Henry Kaufman Roubini And Other Prophets Of Doom Say Financial Crisis Continues - Industry News - Portfolio.com

Economist Henry Kaufman became famous in the 1970s as the bear with the dire view. Now he and his heirs warn that the financial crisis is far from over and that systemic risks threaten to spread from the markets to the geopolitical realm.

Portfolio.com - a bizjournals property
by Suzanne McGee Oct 15 2010


Image: Portfolio.com; designed by Sean Driscoll

Henry Kaufman is far from upbeat about the outlook for the U.S. economy or the financial system.

That should come as anything but a shock to anyone familiar with Kaufman’s background as an economic pundit. After all, he earned the nickname “Dr. Doom” nearly four decades ago for his bearish outlook on interest rates and the bond market and for his fear that financial havoc might spread to the political environment and society as a whole.

Even as politicians and others try to take comfort from the passage of the package of financial reform measures known as the Dodd-Frank Act, Kaufman is reluctant to relinquish his pessimism …“It’s a very cumbersome piece of legislation and creates a tremendous amount of uncertainty,” the economist and financial consultant says. “Many aspects will take years to come into effect, and there are many issues that still have to be resolved by regulators in negotiation with the private sector.”

That, Kaufman says, means that the Dodd-Frank Act has at least two major flaws … In the short term, he argues, rather than accelerating the rate at which credit is created in the economy, the uncertainty means credit growth will actually slow. The longer-term problem is more acute, he says: The legislation doesn’t address the problem of financial institutions that become “too big to fail,” as the saying goes.

“Over a longer period of time, the result of Dodd-Frank will be to increase the size of the government’s role in the economy and in the financial system specifically,” Kaufman says. “Instead of adopting policies that help to downsize financial institutions, we are making this more like the European or Japanese system.” That, he argues, is not a good thing for the financial system or its users. …

Image via WikipediaBut while Kaufman may be the original “Dr. Doom,” these days he is just one figure in a pantheon of prophets of doom. Among his heirs are figures like Nouriel Roubini, a professor at New York University and head of his own economic-forecasting consulting firm, who was one of those who diagnosed the credit bubble and forecast that it would come to an early end. Since 2008, Roubini has warned repeatedly that the financial system and the economy haven’t yet emerged from the crisis and that an intractable public debt problem still looms.

While Roubini has emphasized sovereign-debt problems of the kind that became all too evident in Greece this year, others are trying to draw attention to a different source of concern: … It is the emergence of cash-rich and commodity-rich states as political powerhouses rivaling—and in some cases trumping—traditional geopolitical powers such as the European Union and the United States.

Cover via AmazonThat is the focus of two recent books, one by Ian Bremmer, president of the Eurasia Group (The End of the Free Market: Who Wins the War Between States and Corporations?), and the other by journalist Eric Weiner, entitled The Shadow Market: How a Group of Wealthy Nations and Powerful Investors Secretly Dominate the World.

As the titles imply, the next generation of prophets of doom are focusing on different sources of systemic risk than those that brought the financial system to the brink of disaster in 2008. Weiner, for instance, suggests that if the problems associated with the shadow financial system (all the mortgage originators and architects of structured products) were scary, the problems that could follow the evolution of a “shadow market” composed of countries that view their economic power as something to be deployed in their geopolitical interests could prove far more threatening to the U.S. financial system.

Weiner chooses some well-known examples to prove his point. Among them are China’s ability to use its importance as a source of liquidity in the global markets and as a large investor in U.S. government securities to win favorable treatment in some disputes and fend off criticism of its human-rights policies. … He envisages a secretive new financial world emerging, one in which transactions take place outside of the public arena and end up being hard for regulators or the public to monitor. …

---

Related articles

• Hey, Economic Pundits, Find a New Nickname [Trendwatch] (gawker.com)
• How to Fix the Economy: An Expert Panel (businessweek.com)
• Jackson Hole Debate on Recession Risk Shows Bernanke Challenge (businessweek.com)

A better way to anticipate downturns

Credit markets, though harder to follow than equity markets, provide clearer signs of looming economic decline.

McKinsey Quarterly
OCTOBER 2010 • Tim Koller
Source: Corporate Finance Practice



What executive isn’t challenged by the daily barrage of conflicting economic reports attempting to clarify the question of the hour: will the global recovery build or lapse into another recession? Indeed, executives around the world are evenly split on the topic.¹ And while the savviest executives and investors know better than to get caught up in the short-term fluctuations of the economy, many others, looking for evidence of longer-term trends, still fixate on movements in the equity markets.
They shouldn’t. The fact is that those markets, … don’t predict downturns effectively. Credit markets are a better place to look for signs of impending trouble, in no small part because they have been at the core of most financial crises and recessions for hundreds of years. Parsing the credit markets isn’t easy—there’s no single number remotely like a share price to monitor, and there are many moving parts. But for executives willing to take the time to understand the relationship between the financial and real economies, the credit markets can provide clearer indicators that a recession is on the horizon.

Collective wisdom falls short

Subscribers to the theory that markets process all information efficiently would argue that equity investors should be in very good shape to recognize early indications of a looming downturn. If that were indeed the case, current market valuations might inspire confidence. … And since equity markets do a reasonably good job of tracking long-term economic fundamentals,² investors can expect longer-term returns—dividends and share price appreciation—that are in line with historical real returns, in the range of 6 to 7 percent.
Of course, the fact that the stock market is currently in line with the long-term trend doesn’t rule out the possibility of major fluctuations on the way to the longer term. The performance of equity markets shows that they have not been a good predictor of past recessions. Indeed, during every major recession since the early 1970s, most of the decline in the S&P 500 index occurred after the economy had already slowed (Exhibit 1). … Our analysis suggests that the equity markets give too much weight to current economic activity rather than to the situation likely to materialize in a couple of months or even a year.

Exhibit 1: Most of the decline in equity markets comes after a recession has already begun.

Moreover, when the index’s value does drop during nonrecessionary periods, this rarely signals a coming downturn. In the past 30 years, there have been few major declines in the market outside of recessions (Exhibit 2). Even an extreme case, such as the 20 percent drop during a couple of days in 1987, didn’t portend a systemic downturn, and the index was back to normal a mere two months later. In the past, such market fluctuations have been caused mostly by forces that didn’t have anything to do with the real economy—and any effect they had dissipated very quickly. Equity markets played the more typical role of bystander, buffeted by and reacting to economic events rather than anticipating them.

Exhibit 2: Stock market declines do not indicate economic downturns.

While the equity markets may not predict economic trends well, their depth does provide investors with liquidity, so they generally continue to function smoothly even in difficult times. … During that time, the S&P 500’s long-term trend value—the value you would expect to see if you were confident that the economy would recover to its long-term trend within several years—stood at about 1,100–1,300. Therefore, no one should have been surprised to see a drop to the 900–1,000 level, given uncertainty about the depth and duration of the recession. …

Incubators of crisis

Unlike equity markets, credit markets don’t always function smoothly during difficult times. That, in part, is why they are a better source of clues about where the economy is heading. The credit markets are where crises develop—and then filter through to the real economy and drive downturns in the equity markets. Indeed, some sort of credit crisis has driven most major downturns over the past 30 to 40 years (Exhibit 3). Such crises include not only the recent property debacle in the United States and the 1990 one in Japan but also the crises generated by excessive government borrowing in Latin America in 1980 and by excessive corporate borrowing in Southeast Asia in 1997. So executives who find reasons for optimism in today’s equity market levels might be less sanguine looking at today’s credit markets. It’s still not clear whether prices have stabilized in once overheated real-estate markets. Banks are still somewhat vulnerable. And the level of government debt in the United States and elsewhere is still an issue.

Exhibit 3: Most major downturns in the past 30 to 40 years have been driven by some sort of credit crisis.

Moreover, the pattern of crisis development shows clearly enough that the one thing we can know for certain is that economic crises will erupt in the future—in part because the credit markets work almost as if designed to cause them. That may be a provocative point, but consider this:

• The credit markets are extremely illiquid. The trading volume of most equities is many orders of magnitude greater than that of typical debt instruments. … This illiquidity sometimes makes it difficult for banks or other investors to sell credit assets at a reasonable price. In addition, providers of short-term credit—to banks, hedge funds, and other financial institutions—may be simply unwilling to extend new credit when old debt comes due, forcing debtors to sell assets to pay down debt just as they are least sellable.
• The banking system and many investors, particularly hedge funds, earn a significant portion of their profits on the mismatch between their assets and liabilities: they invest in longer-term loans and other investments and borrow with short-term deposits and debt. … Normally, this formula works well. But two things can happen to disrupt it. Sometimes the yield curve inverts, with short-term interest rates higher than long-term rates; then, normal banking profits disappear. More important, short-term credit markets sometimes freeze up, so banks, hedge funds, or financial institutions can’t get short-term debt at a reasonable price, or any price. As a result, they sell assets at distressed prices—if they can find buyers.
• The system suffers from chronic group-think. … Banks and investors observe which banks or other investors seem to be making the highest profits and then implement similar strategies. If contrarians in the market were to counterbalance credit excesses, the system should stay in equilibrium. But the system makes it very difficult for investors with contrarian views to apply them. …
• Expectations of government bailouts create tremendous moral hazard—… If the European Union hadn’t been expected to step in and rescue the country, the spreads on its debt would have been much higher, years before the crisis hit, relative to, say, German bonds or other euro bonds, given the enormous levels of government debt and its large social obligations. Instead, investors assumed that the EU or one of its members would bail out Greece and continued to lend to it at rates far below levels that would have reflected the true risk of the debt. And in the end they were right, as the EU stepped in.

Unfortunately, it takes several years for crises to develop, and once the conditions are in place, they are nearly inevitable. The only way to stop one is to anticipate it years in advance; for example, preventing the US subprime crisis would have required clamping down on borrowing in 2005. Avoiding the crisis in Greece would have required something similar in 2005, 2006, or even earlier.

Foreshadowing a downturn

The good news, relatively speaking, for managers of companies is that because the conditions for a crisis are in place several years in advance, it is possible to see the signs of one coming—and to avoid getting caught up in credit market hazards.³

Loose lending standards

One clear sign of trouble ahead is a deterioration of lending criteria. … [During] the 2005 real-estate bubble in the United States, buyers with little or no evidence of their ability to carry a mortgage could purchase houses.

Unusually high leverage

Another warning sign of crisis is unusually high debt levels and mismatches between assets and liabilities, whether by financial institutions, companies, governments, or individuals. For example, in the months leading up to the real-estate crisis that erupted in 2007, the leverage of both banks and consumers in the United States was at unusually high levels. In addition, many consumers were financing their homes—long-term, illiquid assets—with debt in the form of adjustable-rate mortgages that had the characteristics of short-term debt.
In the 1997 Asian crisis, companies financed production facilities—obviously long-term investments—with debt in US dollars. When the dollar strengthened, borrowers needed more local currency cash flows to service the debt. And as hedge funds have grown over the past decade, the importance to their returns of their financing model—short-term debt to finance less liquid assets at very high leverage levels of 90 percent or more—has largely been left unspoken. The general public couldn’t see how leveraged these funds were, but the banks lending to them could. And even with full access to their balance sheets, no single bank was willing to give up the business as long as the hedge funds were profitable customers.

Transactions without value

It isn’t always easy for casual observers to notice, but subtle signs often indicate that financial transactions are proliferating even when they aren’t creating value (for example, by substantially easing the allocation of capital). Indeed, many collateralized debt obligations, such as those blamed for the great credit crisis that resulted in the demise of Lehman Brothers two years ago, fall into this category. … Whenever a company tries to take debt off its balance sheet, investors would be well advised to wonder why. These transactions generate a lot of fees for bankers but rarely create any value.
Watching the equity markets for signs of future crises or downturns is unlikely to provide the kind of advance notice that can inform strategic decisions. Executives with the tenacity to follow the many moving parts of the credit markets are likely to be better prepared when the economy does turn sour.

About the Author

Tim Koller is a principal in McKinsey’s New York office.

Notes

¹ “Economic Conditions Snapshot, September 2010: McKinsey Global Survey results,” mckinseyquarterly.com, September 2010.
² See Richard Dobbs, Bill Huyett, and Tim Koller, Value: The Four Cornerstones of Corporate Finance, Hoboken, NJ: Wiley, November 2010.
³ Indeed, US industrial companies that entered the crisis with healthy balance sheets were able to withstand the crisis reasonably well, precisely because they were not overleveraged and had sufficient cash reserves to be flexible as the crisis wore on.

Related articles

• First The Equity Markets Blew Up, Then The Credit Markets And Next Is The Political System (businessinsider.com)
• If the Dollar Stops Falling, the Stock Rally Could Be Over (dailyfinance.com)
• Joseph Stiglitz sees bleak future for euro as New Malaise takes hold (telegraph.co.uk)

Why value value?--defending against crises

Companies, investors, and governments must relearn the guiding principles of value creation if they are to defend against future economic crises.

McKinsey Quarterly - Corporate Finance – Valuation

APRIL 2010 • Timothy M. Koller

In response to the economic crisis that began in 2007, several serious thinkers have argued that our ideas about market economies must change fundamentally if we are to avoid similar crises in the future. Questioning previously accepted financial theory, they promote a new model, with more explicit regulation governing what companies and investors do, as well as new economic theories.

My view, however, is that neither regulation nor new theories will prevent future bubbles or crises. This is because past ones have occurred largely when companies, investors, and governments have forgotten how investments create value, how to measure value properly, or both. The result has been a misunderstanding about which investments are creating real value—a misunderstanding that persists until value-destroying investments have triggered a crisis.

Accordingly, I believe that relearning how to create and measure value in the tried-and-true fashion is an essential step toward creating more secure economies and defending ourselves against future crises. The guiding principle of value creation is that companies create value by using capital they raise from investors to generate future cash flows at rates of return exceeding the cost of capital (the rate investors require as payment). …The combination of growth and return on invested capital (ROIC) relative to its cost is what drives value. Companies can sustain strong growth and high returns on invested capital only if they have a well-defined competitive advantage. …

The corollary of this guiding principle, known as the conservation of value, says anything that doesn’t increase cash flows doesn’t create value.¹ For example, when a company substitutes debt for equity or issues debt to repurchase shares, it changes the ownership of claims to its cash flows. However, it doesn’t change the total available cash flows,² so in this case value is conserved, not created. …

These principles have stood the test of time. Economist Alfred Marshall spoke about the return on capital relative to the cost of capital in 1890.³ … Using them to create value requires an understanding of both the economics of value creation (for instance, how competitive advantage enables some companies to earn higher ROIC than others) and the process of measuring value (for example, how to calculate ROIC from a company’s accounting statements). With this knowledge, companies can make wiser strategic and operating decisions, such as what businesses to own and how to make trade-offs between growth and returns on invested capital—and investors can more confidently calculate the risks and returns of their investments.

Market bubbles

During the dot-com bubble, managers and investors lost sight of what drove ROIC …When Netscape Communications went public in 1995, the company saw its market capitalization soar to $6 billion on an annual revenue base of just $85 million, an astonishing valuation. This phenomenon convinced the financial world that the Internet could change the way business was done and how value was created in every sector, setting off a race to create Internet-related companies and take them public. …

Many of the companies born in this era, including Amazon.com, eBay, and Yahoo!, have created and are likely to continue creating substantial profits and value. But for every solid, innovative, new business idea, there were dozens of companies that turned out to have virtually no ability to generate revenue or value in either the short or the long term. …

Many executives and investors either forgot or threw out fundamental rules of economics … Consider the concept of increasing returns to scale—also known as “network effects” or “demand-side economies of scale”—an idea that enjoyed great popularity during the 1990s in the wake of Carl Shapiro and Hal Varian’s book Information Rules: A Strategic Guide to the Network Economy.⁴ The basic idea is this: in certain situations, as companies get bigger, they can earn higher margins and returns on capital because their product becomes more valuable with each new customer. In most industries, competition forces returns back to reasonable levels. But in industries with increasing returns, competition is kept at bay by the low and decreasing unit costs incurred by the market leader (hence the “winner takes all” tag given to this kind of industry).

Take Microsoft’s Office software, a product that provides word processing, spreadsheets, and graphics. As the installed base of Office users expanded, it became ever more attractive for new customers to use Office as well, because they could share their documents, calculations, and images with so many others. Potential customers became increasingly unwilling to purchase and use competing products. Because of this advantage, in 2009 Microsoft made profit margins of more than 60 percent and earned operating profits of approximately $12 billion on Office software—making it one of the most profitable products of all time.

As Microsoft’s experience illustrates, the concept of increasing returns to scale is sound economics. What was unsound during the Internet era was its misapplication to almost every product and service related to the Internet. …To illustrate, some analysts applied the idea to mobile-phone service providers, even though mobile customers can and do easily switch providers, forcing the providers to compete largely on price. With no sustainable competitive advantage, mobile-phone service providers were unlikely ever to earn the 45 percent ROIC that was projected for them. …

The history of innovation shows how difficult it is to earn monopoly-sized returns on capital for any length of time except in very special circumstances. …

When the laws of economics prevailed, as they always do, it was clear that many Internet businesses, … did not have the unassailable competitive advantages required to earn even modest ROIC. The Internet has revolutionized the economy, … but it did not and could not render obsolete the rules of economics, competition, and value creation.

Financial crises

Behind the more recent financial and economic crises beginning in 2007 lies the fact that banks and investors forgot the principle of the conservation of value. … First, individuals and speculators bought homes—illiquid assets, meaning they take a while to sell. They took out mortgages on which the interest was set at artificially low teaser rates for the first few years but then rose substantially when the teaser rates expired and the required principal payments kicked in. In these transactions, the lender and buyer knew the buyer couldn’t afford the mortgage payments after the teaser period ended. But both assumed either that the buyer’s income would grow by enough that he or she could make the new payments or that the house’s value would increase enough to induce a new lender to refinance the mortgage at similar, low teaser rates.

Banks packaged these high-risk debts into long-term securities and sold them to investors. The securities too were not very liquid, but the investors who bought them—typically hedge funds and other banks—used short-term debt to finance the purchase, thus creating a long-term risk for whoever lent them the money.

When the interest rate on the home buyers’ adjustable-rate debt increased, many could no longer afford the payments. Reflecting their distress, the real-estate market crashed, pushing the values of many homes below the values of the loans taken out to buy them. At that point, homeowners could neither make the required payments nor sell their houses. Seeing this, the banks that had issued short-term loans to investors in securities backed by mortgages became unwilling to roll over the loans, prompting the investors to sell all such securities at once. The value of the securities plummeted. Finally, many of the large banks themselves owned these securities, which they, of course, had also financed with short-term debt that they could no longer roll over.

This story reveals two fundamental flaws in the decisions made by participants in the securitized mortgage market. They assumed that securitizing risky home loans made the loans more valuable because it reduced the risk of the assets. This violates the conservation-of-value rule. Securitization did not increase the aggregated cash flows of the home loans, so no value was created and the initial risks remained. Securitizing the assets simply enabled their risks to be passed on to other owners: some investors, somewhere, had to be holding them. Yet the complexity of the chain of securities made it impossible to know who was holding precisely which risks. After the housing market turned, financial-services companies feared that any of their counterparties could be holding massive risks and almost ceased to do business with one another. This was the start of the credit crunch that triggered a recession in the real economy.

The second flaw was to believe that using leverage to make an investment in itself creates value. It does not, because … it does not increase the cash flows from an investment. Many banks used large amounts of short-term debt to fund their illiquid long-term assets. This debt … increased the risks of holding their equity.

Excessive leverage

As many economic historians have described, aggressive use of leverage is the theme that links most major financial crises. …

In the past 30 years, the world has seen at least six financial crises that arose largely because companies and banks were financing illiquid assets with short-term debt. …

Market bubbles and crashes are painfully disruptive, but we don’t need to rewrite the rules of competition and finance to understand and avoid them. Certainly the Internet … has not created a “New Economy,” as the 1990s catchphrase went. On the contrary, it has made information, especially about prices, transparent in a way that intensifies old-style market competition in many real markets. … [The] key to avoiding the next crisis is to reassert the fundamental economic rules, not to revise them. If investors and lenders value their investments and loans according to the guiding principle of value creation and its corollary, prices for both kinds of assets will reflect the real risks underlying the transactions.

Equity markets

Contrary to popular opinion, stock markets generally continue to reflect a company’s intrinsic value during financial crises. For instance, after the 2007 crisis had started in the credit markets, equity markets too came under criticism. In October 2008, a New York Times editorial thundered, “… In the last month or so, shares in Bank of America plunged to $26, bounced to $37, slid to $30, rebounded to $38, plummeted to $20, sprung above $26 and skidded back to almost $24. Evidently, people don’t have a clue what Bank of America is worth.”⁵ … [This] example points out the fundamental difference between the equity markets and the credit markets. The critical difference is that investors could easily trade shares of Bank of America on the equity markets, whereas credit markets (with the possible exception of the government bond market) are not nearly as liquid. This is why economic crises typically stem from excesses in credit rather than equity markets.

The two types of markets operate very differently. Equities are highly liquid because they trade on organized exchanges with many buyers and sellers for a relatively small number of securities. In contrast, there are many more debt securities than equities … and even more derivatives, many of which are not standardized. The result is a proliferation of small, illiquid credit markets. Furthermore, much debt doesn’t trade at all. … Illiquidity leads to frozen markets where no one will trade or where prices fall to levels far below that which reflect a reasonable economic value. Simply put, illiquid markets cease to function as markets at all.

During the credit crisis that began in 2007, prices on the equity markets became volatile, … The volatility reflected the uncertainty hanging over the real economy. The S&P 500 index traded between 1,200 and 1,400 from January 2008 to September 2008. In October, … the index began its slide to a trading range of 800 to 900. But that drop of about 30 percent was not surprising given the uncertainty about the financial system, the availability of credit, and its impact on the real economy. Moreover, the 30 percent drop in the index was equivalent to an increase in the cost of equity of only about 1 percent,⁶ reflecting investors’ sense of the scale of increase in the risk of investing in equities generally.

… Many investors were apparently sitting on the market sidelines, waiting until the market hit bottom. The moment the index dropped below 700 seemed to trigger their return. From there, the market began a steady increase—reaching about 1,100 in December 2009. Our research suggests that a long-term trend value for the S&P 500 index would have been in the 1,100 to 1,300 range at that time, a reasonable reflection of the real value of equities.

In hindsight, the behavior of the equity market has not been unreasonable. It actually functioned quite well in the sense that trading continued and price changes were not out of line with what was going on in the economy. … [Equity] markets rarely predict inflection points in the economy.⁷

About the Author

Tim Koller is a partner in McKinsey’s New York office. This article is excerpted from Tim Koller, Marc Goedhart, and David Wessels, Valuation: Measuring and Managing the Value of Companies (fifth edition, Hoboken, NJ: John Wiley & Sons, August 2010). Tim Koller is also coauthor, with Richard Dobbs and Bill Huyett, of a forthcoming managers’ guide to value creation, titled Value: The Four Cornerstones of Corporate Finance (Hoboken, NJ: John Wiley & Sons, October 2010).

Notes

¹ Assuming there are no changes in the company’s risk profile.

² Indeed, the tax savings from debt may increase the company’s cash flows.

³ Alfred Marshall, Principles of Economics, Volume 1, New York: Macmillan, 1920, p. 142.

⁴ Carl Shapiro and Hal R. Varian, Information Rules: A Strategic Guide to the Network Economy, Boston: Harvard Business School Press, 1998.

⁵ Eduardo Porter, “The lion, the bull and the bears,” New York Times, October 17, 2008.

⁶ Richard Dobbs, Bin Jiang, and Timothy M. Koller, “Why the crisis hasn’t shaken the cost of capital,” mckinseyquarterly.com, December 2008.

⁷Richard Dobbs and Timothy M. Koller, “The crisis: Timing strategic moves,” mckinseyquarterly.com, April 2009.

What’s next for US banks

Two different kinds of accounting—fair value and hold to maturity—have created two different kinds of crises. One is almost over. The other is only beginning.

McKinsey Quarterly

JUNE 2009 • Lowell Bryan and Toos Daruvala

Source: Financial Services Practice

… How close are we to the restoration of a strong and profitable banking and securities industry that is capable of providing the US economy with the credit it needs to grow?

The good news is that we have probably turned a corner in the credit securities crisis … But the contours of a broader resolution of the crisis will remain fuzzy for some time to come. That’s because what many have been regarding as a single credit crisis is in reality the tale of two closely related but different crises, each with its own pace, duration, and demands on banks to rediscover operational discipline in a harsh economic and regulatory environment.

Twin crises

The first credit crisis was centered in the securities markets and initially manifested itself in the subprime and mortgage-backed securities markets. Because of the fair-value accounting that broker–dealers and investment companies use to mark assets to current market expectations, these firms began to suffer deep losses on mortgage-backed securities long before large volumes of loans started to default. …

The good news is that we appear to be seeing the end of this credit securities crisis. That is in part due to the clarity provided by the stress test exercise and the ongoing commitment on the part of government not to allow a large-scale bank failure. The other credit crisis is a commercial-bank lending crisis. …[It] involves a broader array of lending, including commercial real-estate loans, credit card loans, auto loans, and leveraged/high-yield loans, all of which are now going bad because of the economic downturn. The bulk of these loans are subject to hold-to-maturity accounting, which, in contrast to fair-market accounting, typically does not recognize losses until the loans default. The bad news is that this crisis is still in its early stages and may take two years or more to work through the credit losses from these loans.…

It might seem odd that accounting methodologies can make such a big difference. At the end of the day, what counts is the net present value of the cash flows from each asset, but those are unknowable until after a debt is repaid. Fair-value accounting, based on mark-to-market principles, immediately discounts assets when the expectation of a default arises and ability to trade the assets declines. Fair-value therefore makes the holder of the assets look worse, sooner. Hold-to-maturity accounting works in reverse and makes the holder look better for a longer time.

First-quarter 2009 earnings

Many of the largest banks reported a return to profitability in the first quarter of 2009. The comfort this provided to markets is not necessarily misplaced. …

An analysis of these results shows that quarterly noninterest revenue for corporate- and investment-banking activities (that is, largely broker–dealer operations) increased by a surprisingly large $26.3 billion from the prior year …. Fair-value accounting losses depressed 2008 results but in 2009 were replaced by fair-value gains. Large additional trading profits were made possible by arbitrage and other trading opportunities that became available as market conditions improved.

While the worst may be over for the broker–dealer sector, first-quarter 2009 results tell a different story for commercial-banking activities at the same major banks. These banks took $38 billion in loan-loss provisions in the first quarter, $16 billion more than in the 2008 period. Most of this increase—$12 billion—was from retail-banking and credit card credits. …

This merits concern because loan provisioning under hold-to-maturity accounting is a lagging indicator of future loan losses. … When loan-loss provisions start rising rapidly, it is likely that more losses lie ahead.

Loan losses to come

While 2008 was the year for taking losses on broker–dealers, this year and next will be the years for taking losses on assets subject to hold-to-maturity accounting. These are the losses that show up in stress tests, in which regulators make assumptions about how the economy will perform and calculate the resulting loan losses under various economic outcomes. …

McKinsey research estimates that total credit losses on US-originated debt from mid-2007 through the end of 2010 will probably be in the range of $2.5 trillion to $3 trillion, given the severity of the current recession … Some $1 trillion of these losses has already been realized. Since US banks hold about half of US-originated debt, the US banking and securities industry will incur about $750 billion to $1 trillion … of projected losses on this debt, which includes residential mortgages, commercial mortgages, credit card losses, and high-yield/leveraged debt. …

Since the middle of 2007, the US banking and securities industry has absorbed some $490 billion of losses, or $80 billion per quarter … If the industry incurs additional losses of $1 trillion in 2009 and 2010, the losses will be about $125 billion a quarter. … Importantly, many of these losses will be concentrated in the banks that the stress tests revealed to be undercapitalized….

Grading the stress tests

Stress testing may have set the stage for restoring the health of individual institutions because it has provided the financial markets with information on the quality of each individual institution’s loan portfolio. …

The tests also marked a turning point because they provided much greater clarity regarding how the US government will handle troubled institutions in the future. … The government is clearly prepared to use whatever combination of funding support, guarantees, and capital injections are required to ensure that any future resolution of troubled financial institutions will be orderly.

Restoring earnings strength

While the stress tests have focused on capital adequacy, the only real way for an institution to become strong enough to stand on its own feet is through its ability to earn profits. …

The challenge for many adequately capitalized banks is that they will find it difficult to generate enough income to cover loan-loss provisions over the next two years. …

To meet this earnings challenge, well-capitalized and adequately capitalized banks must play both defense and offense. In terms of defense, investing in building collection and workout skills is essential. …

It is also essential for banks and securities firms to begin reducing operating expenses more programmatically. …[The] 19 stress-tested institutions have actually increased annual operating expenses by 32 percent since 2006…. Many banks need to target reductions in noninterest expenses of 20 percent or more from 2008 levels.

Banks with broker–dealers should have an abundance of opportunities as the markets continue to thaw. The pent-up demand for credit securities issuance, acquisitions, and spin-offs is considerable. Moreover, trading opportunities should be numerous for strong counterparties.

Challenges ahead

… Not only has the economic shock thrown financial markets and industry structures into flux, but the process of saving the banking and securities industry has transformed the nation’s social contract with the industry. The entire industry is now dependent on government support of all kinds, ranging from low-cost funding (courtesy of the Federal Reserve), to debt guarantees, asset guarantees, and capital injections.

There is no clear path to restoring the industry to independence from the US government. Major changes in regulation are coming, and the industry is going to be subject to more government involvement and oversight than it would like for a long, long time. Against that backdrop, stress testing has removed much of the generalized fear that painted all institutions with the same brush. It has also removed the uncertainty related to how the US government is going to treat individual institutions. But it will remain for the industry’s leaders to put in place the operational efficiencies and discipline that may determine when—and how—the credit crisis is finally resolved.

About the Authors

Lowell Bryan and Toos Daruvala are directors in McKinsey’s New York office.

The authors would like to acknowledge the contributions of Kevin Buehler, Chris Mazingo, Kazuhiro Ninomiya, and Hamid Samandari to this article.