Credit Crisis To Last Into 2009

A growing number of bank analysts are saying the Global Credit Crisis will extend well into 2009, if not beyond.

This means more pressure on financial stocks and bank balance sheets; banks have added $25 billion to loss reserves so far, but face mounting consumer credit losses in a second wave of the crisis that some bank executives have acknowledged will be worse than the first, which has cost hundreds of billions of dollars in write-downs and losses.

Wall Street’s originate-to-distribute model, designed to mitigate risk by spreading it around, actually exacerbated those risks. It encouraged banks to loosen lending standards because more loan volume meant higher profits; then it led to over-leverage, and finally to complacency. More and more paper dollars were created for trading on the assumption that housing prices would always go up.

The first wave of the crisis affected trading books, but the second will hit lending.

As long as housing values were rising, borrowers could refinance in perpetuity to avoid default. Losses mounted when the refinancing option disappeared. Banks relied too heavily on the securitization markets to boost lending to consumers, particularly in the form of mortgages.

In time, some lending will return, but the sky-high revenues of recent years will be hard to reclaim.

The banking sector’s pullback in lending will cause further painful losses. Many believe banks will have to reserve an additional $170 billion through the end of next year just to keep up with estimated loan losses. “New and unforeseen strains on consumer liquidity will push more consumers into precarious credit positions and cause consumer credit losses to be far worse than what is currently estimated, even by the most draconian of investors”.

Here in Canada, an accepted truism of the global banking crisis is that the big Canadian banks have done rather better than their global peers, avoiding the worst of the writedowns.

Commentators and analysts have spouted words of comfort about the Canadian banking sector for months, and even Federal Finance Minister Jim Flaherty noted in April after meeting the big bank chiefs in Toronto that Bay Street has avoided the worst pitfalls that have beset banks elsewhere.

But that idea is becoming increasingly difficult to uphold as a few of the Canadian banks ratcheted up their losses in second-quarter results announced this week.

Almost all the bank chiefs warned, too, about slowing capital markets and rising loan losses.

The notion that Canada's banks are relatively unscathed is starting to look like misplaced optimism.

Royal Bank of Canada, the country's biggest bank, confirmed Thursday that its writedowns on structured products now stand at $1.6-billion - a sum that would have been unthinkable last year when Canada's banking sector was on a long winning streak.

RBC chief Gord Nixon was "not happy" about his bank's writedowns, but you have to wonder what he thought of the charges at Canadian Imperial Bank of Commerce, which now total $6.7-billion after the bank acknowledged its investments in structured products produced another $2.5-billion in losses in the second quarter.

RBC and CIBC now share the ignominy of featuring among the global banking top 40 for largest writedowns and credit losses since the banking sector was thrown into crisis last year. (Writedowns refer to structured products being marked to market value, whereas credit losses reflect expected and actual loan defaults.)

RBC sits at number 40 and CIBC's latest charges mean it has leapfrogged up the league table [according to the latest data from Bloomberg], moving into 16th spot above Germany's West LB -- which has taken US$4.8-billion in writedowns and is the subject of a European Union bailout plan -- and Societe Generale, which has incurred US$6.3-billion in writedowns.

In proportion to the size of the bank's assets before the full impact of the crisis hit last year, CIBC's losses are as bad as those of UBS -- the Swiss bank that has suffered US$38.2-billion in writedowns -- and worse than the losses recorded by HSBC Holdings (US$19.5-billion) and JP Morgan Chase & Co. (US$9.7-billion). CIBC's losses as a proportion of total assets are almost as severe as those of Citigroup Inc. (US$43-billion) the poster child for the financial crisis.

Picking on RBC and CIBC alone highlights an important point -- not all Canadian banks are equal when it comes to the financial crisis. Toronto-Dominion Bank has supposedly incurred no writedowns. Bank of Montreal, National Bank of Canada, and Bank of Nova Scotia escaped major writedowns this quarter, but their combined writedowns on structured products stand at more than $1.8-billion since the crisis began.

Leaving writedowns aside, Canadian bank CEOs have painted a bleak picture this week for their outlook on the remainder of 2008.

Even Toronto-Dominion Bank chief Ed Clark -- one of the few CEOs in North America or Europe who can truly claim to have steered his bank through the financial crisis without taking a big hit -- is projecting no earnings growth in 2008 for his bank, amid rising loan losses, stifled investment banking activity, and the potential spillover from the U.S. economic slowdown into Canada.

Still, there are some positives for the Canadian banks.

Their writedowns are so far on paper only, and if the market for certain structured products turns around they will reverse some of their losses, as BMO did this week, announcing it made a gain of $42-million on investments that had previously been written down.

More importantly perhaps, Canada has so far not seen a house price slump like the U.S. and some parts of Europe.

Certainly some Canadian banks are exposed to the collapse of the U.S. housing market through their U.S. subsidiaries -- notably RBC bumped up the provision for loan losses at its bank in Florida and other southern states. But the biggest advantage the Canadian banks have over their peers around the world is the strength of the Canadian economy and their strong domestic retail operations. Let's hope this continues.