Credit Losses Seen Doubling in 2009

To consider the current state of the banking industry is to consider a very sick patient: marks of improvement come in small doses.

There are no improvements, however.

In a sweeping assessment of the banking landscape last night, Christopher Whalen, director of sales and marketing at Institutional Risk Analytics (and my vote for Risk Rock Star of the Year), offered his diagnosis of the banking industry, and it was dour indeed.

It all boils down to credit losses. In Whalen’s view, “we are about halfway through” the credit loss cycle. Whalen breaks down the credit-loss cycle into three stages:

1) Recognition of Losses. In this stage, financial institutions recognize that they have losses in their credit portfolios, although they might not do anything about it. This stage began when the market realized that “securitization was broken” when New Century Financial Corp. failed in early 2007.

2) Realization of Losses. Realization takes place when financial institutions write down the losses they recognized. We’re hot into this phase of the cycle.

3) A Broadening of Losses. This is when it gets ugly. Losses move across the entire spectrum of assets. We’re just getting to this phase now as stress begins to appear in commercial real estate and credit card loans, to name just two. Whalen sees this third phase lasting into 2010.

He cited subprime losses as evidence of where we are in the credit cycle. According to Whalen, subprime credit losses won’t peak until next year.

“We are still early in how these losses will be manifest,” he said of credit losses generally.

So what’s the damage? How about 4% of total chargeoffs in 2009, up from the current 2% or so. And for Citigroup Inc., credit losses peaking at 5% or 6%, he said. Let’s think about this for a moment. Credit losses will go to 4% from 2% — well, that means credit losses will double from where they are now. And you thought the third quarter was bad.

To put this in perspective, Whalen estimates that ALL current capital at banks will need to be replaced. All!

These loss scenarios point to a greater underlying problem, which has Whalen relatively flummoxed: What to do with all the credit default swaps? There are at least $32.5 trillion of CDS outstanding. It is clear that some of these CDS will be “in the money,” forcing the counterparty on the CDS to make the buyer of the credit protection whole. This is essentially what ruined AIG.

In fact, this is why Whalen sees AIG still going into bankruptcy, despite the government’s efforts. Whalen sees no alternative to the CDS problem but to “tear up” the contracts.

“If we don’t get this stuff out of the system, we can’t fix the problem,” he said.

I would venture to say that it is nearly impossible to consider the implications of the current dilemma we face. There are so many question marks. For example, I’ve been focused on the unemployment rate, which I see as being perhaps the greatest determinant of credit performance going forward. Where the unemployment rate ends up could be a result of what happens with the Big Three automakers and so on.

“People just don’t know, and ‘don’t know’ is not an acceptable answer,” Whalen said.