Category Archives: Banking

The Credit Market Panic Will Soon Subside

The credit markets have come to a standstill as evidenced by the skyrocketing TED spread. This is the difference in rates between three-month LIBOR and three-month T-bills and is a gauge of how fearful banks are to lend to one another.


The reason LIBOR has exploded is that the value of the assets on the balance sheets of banks have been declining leading to widespread worry that they could could be worth less than the value of the liabilities resulting in failure. No bank will lend out funds when it has doubts of being repaid.

This is a very serious problem in our credit dependent economy because it can cause economic activity to come to a virtual standstill. For example, naked capitalism examines how letters of credit are not being honored by banks causing global trade to seize up.

Up to this point government responses have not directly addressed this solvency issue, but have tried to cure the symptoms by lending boatloads of money to provide liquidity. This has been ineffective because banks have been taking these funds and using them to shore up reserves rather than lending them out because they question the survivability of other firms as well as themselves. Thus, the credit markets remain arrested.

The Paulson plan recognized that the capital levels of banks needed to be increased and planned to address this by buying up distressed CDOs and subprime loans for a small fraction of par value. The hope was that this would make the balance sheets of banks more attractive for private sources of capital to invest in. Meanwhile, the government, with its low borrowing costs, would hold the assets to maturity for a profit. But the plan is faulty because it requires a lot of time to implement and the $700 billion allocated to it is insufficient. And there is no guarantee that banks will receive sufficient capital from the private sector.

In the meantime the financial system is melting down which has finally made officials realize that the best way to tackle the problem is to directly inject capital into troubled firms. In addition, they plan to guarantee all interbank lending and provide a blanket guarantee on all bank deposits. This should restore confidence in the banks and credit should start flowing again to where it is needed.

In the long-run these policy decisions could lead to big losses for taxpayers and prevent the economy from correcting its many years of malinvestment in the financial sector. I am opposed to any government interference in markets and would much rather see the entire financial system collapse followed by a return to a true gold standard with no fractional reserve banking. After an initial depression, the economy will grow at its full potential. But no one wants to suffer any near term pain. The result is that the government bailout of banks will lead to a less severe downturn in the economy, but no strong recovery for many years, i.e. we get a softer, but longer depression.

But for the time being the credit markets will begin to function more normally. Businesses and individuals who are low risk borrowers will soon be able to get the funds they need and a complete meltdown in the financial system will be averted. However, we will still have to deal with the fact that banks will restrict loans to only the most creditworthy borrowers and demand for loans will drop off as individuals reduce their debts. Consumer spending is going to disappoint for several years and business investment will be sluggish.

But the panic caused by the turmoil in the credit markets will soon subside and the TED spread should moderate.

The US Banking System Faces Collapse

Over the last 6 weeks financial stocks have rallied prompting some market commentators to declare that most of the losses banks will suffer during this downturn have already been written off. I strongly disagree believing that we are still in the early innings of this credit crisis and things are likely to get much worse before they get better. Let me explain.

As I argued here and here, home prices are likely to fall by 30% resulting in approximately 20 million homeowners with negative equity in their homes of which 5 million could face foreclosure. If the average mortgage balance of foreclosed homes is $250,000 and half of the balance is recouped after foreclosure then the total loss for lenders would amount to more than $600 billion.

Since the total mortgage market for single family homes is currently valued at over $10 trillion, this represents a loss of 6%. Some lenders will face greater defaults than others. The GSE’s which guaranteed approximately half of the total mortgages outstanding will probably experience only a 2-3% loss (though that would be disastrous for them considering their thin capital cushion). Commercial banks and savings and loan institutions may experience 8-9% losses; investment banks and hedge funds which speculated on subprime mortgages and CDOs may suffer losses of well over 10%.

According to the FDIC, depositary institutions had $3 trillion of residential real estate loans on their books at the end of 2007. A 8% haircut on this would lead to a loss of around $250 billion. Though mortgage lending is getting all the attention now, it’s important to understand that lending standards were lowered for all types of loans and banks are likely to suffer significant losses in other areas of their loan portfolios as well.

My estimate of these other losses for depositary institutions include at least 7% of their $1 trillion of consumer loans, 10% of their $630 billion of construction and land development loans, 5% of their $970 billion of commercial real estate loans, and 5% of their $1.5 trillion of commercial and industrial loans. In total banks are likely to write down their loan portfolios by at least $500 billion. The problem is that the entire equity capital of banks amounts to $1.35 trillion of which $350 billion is goodwill. This means that half of the tangible equity of US depositary institutions would get wiped out leading to hundreds of bank failures.

But also consider that these banks have entered into $166 trillion of derivatives contracts with one another meaning that if a significant number of banks fail due to loan losses, their counterparties on derivative transactions would be unable to collect payment and could also be dragged down into insolvency and the entire banking system would collapse.

And I have not factored in losses at other financial institutions such as GSEs, investment banks, insurance companies, and hedge funds. In total I think we are looking at losses of at least $1 trillion at US financial institutions and $2 trillion globally over the next few years. Keep in mind that only $500 billion have been written of thus far, and that is why I believe that we are still early in this credit crisis.

This makes me very concerned. It’s quite possible that my estimates could be wrong, but I think I have been conservative enough that any substantial error in loss estimates will understate the actual values. Do I believe the entire banking system is about to collapse? No… at least not anytime soon. We live in a fiat monetary system which means that the government can print as much money as it wants to bail out the creditors of failed banks. To be sure, governments will soon run the printing presses at full speed in an attempt to restore the public’s confidence.

Interview With Mohamed El-Erian

There was an interview in Barron’s over the weekend with PIMCO’s Mohamed El-Erian in which he prescribes to investors how to approach the troubled financials. Here is an excerpt:

Barron’s: What kind of noise do you hear now, and what is it telling you?

El-Erian: “We’re seeing two different realignments. The first is the return of inflation, with the rise of the world vis-à-vis the U.S., and an amazing rally in commodity prices. It’s amazing how quickly the rally occurred. These are reactions to fundamental changes.”

“We will also see new reactions to crisis management steps. This part isn’t in the book because I didn’t foresee the March 16 action by the Federal Reserve. [On March 16, the Fed helped arrange a sale of Bear Stearns to JPMorgan Chase, providing as much as $30 billion in financing for Bear’s less-liquid assets such as mortgage securities. In addition, the Fed allowed securities dealers to borrow from the central bank under terms normally reserved for regulated banks.] Opening up the financing window for investment banks is going to realign the financial system as we know it.”

How so?

“First, it will be very difficult for the Fed to withdraw the window once it’s introduced. What’s temporary will become permanent.”

“Second, once the window is permanent, these institutions will be subject to greater regulations aimed at de-risking. If you’re a senior bondholder, you’ll do well, and if you are an equity holder, you’ll be diluted, because A) the institution is going to be issuing more capital and B) the return on equity is going to come down. That action has very different implications depending on where you are in the capital structure.”

“Third, these de-risked institutions are going to look for deposits as cheap funding. That will cause a wave of mergers and acquisitions in the financial system as they look for small commercial banks they can buy. If they are going to be regulated like commercial banks, they will try to benefit from what commercial banks have, which is access to cheap funding. You will see some alternative institutions — hedge funds, private equity saying, ‘Wait a minute, why don’t we move into the space vacated by the investment banks?’ The sovereign wealth funds have played a critical role; some $69 billion of pure capital came from such funds into the Western financial system. In the future they’ll be important providers of recapitalization because they know the sector well. The problem is they are going to hit limits: They can’t acquire more than 9.9%.”

So what does this mean for investors?

“If you are a bond holder, you want to be ahead of a recapitalization. If you are an equity holder, you always want to come in after. When people have been pushing the financial sector, they haven’t made the distinction between what is good for the bondholder and what is good for the equity holder. The equity holder wanted to buy emerging markets after they recapitalized in the late 1990s, U.S. corporates after they recapitalized in 2002 and 2003 on the back of Enron, WorldCom, etc. The timing is critical. For the bondholder, it’s the other way around because a recapitalization lowers risk and therefore brings in spreads. And the people who are diluted are equity holders.”

El-Erian has hit the nail on its head. The debt of large-cap financials are starting to look attractive because the Fed has set a precedent that it would bail out the creditors of any bank larger than Bear Stearns due to risk of a systemic financial collapse. I’m not buying any debt instruments because I’m worried about inflation in the long run, however, there could be an attractive medium-term trade.

I am shorting financial stocks and selling out of the money call options on them for the exact same reason El-Erian states. Banks are going to come under greater regulation in an attempt to ensure stability and they will be forced to raise a lot more money to strengthen up their balance sheets which would significantly dilute shareholders.

Another well-reasoned idea El-Erian puts forth is that investment banks are going to look at deposits as a cheap source of funding. Their targets will most likely be small regional banks that were conservatively managed with growing deposits. If the sell-off continues, I plan to look for attractive investments in this space.

The ‘Financialization’ of the US Economy

A couple of insightful posts by Sudden Debt here and here elucidate how dependent the US economy has become on a growing financial sector:

About 20% of S&P 500 by capitalization and 30% of earnings are made up by financial shares. Add the finance arms of industrial cos. like GE, GM and Ford and some 35-40% of all S&P 500 earnings are made up of purely financial activities. Not exactly happy times there, right now.

Corporate profits have been able to rise 12% a year since 2002 thanks to robust financial earnings:

Profits Likely to Slow in _07 - WSJ.comGraphic by

But as the following graph shows, financial companies have used increasing leverage to grow earnings:

Sudden Debt_ The Rabelaisian Growth of Financial DebtGraphic by Sudden Debt

If the current liquidity crisis persists for a while longer, then financial earnings will no longer rise and may actually decline. And I don’t see how the S&P 500 will rise to new highs if its most important sector is contracting.

The Subprime Market Implosion and its Consequences

The subprime mortgage market has been dominating news lately with signs that rising defaults and delinquencies are wreaking havoc on the mortgage industry. Here are some of the headlines:

  • Accredited Home Lenders Holding Co. reported a $37.8 million loss for the 4th quarter — three times wider than analysts expected.
  • ResMae Mortgage Corp. became at least the 20th subprime lender to close or be sold when it filed for bankruptcy.
  • Freemont General Corp., a major lender to people with weak credit histories, announced that it has stopped providing “piggyback” mortgages.
  • HSBC added $1.76 billion to its bad-loan costs for 2006 to cover ailing mortgages.

At the start of this year a general consensus has formed that housing is bottoming. This was based on 4th quarter statistics that suggested inventory, sales and starts were stabilizing. On Friday, Alan Greenspan gave an upbeat assessment on housing during a speech here in Toronto and made the following comments:

The worst of the adjustment is over, meaning not that the market is turning, but that the rate of decline was at its maximum in the third quarter and continued over in the fourth quarter and should now be moving to a much less negative direction.

Regarding sub-prime mortgages:

We do have a problem here, it’s probably not over. It may actually infect some parts of the prime mortgage market, but there’s no real evidence that this is a significant issue.

I have a different opinion than the ‘Maestro’. I believe that the subprime market implosion will lead to another leg down for housing activity. To see why, consider that a decade ago subprime mortgages totaled a mere 2% of the entire mortgage market. Today they are one-sixth of all mortgages.


The percentage of subprime delinquencies are at the highest level since 2002. Keep in mind that the subprime mortgage market is now four times bigger than it was then. And the delinquency rate is likely to head much higher.

About 80% of subprime mortgages today are adjustable-rate mortgages that have been nicknamed “exploding ARMs” because they have low fixed-interest payments in their first few years but then usually adjust to higher interest payments. It is estimated that around $1 trillion in adjustable-rate mortgages are due to reset over the next 2 years at much higher interest rates.

A study by the Center for Responsible Lending predicts that 20% of subprime mortgages made over the last 2 years, equivalent to 5% of total mortgages originated could go into foreclosure. This new supply of foreclosed homes dumped on the market would easily push down prices and curtail home building.

Moreover, there is increasing pressure on Capitol Hill to enact legislation sponsored by Barney Frank, the new chairman of the House of Financial Services Committee, designed to tighten up lending standards and disclosure rules. This could shut out 25% of potential subprime buyers from obtaining mortgages according to Merrill Lynch.

It is hard to imagine mortgage equity withdrawals (MEWs) continuing at the same pace as in recent years. Given that MEWs were a major source of household liquidity (as this graph by Calculated Risk depicts), consumer spending will have a tough time increasing.

Increasing foreclosures along with tighter lending standards for new borrowers is going to cause this housing downturn to be one of the worst ever, and likely to drag the economy into a recession.

Doubling Down Against the Brokers

Fueled by stronger than expected earnings and a rising stock market the brokers have rallied by 15-20% since I mentioned that I was going to short them. However, my long-term view of the sector is unchanged. The economy will suffer a housing-led recession in 2007 that will hurt the brokers’ profits significantly. The current rise in their share prices could mean a greater fall once the stock market begins to decline.

Therefore, I am really attracted to the potential payoffs of shorting the brokers at current prices. I am currently short Lehman Brothers (NYSE:LEH) and Bear Stearns (NYSE:BSC). I will be doubling my short position in these stocks.

Increasing Subprime Mortgages Delinquencies

The WSJ reports that delinquencies on subprime mortgages have been increasing at a troubling rate recently.

Based on current performance, 2006 is on track to be one of the worst ever for subprime loans, according to UBS AG. “We are a bit surprised by how fast this has unraveled,” says Thomas Zimmerman, head of asset-backed securities research at UBS. Roughly 80,000 subprime borrowers who took out mortgages packaged into securities this year are behind on their payments, the bank says.


The fact that borrowers with bad credit histories are now having a tough time making loan payments shouldn’t come as a complete surprise if we consider how the boom began:

The subprime industry’s current troubles can be traced back to 2003 and 2004, when defaults were unusually low. Investors who purchased these loans did well and were eager to buy more. That encouraged lenders to lower their standards, making loans to more people with low credit ratings. Lenders also grew less inclined to demand full documentation of income and assets and more willing to offer “piggyback” loans that allowed borrowers to finance 90% or 100% of the purchase price without being required to buy private mortgage insurance.

Many lenders kept introductory “teaser” rates low even after short-term interest rates began rising in June 2005, while increasing the amount the rate could rise on the first adjustment. That meant borrowers would face sharply higher costs when their monthly payments were reset.

The environment has changed over the past year with interest payments increasing for borrowers. And if they aren’t able to make their payments, they can’t sell their houses as quickly and for as much value as before.

The borrowers aren’t the only ones feeling the pinch in the subprime mortgage market:

If delinquencies continue to grow, the pain could also be felt by investors who have flooded into the market for subprime securities. Because of the way mortgage-backed securities are structured, investors who buy investment-grade securities aren’t likely to be hurt if losses are close to expectations. But if losses on the underlying mortgages substantially exceed expectations, some investors who buy the riskiest slices of subprime securities are likely to rack up losses. These include hedge funds and investors who buy collateralized debt obligations, pools of debt instruments that are often snapped up by foreign buyers.

There has been a bubble in subprime mortgage securities which was fueled by foreign governments wishing to invest their dollar reserves in debt instruments and by hedge funds who were engaged in the carry-trade. As delinquencies continue to soar it is reasonable to expect foreigners and hedge funds to pull out of the mortgage-backed securities market. This will force lenders to tighten their lending standards and cause a substantial decline in the volume of subprime mortgages. A fall off in mortgage activity will further hurt the housing market and, of course, the economy

Shorting the Brokers

Earlier this month Marc Faber caught my attention for predicting that the stocks of brokers are set-up for a fall similar to the stocks of the home builders 12 months ago. An article in yesterday’s Barron’s discusses this idea in greater detail;

NOW MIGHT BE A GOOD TIME TO RING UP THAT BROKER who put you into Ford shares two years ago and let him know his best days are probably behind him.

Following a remarkable four-year run that’s more than doubled the value of some Wall Street brokerage stocks, analysts have begun to pare earnings numbers amid worries that slower economic growth and higher rates have substantially increased the risks for this high-flying cyclical group that includes Bear Stearns (ticker: BSC), Goldman Sachs (GS), Lehman Brothers (LEH), Morgan Stanley (MS), Merrill Lynch (MER) as well as global financial conglomerates like Citigroup (C) and JPMorgan Chase (JPM).

The brokers are victims of their own success. Results have been great in all of their most important business lines, including equities, mergers and acquisitions, asset management and private equity. The firms’ prime brokerage services, which mainly serve hedge funds, have thrived, and improved markets have spurred record proprietary trading gains. Even fixed-income profits in areas like mortgage securities have held up despite the Federal Reserve’s interest-rate hikes.

“There’s nothing that can get better. Every cylinder has been firing away,” contends Charles Peabody, an analyst at Portales Partners, a New York financial-services research boutique.

Peabody is among those who believe a more hostile environment won’t allow the brokers to jump from success to success much longer. The Fed’s tighter monetary policy has drained liquidity from U.S. markets and central banks around the world have started to follow the same path. As funding gets more expensive, investors’ appetite for risk will decline, making it tougher to underwrite profitable equity and debt offerings or to continue Wall Street’s incredible streak of trading gains.

No doubt rallying stock and bond markets would continue to bolster brokers’ shares, but the odds against that occurring seem to be growing. The bottom line, says Peabody, who rates the brokers a Sell: “I think you could have earnings drop 30% next year.” That presumably would take a commensurate chunk out of the stocks.

Brian Rauscher, director of portfolio strategy at Brown Brothers Harriman, also has a Sell recommendation on the group because he believes their relative-earnings-estimate revisions have peaked. In other words, the group’s earnings aren’t going up as quickly as they had in the past. And, before this cycle ends, Rauscher believes, earnings estimates will start to get cut.

A quick reversal of fortune is possible if private-equity gains slow or margins in the prime brokerage business get skinnier because of increasing competition. A housing-industry slowdown could dramatically reduce the production of new mortgages, leaving some firms with bloated overheads. And if the recent stock-market rally turns out to be a bear-market bounce, the summer doldrums that have depressed equity underwriting volumes could extend into the fall.

The dollar value of initial public offerings in the U.S. for this summer is down 49% this year and the number of IPOs is down by 52%. Similarly, the value of IPOs worldwide is off 9% and the number is down 25%, says Thomson Financial. The decline not only hits underwriting profits but also makes it more difficult for private-equity shops — including those within Wall Street firms — to exit their investments via IPOs.

The flood of money into private equity (see Eliminate the Middleman) may ultimately shrink returns in one of Wall Street’s most profitable areas. Private-equity investments have boasted returns of 20% or more for the past three years, so everyone and his uncle has raised a fund. Total fund-raising doubled from 2004 to 2005, when it exceeded $100 billion, reports Brad Hintz, an analyst at Sanford C. Bernstein. As venture capitalists of the late 1990s can attest, excellent returns attract huge waves of capital, which in turn can kill the returns for those who are late to the party.

Goldman Sachs has the largest private-equity division on Wall Street, having raised an $8.5 billion fund last year. The company reported $354 million of gains and overrides from corporate and real- estate-principal transactions in the second quarter alone. The problem with these returns, as well as those from proprietary trading, is that they’re usually nonrecurring. So a firm must run faster each quarter to top its previous returns.

Investment banks don’t typically divulge their proprietary trading gains or losses, though most acknowledge the profits have been substantial. The success has also persuaded the firms to take on more risk with their own capital. At Goldman the average daily value-at-risk, or VaR, was $112 million last quarter, almost twice the $60 million reported a year before. VaR estimates the potential loss in value of a firm’s trading positions on a bad day.

“Everyone is extrapolating the strength of proprietary desks into the future, and I think that’s a mistake,” says Doug Kass, head of hedge fund Seabreeze Partners.

Uncertainty is evident in the wide spread of analyst opinion about Goldman’s earnings per share next year: $14.48 to $21.05. It’s also why multiples in the sector, which range between nine and 11 times ‘07 estimates, might not be as low as they first appear. If, say, 30% of earnings disappear overnight, multiples jump pretty fast.

A Goldman spokesman counters that history is on the firm’s side. “Over the course of a business cycle, our geographic, business and product diversity can be expected to deliver earnings growth, as they have in 18 out of the past 21 years,” he says.

A housing slowdown may also hurt brokerages that have built up massive businesses around residential mortgages. Last year $460 billion of home-equity asset-backed securities were sold, up from $74 billion in 2000, and $991 billion of mortgage-backed securities were issued, up from $185 billion five years prior, according to Thomson Financial.

Lehman dominates this market. In 2003 it acquired Aurora Loan Services, a residential loan originator, and it has since made additional acquisitions. Now it can originate loans, service them, securitize and sell the bonds backed by the mortgages and then trade the securities.

In the first half of 2006 Lehman originated about $31 billion of residential mortgage loans. It also purchased loans in the open market and pooled them to securitize $67 billion of residential mortgages in the first six months of the year. But not everything is securitized every night. At the end of the second quarter, Lehman had $4.2 billion of loan inventory on its books.

The firm also held about $800 million of non-investment-grade interests in securitizations at the end of the quarter. Underwriters often retain the most junior, risky pieces of a securitization if investors won’t. The value of these volatile residual securities typically are hit first if more mortgage holders than expected default or prepay their mortgages. It’s unclear how much of Lehman’s inventory is hedged for interest-rate or credit risk, and the firm declined to comment. In any event, Lehman seems to have a vested interest in the continuation of the housing boom.

While Lehman and Bear Stearns have the most active mortgage operations, juicy profits have lured others into the game. Most recently Morgan Stanley purchased Saxon Capital, which originates and services subprime residential mortgages, for $706 million.

If the residential mortgage market declines — as the 25% year-over-year drop in mortgage applications suggests — brokers might soon find they have lots of folks looking for something to do. The firms hope their origination arms will gain market share to keep the flow of mortgage loans going. They’re also eyeing the reset of adjustable-rate mortgages in the next few years and the global expansion of the mortgage business as new sources of business.

The prime-brokerage business also runs the risk of disappointing investors. Morgan, Goldman and Bear Stearns control almost two-thirds of this business, estimates Hintz of Bernstein. The shops cater to hedge funds and lend out stock to cover short positions, provide cash-management services, lend on margin, clear trades and provide reporting and custody services.

Hedge-fund clients tend to execute about 20% of their trades on their prime broker’s equity desk. Hintz estimates the hyperactive funds now generate 30% to 35% of the U.S. securities industry’s equity commissions. Their high portfolio turnover and interest in exotic — read: higher-margin — securities makes them hugely attractive Wall Street clients.

Here, too, competition has arrived and profits will be tougher to come by. Merrill, Lehman, UBS and Deutsche Bank are among those who have jumped in. Hedge funds increasingly split their prime business among two or three players instead of staying with just one shop.

And the business may be getting riskier as new entrants offer easier borrowing terms, says Hintz. Firms are more inclined today to lend the same amount against a security or a portfolio for 30 or 60 days, whereas in the past the loan varied daily with changes in the security’s price. Such a change exposes the broker to more risk should the value of the security drop sharply. Newer entrants are also extending loans against entire portfolios instead of against specific securities.

“They’re becoming liquidity guarantors to the hedge funds,” says Hintz, who has Market Perform ratings on Goldman, Morgan, Bear and Lehman, and Outperform ratings on Merrill and JPMorgan Chase.

Morgan Stanley’s prime brokerage unit, says a spokesman, expects “demand for these types of services will increase, not decrease, as modern asset managers trade in an increasing number of different asset classes and markets.”

Hintz estimates that Morgan and Goldman’s prime-brokerage pretax net income will rise about 12% annually over the next few years, down from the 20% gains enjoyed in past years. Bear Stearns, which has the most exposure to domestic business, is the most vulnerable of the three and may find it can increase the group’s bottom line by only 3% in that time.

Growth like that might not satisfy investors who’ve come to expect much more from their brokers.

I plan on taking a short position on the brokers this week. My favorite short candidates are Lehman Brothers (NYSE:LEH) and Bear Stearns (NYSE:BSC).