First Housing Market, Now Banks and Next Insurance Companies!

The second quarter FDIC banking profile report shows a higher number of 'problem' banks to 117 from 90 a quarter ago. Value of assets 'in pain' rose to US$78 billion from US$26 billion and it is very likely that more banks will come on the list due to credit concerns.

It is no surprise to me at all as this is a result as the industry has begun to shed assets, declining deposits and as credit rating agencies continue to downgrade subordinated debt and preferred stock from A- to BBB+ and BBB- respectively. All non-senior ratings were placed on Watch Negative until Treasury's intentions are clarified.

Housing market will continue to ease for some time until home prices approach levels consistent with underlying rents, suggesting that the rising trend of troubled loans shows no sign of abating. Some observers are suggesting that a slower pace of home price decline could continue for a rather substantial period, perhaps 6 quarters or more. The number of homes for sale and under construction was off by 6.6% in July. This suggests that residential construction will be weak in the 3Q08 and that the decline will be similar to the second quarter's decline of almost 24% on an annualized basis. Separately, Fannie and Freddie are reporting increases in delinquency rates of 6 and 8 bps from 1.3% and 0.9% in June and July respectively.

In my own opinion, this is yet to be the main course. Get ready for the latest chapter in the crisis beyond sub-prime saga - the hits in the insurance industry. News earlier this year that insurance giant AIG had taken a charge of $5 billion related to mortgage credit derivatives catapulted the sector onto center stage. That was followed by a forecast from rating agency Fitch that the life insurance sector would take losses of up to $8 billion -- all related to home loans made to borrowers with sketchy credit histories. The way assets in mortgage-backed securities are reported, there could be problems lurking in the future, even if balance sheets look solid now. A significant portion of life insurers' assets is generally in mortgage-backed securities and other assets like stocks or venture capital, because the long-dated nature of the liabilities gives life insurers the opportunity to add some risk in exchange for larger return. On average, a life insurance company held about 30% of its assets in mortgage-related securities, vs. about 23% for health insurers and 19% for property/casualty companies.

Unlike banks, which value of debt held must be marked to the lower of cost or market -- the same is not true in insurance regulations. The very people charged with ensuring that insurance companies have adequate capital to meet their obligations allow the firms to value bonds held at their original par value, even when the market price is clearly substantially lower. The rules on when to mark down the value of debt reported to the state regulators are a little murky, but if the debt goes into default it must be immediately reduced in value and there is where the time bomb lies.

And in the case of health insurers like Aetna, UnitedHealth, WellPoint, the cash needs are much nearer term -- less than a year in many cases because of the constant need for medical cost reimbursement. As such, they are typically invest in liquid short-term assets such as asset-backed commercial paper and collateralized debt obligations. Those are some of the very same securities which have been hardest hit in the credit crunch.