From the above article.
The start of earnings season is exposing a potential crack in the stock market’s frothy foundation: risky lending by some regional banks.
Shares of Zions Bancorp and Western Alliance Bancorp plunged Thursday after the companies said they were victims of fraud on loans to funds that invest in distressed commercial mortgages. The disclosures sent the KBW Bank Index to its worst day since April’s tariff tantrum.
You have likely never heard of these banks, except if you live in certain parts of America. In the US, most mortgages originate from smaller regional banks like these.
The Wall Street behemoths that we’ve all heard about, such as J.P Morgan (NYSE – JPM), do lend to real estate, but they have a multitude of investment arms which generate most of their earnings.
From the point of view of these large banks, things look great: the first full week of the third-quarter earnings season featured a string of very positive reports from financial giants such as Bank of America Corp. (NYSE – BAC), Morgan Stanley (NYSE – MS), and Goldman Sachs Group Inc (NYSE – GS).
But next week might well offer a different view when regional lenders – such as Zions (NASDAQ – ZION), Western Alliance (NYSE – WAL) and East West Bancorp Inc (NASDAQ – EWBC). – are due to report.
So, what’s at stake here?
Well, you might find it interesting to note that the loan books of these regional banks are rehypothecated by Fannie Mae and Freddie Mac into mortgage-backed securities (or MBS for short). Rehypothecation is where Fannie and Freddie take the collateral pledged for the original mortgage and package and on sells them to firms on Wall Street.
And if you invested through the last global financial crisis, that MSB acronym will send shivers down your back.
Folks, we need to talk.
The first crack in the global financial system has just opened. You cannot dismiss this story as simply a bad few quarters of earnings for a handful of mid-tier banks who should otherwise have no bearing on the stock market.
And today, I’ll explain to you why.
Because as you’ll see, a little knowledge can indeed go a long, long way. And give you the early warning that 99.9% of the market participants, right now, are ignoring.
Let’s start.
Law of entanglement.
Most didn’t care when a non-descript auto lender and auto part suppliers’ business in the US went bankrupt. Eyebrows however were raised when it became apparent they couldn’t pay back loans from private credit.
But this was important because to then have these regional banks reporting troubles right after this is spooking investors.
Zion Bancorp has had to write off millions’ worth of loans and been forced to go to court about apparent bad loans tied to an alleged fraud. Western Alliance Bancorp are also in the same boat.
As Mike Mayo, an analyst at Wells Fargo & Co., said in an interview; “If JPMorgan has a loan problem with Tricolor, it’s puny. But if smaller banks have problems with these loans, it takes more of a hit.”
The shares of Zions Bancorp sank 13% after it disclosed a $50 million charge-off for a loan underwritten by its wholly owned subsidiary, California Bank & Trust, in San Diego. And Western Alliance Bancorp tumbled almost 11% after it said it had made loans to the same borrowers.
California Bank & Trust provided two revolving credit facilities to the borrowers in 2016 and 2017, totalling more than $60 million, to finance their purchase of distressed commercial mortgage loans, according to the lawsuit.
The terms gave the bank “first-priority, perfected security interest” in all collateral, including each mortgage loan purchased by the investment funds. In English, they are first in line to get their money back in a collapse.
But after an investigation, the lender found that many of the notes and underlying properties were transferred to other entities and that those properties have already been foreclosed on or were about to be.
Ok, two things to say here. First, can you start to appreciate just how interrelated all these loan providers actually are? It isn’t Bank A lending to Client B on the back of fresh collateral. Instead, as you see here, the actual collateral behind these loans had already been foreclosed!
Second, Global credit markets rely on good collateral. No one has any problems with lending provided your collateral is good.
The fraud here is, however, the fact the borrower created fake title policies which tricked the lenders into thinking they had first priority on the pledged collateral.
This news led to a classic quote from JP Morgan CEO Jamie Dimon. (He is one of the few remaining American bank CEOs who lived through the global financial crisis, which is why listen to what he says):
“I probably shouldn’t say this, but when you see one cockroach, there are probably more. Everyone should be forewarned on this one.” Some private-credit executives saw his words as a barb aimed at them.
Zions Bancorp’s CEO Harris Simmons warned that the speedy expansion of private credit could lead to risks down the line, adding to the debate between banks and private lenders over who is responsible for these recent high-profile collapses.
The bold text below is my own.
“If I think there’s a risk out there, I think it’s probably in private credit,” Simmons said on an earnings conference call late Monday. “When you get something growing as quickly as that’s been growing and with the magnitude of the size of that sector — at least there’s a kind of a yellow flag.”
Well, now, you don’t say.
|
