The Risk of Over-Allocating for Losses Grows

There has been such a ravaging of banks and assets that the mark-to-model exercises today are starting to look like the collective panic button has been slammed down.

This is usually the case, after all. Risk gets out of whack as credit performance starts to unwind, and the fear of implosion leads to the ballooning of assumptions on the negative side. How much more so today as we face a “once in 100 years” financial calamity, in the words of Lloyd Blankfein, Goldman Sachs’s CEO? To put it bluntly, people are getting crazy with their valuations – despite the darkness of our current recession.

The spread between the loss allowance-to-loans ratio and the net-credit-losses-to-loans ratio was widening through the third quarter of 2008, and it no doubt continued to widen last quarter. In other words, the rate of increase of allowances banks are taking for losses is climbing faster than the actual losses.

THE ONLY THING WE HAVE TO FEAR … ARE LOSSES

Some might say that a loss-allowance-to-total-loans ratio of 1.98% in the third quarter is nowhere near as high as it should be, but at some point the ratio is going to get out of whack. This End of Days modeling will have to end at some point. I just hope the overshot on the down side will not be too great.

The one bright spot in all this is the business opportunities it presents to those who can understand true value vs. fear-tainted valuation. Those investors are mobilizing to take advantage of this foolhardiness. To the victors go the spoils, as they say.

I am all for prudence and sound risk management. Heck, watching risk management treated as a perfunctory exercise over the last several years has been jarring and sad. Who wants to see bank after bank blow up? But sound risk management does not mean logic gets subverted. Bankers underestimated credit performance on the climb up the interest rate cycle and now they are overestimating on the downside. Why is it that rational behavior gets shelved in favor of reactionary responses? Wait, I know that answer: it is called fear. Don’t let fear get the best of you. Mark your models with logic, not the opposite.