As the credit downturn enters its second year, financial institutions are searching for evidence that the worst is over. Capital markets have regained some life, but most U.S. and European banks maintain a heightened sense of alert as difficult business conditions and substantial writedowns continue to weigh on financial performance.
Is this as bad as it gets for banks, or are more bleak times ahead? Current conditions demand intimate understanding of credit and liquidity risks and will require banks to make some tough choices as the downturn evolves. Government support and sovereign wealth funds' cash infusions have helped put the industry on a path to recovery. However, the rebound will be slow and painful.
Indeed, Standard & Poor's Ratings Services believes a return to a stable banking industry outlook is at least a year away in the U.S. Beyond the high-profile downgrades we issued during second-quarter 2008, our outlooks on U.S. banking groups shifted toward negative by the quarter's end. In the U.S., 22 of our 50 top-rated financial institutions had a negative outlook as of June 30, 2008, the highest proportion of negative outlooks in top-tier mature-market financial groups in the past 15 years. This means we may downgrade leading financial institutions during the next one to two years, on top of the 31 negative actions we've already taken since the beginning of 2008.
Of course, our future actions will depend on economic conditions and how individual companies handle the downturn. With the U.S. facing worsening economic prospects, in the opinion of S&P's Chief Economist David Wyss, further stress on the industry is likely. The news hasn't been all bad, however. A handful of financial institutions with strong balance sheets and robust capital are in a prime position to take advantage of the credit-market dislocation.
To provide insight into what might happen in the months ahead, Standard & Poor's analysts gathered on July 30 for a roundtable discussion of the most critical issues facing financial institutions, particularly in the U.S. and Europe. Excerpts from the discussion, moderated by Jay Dhru, global head of financial institutions ratings, follow:
Financial institutions worldwide have experienced a wild ride so far, from huge writedowns of asset-backed securities (ABS) to the disappearance of Bear Stearns to the recent failure of IndyMac Bank in the U.S. Could you put the seriousness of the situation in historical perspective and hazard a guess as to when this sector might right itself?
Tanya Azarchs, North American regional criteria officer: This will probably go down in history as one of the worst periods for banks, not only in the U.S. but potentially abroad as well. It's worse than 1998 and worse than 1994 in that it has not only caused very, very sharp drops in asset prices, but also has resulted in market illiquidity for more than a year now. Previous periods had lasted just a few months at a time.
The reason for the illiquidity is real asset price declines following a period of very sharp increases in those asset prices. These price declines have essentially telescoped into losses in a very short period that would have otherwise been taken by the banks during a long period under the accrual method of accounting. This has hit banks with large capital market activities extremely hard. In these harsh conditions, central bankers have done an excellent job of trying to alleviate some of the liquidity conditions, but we don't really expect those conditions to improve dramatically in the next year.
On top of that, we're now entering what we would call phase two of the problem, which is that the banks' loan books are starting to deteriorate very rapidly. This is hitting a wider array of financial institutions, not just those with capital-markets activities but also those with traditional banking activities. The problems are now hitting mortgage-related loans, but we expect credit losses to migrate into the other sectors of consumer lending. Eventually, they may also widen out into commercial lending as well, particularly in the real estate sector.
Rodrigo Quintanilla, head of North American bank ratings: The stress that the housing markets are enduring hasn't been seen since the 1930s, and unlike during other previous crises or downturns, the central bank has limited flexibility to conduct supportive monetary policies because of competing factors such as inflation, currency rates, and oil prices. So it's sort of a perfect storm.
I would also say that this cycle is unprecedented not only in terms of the types and amount of losses but also in terms of capital raising. We haven't seen in any previous cycle as much capital raising to match potential losses, and that's a positive balancing effect. How long this will go on and how much of this capital-raising capability smaller banks will have available to them are questions that remain unanswered. That said, as Tanya pointed out, we probably will see the lagging effect of consumer lending and commercial real estate delinquency flowing well into 2009. So we won't likely see the beginning of the recovery or firm signs of a recovery until very late in 2009 or the beginning of 2010.