Banks Are Ill-Prepared for the Coming Tsunami

Up, Up, and Away? That's what the stock market seems to be saying, but the line above is pointing in the other direction. ALLL stands for "Allowances for Loan and Lease Losses," and the graph indicates that only 20% of all bank assets reside in banks with sufficient allowances set aside to cover their nonperforming loans. In other words, as more and more loans become delinquent, banks are under-reserving for possible defaults. Instead, they are puffing up their current earnings in hopes of appeasing regulators and attracting investors (and, of course, paying their top executives).

A new wave of defaults will arrive in 2010 as option ARMs (adjustable-rate mortgages) do what they were designed to do: explode. These are teaser loans that start borrowers off at absurdly low monthly payments for the first few years. The payments might be interest-only (leaving the principal untouched) or even less (allowing the balance owed to increase). Then, once the introductory period expires, the payments on principal begin. That's when the rubber finally meets the road.

These products were perfect for speculators flipping properties in an overheated market. Borrowers could sell for a profit before the loans re-set. But option ARMs will prove deadly to homeowners who have suddenly lost their jobs and, thus, the income to cover the higher payments due after the re-set. The U.S. economy has shed jobs for twenty months in a row (a total of 6.9 million) and is expected to continue doing so at least until the middle of 2010. The mortgages, alas, allow no grace periods for unemployed borrowers. [Hours after I posted this, FDIC Chair Sheila Bair revealed in a statement that "the FDIC is urging its loss-share partners to consider the borrower for a temporary forbearance plan, reducing the loan payment to an affordable level for at least six months." The initiative applies to banks that have acquired failed FDIC-insured banks and would offer relief to "unemployed and underemployed" borrowers.]

Almost $100 billion in option ARMs will reset between now and the end of 2010. Mounting foreclosures are inevitable, and hundreds of banks will be forced to close. Surviving banks will be hit by the feds with a double whammy: "special assessments" to help indemnify insured deposits as well as stricter capital-reserve requirements to backstop defaults. Turning a profit will be a tall order (as described here). Lending to entrepreneurial start-ups--and creating jobs--will be out of the question.

But bank CEOs don't mind. They already have theirs.