Truancy + Delinquency = Charge Offs
Apology in advance for the left/right charts displayed in this piece as I try to make my point.
So the Federal Reserve Board stats for bank delinquencies and charge-offs are out, a little early this quarter to beat the holiday rush.....and they ain't pretty. Recall that these numbers cover only federally regulated banks, but it's a big enough and broad enough sample size that it is highly indicative of the state of bank balance sheets overall. Let's start with the source of all the problems, residential real estate loans. Delinquencies hit 3.64%, which rings the bell, it's the highest level in the data, which goes back to Q1 1991 - the last real estate down cycle - exceeding the 3.43% level of Q4 1991. Here is the chart:
Banks have now started to react to the pipeline of souring loans, by charging off the value of more of these loans as outright losses. Charge-offs exploded to .84% of residential loans. This was well above prior spikes of .45% in Q3 2001 and Q4 2003 of .35%. 
In the early 1990s real estate down cycle residential loan charge offs appear to have peaked during Q4 1992 at .31% (data only go back to Q1 1991 and could have been higher in the late 80s as several regional residential markets had severe problems from the late 1980s to early 1990s).
Many times delinquent loans are remedied before bank's actually have to charge them off and charge offs are sometimes reversed if the sale of a property produces a value for the bank above what was charged off. This all depends on the "severity" of losses on the underlying real estate. Unfortunately, with charge offs already well ahead of the early 1990s experience, and delinquencies now above the early 1990s level, it can be surmised that charge offs will get worse from here and severity may be.....more severe.... than the last cycle.
As you can see from the chart below, higher mortgage resets, loss of household wealth and the slow economy are now taking a toll on credit card borrowers and lenders.
Credit card delinquencies are getting back up to recessionary levels around 5%. Due to periodic bouts of poor underwriting, this is territory the industry has been in more often than not. Interestingly, according to Seeking Alpha, Capitol One displayed a slide at a recent investor presentation showing that credit card delinquencies rise ahead of unemployment, not vice versa. So the rise we see in credit card delinquencies probably pre-sages further job losses. The question becomes, does this feed into more credit card losses due to the levered state of the consumer?
Credit card charge offs are not worth dedicating a chart to. Suffice it to say that they are near early 1990s levels, as would be expected, but have not spiked as they did just after 9-11 and the bankruptcy reform of late 2005.
Commercial real estate: Now here is where things get interesting. Recall that last quarter there was a clear "break-out" in commercial real estate delinquencies after many years of being under-wraps, post the cataclysmic early 1990s. As expected, we moved further towards 1990s territory this quarter with delinquencies jumping almost a full percentage point, from 2.75% last quarter to 3.72% and reaching a level not seen since Q3 1995, when it was recovering from a peak of 12.75%.
Now those were very different times and I don't expect that we are going anywhere near those numbers, which were caused by a huge supply glut, which just doesn't exist today in most markets and segments. Today's commercial real estate delinquencies seem very likely to get worse, based on the big acceleration we have seen recently, tighter credit markets, and tougher underwriting standards. My guess is that the fact that real estate owners more often have 5 year loans these days than the 10 year loans that used to be more fashionable years ago will mean that many more owners will need to refinance during this down cycle.
As you can see in the chart to the right, commercial real estate charge offs have begun to follow suit with delinquencies. My guess is that this cycle severity will be less, as despite the fact that many owners of commercial real estate are over-leveraged, the underlying assets supporting loans are in better shape this time around due to less over-building.
Now in the last credit cycle, what really hurt the banks were their commercial real estate losses. This is not the case today, as we can see from these charts. It's the residential losses that are driving the downturn. 
The interesting thing is that although residential delinquencies and charge offs are now in record territory, the overall impact on total bank loan delinquencies and charge offs has not driven us anywhere near the levels of the 1990s.
Additionally, the data which goes back further in time than the loan specific data shows; that very high rates of delinquencies and charge offs persisted for much of the late 1980s and early 1990s. The bottom line is that as of today we are just hitting the levels reached in the last recession. There is still room for loan delinquencies and charge offs to move much higher without getting to the levels seen in the early 1990s, when the banking system was literally teetering on insolvency. Additionally, enormous amounts of capital have been raised in the last couple of months to shore up the capital structures of banks (and even more so for brokers and hybrid bank/brokers). We may actually squeak through this without a full fledged banking debacle.
Charts Courtesy of Guild Partners
From the Blogosphere:
Bernanke: Mortgage Delinquencies & Foreclosures Speech
U.S. Credit Card Industry Moving into Uncharted Territory
Comments (6)
just a great analysis Jeff.
Which begs the question, how severe will this consumer (residential) led recession be as the residential housing downturn hurts consumer, the effect destroys bank balance sheets which results in tight credit conditions and stricter underwriting, which removes a huge growth driver for GDP moving forward?
All this at a time when commodity inflation will result in a rise in inflation expectations, mostly due to food & energy inflation's nibbling at consumers pockets.
Truly, a difficult environment to predict the severity of.
Posted by Noah | May 23, 2008 6:02 PM
Thanks Noah,
It is an ugly time and in my opinion it won't get prettier for consumer balance sheets, bank balance sheets or the economy for a long time. Interestingly, Warren Buffett is out saying this will be a longer deeper recession than anyone thinks. Now I recently made the call that the stock market will see a better period ahead, starting some time in the next two months after a last bout of angst. You might think I'm crazy but here is the logic. There is way too much hero money, thinking it is going to get investment steals as a result of this downturn...when in fact real risk free rates of return are negative and just earning a piddly return will entail a lot of risk. Real rates are severely negative if you believe...as I know you do Noah...that inflation is much higher than the watered down Gov't stats suggest. This hero money is going to get sucked into the markets by a "less worse" news flow and stock market before the boom comes down and crushes all hopes for outsized returns in the inflationary re-liquifying decade to come. That's my call because the scenario that causes the most pain is usually what happens. Additionally, vultures can make great returns but they don't get free meals, they feed until an 18 wheeler comes buy and makes them road kill....unless they are old experienced and wise. Today's vultures will prove to be none of the above.
Posted by jeff | May 26, 2008 8:19 PM
Very well stated Jeff. I have been stating for more than a year that we are facing a structural rather than cyclical recession.
Our Nation is broke, and you are seeing the beggining stages of some very real change.
I do believe that Buffet and other that are calling for a decade or so of tight credit may be wrong.
Here is my theory. Our dependence on depletable natural resources has in the past and continues every day to transfer wealth out of America.
I'm optimistic that the next president and congress will take the necessary steps to fund research, and production of solar, wind, and ocean generated power.
A "National Declaration" to becoming energy independent can and must occur, in order to stabilize our standard of living.
The next "Bubble" will be energy independence.
Economic reality will produce political change in Washington.
Posted by Mike | May 26, 2008 8:59 PM
You may be on to something Mike....wouldn't it be great if energy independence was the next space race?
Posted by jeff | May 27, 2008 7:11 AM
Jeff, Would you say that we are looking at now in residental loan writeoffs more or less what was seen in 1990-1994 as to commercial loan write-offs? In both cases too many units were built at unsustainably high prices.
As to Noah's point about how severe this cycle may be, wouldn't a key metric be the affordability index. The lenders ultimately on a permanent basis have to fill the hole that the write-offs are making through new lending and after that continue to increase profits to return to normalcy. Since the high unaffordability we have now is a direct result of the "lending hole" that is beginning to form, one would think affordablity would have to improve beyond the point of where it was when what became the bad loans started to be made.
Posted by Query1 | May 27, 2008 3:43 PM
Query1,
It is hard to compare the early 1990s commercial real estate situation with the residential situation today, because the asset classes are very different animals (commercial properties like office buildings, malls and hotels all act differently from each other and from residences). However, from a bank balance sheet perspective, things are somewhat similar. "Malinvestment" created both problems, the first time around people invested in commercial real estate in part to shelter taxes and the fundamental economics were often forgotten as a result. This time peole "invested" in residential real estate to get in on the boom and fundamental economics were forgotten. Lowering the prices of the assets or lowering the cost of money for investing in these assets won't matter much (affordability improving will clear the market but won't help bank losses much). The bubble can't be reflated, it will simply take years of digestion of losses. The last time around the fed reflated bank balance sheets by holding short-rates low, while long rates remained higher. Banks simply borrowed from the government at short rates and invested in government bonds paying long rates. For about 4 years this is how banks repaired their balance sheets, they had very little appettite for lending....same as today. While vultures took bad loans and real estate off the banks' books, it was often for a steep haircut. This time banks may resist that, raise capital early in hopes of being able to carry the bad stuff until it comes back, years from now. But in my opinion simply playing the yield curve between fed funds and the 10 and 30 year bonds will likely be the IV that keeps them alive.
Posted by jeff | May 27, 2008 6:30 PM