World must brace itself as the US banking sector ‘fesses up’ to losses

By Liam Halligan

On Friday we learnt that, here in the UK, GDP growth was flat during the second quarter of 2008. Grim economic headlines have also emanated from the eurozone and Japan. But the reaffirmation that “sub-prime” is so much more than a US problem doesn’t mean, for one second, that America’s problems are over.

For all the talk of “de-coupling” and the new emerging markets, the US is still the world’s biggest economy. In this age of “ultra-connectedness” and “financial innovation”, the health of America’s banking system matters more than ever to the rest of the world. We should be very worried, then, that this pivotal sector’s predicament will get much worse before it gets better.

The latest Federal Reserve data shows that between April and June, American banks significantly tightened their lending standards and are about to do so even more – across all types of credit.

What started, just over a year ago, as a squeeze on the dodgy end of the mortgage market has now spread to all forms of household and corporate borrowing.

A net 62 per cent of US banks turned the screw on the prime mortgage sector during the second quarter – with almost 75 per cent signalling a further tightening in the third. A similar pattern prevails across credit cards and other consumer lending, as well as commercial and industrial loans.

This credit contraction has had a serious impact on economic activity – an impact that’s about to become more severe. Some stock ramping Wall Street institutions and their pet in-house economists have suggested lately that the US “will avoid recession”. Ignore them. In many cases, they’re the same institutions that used to make hay ramping “mortgage-backed securities” – those toxic packages of sub-prime waste which caused this crisis in the first place.

The on-going credit crunch – combined with America’s huge overhang of unsold homes – explains why US house prices will keep falling.

The futures market has priced in a further 14 per cent decline in the S&P/Case-Shiller 10-city composite house price index over the next year.

What’s more, once American house prices do hit rock-bottom, it will take a long time for them to come back. Prices will only recover once US households are willing and able to start buying homes again, which means taking on more debt. But that won’t happen soon – with consumers nervous, and banks more nervous still.

The financial sector’s paranoia is rooted in the on-going reality that there are still a lot of nasty mortgage-backed securities out there, burning holes in bank balance sheets – holes which many banks continue to deny are there.

As US house prices keep falling, repossessions rise and defaults increase, banks will eventually have to “fess up” to the scale of their losses. So far, this sub-prime debacle has seen US banks endure around $505bn – some £270bn – in “write-offs”. There is a lot more to come – as defaults spread to credit cards, auto loans and other consumer debt, to say nothing of corporate debts going bad as the recession really kicks in.

Not known for hyperbole, the International Monetary Fund suggests total write-offs by all US banks could reach $1,000bn before this episode is over. Serious industry experts think $2,000bn is more likely – four times what we’ve seen so far.

Over the coming months, US banks will have to increase their loan loss provisions even more – which, of course, will further depress their share prices and ability to raise new capital. That’s why a major banking crisis is brewing.

I don’t say this lightly, but up to 100 US banks could go bust over the coming year. Many of them will be small, but some could be large. Last week, Harvard Professor Ken Rogoff, a former IMF chief economist and Fed insider, said “we’re going to see a whopper, a really big one” – suggesting a big US bank is about to go belly-up. Conventional wisdom has it that America’s well developed system of deposit insurance will shield savers from any losses. But the Federal Deposit Insurance Corporation has assets of only $50bn, while the combined assets of the banks in danger total around $900bn.

Not all those loans will be bad, of course, but up to 20 per cent could be. FDIC – generally funded by levies on the banking industry – is going to need buckets of government cash.

And then there’s Fannie Mae and Freddie Mac – which, between them, own or guarantee a mind-boggling $5,300bn of US mortgages – half of all outstanding home loans. As defaults have risen, these quasi-private lenders have swallowed massive losses – they’ve lost 90 per cent of their value in 12 months – and are now in grave danger of collapse.

That would spark systemic meltdown – which is why Congress recently passed a bill allowing an unprecedented taxpayer funded bailout. Last week, the share prices of Fannie and Freddie plunged -understandably given that a government rescue would see shareholders wiped out.

Such drastic events are now almost unavoidable and could very soon be upon us. And when they happen, a sense of shock will pervade not only the US financial sector, but the Western world and, in fact, the entire global economy.

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/08/24/ccliam124.xml