US Financial Sector Still in the Thick of It
Heading into the second half of 2008, US financial institutions can expect a variety of challenges as they find themselves in an unenviable position of falling asset values and increased regulatory oversight. As the repercussions of the subprime mortgage meltdown and credit crunch continue, many banks are facing the prospect of having to raise additional capital to meet required capital ratios to remain well capitalised. At the same time, all banks are facing increased regulatory requirements imposed, in part, to address enhanced consumer protection requirements and also some of the perceived causes of the current crisis.
The ongoing subprime mortgage implosion has resulted in financial institutions suffering significant losses from defaulting borrowers, as well as falling property values impacting the value of mortgage-backed assets. It is estimated that by the close of the second quarter of 2008 financial institutions will recognise subprime related losses and write downs exceeding US$379bn. Worse still is that there is no credible evidence suggesting that all losses have been recognised. Although some Wall Street bankers as well as bank regulators are starting to suggest that the worst of the crisis has passed, financial results for the first quarter of 2008 suggest that we do not yet know where the bottom of the crisis lies. For example, Morgan Stanley reported profits down 61%, Lehman Brothers Holdings posted a nearly US$3bn loss and Goldman Sachs Group reported a dip in profits of 11%. Moreover, the International Monetary Fund (IMF) believes that the credit crisis is likely to get worse before it gets better, predicting losses to the global financial industry approaching US$1 trillion.
Although many recent financial headlines have focused on the troubles at Bear Stearns and measures to prevent other investment bank meltdowns, many (non-investment) banks face their own challenges. Profits at the 8,533 FDIC insured banks declined 89% during the fourth quarter of 2007 versus the prior year, primarily due to soaring loan defaults and provisions for loan losses, amounting to the worst bank and thrift quarterly performance since 1990. During the first quarter of 2008, profits were down 46% compared to the same period in 2007.
Rapid declines in the valuation of mortgage assets and poor financial performance have banks in the position of needing to secure additional funds to maintain compliance with capital ratios, either through the issuance of equity or sale of assets. For example, on 18 June, one highly successful regional bank, Fifth Third Bancorp, announced plans to raise US$2bn to cope with mounting credit losses. Fifth Third intends to sell US$1bn of convertible preferred shares and raise an additional billion from the sale of non-core businesses over the next several quarters. Such sales could include’crown jewel’ assets such as Fifth Third Processing Solutions, an electronic payment processing unit generating 16% of the company’s overall profits for the fiscal year ended 31 March. Fifth Third’s announcement comes on the heels of a similar move by its rival KeyCorp, which stated on 13 June plans to issue new shares in an effort to raise US$1.5bn, and also follows capital raising activities by cross-town rival National City Bank, as well as National City’s public disclosure of enhanced regulatory oversight over the bank.
The moves by Fifth Third, KeyCorp and National City are representative of an industry-wide scramble for capital. As of May 2008, major financial institutions had obtained approximately US$260bn in new capital to shore up balance sheets hard hit by mortgage-related losses. And it is increasingly likely that more capital will be needed in the coming quarters. For example, on 17 June, Goldman Sachs reported that US banks may need US$65bn more for losses that may not peak until sometime in 2009.
The search for capital has increasingly led US financial institutions and their holding companies to turn to foreign sources in the form of sovereign wealth funds. Flush with cash from record oil prices and strong Asian exports, sovereign wealth funds from Gulf States and Asian countries have seemingly emerged as the white knights of Wall Street. For example, in the past 18 months, sovereign wealth funds have invested an estimated US$69bn on recapitalising US financial institutions, highlighted by the US$21bn investment in Citi and Merrill Lynch by the governments of Kuwait, Singapore and South Korea.
Another source of capital has been private equity funds. In April of 2008, Washington Mutual and National City Bank each raised approximately US$7bn that included minority investments from various private equity firms. Historically, the increased regulatory oversight that accompanies a controlling stake in a financial institution has been an impediment to big investments from these firms. Private equity firms, however, have been increasingly attracted to the US financial services sector with equity prices for financial institutions appearing as bargains in the current climate. The challenge for private equity firms, and for the banks that benefit from their capital, is how to structure deals in a way that would allow private equity firms to make large enough investments in financial institutions without coming under regulatory purview. In general, to avoid the most onerous level of regulatory oversight, investments must be below 25% of any class of a financial institution’s voting securities, while investments in excess of 10% of any class of voting securities still involve some regulatory scrutiny.
While under pressure to raise or maintain capital, US banks are also facing an increasingly complex regulatory landscape primarily governing their lending businesses. Abuses, both perceived and real, that fuelled the subprime credit crisis have led to US regulators and Congress taking a closer look at a variety of consumer lending practices. As a result, lenders now face increased scrutiny in the realm of consumer finance transactions. Calls for reform of the consumer lending industry, both from consumer groups and lawmakers, have increased in recent months and the Federal Reserve Board (FRB), in particular, has been under considerable pressure to issue rules on the subject. Further, several members of Congress have introduced legislation aimed at curbing certain practices perceived as unfair to consumers. Two key regulatory proposals serve as a barometer of the changing climate in this regard.
In December 2007, the FRB issued proposed rules addressing the subprime mortgage crisis. The proposed changes to Regulation Z, issued under the Home Ownership and Equity Protection Act, are ostensibly designed to protect consumers from unfair or deceptive home mortgage lending and advertising practices. The proposal targets these practices in connection with higher-priced mortgage loans secured by a consumer’s principal dwelling. Of principal importance, the revisions to Regulation Z impose common sense requirements and would prohibit creditors from extending credit without considering a borrower’s ability to repay the loan. Creditors would also have to verify the income and assets that creditors rely upon in making a loan. Further, pre-payment penalties would only be permitted if certain conditions are met, including the condition that no penalty will apply for at least 60 days before any possible payment increase. Moreover, creditors would be required to establish escrow accounts for taxes and insurance – expenses frequently ignored in marketing loans to subprime borrowers, who then faced increased and unexpected costs associated with their loans.
The second proposal, issued by the FRB and other federal regulators in May 2008, would prohibit or regulate certain credit card lending practices that are perceived to be unfair and deceptive. The proposal expands on proposed amendments to Regulation Z issued in 2007. It also embraces certain aspects of currently pending legislation. The proposal, applicable to most institutions, would declare certain practices to be’unfair and deceptive’ and thus prohibited by Section 5 of the Federal Trade Commission Act. Most visibly, the proposal would prohibit creditors from increasing the rate of finance charges on existing credit card balances except in connection with either a properly disclosed variable rate feature when the index rate increases, the expiration of a promotion, or if the creditor has not received a minimum payment within 30 days of its due date. The proposal would also require credit card lenders to provide a reasonable amount of time for consumers to make a payment before treating the payment as delinquent for purposes of imposing finance charges. Further, it would impose certain limits on the financing of security deposits and fees, practices that are generally associated with subprime credit card loans, and place limits on the imposition of credit overdraft fees based on authorisation holds.
These regulatory initiatives come at a time when regulators are increasingly imposing operating requirements on banks with higher levels of potentially risky assets, through the imposition of supervisory directives and other types of enforcement actions. Concurrently, the administration has proposed a framework for a significant overhaul to the entire US-based financial regulatory system, including the consolidation of certain existing regulators and the creation of new regulators. While fundamental changes are unlikely to occur in the near term, especially given the stress the industry is currently facing, future changes to financial regulation lurk on the horizon.
Between the need to secure capital and navigate increasingly complex regulatory waters, financial institutions face unprecedented challenges. Even if the credit crisis were to abate in 2009, financial institutions are bound to emerge into a new regulatory landscape, with the effects of the current crisis to be felt for many years thereafter.