Banks Could Face Serious Trouble from Losses on Residential and Commercial Real Estate

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The task of today’s Daily Reckoning is simple: ignore the largely irrelevant earnings news driving short-term stock prices and try to determine is the entire market is about to get smashed by another round of deleveraging in the financial system. This would result in another collapse in bank collateral, tighter Australian credit, slower economic growth, and falling equity and house prices (plus rising interest rates).

But before we make the conclusion, we should make the case. There is an Australian grouping of evidence. And there is an American grouping of evidence. Let’s deal with American evidence first. And let us call to the stand Reserve Bank of Australia assistant Governor Guy Debelle.

“While most of the recent jitters have been associated with sovereign concerns,” Mr. Debelle said in a recent speech, “I think the risks stemming from the financial sector are still there. A significant risk is that that we are still yet to see the full impact of the weakness in the North Atlantic economies on the loans on the books of financial institutions.

It might seem strange to begin the case for a further write down in bank collateral with an Australian central banker. But the good Mr. Debelle has done our work for us. He told a crowd in Sydney that, “We are now into the phase where weakness in the global macro-economy is feeding back into the financial sector…We are not all that far advanced in the adverse cycle that normally accompanies recessions.”

In other words, if we understand those comments correctly, there are more losses to come. It’s not just sovereign nations that are feeling the weight of bad debts. It’s the banks themselves – even after a year of recapitalisation and profit growth thanks to low interest rates – that could face serious trouble from a second of losses on residential and commercial real estate.

“For the North Atlantic economies,” Debelle concludes, “this was a big recession which, combined with large falls in both commercial and housing property prices, should result in large losses.” He goes on to point out that the government-guaranteed larger lenders might survive these larger losses. But smaller regional banks might not.

If those regional American banks fail you can expect two results. First, a larger burden the Federal Deposit Insurance Corporation (FDIC), the U.S. (underfunded) entity that insures bank depositors against just this sort of thing (up to US$100,000 per account). The other result would be a second-cousin of what happened when the Fed raised interest rates in the Great Depression: a contraction in credit.

Banks are the engine of money creation in the modern economy. If you have fewer banks, you have fewer engines of credit creation. Meanwhile, national assets and liabilities get concentrated on fewer and fewer but larger and larger balance sheets. It’s the collectivisation of finance, which in corporatist style, greatly benefits Wall Street money centre banks.

And this is all at the private and corporate level. In the world of public finances, American deficits are already spiralling out of control. The Federal Reserve, through its System Open Market Account, is taking an increasingly active role in supporting U.S. bond auctions. This is a fancy way of saying that as foreign investors refuse to finance U.S. deficits, the Fed must print money to paper over the gap itself. More details on this operation tomorrow.

Today, let’s ask the direct question: so what?

Why should Australians care if the United States has begun to monetises its debts? Well, it’s not certain, but you we’re pretty sure that U.S. monetary and fiscal policy is going to give rise to inflation, and higher interest rates. It will make credit harder to come by globally, just as it did in 2008 when the investment banks blew up.

This is bad news for Australia on two fronts. At the banking level, something terrible has happened since 2008. Bank collateral has not, in our opinion, materially improved. On the one hand, it still consists of huge chunks of U.S. commercial and residential real estate. Collateral damage!

On the other hand, those same U.S. banks have loaded up on another kind of equally toxic collateral. They replaced something bad with something equally bad, but perhaps less putrid (sovereign debt). U.S. banks, then, face a double collateral whammy this year from falling house prices and falling U.S. government debt prices.

Even if Australian banks don’t own U.S. backed real estate (and some do, mind you) and even if Australian financial institutions are not direct holders of U.S. sovereign debt (and some no doubt are), they’re still directly exposed to a world of tighter credit. And that world would be an accomplished fact if U.S. banks either ceased to exist or, as a result of more credit write downs, stopped lending globally.

The prosecution for another massive financial deleveraging in America rests. But what about our promised Australian evidence? Won’t things just be fine here, especially since China’s savers are set to become Australia’s creditors?

Well, maybe not. A speech today by RBA Assistant Governor Phil Lowe shows that Australia faces a similar collapse in private demand as in America. In turn, business investment is falling. Government is trying to fill the breach with a larger fiscal deficit. The end result may be economic stagnation and higher public debts and interest rates.

This all goes against the grain of the positive, earnings-driven news about the economy. But remember, the modern economy runs on huge supplies of credit to consumers and businesses. Take away that credit and you take away the fuel of GDP growth. Not even government intervention can offset the massive write downs in asset values required to put the economy on a sounder footing.

But how about the visual evidence. Mr Lowe provides the first chart below which shows falling private demand in the U.S., Europe, and Japan. This doesn’t include Australia. But we’d expect Australia to follow these trends if global credit becomes scarcer and asset values fall. Households and businesses will retreat into a more conservative cocoon.

Domestic Private Demand

Speaking of cocoons, Lowe’s next chart shows’s a figure specific to Australia: business credit growth. It’s fallen over 7% in the last year. Whether it’s because demand for credit is down or because supply is down (the willingness of bank’s to lend) is a relevant question. But the chart itself suggests another credit contraction, leading to more shockwaves in financial markets.

Business Credit Growth

This slump in business credit growth has not yet affected access to capital for Aussie companies. Well, it has for companies on the margin of the mining business. But many other companies have turned away from the debt market (only the big banks got government guarantees to borrow). Instead, Aussie firms have tapped the equity markets. The chart below shows that listed companies raised over $85 billion in new share sales last year alone.

Equity Raisings

With a steady flow of compulsory super annuation money into the system, you could argue that Australian firms are going to have access to equity capital no matter how tight credit gets globally. And that might be true to a certain extent. But even assuming capital is available to listed companies, how will Austrlian firms grow profits in a world smothered by another credit crunch?

Quite clearly, they won’t. That, anyway, is the case for how a second round of deleveraging – driving by credit writedowns at American banks – will crush the Aussie market rally. There is, though, one saving grace. Maybe.

That saving grace is that if the sovereign debt risk in America supersedes the banking story, you will see an outright U.S. dollar crisis this year. That ought to benefit higher-yielding currencies like the Aussie dollar, although truth be told no one really knows how other paper currencies would fare in a full-blown dollar crisis.

What we do suspect is that the dollar crisis will be inflationary in nature. The monetisation of U.S. debts (public or private) will lead to a weaker dollar. And all things being equal, that ought to lead to much higher precious metals and oil prices.

Whether than translates into higher prices for precious metals and energy shares is also an open question. Do you want to be in the equity markets during another round of deleveraging? Last time around, resource stocks proved no refuge at all. And commodities themselves were as inflated as anything else. This time around, what is the best refuge?

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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50 Comments on "Banks Could Face Serious Trouble from Losses on Residential and Commercial Real Estate"

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Matto
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i dont see how speculation driven commodity/stock increases will offset the fall in underlying demand, except perhaps in the case of a few distinct metals.

the best refuge, so far as i can tell, will be on the short side (if they dont ban it)

Ross
Guest
I am not reading reports of the detail of the RBA speeches elsewhere and appreciate moreso reading them here. In my mind a significant sovereign debt crisis will trip a deleveraging globally like any mark to market event. Iceland is tiny and that even went close. If the originating leverage is fake (just like mezzanining) the collateral is not worth the colour and the events cascade on fear on the bona fides of all collateral from there onward. Thus uncontrollable deleverage in all risk assets and commodities. If the USD isn’t worth the paper and the USD’s leverage has powered… Read more »
Ross
Guest

Oh and DOW futures down 94 even before EU trade, ASX was flat, jumped on Stevens comments and then went sharply backward. AUD down the last 3 day’s gains. Good thing I retired from daytrading on the hunch. Wonder how the caring and sharing medicated young gentleman went today?

Matto
Guest

Ross – Bill Goss’s latest commentary from Pimco is worth a read. just skip the first 2 paragraphs and remember that one of his charts shows the aussie public debt scenario without considering the private debt.

http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2010/February+2010+Gross+Ring+of+Fire.htm

Ross
Guest
Matto, I enjoy reading Bill Gross but look for the twist because one thing you can count on is that he nevers wastes a breath when given an opportunity to talk his own book. Reminds me of Kerry Packer the way he plays governments more than anyone else. The twist in the one you have linked is that everything he says makes perfect sense … and he runs his book in the very gap you identified. Underserviced private debt and junk collateral is a venereal disease being transmitted to government who will offload them to their mates at mates rates.… Read more »
Justin
Guest

You underestimate the power inflation Matto. Hallucinogenic it is.

Ok, so the Treasury & RBA has suddenly found prudence, but it can’t last. Maybe if we’d ‘come down’ about 20 years ago, but not now.

Banning the short side is just another in their bag of tricks.

Justin
Guest

power of inflaton

Justin
Guest

inflation

Matto
Guest

Justin, my *guess* is that inflation will come about gradually (over months)while the issues mentioned in the article will lead to a much more sudden shock/correction. i see australia going down hard in the near term but fairing better through inflation driven recovery in the mid term.

friday!

Justin
Guest

Fed raises discount rate to 0.75%
 US central bank moves to further normalise lending on improved conditions.

This was the headline on business spectator. Actually, the improved conditions had little to do with it. Try the public statements by one of the Federal Reserve governors saying if they don’t ‘tighten’ there will be trouble.

There will be trouble anyhow, this ‘tightening’ is the source of the current shock/correction. There’s only one road out of this & it leads straight off the cliff!

Justin
Guest

one road out of this swamp, would have been a better description

Justin
Guest

One of the best articles I’ve read is this one;

War against Gold: Central Banks Fight for Japan

at http://www.goldensextant.com

Biker Pete
Guest
Gross: “Of all of the developed countries, three broad fixed-income observations stand out: 1) given enough liquidity and current yields I would prefer to invest money in Canada. Its conservative banks never did participate in the housing crisis and it moved toward and stayed closer to fiscal balance than any other country… ” Interesting comment. Bank of Montreal shares fell from around $55/share to $26… but recovered quickly, as did our own banks. Property remained relatively unscathed. Some provinces may have fallen around 6%, similar to our own across-Australia figure. What is even truer for Canada than it is for… Read more »
wasabu
Guest

Pray for my mate who is off to the Abbott-oir* to be slaughtered tomorrow. He’s bidding on a $1.2M house in Williamstown, for which he’ll have to borrow some 700K, or half of his pay packet.

*Abbot-oir, since Tony will likely preside over the blood letting after next election. You heard it here first!

mike
Guest

…canadian bank shares did indeed fall by nearly 50% causing shock and fainting spells among ottawa bluebloods, but…lo and behold…73 billion canadian dollars of stealth stimulus later what do you know…banks stocks did recover…what a coincidence, n’est-ce pas?..

Biker Pete
Guest

Our view is that Canada _may_ have got better kilometrage from stimulus spending than Australia did. Again some provinces _appeared_ to benefit more than others, but that may be a superficial observation. Quebec’s roadworks certainly made driving around that province a slow(er) experience. No doubt that stimulus spending insulated both economies from the disasters we see in the UK, US, and U-rope… . Long-term effects for Canada and Australia? Who knows? Think I’d rather be in either/both, than weathering the falling ash from the Ughs…

Ross
Guest
Mike/Biker, I am interested in the flexibility/variability of asset prices in Canada. I have often thought that the US and WA have much in common with their can-do and their ghost towns linked. In the US you can still see it despite the “extend and pretend” of the major banks the regional banks are getting knocked down like pins and asset prices are responding like this http://money.cnn.com/galleries/2010/real_estate/1002/gallery.most_and_least_affordable_markets/index.html So I am interested in your thoughts on how much a factor people packing up their households and going to chase work in other regions is a factor in Canada. I am interested… Read more »
watcher7
Guest
“Indeed the temporary breaks in the market which preceded the crash [of October 1929] were a serious trial for those who had declined fantasy. Early in 1928, in June, in December, and in February and March of 1929 it seemed the end had come” (John Kenneth Galbraith, The Great Crash 1929, London: Penguin Books, 1992, , p.98). “Corrections do what they have to do. They will flush out latecomers, top-callers, in-and-out traders, the timid … emotional investors and momentum players. None stand to reap much benefit from this historic bull market… “Ignore the media’s take on markets. They have no… Read more »
Evan
Guest

Abbot-oir…LOL…good one…but seriously…who borrows $700K???? Does this person, who will bid on a $1.2m house in Williamstown know no fear?

Ross
Guest
Watcher, despite precedent I am having a hard time swallowing this one and I am one long AU equities. Where is even the smell of those US green shoots? Where is the trading volume? Adam Carr is one running on the smell of activity and inflation grabbing the reports that are always rerated down the following month and doing his best to ignore the lack of lending on main st and the unemployment and the regional banks imploding and the state tax bases evaporating. I am on the Bill Bonner bent toward deflation, and the unravelling of the extend &… Read more »
Biker Pete
Guest
Ross: “…how much a factor people packing up their households and going to chase work in other regions is a factor in Canada(?)” Canada is a little ahead of us in the ‘retirement flow’, Ross. We attended a dinner party for twelve people our age one night… found ourselves just slightly older than anyone else… and the only people present who were still working. Everyone else had retired at 55 – 57 years of age. Their pension plans are more generous, less means-tested, more flexible and ‘guaranteed’ (ie., not market-linked). It seemed to us that the economy is more focussed… Read more »
Biker Pete
Guest

Should have added that I enjoyed the link, Ross. Thanks!

Here’s one for the Shaughnessy suburb I mentioned. Remember that most of the homes in both our links are chipboard or ply, sprayed with stucco; or cedar clad… .

http://www.shaughnessyhouses.com/ShaughnessyHouses.php

I know two of these streets fairly well. Check out 3995 Maple Crescent; and 1162 West 26th Avenue. The houses are nothing very special… and make Sydney look fairly cheap… . :)

Dan
Guest

Nothing makes people agree to something better than the feeling of vulnerability.

Biker Pete
Guest

Bard Luck: “There is nothing either good or bad, but thinking makes it so.”

Ross
Guest

ah repartee and good ones too.

Don
Guest
Holy moly at those house prices Biker! I have often entertained the thought of finding mining work in Canada or at least checking them out to see how things are done over there. Checking out concentrators and mines might not sound very stimulating for some but they seem to do things very differently over there and more knowledge is not a bad thing. Where do all the mines tend to be situated? If Australia is any guide, I suppose they are in the middle of nowhere :) There was a story going around years ago about a young exploration geologist… Read more »
Lachlan
Guest
Im barely long any stocks but if the usual suspects are buying up equities on every shake out then it will be harder and harder (in the immediate sense and presuming the suspects hold) for an equities correction of the predicted 1930s style. It may be a central planning objective to hold equities at least in stagflation mode since the social disorder that would result from a brutal sell-off. I agree over the cliff is the only way out of the swamp in the final sense. Maybe for now though its just a flush out of weak hands/short termers then… Read more »
Lachlan
Guest

Doesnt Benny have a second date with Printing Press.

Biker Pete
Guest
Whenever I read that there’s a limit to what people can and will pay for location, I have to reflect on the Vancouver situation. It’s extreme, granted, but it is an interesting property market I’ve watched for three decades now. Remember too, Don, that these are very, _very_ ordinary Canadian homes. Clifftop and waterside homes we stayed in during the last three months were valued at many times those prices. Our friends’ Whistler chalet made all those examples look very cheap indeed… . Thirty years ago, the Oz Readymix fella had an $8mil holiday home close to their previous holiday… Read more »
Lachlan
Guest

Wish I had a girlfriend so generous….she just keeps on giving.

Don
Guest
Thanks for that Pete. I know the name Kamloops – they have a major metallurgical laboratory (of the same name) and I have come across their work quite a few times over the years. I suspect that their mines are similar to the ones in north queensland that I work on. Sh*ts and bits, high grade but rarely above 1 million tonnes or so. Makes life interesting for sure and I find smaller mines don’t have the big swinging d*ck syndrome that the big operations have. Politics and associated crap seems to go up exponentially with mill tonnage – under… Read more »
Biker Pete
Guest
We drove through Kamloops back in ’95, returning from the Calgary Stampede. Have a feeling you’re right about the size of operations there, Don. Couldn’t generate enough interest from the rest of the family to chase up the mine Granddad Rand had floated. It was called ‘Makaao’, but I think it’s now ‘Similkameen’. This URL may or may not relate to the original site: http://bcgold.com/mining-properties-14.html Rand held numerous US patents in his time. It’s Mexico which really intrigues me, Don. I’ve no idea what the state of goldmining is in the Sierra Madres, but swimming in clear-water high mountain streams… Read more »
Biker Pete
Guest

Gotta laugh, Don… missus just looked at my coordinates and reckons my URL is nearly 200kms or so off. Inlaws have drawerfuls of the scrip. Can’t be worth much now, anyway… ! :)

With very ‘local’ knowledge, I found the site the Rands picked up:

http://minfile.gov.bc.ca/Summary.aspx?minfilno=092INE002

Copper was the main objective, apparently. The price of gold and silver made exploration unfeasible at the time… . Makaoo (correct spelling) had registered 61 different claims including up in Alaska. As I suggested, it never moved much from the penny stocks, later swallowed up by bigger fish… .

Don
Guest
Ahh the hit and miss of exploration. Nothing worse than getting half a sniff and then finding bugger all afterwards. I was involved in Cobar Consolidated Resources as a seed investor and then the market float etc etc. Did ok and they are still going on but similar story in the beginning. Found a few stringers – follow up drilling found nothing and they are now in the process of seeing if they can make a buck from the old Womawinta silver/lead oxide deposit south of Cobar. That deposit is much easier – shallow enough for RC drilling (instead of… Read more »
Anon
Guest
“This time around, what is the best refuge?” Large Multinationals with less cyclical earnings — namely consumer staples, healthcare (careful of US reforms), insurance (provided no massive catastrophes). I agree with your assessment re: resources equities performance. China has bght more raw materials than they need short term and stockpiles of alot of base metals are at/near March 09 highs. Regardless of whether China continues to grow or not short-intermediate term its a lose/lose for commodities and anything commodity related (including countries riding on the commodity “slip stream”) The AUD destiny relies on the carry trade. If you overlay the… Read more »
Ned S
Guest

My accountant reckons the US isn’t going to run a surplus for 100 years!

He’s pretty thorough. So I’ve got no reason to suggest his thought isn’t correct? But along the way, one might expect a few practical issues to pop up perhaps??? With timing same being REAL dodgy! :)

Anon
Guest

@Ned
Sounds analogous to what was said in the States about property prices just before the collapse ;)
When people feel euphoric and definite about certain ideas its usually (not always) a better idea to move in the opposite direction.

Remember above not advice, just discussion, seek financial advice/info from a financial adviser.

Ned S
Guest

I’ve got no real big opinions on anything financial at the moment Anon. Except that if one is amongst the 5% (?) who have trading skills, then the world has opportunities perhaps? But with the other 95% of us being well advised to hedge our bets; remain vigilent; and prepared to move if a clear trend regarding inflation/deflation should reveal itself in relation to our national economy. And Yes … Certainly just IMO as you say.

Anon
Guest

@Ned
“Except that if one is amongst the 5%”

lol i think thats a generous percentage ;)

Remember above not advice, just discussion, seek financial advice/info from a financial adviser.

Ned S
Guest

I’ve never played the game as such – Because I surely do know I DON’T have the skills – But Yes, given the bit of general reading I’ve done on various things, and a few personal impressions, I’d expect 5% would wrap it up. And the percent probably is lower. Because at about that level, one starts to get in amongst the truly competent professionals beginning to joust. And a good number of THEM still lose. It’s a tough game – I take my hat off to traders as I’ve said before.

Biker Pete
Guest

Fundamentalists or chartists… all those I knew in both camps were badly burnt when the ASX fell 54.5%. Maybe 5% emerged unscathed(?) Meanwhile Oz property averaged a 5.5% fall across Australia… .

Anon: “When people feel euphoric and definite about certain ideas its usually (not always) a better idea to move in the opposite direction.”

And that’s why we _bought_ two more blocks at perhaps a 10% discount during that brief plateau. Counter-cyclical. Think those days, or ‘worse’, will come again? You’ll _buy,_ won’t you? I know we will… . ;)

Dan
Guest

“Fundamentalists or chartists” … there are those who are neither. Still though, Pete, at current variable rates (and as they rise), it all becomes a bit of a squeeze on disposable income. Can’t see wages rising fast enough at the moment, to be honest.

Biker Pete
Guest
“Fundamentalists or chartists” … there are those who are neither.” Agreed. Our son plays a very different game, which he appears to be winning; and which is a little more complex than our own very simple strategy. We may be watching a phenomenon play itself out, as WA’s regional centres already appear to be losing catering and restaurant staff to the attraction of remarkably high(er) wages in the north-west. And we’re told that the boom hasn’t started yet. If that’s right… and it seems inevitable… the cities are about to lose population to the northern mining centres, job vacancies will… Read more »
Dan
Guest

I reckon the North West is relatively uninhabited for a reason, and in the long term that won’t change (expect it to be dotted with ghost towns at some point) unless there are actual efforts to make at least some of the coastal land arable. Desalination, perhaps? Still it is an expensive way to do things and it’s a lot easier just to rape and run, as miners have always done.

Biker Pete
Guest
Dan, you’re correct about the current situation. FIFO enables young couples to easily crack over $200K per year… and ‘live’ a thousand kms south. But it is changing. I think we’ll all be surprised at the extent to which the Kimberley develops, as technology advances. Desal plants are springing up in the south, but water may still be pumped from immense reserves in the Ord, if desal costs aren’t feasible. And yes, ghost towns are common around the planet wherever booms go bust. Could be different this time. (Now where have I read _that_ before?! ;) ) If I had… Read more »
Anon
Guest
“And that’s why we _bought_ two more blocks at perhaps a 10% discount during that brief plateau. Counter-cyclical. Think those days, or ‘worse’, will come again? You’ll _buy,_ won’t you? I know we will…” Well was a very ballsy move given you bght when American housing was falling off a cliff. Buy when blood is on the streets? I guess a mistake alot of us make is to assume if the equivalent US market tanks, Australia follows. It certainly hasn’t for housing, but will it in the future? Who knows, but the media preaching of a housing crash is not… Read more »
Don
Guest
Apologies for the long post but I found this on a real estate article – in the comments below. It appears that Steve Keen does respond to online critics in obscure places. What is the chance he will turn up here? :) Steve Keen Writes: As I’ve said many times – to the point of going blue in the face over it – my call was always over 10-15 years, not a year or less, and still less one where prices were deliberately manipulated by the government in what I prefer to call the First Home Vendors Boost. I observed… Read more »
Biker Pete
Guest
US property? Well, we looked, Anon. Friends recently bought cheaply in Tucson. They say they’ve bought well. We’d be more interested in a NH location in which we’d actually spend some time ourselves. For us, that’s not the US. We’re happy with our returns in WA. Our tenants are often just a lot smarter than we are. ;) “Who knows, but the media preaching of a housing crash is not a good sign for the bears.” Sorry, I don’t understand that comment. “Well was a very ballsy move given you bought when American housing was falling off a cliff.” Not… Read more »
Bargeass@yahoo.com
Guest

The Aussie real estate bubble built by unholy trinity of Labor politicians, their developer buddies and the Greedy-Boomers will bust of that there is no doubt.
The unholy trinity now has the Australian economy in a death embrace and is slowly strangling it like an Anaconda.

Biker Pete
Guest

Greedy-Boomers? Love it! When Keen was ridin’ high… along with interest rates… it was Stupid-Fools. I’ll take the new term as both a promotion and a compliment, Bargearse. :)

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