Traders Forecast Banking Stress to Last to End of 2010

The Financial Times reports that despite the snappy rally in bank stocks in the US, which may have been partly fueled by short covering, money market traders expect banks to face rough sailing till the end of 2010.

From the Financial Times:

Traders are betting that the credit crunch will still be hurting banks at the end of 2010 with financial institutions expected to be scrambling for cash to shore up their end-of-year balance sheets.

A popular so-called butterfly trade in the money markets is showing expectations of three to four times the stress at the end of 2010 as before the credit crisis started to bite last summer, although it implies the situation will have improved sharply compared with today.

Many executives are assuming the credit crunch will not carry on that long, although the majority of financial services senior managers believe it will take more than six months, according to a CBI/PwC survey last month.

Laurence Mutkin, head of European rates strategy at Morgan Stanley, said money markets were pointing to long-running financial strains. “The market expects that these stresses will persist,” he said. “It is saying the system survives but individual institutions will have to fight hard to be among the survivors.”….

Other measures of stress are running at high levels. The spread between the overnight index swap rate and Libor, the rate at which banks lend to each other, a spread seen as a pure measure of the risk, is seven to eight times as high as before the crunch. But it remains below the spikes prompted by fears of a complete collapse in the financial system last summer, at the end of last year and just before Bear Stearns was rescued in spring.

In case you took cheer from the Wells Fargo earnings report, which was the trigger to the rally in financials, consider this tidbit from Housing Wire:

Despite the optimism, a burgeoning portfolio of second-lien mortgages at Wells Fargo that had in recent weeks concerned analysts and investors hasn’t gone anywhere; and, if anything, Wednesday’s quarterly result also holds evidence that the credit losses in that particular portfolio have yet to fully reverberate throughout the bank.Wells has a substantial $84 billion portfolio of home equity loans — and half of those are located in hard hit states like California and Florida; of that total, it has carved out the worst $11 billion for liquidation, with rest remaining as part of its “core” home equity portfolio.

In the second lien portfolio set up for liquidation, the percent of loans that saw borrowers miss two or more payments rose during Q2 to 3.6 percent, up from 2.79 percent one quarter earlier. The $73 billion “core” home equity portfolio saw a similar rise to 1.88 percent in 60 day delinquencies, compared with 1.71 percent in Q1.

So delinquencies continued to rise during Q2; net credit losses, however, did not. Charge-offs on second liens were actually down $104 million compared with first quarter 2008 — but don’t let that fool you. The improvement was primarily due to a change in how the bank handles its home equity portfolio charge-offs; earlier in Q2, the bank extended its charge-off policy from 120 days to 180 days, in an effort to give troubled borrowers more time to reach a loan workout (or to protect earnings, take your pick)…..

As second lien borrowers see equity in their homes evaporate due to price depreciation, second liens become extremely vulnerable to loss.

Which is why this stat matters more than most: approximately $35.6 billion of Wells Fargo’s $84 billion in home equity loans had combined loan-to-value ratios above 90 percent, according to the second quarter report. And that’s a figure based on automated value models, or AVMs, that were run in March 2008; were those AVMs run again today, it’s almost a sure bet that the number has gone up even further.

Of course, seconds are only one part of the equation here. Wells boosted its total loss reserves to $7.52 billion during the quarter, compared with 6.01 billion one quarter earlier; against that, overall non-performing assets (including seconds) rose to $5.23 billion, up from the $4.5 billion recorded during Q1. Which means that loss reserves are well ahead of NPAs, a good trend.

Maybe I am old fashoined, but I don’t see increasing a dividend when earnings are falling as a good move in general, and in particular in an environment as fraught as this one. Presumably, it was done with the intent of boosting the stock price. That gamble might pay off if it helps Wells raise equity this quarter. Otherwise, it looks to be an unnecessary risk.

Originally published at Naked Capitalism and reproduced here with the author’s permission.