Where the Risk Went
Financial stocks soared on Oct. 15 after Citigroup Inc. (C ) announced that its net income in the third quarter was up 23% from last year. But the jubilation proved premature. The rally stalled the next day, when J.P. Morgan Chase & Co. (JPM ) announced a 91% drop in net income after writing off bad loans to telecom and cable companies.
There's good reason for caution. True, the U.S. financial system is stronger than in the 1990-91 recession, when dozens of savings and loans failed and even giant Citi was weakened. But it is exposed to new risks that aren't fully visible to investors, rating agencies, and maybe even regulators.
The explosive growth of securitization and derivatives during the 1990s may have enabled banks to reduce their risks, but it also made their balance sheets harder to decipher. Sometimes, banks have retained risks that they had seemingly transferred. Other times, they have shifted the risks to institutions that are less-equipped to handle them--from insurers to highly leveraged hedge funds. And because disclosure is limited, it's not always clear just who is exposed. "Securitization cannot make risk disappear. It can only segment and redistribute the risk," says Standard & Poor's Corp. banking analyst Tanya Azarchs.
The danger is that if the financial system's health is impaired, consumers and businesses will be starved of credit, and the economy will slump. Already, it's apparent the banking system is under stress. J.P. Morgan Chase, whose stock has fallen 50% this year, had its credit ratings lowered this fall. Even Citigroup would have missed some earnings estimates if it hadn't counted the sale of its Manhattan headquarters for $1.1 billion as ordinary income. In the third quarter, its nonperforming corporate loans rose to $4.8 billion--more than 50% above last year's level. Oliver, Wyman & Co., New York financial consultants, estimates that banks in the U.S. and Europe will write off more than $130 billion for loan losses this year, a record.
As high as the default rate is now, it would rise sharply if today's disinflation tipped over into destructive deflation, which increases the real burden of debts. Banking regulators say company debt is 6.1 times the cash flow available to pay it, the highest since recordkeeping began in 1966. Meantime, the banks' margin of safety is narrowing, as the profits they make on the difference between their costs of borrowing and their income from lending shrinks. "I don't know that I can say this is the peak [of bad syndicated loans]," says David D. Gibbons, deputy comptroller of the currency.
While the risks of ordinary loans are well-understood, those stemming from the rapid rise of securitization and derivatives are not. Securitization is the creation of fixed-income securities backed by mortgage and auto loans, credit-card receivables, and the like. About $6 trillion in mortgage- and asset-backed securities is outstanding. Derivatives are instruments for hedging or speculation such as swaps and options whose value is derived from some underlying asset. Their face value surpassed $110 trillion last year, says the Bank for International Settlements.
Who's bearing the risk that has been redistributed by all of those securitizations and derivatives? Surprisingly, some of it has stayed in the banking system. When banks securitize a pool of assets, they sell the low-risk, low-yield portion to conservative investors. But sometimes they keep the high-risk, high-yield portion on their own books. Home mortgages are an exception: Fannie Mae (FNM ) and Freddie Mac (FRE ) usually take full responsibility for making up payments to buyers of securities if the income from the mortgage portfolio doesn't cover them.
Regulators and rating agencies generally understand banks' retention of exposure to risk from loans they've securitized. But it isn't always obvious to someone who looks only at the banks' financial statements. The Financial Accounting Standards Board (FASB) is expected to put out rules in December that could force more explicit recognition of risks.
The risks are real. Consider what happened to Conseco Inc. (CNCE ). The Carmel (Ind.) insurer's finance arm is the largest issuer of loans backed by manufactured homes. Although it securitized most of the loans, it was Conseco--rather than the securities holders--that got stuck with the losses when borrowers began to default. Because it retained the "first-loss" slice of the asset pool, it had to take a nearly $3 billion write-down this year.
During the 1990s, lending standards slipped in the asset-backed securitization (ABS) market, says John M. Cerra, managing director of the asset-backed portfolio at Teachers Insurance & Annuity Assn. (TIAA). Because it takes about two years from when bad loans are made until they start going south, says Cerra, "we're seeing a natural lag of the stresses in the economy hitting the ABS market now."
Derivatives don't always reduce banks' riskiness, either. While they can be hedges, they can also be used to speculate. And the risks are highly concentrated: In the U.S., seven banks hold 96% of all derivatives in the commercial banking system. They try to balance their positions so that they aren't exposed to sharp market movements. But with such enormous sums in play, even a slight error could spark huge losses.
Banks like credit default swaps--a derivative that's a kind of loan or bond insurance--because the parties who provide protection have generally paid quickly and without question when an event such as a default occurs. But that record is now tarnished by a recent dispute over swaps written on Xerox Corp. (XRX ) loans. Earlier this year, Xerox asked banks to stretch out its loan repayments. Some banks say this should have triggered payment on the swaps. But insurers are disputing the claim, which is in arbitration. Now, the worry is that the swaps won't work as promised in a systemic crisis.
Even when derivatives and securitizations do shift risk from banks, some of the parties that take it on aren't fully capable of handling it. For example, British regulators said earlier this year that some insurers had "burnt their fingers" in the credit-default swap market. During the go-go 1990s, insurers broadened the use of commercial surety bonds to shoulder credit risks once borne by banks. Last year, their payouts on claims tripled, to $2.7 billion, from 1999. "Amazingly enough, almost everyone [in the business] seems to be admitting they messed up," says one industry insider. Fireman's Fund Insurance Co. is dropping out of the business. J.P. Morgan Chase is battling 11 insurers including Fireman's in court to collect $1 billion in surety bonds that were supposed to cover an off-balance-sheet partnership's deal with Enron Corp. (ENRNQ ).
While banks have had big losses on their corporate lending, they're still making handsome profits on consumer loans. The question is how long that can last--particularly since customers who are just barely creditworthy are often the most profitable ones: They pay the highest rates and, in the case of credit cards, routinely carry high balances. But if lenders reach too low down the credit scale, profit quickly turns to loss. That's what hurt Providian Corp. (PVN ), NextCard Inc. (NXCD ), and other companies that provided credit-cards to high-risk borrowers.
Could such problems spread? As lenders have opened the spigot of credit, they've come to rely more than ever on computerized risk models to make lending decisions. One small company--Fair, Isaac & Co. (FIC ) in San Rafael, Calif.--produces a so-called FICO score of borrowers' estimated creditworthiness, which plays a part in more than three-quarters of all mortgage lending decisions in the U.S. While the model has worked well so far, says TIAA's Cerra, "we're seeing lenders move to fully automated systems, where an underwriter isn't even taking a look at a file. There is a danger the market is actually overrelying on FICO scores." Karlene Bowen, a solutions delivery manager at Fair Isaac, says lenders understand they must supplement the FICO score with other data and continually reevaluate their lending standards in view of "the nuances of the changing economy."
Securitization and derivatives may be a positive force on the whole. What they cannot do, however, is reduce the total amount of risk in the economy. Azarchs, the Standard & Poor's banking analyst, calls it "the law of conservation of risk." No one is quite sure where all the risk is, but if history is any guide, it's bound to appear at the very worst time.
By Peter Coy and Heather Timmons in New York, with Rich Miller in Washington