Tuesday, January 29, 2008

Wednesday, January 23, 2008

The worst market crisis in 60 years - George Soros

Everything that could go wrong did. What started with subprime mortgages spread to all collateralised debt obligations, endangered municipal and mortgage insurance and reinsurance companies and threatened to unravel the multi-trillion-dollar credit default swap market. Investment banks’ commitments to leveraged buyouts became liabilities. Market-neutral hedge funds turned out not to be market-neutral and had to be unwound. The asset-backed commercial paper market came to a standstill and the special investment vehicles set up by banks to get mortgages off their balance sheets could no longer get outside financing. The final blow came when interbank lending, which is at the heart of the financial system, was disrupted because banks had to husband their resources and could not trust their counterparties. The central banks had to inject an unprecedented amount of money and extend credit on an unprecedented range of securities to a broader range of institutions than ever before. That made the crisis more severe than any since the second world war.

Credit expansion must now be followed by a period of contraction, because some of the new credit instruments and practices are unsound and unsustainable. The ability of the financial authorities to stimulate the economy is constrained by the unwillingness of the rest of the world to accumulate additional dollar reserves. Until recently, investors were hoping that the US Federal Reserve would do whatever it takes to avoid a recession, because that is what it did on previous occasions. Now they will have to realise that the Fed may no longer be in a position to do so. With oil, food and other commodities firm, and the renminbi appreciating somewhat faster, the Fed also has to worry about inflation. If federal funds were lowered beyond a certain point, the dollar would come under renewed pressure and long-term bonds would actually go up in yield. Where that point is, is impossible to determine. When it is reached, the ability of the Fed to stimulate the economy comes to an end.

Tuesday, January 15, 2008

Citigroup Posts Record Loss on $18 Billion Writedown

Citigroup Inc. posted the biggest loss in the bank's 196-year history as surging defaults on home loans forced it to write down the value of subprime-mortgage investments by $18 billion.The fourth-quarter net loss of $9.83 billion, or $1.99 a share, compared with a profit of $5.1 billion, or $1.03, a year earlier, the New York-based bank said in statement. Citigroup reduced its dividend by 41 percent and is selling $14.5 billion of preferred stock to investors including the government of Singapore to shore up depleted capital. Chief Executive Officer Vikram Pandit eliminated 4,200 jobs and plans more cuts.

The above charts tell a sad story. Citi had losses on Subprime, consumer credit, and headcount reductions. Cost of capital is going up with ratchet provisions.

Just as Bernanke Reached a Point of Recognition, so it seems has Citigroup, with a dividend cut and expected massive headcount reductions in the works.

But the market has reached a point of recognition as well. This can be seen in the ratchet provisions. Those provisions are going to make it difficult for Citi to raise more capital down the road. Yet it is clear that more housing related losses are coming, and more consumer credit losses are coming as well. A Credit Card Time Bomb Is Ticking Away.

Like it or not, Citigroup is going to have to start selling off business units to raise more capital. By the time all is said and done, Citigroup is likely to be a mere shadow of its former self. Source

Monday, January 14, 2008

A Bears Questions

David A. Rosenberg, a Merrill Lynch economist, is out with a report today that concludes that home prices need to fall another 20 percent or more to get into reasonable territory relative to rental prices.

And he asks an interesting set of questions on a day when a combination of good IBM profits (largely from overseas) and faith in the Fed has lifted share prices:

“Finally, the question must be asked: if the first 7 percent downleg [Citigroup Model Assumption is 7% for 2008 and 2009] in home prices could manage to trigger …

1. Almost $100 billion in write-downs in the banking sector;
2. A 65 percent year-over-year surge in foreclosures;
3. The highest residential real estate loan delinquency rate in 20 years; and,
4. A 20 percent plunge in S&P financials …

… then what, pray tell, will the next 20-30 percent have in store?

Sunday, January 13, 2008

Inquiry Focuses on Withholding of Data on Loans

An investigation into the mortgage crisis by New York State prosecutors is now focusing on whether Wall Street banks withheld crucial information about the risks posed by investments linked to subprime loans.

Reports commissioned by the banks raised red flags about high-risk loans known as exceptions, which failed to meet even the lax credit standards of subprime mortgage companies and the Wall Street firms. But the banks did not disclose the details of these reports to credit-rating agencies or investors. The inquiry, which was opened last summer by New York’s attorney general, Andrew M. Cuomo, centers on how the banks bundled billions of dollars of exception loans and other subprime debt into complex mortgage investments, according to people with knowledge of the matter. Charges could be filed in coming weeks.

It is unclear how much of the $1 trillion subprime mortgage market is composed of exception loans. Some industry officials say such loans made up a quarter to a half of the portfolios they saw. In some cases, the loans accounted for as much as 80 percent. While exception loans are more likely to default than ordinary subprime loans, it is difficult to know how many of these loans have soured because banks disclose little information about them, officials say.

Wall Street banks bought many of the exception loans from subprime lenders, mixed them with other mortgages and pooled the resulting debt into securities for sale to investors around the world.

The banks also did not disclose how many [or how much] exception loans were backing the securities they sold. In prospectuses filed with regulators, underwriters, in boilerplate legal language, typically said the exceptions accounted for a “significant” or “substantial” portion. Under securities laws, banks must disclose all material facts about the securities they underwrite.

Mr. Cuomo, who declined to comment through a spokesman, subpoenaed several Wall Street banks last summer, including Lehman Brothers and Deutsche Bank, which are big underwriters of mortgage securities; the three major credit-rating companies: Moody’s Investors Service, Standard & Poor’s and Fitch Ratings; and a number of mortgage consultants, known as due diligence firms, which vetted the loans, among them Clayton Holdings in Connecticut and the Bohan Group, based in San Francisco. Mr. Blumenthal said his office issued up to 30 subpoenas in its investigation, which began in late August.

Investment banks often bought the exception loans, sometimes at a discount, and packaged them into securities. Deutsche Bank, for example, underwrote securities backed by $1.5 billion of New Century loans in 2006 that included a “substantial” portion of exceptions, according to the prospectus, which lists “pride of ownership” among the reasons the loans were made.

Nearly 26 percent of the loans backing the pool are now delinquent, in foreclosure or have resulted in a repossessed home; some of the securities backed by the loans have been downgraded.

And as mortgage lending boomed, many due diligence firms scaled back their checks at Wall Street’s behest. By 2005 , the firms were evaluating as few as 5 percent of loans in mortgage pools they were buying, down from as much as 30 percent at the start of the decade, according to Kathleen Tillwitz, a senior vice president at DBRS, a credit-rating firm that has not been subpoenaed. These firms charged Wall Street banks about $350 to evaluate a loan, so sampling fewer loans cost less.

In recent months, Moody’s and Fitch have said that they would like to receive third-party due diligence reports and that the information should be provided to investors, too. Glenn T. Costello, who heads the residential mortgage group at Fitch, said his firm would not rate securities that include loans from lenders whose procedures and loan files it was not allowed to review.
Since the investment banks withheld the third party due diligence reports to credit agencies & investors, and knew the number and amount of subprime exception loans were in many cases a substantial portion of the loan pool, and only made boilerplate disclosures in SEC filings, these exception loans basically should never have been originated or sold to investors; as the probability of default (FPD or EPD) was almost a certainty! The legal issue is can the investment banks now be held liable for the losses on these securities for failing to disclose material facts or risks under the Securities Act of 1933 or Securities Exchange Act of 1934? Civil or criminal charges by the SEC or NY AG maybe coming soon!

Mortgage Securitization

From this ...
To this ...
= More Risk!

Friday, January 11, 2008

Nationalization of the Banking System

We are starting to see the first steps in nationalization of the U.S. banking system. Large institutions are being "cajoled" into buying smaller ones. They could wait for bankruptcy to buy the assets, which would be smart, but they aren't as I believe the show is worth much to Washington: it is very important that equity investors be calmed by that stabilization effect.

No matter. As the bad assets are pooled we will eventually see some type of government bailout or quasi-nationalization of the banking system. Banks literally have no capital left.

Stay the course. Risk is high. We will be seeing many more "interesting" things from government as it becomes a larger and larger part of the economy. But remember, stocks are options on profits. The real owners of companies are bondholders who always get paid first.

When companies raise capital at 12%, like Citigroup (C), profits go away. When the government steps in, profits go away.

Thursday, January 10, 2008

A Scary Tidbit from Naked Capitalism Blog!

Banks will not be technically bankrupt, but will have so many bad assets on their balance sheets, and will have taken hits to their equity bases, that 18 months from now they will be unable to make new loans. They will be quasi nationalized.

This, mind you, comes from someone who has written frequently for the American Enterprise Institute and tells me the Treasury and the Fed are working on this scenario now. This is far more dire than any forecast either yours truly, a constitutional skeptic, or even uberbears like Nouriel Roubini, have been putting forward.

UN warns of 'clear and present danger' to world economy

The U.S. problems "could trigger a worldwide recession and a disorderly adjustment of global imbalances," the report said. "The recent global financial turmoil has heightened these risks and shown them to be clear and present dangers."

Freddie Mac Distressed Counties in California

Number 2 is playing a huge role right now because all lenders have now cut the LTV by 5% in any declining area that Freddie or Fannie recognizes. This alone shuts out nearly everyone who bought in California in the last 3 yrs who did 90% financing or more.
Notice Los Angeles County is classified as "distressed" while Riverside & San Bernardino counties are "severely distressed".

Wednesday, January 9, 2008

Goldman Sees Recession in 2008

“Over the past few months, we have become increasingly concerned that the U.S. housing and credit market downturn would trigger not just a growth slowdown and substantial Fed easing — our long-standing view — but also an outright recession. The latest data suggest that recession has now arrived, or will very shortly,” Goldman said in a research note. The bank also expects a decline in consumer spending, which didn’t happen during the 2001 recession, amid spillover from the housing market.

Lehman Brothers has $115.8 Billion in CMBS exposure

Lehmans Achilles Heel
The next shoe to drop may be at Lehman Brothers, reports CNBCs Charlie Gasparino.
Morgan Stanley $93.1 Billion and Bear Stearns $86.5 Billion in CMBS

Citi Sees Terminal Decline to Bank's Business Model

Here’s a snap from a Citi research note looking at the strained condition of all things financial. In a 70-page tome entitled “Testing Times,” the bank’s chief IB watcher in Europe, Jeremy Sigee, makes a convincing case for sector-wide capitulation.

Investment banking business models are, of course, being put to the test. While hedge funds and private equity are still attracting inflows, and emerging markets are still riding high, proprietary risk taking and product innovation are being scaled back. So, having already been bearish on fixed income revenues, which are forecast to fall back to 2004/5 levels this year, the Citi team now see revenues from equities and advisory work falling by 10 and 20 per cent, respectively.

But what’s really got Sigee questioning his very employment is the collapse of securitisation and structured credit.

Unmeasurable Uncertainty v. Priceable Risk in the Shawdow Banking System!

Nouriel Roubini, January 7, 2008
Mood and Views at the American Economic Association Meetings: Recession Ahead:

This is a crisis of insolvency, not just illiquidity; it is a problem of unmeasurable uncertainty (on the size of the losses and who is holding the toxic waste) rather than priceable risk; and liquidity risk is now severe and not manageable as we have a shadow financial system where non-bank institutions (SIVs, conduits, money market funds, hedge funds, investment banks, etc.) borrow short/liquid and invest in long/illiquid assets; so they are subject to a severe liquidity/rollover risk but they don’t have access to the lender of last resort support of the central bank in the case of a liquidity run.

Bill Gross, PIMCO, Total Return Fund, January 2008
Pyramids Crumbling
The Economist magazine points out in its September 22nd issue, [both banking & shadow banking] are built on a fundamental (and ever present) mismatch: they borrow short and lend longer and riskier. Recognizing this flaw, governments have for over a century mandated that banks have an ample percentage of reserves in order to bridge the liquidity and investment risks that periodically ensue. Like Jimmy Stewart in It’s a Wonderful Life, the critical job of a traditional banker was to have enough reserves or cash on hand to prevent a run. Stewart’s modern day counterpart must follow similar guidelines, although a 21st century banker now can always look skyward for a guardian angel in the form of the Fed, the ECB, or the Bank of England. Recent infusions of over a half a trillion dollars by this triumvirate point to the perennial need for reserve banking in either an earthly or a more heavenly sense.

But today’s banking system as pointed out in recent Investment Outlooks, has morphed into something entirely different and inherently more risky. Our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever. Financial derivatives of all descriptions are involved but credit default swaps (CDS) are perhaps the most egregious offenders.

According to the Bank for International Settlements (BIS), CDS totaling $45 trillion were outstanding at year end 2007, more than half the size of the entire asset base of the global banking system. Total derivatives amount to over $500 trillion, many of them finding their way onto the balance sheets of SIVs, CDOs and other conduits of their ilk comprising the Frankensteinian levered body of shadow banks.

Originators and existing supporters of these securitized WMDs might also point out that their reserves come in the form of equity and subordinated tranches comprising 10 or 20% of the repackaged loans. They do. But as this equity/subordination shrinks due to underlying defaults, the pyramid begins to unravel. Rating servicer downgrades can and do lead to the immediate liquidation of certain CDOs. The inability to rollover asset-backed commercial paper does and has led to the liquidation of SIVs or, pray tell, a misguided attempt to restructure them as super SIVs. CDOs and even levered municipal bond conduits known as "Tender Option Bonds" have been and will be similarly vulnerable to "Jimmy Stewart-like" runs as the monoline insurers that theoretically stand behind them are themselves downgraded to less than Aaa status.

The withdrawal of deposits from our new age shadow banking system has frightening potential consequences because a thinly capitalized banking system is always at risk relative to its more conservative counterpart. Visualize, as does Chart 1, in crude yet understandable form, today’s shadow system versus that of two decades ago.

While the exact amount of reserves supporting the Bank of Shadows is undeterminable, let’s go back to the $45 trillion BIS estimate of outstanding CDS for more insight. If total investment grade and junk bond defaults approach historical norms of 1¼% in 2008 (Moody’s and S&P forecast something close) then $500 billion of these default contracts will be triggered resulting in losses of $250 billion or more to the "protection selling" party once recoveries are inserted into the equation.

The unfairly "Ben Stein pilloried" Jan Hatzius of Goldman Sachs estimates that mortgage related losses of $200-400 billion alone might lead to a pullback of $2 trillion of aggregate lending. Even if this occurs gradually, he writes, "The drag on economic activity could be substantial." Add to that my $250 billion loss estimate from CDS, as well as prospective losses in commercial real estate and credit cards in 2008 and you have a recipe for a contraction in credit leading to a recession.

CDS are like put options with the addition of counterparty risk because traded over-the-counter with no binding margin requirements. "imagine what would happen if $45 trillion worth of insurance policies experienced an actuarial average of 5% losses and no one had $2.25 trillion sitting around to foot the bill!" Source

Monday, January 7, 2008

Negative Equity

The basic problem is that house price declines create large amounts of negative equity. Homeowners with negative equity lose their ability to respond to adverse financial events such as job loss or mortgage reset by refinancing or selling their home, and they therefore become much more likely to default. The importance of this problem is illustrated in Exhibit 16, which shows the distribution of home equity among US mortgage holders at the end of 2006 according to an analysis by First American CoreLogic, Inc. About 7% of US mortgage holders had negative equity at that point, and another 14% had equity of less than 15%. Thus, 21% of all mortgage holders—holding about $3 trillion in aggregate mortgage debt given the average mortgage debt held by the vulnerable borrowers—would be put into a negative-equity position if home prices fell by 15%. Source: Calculated Risk/Goldman Sachs/First American Core Logic
If real estate drops 30% the red sector will be upside down. If housing prices drop 50%, then include the yellow area in the total. Figure a worse case scenario of a 50 percent drop, one fourth of all housing has the potential to become "Jingle Mail."

People in the purple band have no equity to lose. Those foreclosures were the first to affect housing prices. Now the home owners in the red region are in trouble. Bank REO's are pricing into the yellow region right now. The red and yellow areas represent cash that was in the home owner's wallet. It's slowly disappearing. Figure about 25% of home owners in the United States have a good shot at losing their down payment and paid in equity. This will affect consumer spending for many years into the future. A drop like that could take the "hurry" aspect out of any future home purchase. Source

Sunday, January 6, 2008

Putting Subprime Mortgages in Perspective

It's true: 55.5% of American households either rent their home or apartment (32%), or own a home with no mortgage (23.5%), see chart above. Then add in the 34.5% of homeowners with a prime mortgage, and the 4.2% of homeowners with a FHA or VA mortgage, and you've got more than 94% of American households who are NOT subprime borrowers, and fewer than 6% who are subprime borrowers. And the subprime fixed-rate mortgages are not really a problem, it's only the subprime adjustable mortgages that are having problems with delinquencies and foreclosures.

Then consider that according to the Mortgage Bankers Association, the percentage of loans in the foreclosure process was 1.69% of all loans outstanding at the end of the third quarter 2007 (both subprime and prime). But because only 44.4% of all homes have a mortgages, that means that only about .75% of all American household own a home in foreclosure.