End may be in sight for credit crunch

This week’s earnings reports from Canada’s biggest banks may have been marked by double-digit profit erosion and hundreds of millions of dollars in fresh writedowns, but they may also be a sign that the worst of the credit crunch is behind us.

“Probably all of these numbers are better than were feared,” says Chris Lowe, senior vice-president of AIC Limited. “They’re not as bad as they could have been, and they’re not as bad as we’ve seen in other banks across the world that had far more concentrated portfolios in these credit-related matters.

“Analysts across the world have learned that trying to put a number on some of these [securitized debt products] has been extraordinarily difficult.”

In fact, the banks that have taken the worst beating may eventually rise to become top performers. When the market for securitized debt dried up, these assets were marked to a market with no buyers.

The U.S. housing market is at the root of the credit crisis, and recent reports have shown that housing price declines have slowed in most major markets.

“What we’re gradually seeing is that the huge downdraft in housing prices — that rate of falling has slowed down quite materially,” he says. “Perhaps the worst is behind us now, and we can get a feeling of what those properties are worth.”

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If American homeowners feel that their houses may hold some of their value, or even begin to appreciate again, they may be less likely to walk away from their mortgages. If default rates stabilize and decline, the market for securitized debt may see increased liquidity.

Financial institutions that were caught holding the bag on these packaged debt products may find that they are not so worthless as they once appeared. Marking them to market when no one was buying resulted in massive writedowns on the balance sheet. Once the buyers return, the banks may be able to “write up” their securitized debt holdings.

“If you are a bank that got involved in sub-prime debt, then we are beginning to see the seeds of a revival,” says Lowe. “The one- to two-year outlook on a number of banks with large investment bank franchises — they [write-ups] are what you’re looking for.”

He points out, though, that these banks would need to have been able to hold on to their mortgage-backed securities.

Fortunately, Canadian banks are well capitalized and have not been forced into selling their portfolios at a loss. This was not the case for some of the global players, notably Merrill Lynch and UBS, which had to sell off portions of their assets.

“They are giving up on the ability for them to come back,” says Lowe. “How long will we be from when house prices stop falling to when they start rising again? That would normally be at least six months or so.”

With house prices stabilizing — albeit at much lower levels — it appears that damage to the overall economy has been held to a minimum.

“There’s been a dramatic slowdown in the economy of the United States, but it does what the Federal Reserve did early on, appears to be working,” he says.

“The quantum of problems that have hit [Canadian banks] have been nothing like the quantum of problems that have hit the U.K. and U.S. banks, so the downdraft hasn’t been as severe.”

Canadian banks, for the most part, have a well-deserved reputation for being a little boring. While their global counterparts placed huge bets on U.S. housing-related derivatives, Canadian banks tended to focus on the domestic market.

While the domestic housing market did see strong price appreciation, Lowe points out that “Vancouver is not California,” and few homeowners have “left the keys and walked away.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(08/29/08)