Banks, Crude Oil, Mark-To-Market, The Federal Reserve And Yes, Real Estate!

By | February 8, 2016

Why you may be asking yourself is this title insurance guy incessantly writing about non-real estate related issues? 

The answer is of course that the economy, and the real estate sector specifically, are all impacted by what is happening to the global economy.

And this includes the oil industrybank loans to the oil industry, high yield debt from oil industry related corporations and the dark and under-the-radar world of derivatives.

Ask yourself…

  • What if, as happened in 2008, the economy of the United States and the world is pushed into recession and banks become either unable or more unwilling than they already are to make loans?
  • What happens if, due to the fears of some banks that other banks they do business with may not be able to repay short-term interbank loans, that the credit markets seize as they did during the 2008 financial crisis (keep an eye on the TED spread)?
  • What happens to the real estate industry if, for any number of reasons, foreign buyers who typically are all-cash investors cease to invest?
  • And what happens is consumer confidence in the stability of their jobs, income and future prospects are hit to the point that the purchase of a home is moved way back onto the back-burner?

The answers to all of the questions above?

Banks, Crude Oil and Mark-To-Market!

Yesterday in an article at the Hallmark Abstract Service blog the significant underperformance of bank stocks when compared to the overall market was examined…Oil Industry Exposure: Are Bank Stocks Telling A Story That Investors Should Be Listening To?

…As we have watched the price of a barrel of crude oil crash to the low $30 range, it makes one wonder if a banking crisis similar to the one brought on by the mortgage crisis that pre-dated the financial crisis is even possible and, if it is, whether it might be lurking in the wings.

Many banks hold significant exposure to the energy sector and how that exposure is being handled, or not handled, may hold some clues to whether there may be a shoe to drop in the future….

In December 2014 from the same blog the potential impact of falling crude oil prices and bank exposure to derivatives was discussed…Is there a downside to plunging oil prices?

Derivatives – These are complex financial instruments created in the ‘lab’ by quants from schools like MIT, that exist as a contract between two parties over the price moves of some financial instrument or commodity and that can serve either as a hedge or a bet.

When prices of that instrument are stable or move within reasonable boundaries there are no great issues but, when severe and quick price moves occur such as we have recently experienced in the crude oil market (or mortgage-backed securities in 2007-2008), problems stemming from counterparty risk can present themselves.

Counterparty risk is defined as , ‘The risk to each party of a contract that the counterparty will not live up to its contractual obligations. Counterparty risk as a risk to both parties and should be considered when evaluating a contract.’ (Source)

While we don’t know the exact dollar amount of derivatives contracts that exist or how much of those are based on crude oil, this is what we do know as reported byReuters:

‘Last year, the top ten regional banks active in the space together held an average of $23 billion in commodity derivatives contracts on their books, up nearly 50 percent from their holdings in 2009, according to a Reuters analysis of quarterly regulatory data from Thomson Reuters Bank Insight.

This is still miniscule relative to the $3.9 trillion in commodity derivatives that the top six Wall Street banks still controlled, according to the data, though that sum has barely risen over four years.‘

So if derivatives are a zero sum-game meaning that what one side of the transaction makes the other side will lose, crude oil taking a $40 plunge means that there are some huge losses on the books out there.

We just don’t know whose!

One day these losses will likely have to be realized with unknown financial or ‘unintended’ consequences occurring as a result.

And what will occur if the losing side of a transaction, possibly some of the ‘Too Big To Fail’ institutions, had to actually recognize these trades on their books using mark-to-market?…’

And finally, from a January 2016 article at Zero Hedge, a look at the potential wink and a nod given by the Federal Reserve to banks concerning a moratorium from marking oil industry loans to market. In other words if a loan should be valued at $.50 on the dollar the bank can continue to recognize it on its books at $1.00.

The significance? Solvency!

…We can now make it official, because moments ago we got confirmation from a second source who reports that according to an energy analyst who had recently met Houston funds to give his 1H16e update, one of his clients indicated that his firm was invited to a lunch attended by the Dallas Fed, which had previously instructed lenders to open up their entire loan books for Fed oversight; the Fed was shocked by with it had found in the non-public facing records. The lunch was also confirmed by employees at a reputable Swiss investment bank operating in Houston.

This is what took place: the Dallas Fed met with the banks a week ago and effectively suspended mark-to-market on energy debts and as a result no impairments are being written down. Furthermore, as we reported earlier this week, the Fed indicated “under the table” that banks were to work with the energy companies on delivering without a markdown on worry that a backstop, or bail-in, was needed after reviewing loan losses which would exceed the current tier 1 capital tranches.

In other words, the Fed has advised banks to cover up major energy-related losses...’

So it is entirely possible, although we need to all hope not likely to happen, that the crash in crude oil and other commodity prices could have a far more reaching impact on the economy than simply investor losses in the stock market!

As such, it is imperative for company executives and strategic planners to at the very least consider the potential impact when making decisions!

Michael Haltman is President of Hallmark Abstract Service in New York. He can be reached at mhaltman@hallmarkabstractllc.com.

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