all-time low, what do you think will happen to the CRE market once interest rates finally begin to rise?

In addition, the residential real estate sector will most likely experience a double dip due to a massive oversupply of foreclosed properties waiting to reach the marketplace.  Many ARM legacy loans will re-set between 2011-2012 leading to more defaults and bank failures.  There are roughly 8 million homes in the delinquent, default, and foreclosure pipeline, and at current liquidation rates it will take between four to ten years to clear the distressed inventory.

The FDIC is slowly unwinding the banking system through an orderly process of bank closings.  There are currently 700+ banks on the FDIC Troubled Bank Watch List and many will eventually fail over the next few years, which will further reduce the amount of lending capacity in the market.

Lastly, the passage of bank reform/Volker rule and Basel III are leading to higher capital requirements and lower leverage.  The end result is constrained lending activities by banks for many years to come.

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