La Salle Street; home of the former Continental Illinois

As I read the daily articles about the “credit crisis”, my banking experience tells me that this crisis will not end painlessly. Lower rates on Fed Funds, a more accommodating Discount Window, and a Super SIV sound like they will solve the crisis, but they will only delay the inevitable. The inevitable result is the failure of the worst offenders of credit risk disregard. Many of the world’s largest financial institutions played the game. All will be hurt, the most egregious violators will fail. In addition to the shareholders of the failed institutions, we all lose as most financial companies will have lower earnings, credit is curtailed, and the economy slows.

When a credit bubble develops it appears to affect only a certain industry. That is rarely the case as it couldn’t develop if the tried and true standards of controlling risk were adhered to. Subprime real estate lending was at the forefront of our current crisis and initially it appeared to be a minor irritant for the economy. We are now seeing that decisions at the CEO level of commercial banks, investment banks, hedge funds and other investment companies, around the world, fed the spread of loose credit throughout the economy.

Not only have we seen buckets of poorly underwritten subprime mortgages, we’ve seen the home equity market decline, the Alt-A ARMs approach reset disaster, and asset backed commercial paper become unmarketable. With a sputtering economy and no home equity to refinance, credit card portfolios will soon have major delinquencies. Commercial credit looks okay today, but when the music stops there will be problems there also. The first indication of those problems was when the bank’s, all of a sudden, woke up and decided they had been too easy on LBO credit and couldn’t find participants for their commitments.

The headlines always bring me back to the 1980’s and a booming oil patch. A small Oklahoma City bank, Penn Square, failed due to loose lending. It’s problems appeared contained to Oklahoma. They wasn’t. Penn Square originated loans, other bank’s letters of credit guaranteed the loans, Continental Illinois and other big banks purchased the loans and resold participations to smaller banks and insurers.Everyone was happy. Growth was robust, yields were high, and why worry, the nation’s 7th largest bank was involved.

Penn Square failed. Bank’s issuing the guarantees failed. Continental thought the problem was contained to their oil patch lending division until they started looking closer at all of their lending. They had relaxed their risk controls throughout the bank and the result was problems across all lending platforms. Is this starting to sound familiar?

People thought that CINB was too big to fail. The Fed loosened it’s discount window rules and kept the liquidity flowing. The problem was too large. The FDIC closed the bank and reopened it as Receiver. Chicago lost it’s biggest bank, shareholders were creamed, bank regulators were embarrassed, and prudent lending rules, though old fashioned, were proven to be of value.

But we easily forget, and a new generation of whiz kids create new products [ derivatives CDO’s & conduits ] that disregard the risk inherent in them. Citicorp, Merrill, Barclays or some other large financial institution will fail. The ones that feasted the most will disappear, all will develop a renewed appreciation for calculating the risk inherent in loan repayment.

As the banks start to slow their lending, coupled with very expensive oil, the economies of the developed world will cool. Earnings will come down and so will stock prices. It won’t be the end of the world, but investors will need to be good stock pickers and it will help overall portfolio results if one has a moved a decent amount of net worth into short term bonds. A 4% T-Bill won’t look bad compared to falling equities.

Steer clear of financial stocks, raise some cash, and be aware that times will become more difficult over the next 24 months.