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November 13, 2007

Morgan Stanley points to wider subprime credit contagion

Morgan Stanley points to wider subprime credit contagionUS issuers are already feeling the effects of the subprime fallout and ensuing credit crunch (see US banks post disappointing results) and now Morgan Stanley has added to concerns that the crisis could spread into the wider credit market, saying a consumer credit recession was likely.In a client note, Morgan Stanley analyst Betsy Graseck said the effects of tightening in credit markets on US large-cap banks would be greater than anticipated and would spread into auto and card loans

By Verdict Staff

US issuers are already feeling the effects of the subprime fallout and ensuing credit crunch (see US banks post disappointing results) and now Morgan Stanley has added to concerns that the crisis could spread into the wider credit market, saying a consumer credit recession was likely.

In a client note, Morgan Stanley analyst Betsy Graseck said the effects of tightening in credit markets on US large-cap banks would be greater than anticipated and would spread into auto and card loans. Graseck revised ratings for some of the US’s largest card issuers, notably Citi, Wachovia, Bank of America (BofA) and Wells Fargo; both Citi and BofA received downgrades.

In the client note, Graseck indicated: “We believe the liquidity squeeze that started in July will drive up losses in consumer loan portfolios over the next four quarters beyond our prior forecasts. Our downgrade reflects our view that the coming consumer credit recession we see will trump capital market healing, which had been the basis of our ‘attractive’ call.

“The three primary drivers are tightening standards, significantly higher subprime delinquencies and lower home prices. We now expect a consumer credit recession in 2008 with losses above peak-of-cycle in mortgage and at peak-of-cycle in cards, auto and other consumer [sectors].”

Effect on Citi and Bank of America

For Citi, Graseck predicted $1.1 billion in collateralised debt obligation (CDO) write-downs in the final quarter of 2007, with another $1 billion slated for the first quarter in 2008. There were concerns about subprime consumer exposure, structured investment vehicle exposure and thin capital levels.

According to Morgan Stanley, Citi has the largest subprime exposure of the banks analysed, at 13 percent of loans and 5 percent of earnings assets. Those concerns were borne out when Citigroup revealed CDO writedowns of between $8 and $11 billion, forcing Chuck Prince, the beleaguered chairman and chief executive, to resign on 3 November.

BofA was downgraded by Morgan Stanley to “equal weight” from “overweight” because of exposure to deteriorating consumer credit in its credit card portfolio. Graseck said there would be lower than expected growth in credit card account acquisitions and higher than expected investment spend in key businesses of retail banking and credit cards. But Morgan Stanley added that BofA’s improving share in the mortgage market and cost savings in the card group were potential positives.

Looking to the wider bank sector, Morgan Stanley said it was concerned that banks are reducing their capital allocated to consumers, exacerbating the credit squeeze. With $77 billion of subprime debt to be refinanced in the fourth quarter, it expects the delinquency rate to rise sharply, coupled with declining house prices.

Graseck’s report also had a few caveats. It said Federal Reserve interest rate cuts might lessen the impact, but would be hampered by the higher spread in the inter-bank lending rate. Any reduction in interest rates would be unlikely to kick in for another two quarters.

Morgan Stanley’s report comes two months after global credit ratings agency Moody’s warned that US consumers were defaulting on credit card payments at a significantly higher rate in the first half of 2007 compared with the year-ago period (see CI 386).

All eyes will now be on next month’s third-quarter credit card delinquency figures, which will be released by the American Banking Association.

Francesco Burelli, principal consultant and head of card services for Europe at global strategy company Capco, told CI that the outlook was weakening for the cards industry. He said there were a number of reasons behind the continued threat of the credit crunch extending into the consumer credit markets. Lenders were not being fully accountable for risk through CDOs and interest rates were likely to remain high, in addition to changing consumer attitudes towards credit and increased lending to finance lifestyle.

Burelli said: “Competing for market share is a difficult business. It’s much easier to chase additional customers in less credit-worthy markets. But, all of a sudden there’s a problem with liquidity, inter-bank lending becomes more difficult and interest rates rise, adding to the overall cost of lending. Credit becomes more expensive and when you put these things together with clinical borrowers taking on more and more debt, you have an avalanche effect – and at some stage the avalanche is going to become too big.”

Burelli added that profitability could be further squeezed by regulatory pressures, for example on interchange costs.

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