Here's the transcript of the interview between Steve Forbes and Meredith Whitney. The point Meredith made about the potential credit card crisis is most interesting!
Transcript: Meredith Whitney Interview
[01:54] The Running On The Banks
Steve Forbes: Well, thank you very much for joining us, Meredith. Back in the summer of 2008 when a lot of people thought we were out of the woods on the financial crisis, you said no, the worst was to come. First of all, why did you think there was such devastation in the banking sector that was unprecedented? And are we finally climbing out of the thing?
Meredith Whitney: What worried me last summer, summer of 2008--
Because you were alone on that. You were virtually alone on that.
I was alone, I felt very alone. And the scariest thing, I think, I've seen yet, was what happened to IndyMac in the summer, in July, when you had a run on the banks. And what I knew at the time, was that there would be runs on other banks, and those that were heavily weighted towards commercial deposits.
So, at the time, it was a guarantee of $100,000 or below. And so, the commercial deposits, that which you pay your payroll through, there was your 30-plus percent of the banking system, 35% of the banking system, uninsured. And so, if you look at what was, who had the most exposure to the commercial deposits, obviously, those were the first to flight.
So, what you saw then was an effective on the bank of Washington Mutual, and an effective on the bank at Wachovia, and NatCity and some others. And so, what we didn't see was, all of those deals were done inside of the third quarter. So, what you didn't see was what happened to their deposits inside of the third quarter. So, July was part of the third quarter.
And by September, Wachovia and Washington Mutual were part of another entity. We never saw how bad things were. But I saw that on the come. I also knew that it was clear that the banks were carrying bad math assumptions. So, one key variable in evaluating your mortgage, what your mortgage portfolio is worth is, No. 1, what employment is.
But No. 2, where you think home prices are going to go. And as an example, Wachovia, which was, I put a sell rating on Wachovia in July. And the stock was $9 or something. It was a pretty wild call. But I knew that they were expecting home prices to decline by 21%; 60% of their exposures were in California. Case-Schiller is now down 30% in the top 10 MSAs. So, it was clear that they would have to play catch-up. And it is also clear that the banks still have to play catch-up. The banks, all the big banks anyway, carry their mortgage books with an assumption that home prices would decline peak-to-trough 30%, 31%.
Well, we're already there. So, what you'll see in first-quarter results is a catch-up to what now the future of market is doing, viewing the peak-to-trough home prices to be 37%. So, you're constantly having to reevaluate your reserves against loans. That puts earnings pressure on companies.
And it creates an environment where it's almost impossible to regenerate your own capital, to grow your own capital. So, you've got to have your hands out for other people's capital. And it's been sovereign wealth fund's capital. It's been U.S. investor's capital. It's been our taxpayer's dollars as capital. And I don't see that ending anytime soon.
Now, in January and February, it seemed, at least to an outsider, that even regardless of what the books said, the banks seemed to be doing very well on a cash-operating basis, the rollover alone. You were paying fees. You are paying fees. You were paying 10,000 points above LIBOR. Do we have a disconnect here? Where on a cash basis, the banks are doing well; where in a statutory, regulatory basis, they're still not out of the woods?
Well, on a cash basis and on a trading basis, they're doing, facilitating transactions. January and February, it's all relative, right?
[05:45] Shun Bank Stocks
Right.
Relatively good months. On an accrual basis, that's where you get into problem areas. Because your loan is only as good as it pays you back. And so, the loans are paying back less. As I said, one of the two main assumptions that goes into valuing any of your loans, accrual-based loans, is home price appreciation, but also unemployment.
A lot of the banks were carrying seven-and-a-half to eight percent unemployment. We're already over 8%. So, there are going to be big true-ups this quarter. Some parts of the business are OK. And what's interesting, for a Goldman Sachs, 70% of the capital markets competition has gone away, or dramatically pulled in their horns.
So, it's a smaller pie. But you're getting more of a market. And the government actually is churning a lot of fees for Wall Street. So, there's trading activity there. I don't know how sustainable it is because bank revenues, cash-based revenues on the non-accrual-based loans, should correlate to some multiple of the GDP and global GDP. And as we know, the global GDP is coming down.
So, you're staying away from bank stocks still?
I am staying away from bank stocks still.
Any hope for the regionals? Is there some difference between the regionals and the five biggies?
I have a view of what I want to happen. And I don't know how much, how many legs it has in D.C. Because it's hard. But there are small regionals. And by regionals, I mean, well below the top 100 banks, or even, well, let's say safely, the top 50 banks, that have clean balance sheets, that want to lend, that have ample deposit bases.
But they don't have scale. So, the best thing about this market is, you have 8,000-plus banks that are healthy and want to lend. The worst thing about this market is, they don't matter because they don't have any market share. So, two-thirds of the lending market for both mortgages, and then for credit cards, is dominated by the top five banks. So, you've really got to dislodge that to make any material improvement in the system. And I don't think the government is prepared yet to dislodge that because it's too disruptive and too uncertain of an economy.
Now, does "dislodge" that mean force-feed capital to the regional banks so they can move in to where the big ones can't?
It's ultimately going to happen anyway. Because lending will go back to where my deposits fund your mortgage and your deposits fund my mortgage. That's where it's going to go. Because as we know it, the shadow-banking industry, in terms of securitization as a vehicle to fund loans is not coming back, right. Maybe it comes back in three, five years. I don't know.
But for certainly in the next couple years, it's not coming back. So, to fulfill that you can't expect that type of liquidity to come back. So, the regional banks are going to have to pick up a larger percent of market share, a larger percent of the movement within consumer liquidity.
They're not equipped yet. And the large banks aren't also equipped to lend with the veracity that they did before. They still have shrinking capital bases. So, I think, and they're risk averse, too. So if you're the greatest correlation between defaults and borrowers is distance, right--or lender and borrowers, is distance. So, you've got to get closer to your borrower to understand, really, the sensitivities of that borrower. And the big banks, you know, won't be able to do it. They'll have to pass some market share onto the smaller ones.
So, would you buy some of the smaller ones now? Or you've just got to wait for this thing to start to shake out even more?
You know, I bet most people couldn't even name some of the smaller ones. I think that on pullbacks, you can buy a basket of small stocks that are clean, obviously non-TARP-based stocks.
Is there an ETF that does small names?
I'm sure there is. I'm sure there is, rounding our names. But if you buy them as individual stocks, you're going to have a big liquidity premium. And it's probably not the best thing for an individual investor. What I'm looking forward to on the long side is when these big banks get disaggregated. So, when a Citigroup sells portions of its business, it's because they'll call it, say, non-corp. But really, the next wave is banks sell stuff to raise capital. So, you can't raise capital through taxpayer dollars. So, you sell stuff to raise capital, and recent fabulous combinations from that. I'm still crossing my fingers and hoping for an American Express/Citi credit cards and retail deposit combination. That's a great growth vehicle.
[10:27] Credit Card Crisis
But talking about credit cards, you've been sounding the alarm talking about a squeeze that banks are--and gee, American Express already has--and other banks have, cut back on your lines. You may not have used them. But you may have thought you had $10,000. Now you have what, $500?
This is the most interesting topic for me out there, which is credit card lines. So, there are about $4.6 trillion in unused credit card lines. And there are about $840 billion of used credit lines. So, in the fourth quarter alone, I'm sorry, now of course it's $4.2 trillion. In the fourth quarter alone, half a trillion dollars of lines were cut from the consumer, half a trillion.
And this is before any type of regulatory changes. So, banks are cutting lines for a couple of reasons. No. 1, risk aversion. No. 2, they don't want to hold regulatory capital against unused lines when they are so capital-dependent. And No. 3, which is also risk dependent is, where I have a monogamous relationship with you as a mortgage borrower, I have multiple relationships with my credit cards.
So, when, you know, cameraman A cuts my credit card line, I have more exposure to you and cameraman B. So, you don't want to be the last one holding the hot potato. So, you pull your line. And I'm stuck with fewer lines. And my borrower's, my lender's stuck with more exposure to my line. That's the last place he wants to be.
So, the credit card version of a run on the bank?
I haven't thought about it, but that's exactly right. And when you get a pay cut, 90% of Americans use their credit card to--
Tide them over?
Tide them over and as a cash-flow management vehicle. So, when your credit card line gets cut, it's the equivalent of getting a pay cut.
And there's a regulation coming along from the Office of Thrift Supervision, can you explain that?
Sure.
That's going to throw a real wrench into people's access to credit card capital.
I'm sure you will get shivers up your spine, unintended consequences. This is "Unfair and Deceptive Acts and Practices." And there are a lot of good things that it does. This is regulation to protect the consumer. And that's passed by, it's already passed. It's just a question of, it's supposed to go into effect by mid-2010.
It may get accelerated by Congress before that, but passed by the Office of Thrift and Supervision, National Credit Union Association, and who am I forgetting, the Fed, all three regulatory bodies that govern credit cards. So, what happens is, to protect the consumer, they say OK, well you're going to need a grace period through which to pay your credit card bill. So, you go on vacation. You come back. "Wait, I have to pay my bill in two days?" Oh, now you get a required 21-day grace period.
And there are other things it does in terms of, if I give you a teaser-rate product and you make a payment, right now it goes, your payment goes to the low-interest-rate part of the credit card portion. Going forward, it'll go to the high-interest credit card payment. So, you can ultimately get out of debt.
The unintended consequence it risks doing, and I think it will do, is I, as a lender for your credit card, an unsecured lender for your credit card, monitor your credit bureau monthly. And so, I know when you're late with your phone bill, your utility bill, your sacrosanct cable bill. Right, for a man, it's all about the cable bill. And so, I'm going to monitor that and change your rate accordingly. Well, going forward, after this is adopted, I can look at your credit bureau, but I can't do anything to you unless you're late with me.
And the obvious risk here is, by the time you're late with me, you've maxed out your credit card bill in Mohegan Sun or Atlantic City--sorry, New Jersey native--and I'm left holding the bag. My natural instinct is to cut your line. And that's what's going to happen. But the half-a-trillion dollars of lines that were cut last year were well in advance, and, I would say, had nothing to do with the UDAP proposal. So, that's more on the come. Now, I think there's going to be $2.7 trillion in lines reduced. So, a 50% cut of the lines outstanding.
Wow.
That's going to have the scariest impact on the economy, I think.
And that's ongoing now?
Yeah.
Wow.
So, we talk about housing and whatnot. Your ability to transact is essential to preserving commerce.
Now, so is what happened in January and February in retail sales, was that sort of an anomaly, sort of a little catch-up from what people didn't do in the fourth quarter of last year? Or why were they relatively good?
Well, the consumer has money. Well, most consumers still have money. There's over $7 trillion in cash on consumer-balance sheets. But they're spending at lower-end stores. They're not "living la vida loca" at Neiman Marcus and Saks Fifth Avenue. And there's no sense of urgency to buy.
So, I think the consumer appreciates a deflationary pressure in the market. Now it's, by and large, a willingness impact on the consumer. When unemployment goes over 10%, it will be an ability-based issue. So, all of this is still very much a willingness issue. And you've seen how much consumer spending is contracted. You know, we've got the benefit of lower oil prices now. We've got the benefit of other factors. The good thing is the consumer came into this on much better footing than consumers come into prior recessions.
And so, if they ever got the economy moving, the consumer could get back in action pretty quickly?
I think so. And also, supply management's so much better. Productivity is so much better. You know, the "starve the beast" mentality, it forces a lot of businesses to make streamlined improvements.
And you look at the financial sector, for example, it, despite the incredible profits of the industry, it's pretty fat. And I can say this--a lot of stuff is given away for free. If Wall Street were ultimately downsized peak-to-trough by 50%, I think Wall Street would be a lot more profitable.
[17:06] States and Munis
Now, one of the other areas you worry about is state and municipal spending.
You're good!
Well, grim reading. But that there's going to be cutbacks there. They're obviously raising taxes. But what kind of impact do you think that's going to have on the broad economy?
Well, I should be asking you this, because you're more of an expert than I am.
No, I get the information from you and then recycle it.
OK, 12% of the U.S. GDP comes from state and local spending. And the states and the local municipalities are just as guilty as the over-levered consumer. Because when you look at the big states that are under-funded, and most notably California, Arizona, but Florida's behind it and you've got over 34 states under-funded for 2009 and then for 2010 budgets. They built infrastructures that were dependent upon 2006 sales-tax receipts, home property sales-tax receipts. And those infrastructures, expenses, are not supported by the current income-tax structure. And it's going to be painful. So, you start by cutting derivative jobs, then you're closer into the marrow.
And California, that has been well ahead of the curve in terms of addressing its budget issues, has already shown you what type of job cuts and pay freezes and furlough exercises they've done, you know, giddy-up for the rest of the country catching up. And the issue with the banks, which is an aside from what you brought up is, the government can't bail everyone out.
So, they've focused on bailing the auto guys out. They focused on bailing AIG out, the banks. But the state and local governments are right behind them. And so, California's going to default? I don't think so. Everyone's got their hands out. So, the government's got to be very judicious about how they spread taxpayer dollars.
[19:02] When Banks Will Lend
You mentioned banks reluctant to lend. And you've talked about it in the past. JP Morgan is emblematic of that. What will it take to get them to loosen up again?
It's just sentiment, you know, sentiment.
Animal spirits, as Keynes would put it?
That's right. On the economy, without the government dole and the government wrap programs, cost of capital is still expensive. So, to lend above that cost, that hurdle rate or cost of capital, is tough. And I think that you have so much. One thing that I look at which is a pretty good barometer, is home-ownership rates. So, home-ownership rates peaked right on 70%. There is still over 67, just about 67 and a half, percent. They probably have to go.
And you think it should go back to what, 64%, 65%?
Yeah, yeah. So, if that happens, you've got still more pressure. So, who's going to lend in that environment? Now, there are monthly reports that the banks have got to give the treasury, the lending reports. And they will all show you positive numbers. But the loans that they're making are not big enough to offset the loans that are naturally running off, paying off, and the loans that are charging off. So, they're net lending is down.
So, we're still in a deflationary environment? Liquidity's still being sucked out of the system, in essence?
Yeah. The mortgage industry shrunk for the second quarter in a row last year. And that's never happened before.
[20:31] Where's The Fed?
Now, this raises an interesting question. The Fed is supposed to be the people who pump out liquidity when the system seizes up. Yet, between December and early March, they withdrew $400 billion. They shrank their balance sheet $400 billion. Now, they're starting to ramp it up a little bit. But it looks like it's still not equaling the decline in liquidity.
Yeah. How do they do it? A lot of what the Fed has done with respect to the agency paper, they've been sort of a back-door lender or had given money to the banks on a back-door basis. So, they're buying what now, $750 billion of agency paper? Who was the largest holder of agency paper? The banks.
So, that was an interesting movement. Once they announced that repurchase program or the intent-to-repurchase program, it's difficult to tell when. But if you look at the fourth quarter, the banks increased their exposure to agency paper. And whether that was because they got TARP money, or whether that was because the government said they were going to start buying agency paper, who knows. But it was a material increase in agency paper.
So, should the Fed be doing a lot more since velocity is dead? People are holding onto cash the way people do food when they fear a famine. Should the Fed say, "Hey, this is an unusual environment, how about a trillion, 2 trillion, 3 trillion?"
I feel like they are. So, you've got the $800 billion in TARP that's been all but used where $100 billion or so is left. Then you have so many different liquidity programs. I look at the fed agency program as a different version of TARP. It's directly benefiting the banks. So, I think that they're pretty stimulative.
[22:24] Geithner's Gambit
So, are we at a state where there's nothing government can do? We just have to wear through this storm?
Clearly, when you have so much in the way of trillions of dollars of assets underwritten with bad math, you just have to run that off. I was surprised to learn last week.
So, the Geithner plan is not going to, other than enrich some hedge funds, not going to do very much in terms of hastening this process?
It all depends. I mean, the obvious, the private partnership program is obviously conflicted in terms of what price do you pay? You can't blatantly rip off the taxpayer. And you can't force people to buy overvalued securities or banks to sell at what they deem to be undervalued levels.
So, it may move. Even if $1 of that program trades, and it still could set a base for an observable market index that allows all the banks to write up their assets. And as you look at what happened with Smith Barney and Morgan Stanley with that transaction in the fourth quarter, not that much money transacted. But Citi was able to write up that transaction by $6.5 billion on their balance sheet.
That's not so bad for a day's work, right? And nothing really has to go on. But you just have one trade in the market. And people can mark accordingly. If that's all, it can either be wishful thinking or the government could be really clever. I don't know which one it is yet.
[23:50] Dumb Risks
Well, hope they figure it out right, to replenish bank balance sheets. So, what has all this taught us about risk and what can we take from that in the future?
It comes in many forms. I guess the lesson is, when an industry gives you lemons, sometimes it's just lemons. It doesn't turn into lemonade. How we got here is, margins collapsed to such a level that banks felt entitled to make all these sorts of profits. So, you've got a cruddy business.
So, how do you make, lever it, right? Take a bad business and lever it. And, you know, great things come. How about finding good businesses? So many great things about financial services were product innovation, and really good product innovation. Because I think that there were so many great things that came out of the securitization industry in terms of distribution of low-cost funding and low-cost borrowing for more Americans. Globally, distribution of lower-cost borrowing for more citizens of the world, that's great financial innovation. But leverage is not great financial innovation. It's one of the oldest--
It's like an up market. It makes you look like a genius.
That's exactly right. So, I think, we had really dumb risk this time. It wasn't clever risk. It wasn't calculated risk. It was just dumb risk. And that's probably what's so frustrating about it.
Painting the pig?
Yeah.
[25:20] No Recovery
So, what is the one still big, misplaced assumption out in the marketplace today when you look at it, despite what's happened in the last year and a half?
Well, it's sort of nice that people have hope that a lot of these government plans will work. A misplaced assumption could be that something can change and you'll have a V-shaped recovery inside of 2009. I don't see that happening. I don't see an L-shaped recovery, either.
I think that we're just better than that. I think that we'll be innovative. This is notwithstanding the government making this a socialist state, which I'm hoping that they won't. It will be somewhere in the middle. So, it's not all bad, and it's sure as heck not all good from my vantage point. But it's not all bad. Resourcefulness can make you a lot of money in this market.
So, your bold prediction for the future is? How do you see this all shaping out? Is it going to be two years of a slog, three years and then suddenly we pull out? Or it'll be a gradual buildup and people say, "Hey, things are starting to get better?"
It all depends. It'll be really curious to see which industries lead us out of this cycle, and what areas of innovation this country then becomes famous for. Because no doubt in my mind, the single greatest export over the last 40 years from the United States was the financial services industry.
Not technology. It's the financial services industry. So, we've got to find a new export. And that'll be curious. I don't know what that is. A bold prediction is, our entire economy has got to reshape, redefine and restructure itself. And that of course can't take a year. It can't take two years.
It'll take several years. And we're going to be better and stronger for it. Because we got so addicted to this crack pipe of housing leverage. That's not a business. That's making, again, something great out of something that's pretty simple, right. Let's do great things with greatness, right, to be redundant. But let's find really innovative solutions and build an economy around it.
So, your bottom line is, there's more to growth than borrowing?
Yes, yes. You say it so much more eloquently than I do.
Not at all. Meredith, thank you so much.
Thanks so much.
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