The credit crunch’s initial quake has been painful, and the effects are obvious. Banks and investment dealers have been forced to write down billions of dollars in troubled securities and to seek massive capital injections to shore up their balance sheets.

But it’s the less palpable aftershocks that are likely to resonate most meaningfully throughout the financial services sector in the months and even years to come.

While plenty of factors have exacerbated the severity of the credit-market disruption, at its heart, the crisis represents a dramatic repricing of risk. As indiscriminate securitization convinced many financial services firms that they could hand off much of the risk of their lending, the cost of risk got seriously out of whack. The fact that credit risks now carry more realistic price-tags is a good thing, and it shows that markets do work — eventually.

But, in the meantime, many firms — and consumers, for that matter — have grown accustomed to the cheap, plentiful credit that these mispricings produced. Weaning them off that habit may prove troubling to economies that have been, to some extent, fuelled by such inexpensive funding.

Indeed, many lenders have begun pulling in their horns. According to a recent report by Montreal-based National Bank Financial Ltd., the U.S. Federal Reserve Board’s latest survey of loan officers shows a sharp jump in the proportion of U.S. banks that have tightened their commercial lending standards since the start of the year.

And most U.S. banks have already tightened their standards for commercial and residential real estate loans (both prime and subprime).

“Making it tougher for companies and consumers to borrow,” notes the NBF report, “results in a bottom-up tightening, which partly counters the Fed’s easing campaign.”

This could also mean that it will take longer for the effects of the Fed’s rate cuts to revive the U.S. economy. Typically, monetary policy lags are nine to 12 months. But the shrinking availability of credit could push the policy lag to between 18 and 24 months, the NBF report suggests. If that happens, it warns, the economic recovery could be slower in coming than many investors currently expect.

While the evaporation of cheap credit is biting consumers from one end, rising inflation is starting to nibble on their purchasing power from the other. A report by analysts at New York-basedJ.P. Morgan Chase Bank sees the tighter credit environment taking the steam out of U.S. growth in the months ahead, but not sharply enough to derail global price pressures heading into 2009.

“How this epic battle between King Kong (the downturn in the credit cycle) and Godzilla (the upturn in global price pressures) unfolds is the key outlook issue,” the analysts counsel in their report.

In the meantime, mounting inflation fears are expected to bring the Fed’s rate-cutting cycle to an end sooner rather than later, and to push other major central banks to a tighter stance on rates, too.

“With inflation almost universally above central banks’ targets, this is causing a more hawkish tilt in global monetary policy,” says the J.P. Morgan’s report. “At the same time, higher inflation is squeezing household purchasing power, creating a stiff headwind for consumer spending.”

As inflation becomes a bigger worry, it limits the central banks’ latitude to use monetary policy to fight the tight credit conditions. The result: some analysts now expect the credit crunch to persist for some time.

Bank analysts at New York-based Oppenheimer & Co. Inc., for example, warn in a recent report that they expect the effects of the credit crunch to linger through 2009, and, perhaps, even longer.

Among other things, this suggests that worse times are ahead for the big banks. A longer, slower economic recovery would affect all firms; but, given the banks’ underlying credit woes, they are likely to be among the hardest hit.

“We draw a direct correlation between a shutdown in securitization volumes and accelerating losses on bank balance sheets,” says the Oppenheimer report. “As we see no near- or medium-term come-back in securitization volumes, we believe losses will only accelerate further, and far worse than even the most draconian estimates.”

To date, much of the focus on the evaporation of securitization markets has been devoted to the negative impact on investment banking profits. “However,” the report notes, “we argue the far more important consequence of the ‘buyers strike’ in the securitization market is the impact on overall consumer liquidity, consumer spending and, ultimately, on consumer defaults.”

@page_break@The Oppenheimer report notes that the large-cap U.S. banks that the firm covers have so far booked about US$70 billion in real estate securities-related writedowns. As well, they have added US$25 billion to loan-loss reserves. But, the report adds, Oppenheimer analysts expect that loan-loss provisions will swell to more than US$170 billion by the end of next year.

Whether the result comes in the form of writedowns or added reserves, the effect is the same, the report says: “…revenue reversal from years worth of inherently flawed underwriting.”

The likelihood of regulatory changes in response to the underlying causes of the credit crisis will probably make matters even worse, the Oppenheimer report warns, by stripping even more liquidity from the consumer loan market.

As a result of all these factors, Oppenheimer analysts are lowering their earnings expectations for the banks well below consensus levels for this year and next.

As if this gloomy outlook wasn’t bad enough, some market-watchers worry that there are even bigger bombs than the U.S. subprime mortgage debacle lurking in the global financial system. The massive market for credit-default swaps, known as CDS, has been singled out as a possible source of systemic calamity, too.

This industry segment has grown dramatically, with little regulatory oversight. And the near-death experience of new York-based Bear Stearns & Co. Inc.has heightened fears of the counterparty risk that could lurk in this area.

If the CDS market does come under pressure as the economic cycle darkens and defaults rise, the potential turmoil could be huge. According to the latest data from the Bank for International Settlements, the CDS market now has a notional value of almost US$60 trillion, based on a market value of about US$2 trillion.

Worries about the stability of such markets may solidify regulators’ resolve to tighten restrictions on financial firms.

Notwithstanding these actual and hypothetical threats to market stability, the outlook for Canadian banks is a bit brighter. They haven’t had to face balance-sheet woes on par with some of the U.S. and European banks. And domestic markets and the economy have held up relatively well, thanks primarily to soaring commodity prices.

As Investment Executive went to press, Canadian banks were on the verge of announcing their results for the second quarter ended Jan. 31. In general, analysts were expecting some modest deterioration of earnings, largely due to the drag certain business lines are experiencing amid the evolving credit cycle.

For example, a recent report by UBS Securities Canada Inc. forecasts a 1% decline in overall earnings for the second quarter, followed by a projected 4% slide in the third quarter, which will be driven by a combination of weaker capital markets, softer wealth-management growth and higher loan-loss provisions.

The UBS report, however, doesn’t expect the Canadian banks to come under the pressure that U.S. banks are facing to increase their loan-loss provisions.

“Given a solid albeit a moderating economic outlook, low corporate debt, high corporate profitability, continued solid loan growth, average consumer indebtedness and low unemployment,” the report says, “we don’t see the structural underpinnings for a significant increase in loan provisions.”

Notably, the UBS report is overweighting Canadian and emerging-markets banks rather than U.S. and European firms.

But Canadian banks are not immune to some of the troubles affecting their U.S. counterparts. Most of the Canadian Big Six banks have reported writedowns already, and several of them are directly exposed to conditions in the U.S. market due to significant operations there. There are also some signs of tighter credit markets here, too.

In a recent report, analysts at Toronto-based investment dealer Blackmont Capital Inc. indicate that data from the Bank of Canada suggests that the availability of domestic credit retrenched somewhat in the first quarter of 2008.

“While overall credit expansion remained positive, the observed deceleration, if unchecked, could contribute to a reduction in economic activity and a cyclical reduction in domestic bank intermediation-based revenues and profits,” the Blackmont report warns.

In another report, analysts at Bank of Montreal say that while loan growth remains relatively strong in Canada, the banks are being pressured by rising funding costs. Looking ahead, the BMO report contains reduced forecasts for Canadian bank earnings in 2009 by about 3%.

“The downward revision reflects a lower estimate for wholesale revenues (capital markets and investment banking) and a higher estimate for loan losses,” the report explains.

While the shifting credit environment appears to be posing a short-term obstacle to growth in bank earnings, the associated fallout may also represent a barrier to the banks’ long-term strategic aspirations. The Blackmont report points out that regulatory reform remains a significant risk for Canadian banks, too.

“The evolutionary challenge posed by slowing organic growth may be compounded by revolutionary challenges to existing business models, as policy-makers attempt to devise and implement changes in oversight practices to ensure that the next crisis, if not averted, is at least different than the ongoing credit/liquidity crisis,” it cautions.

Moreover, the Blackmont report predicts that the pressure for bank mergers will probably resurface, but that opposition to domestic deals has probably “significantly strengthened,” due to prudential concerns raised by the current crisis.

International acquisitions remain the other obvious avenue of growth for the Canadian banks — and now looks like a pretty good time to buy.

Indeed, a report from New York-based Merrill Lynch & Co. Inc. suggests that consolidation should become an emerging investment theme if credit remains tight and the global economy’s cost of capital rises.

The Merrill report recalls that during the severe credit contraction of 1989-90, roughly 25% of financial services companies were bought out or went bust. “There has been minimal consolidation in the sector so far during this post-credit-bubble contraction,” the report notes. “We expect a lot more to come.”

Having weathered the current crisis rather well, compared with banks in other regions, the Canadian banks may be in a position to become strategic acquirors.

But, again, there can be considerable risk buying into foreign markets, particularly at a time when the banks can’t necessarily exploit their advantages in size and sophistication because of tight credit and funding markets. That risk is coupled with rising regulatory risk. Moreover, the experience of the Canadian banks in buying U.S. assets has, so far, been mixed at best.

“Domestic banks may be able to benefit by participating in future U.S. bank-sector consolidation,” the Blackmont report says, but cautions, however, that the operational risks of these types of deals “must be carefully weighed against likely long-run return potential to ensure shareholder value is enhanced and not impaired.”

Amid such tumultuous and uncertain markets, Canadian banks are likely to be shy about attempting foreign acquisitions that could transform their balance sheets. Instead, they may be forced to turn their focus inward to find growth. The Blackmont report suggests that the already hotly contested asset-management and wealth-management areas may face even more intense competition as a result. After all, these are lines of business in which the banks can enjoy strong returns with little credit risk.

Even if most of the big writedowns and nasty headlines are in the past, the credit crunch looks likely to cast a long shadow over both foreign and domestic banks and their strategies for years
to come. IE