You know how I feel on this topic - Reggie Middleton says don't believe 'em ...

 "In my judgment, we are closer to the end of the market turmoil than the beginning," Henry Paulson said in the text of a speech he plans to deliver in Washington. "Looking forward, I expect that financial markets will be driven less by the recent turmoil and more by broader economic conditions and, specifically, by the recovery of the housing sector."

_____________________________ 

“Frankly, things may get worse before they get better. As regulators, we continue to see a lot of distress out there,” Sheila Bair, chairman of the Federal Deposit Insurance Corp., said in the text of a speech to the Brookings Institution...“Too many unaffordable mortgages are causing a never-ending cycle — a whirlpool of falling house prices and limited refinancing options that contribute to more defaults, foreclosures and the ballooning of the housing stock,” Bair said.

Hmmm... Who do you believe???

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Anybody in the residential real estate biz can tell you that rentals compete with sales. Sales boom, rentals suffer. Rentals suffer, sales boom. Unless you have an overall crappy macro scene, then everything can suffer some. Well, with the housing boom, raw land became much too expensive to justify building rentals, which effectively have an annuity stream in lieu of the lump sum paybacks of the actual sales. As the market broke, land got cheaper and when combined with the tight housing market caused rents to rise in urban areas, allowed apartment builders to jump into the fray. We haven't even broached the volaitlity of these numbers, being revised up, down, and all around. This is a BAD thing for homebuilders! This is a BAD thing for extant housing inventory looking for sales! This is a BAD thing for banks trying to move REOs! Basically, this just more supply added to a glutted market. For those who even consider buying the builders or banks on this news, caveat emptor! The homebuilders are at a historical low in terms of sentiment - do you think they are lying to themselves? 

From the WSJ :

Home construction turned up unexpectedly in April and showed surprising vigor, making the biggest increase in two years, while building permits also rose, a sign of optimism for the sickly housing sector. How so?!

Housing starts increased 8.2% to a seasonally adjusted 1.032 million annual rate, driven higher by a surge in apartment building construction, the Commerce Department said Friday. Starts plunged 13.8% in March to 954,000, the data showed; Commerce initially estimated March starts down 11.9% to 947,000.

Economists surveyed by Dow Jones Newswires expected April starts to drop by 1.4% to a 934,000-unit annual rate. The 8.2% increase was the largest monthly climb since a 14.0% jump in January 2006.

But year over year, housing starts were 30.6% below the level of construction in April 2007.

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I fancy myself to be a pretty good investor. While I think I'm a pretty bright guy, I know I am not at the level of the rocket scientist known to be hired by the quant funds. While I am fairly creative, I am far from an artist. While I am not a high school drop out, I don't have a PhD. So, what makes me a good investor? I have this uncanny knack of being able to smell bullsh1t a mile away!

Now, for those banking CEOs, homebuilder CEOs (ex. Mr. Hovnanian), monoline CEOs and government officials (ex. Mr. Paulson), who claim that the worst is behind us - I can smell you guys!

I am starting to come clean on my commercial bank research and personal  investment positions. I do not publish my research until after I have established my positions, but I do release broader market and macro stuff early - figuring it can do little harm.

So, I hear Paulson says the worst is behind us!? I am assuming he is referring to the subprime mess, and the capital market melee that followed. Well, I don't believe the subprime mess is over, but if it is we still have to contend with at least 5 other failing categories of bank products that are imploding due to securitization imprudence - all rivaling or surpassing that of subprime.

Let's go over my research trail on the Current US Credit Crisis. Sections 1 through 5 are background material that is probably known to the professional in this arena, but will make good reading for the lay person. I used it to make sure I made judgments based on observable facts vs. media representation and/or personal bias. I feel the section on counterparty risk should be required reading for everybody, though. The report on PNC basically outlines, in full detail, why I chose that bank out of 329 others, to initiate my short foray into the regionals.

1. Intro: The great housing bull run – creation of asset bubble, Declining lending standards, lax underwriting activities increased the bubble – A comparison with the same during the S&L crisis
2. Securitization – dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble – declining home prices and rising foreclosure
3. Counterparty risk analyses – counterparty failure will open up another Pandora’s box
4. The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue
5. Municipal bond market and the securitization crisis – part I  
6. An overview of my personal Regional Bank short prospects Part I: PNC Bank - risky loans skating on razor thin capital

Now, let's take a more mundane look at the banking sector in general. Looking at how much of the banking industry's portfolio is concentrated in real estate, one should be concerned when housing priced drop precipitously (no spell checker, and I'm tired). We are in much more heady territory than in the S&L crisis (started by CRE lending), and the housing price drop is much worse as well.

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To begin with, I would like to remind all that I am a private investor, not an analyst, nor a reporter or media professional. Hence, expect me to be short anything that I am bearish on, and long anything that I am bullish on. Very strong investment results are my goals, with the blog being a hobby. With that being said, I am bearish on the regional banking sector with large concentrations of commercial real estate, consumer finance and 2nd lien residential real estate risk. I screened about 330 S&Ls, regional and small/mid-cap banks and the finalist of this contest was... PNC. Below is my (textual) take on PNC. Later, I will post some other banks that I have looked at along with additional info on the state of the industry that emboldens me to hold short positions during this bear rally. I will also be posting updates on the homebuilders.

This analysis was very richly formatted with plenty of charts and graphs, hence I decided to leave most of it out of the blog post. Anyone who wishes to see it in its full fidelity should simply register (for free) and download the pdf version -  PNC Report 050508 revised (711.95 kB 2008-05-15 12:26:16).

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Note: for some arcane reason, the graphs refuse to show up on this post so here is a pdf version for the blogs registered users: Municipal Bond Market and the Securitization Crisis (242.88 kB 2008-05-14 18:09:27)

his is a DRAFT of part 5 of Reggie Middleton on the Asset Securitization Crisis – Why using other people’s money has wrecked the banking system: a comparison to the S&L crisis of 80s and 90s. As was stated in the earlier parts, I periodically have third parties fact check my investment thesis to make sure I am on the right track. This prevents the "hubris" scenario that is prone to cause me to lose my hard earned money. I have decided to release these "fact checks" as periodic reports. This installment covers consumer finance, an aspect at risk in the banking system that is both overlooked and underestimated, in my opinion.

I urge discourse, conversation and debate on this post and the entire series. To me, it is necessary to make sure the world is as I percieve it.

The Current US Credit Crisis: What went wrong?

1. Intro: The great housing bull run – creation of asset bubble, Declining lending standards, lax underwriting activities increased the bubble – A comparison with the same during the S&L crisis
2. Securitization – dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble – declining home prices and rising foreclosure
3. Counterparty risk analyses – counterparty failure will open up another Pandora’s box
4. The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue
5. You are here => Municipal bond market and the securitization crisis – where do we stand
6. To be Published: An overview of my personal Regional Bank short prospects

The following municipal bond portion of the asset securitization crisis is also a tie-in to the prospects of the monoline insurance industry. The latest of my monoline analyses is the Assured Guaranty Report. You can also peruse the work I did on MBIA and Ambac starting from the inception of my short position in these companies last year.

1. A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton
2. Tie-in to the Halloween Story
3. Welcome to the World of Dr. FrankenFinance!
4. Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion
5. Follow up to the Ambac Analysis
6. Monolines swoon, CDOs go boom & I really wonder why the ratings agencies are given any credibili
7. More tidbits on the monolines
   
8. What does Brittany Spears, Snow White and MBIA have in Common?
   
9. Moody's Affirms Ratings of Ambac and MBIA & Loses any Credibility They May Have Had Left
10. My Analyst's Comments on MBIA/Ambac/Moody's Post
11. As was warned in this blog, the S&P downgrade of a monoline insurer reverberated losses through c

And now, on to the Muni report...

Municipal bond market and the securitization crisis – where do we stand

As defined by the Securities Industry And Financial Markets Association (SIFMA), municipal bonds (often called munis) are debt obligations issued by states, cities, counties and other governmental entities to raise money to build schools, highways, hospitals and sewer systems, as well as many other projects for the public good. The interest income generated from these bonds is free from federal taxes, state taxes, local taxes or all the above. However, not all munis are tax-free.

Municipal bonds generally are classified as general obligations and revenue bonds. General obligation bonds (or GO bonds) are mostly backed by the credit and the ‘taxing power’ (inflow of tax revenues) of the issuing municipality. They are generally considered one of the safest investments as they have governmental support.

Revenue bonds, on the other hand, depend upon the revenue generation capability of the project in which the bond proceeds are to be invested. Hence, they are generally perceived to be riskier than the GO bonds.

Out of a total market worth US$2.62 trillion municipal bonds outstanding, mutual funds hold the maximum (35.8%), while individuals hold the second highest amount (35.0%) of the municipal bonds in the US.

Municipal bonds breakdown - outstanding and issued in 2007

Source: Financial statements, US Federal Reserve

With the economic hard landing in the US, income tax collections are likely to get hit, going forward. According to advance estimates from the Bureau of Economic Analysis, the US economy grew by only 0.6% y-o-y in 1Q 08 with unemployment rate having jumped from 4.5% in April 2007 to 5.0% in April 2008. With high food prices across the globe, higher fuel costs, increasing debt component pressurizing the household income and the decline in the values of houses of US citizens, there is an unavoidable pressure on personal disposable income. With rising unemployment across the country, a declining or even a marginally negative growth rate of revenues generated through income tax would severely pinch the Government’s earnings. With homeowners expecting at least as much assistance as was provided to the financial industry, tough times await the US Government.

An impact in tax revenues directly affects the credibility and capability of the government to issue any bonds based on its taxing powers – whether they be municipal or federal. This is also a major reason why the overall outlook for municipal bonds market appears grim in the near to medium term.

Bloated budgeting in the boom times

Most US state and local governments had prepared budgets based on the revenue from the (then) extant real estate boom. Hence, they continued to issue munis to fund their expansion plans; even the interest rate scenario was conducive and they could pay the investors due to a consistent inflow of taxes. However, after the housing market collapsed, property values went down and an increasing number of homeowners went for the property revaluation to cut down the property tax figures from the list of their financial obligations.

Consequently, tax inflow for these state and local governments slowed down. Due to this, payments on the long term municipal bonds became riskier than at the time of their issue. The government of California has already reduced the budgets of its police and fire departments for the coming year by approximately 20% following these developments. This, combined with private sector workforce reductions, serve to act as a reflexive mechanism that causes a feedback loop, wherein cost reductions reduce income tax revenue which exacerbated the need for further cost reductions.

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I don't want to sound like I am better than the sell side analysts and the banks that they work for. It is just that I don't have the political constraints that they have. Perusing my blog, you can see that I don't pull any punches. I call trash, trash. We shall see if the guys at Merrill share the same acumen and have the balls to act on it. I have 4 major propietary research pieces sitting on my hard drives, and just have not had the time to post them. I will try to get them up between today and Friday.

 From Bloomberg :

Merrill Analysts to Rate 20% of Stocks `Underperform'

 Merrill Lynch & Co. will require its equity analysts to rate at least 20 percent of the companies they cover the equivalent of ``sell,'' about four times the Wall Street average.

Merrill's new ``dispersion guidelines'' will also limit ``buy'' ratings to 70 percent of the shares an analyst covers, while ``neutral''-rated stocks won't exceed 30 percent.

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From the Naked Capitalism blog :

In "The crisis rotates from America to Europe, and Asia," Evans-Prichard argues that many of the world's other large economies will start to falter, not due to the US slowdown but their own flagging fundamentals. The bit that caught my eye was this:

I confess that I do not speak with authority on China, and may be wrong to doubt the miracle -- so much like the Japan hype of the late 1980s to my jaded eye.

I look to clever people who know what is going on, such as Dr Kwan Chi Hung from the Nomura Institute -- an esteemed figure in the Far East, and himself Chinese - who believes that China's long-term prospects are "horrible".

China's workforce will peak in seven years (the delayed fruit of the one-child policy) and then go into the steepest downward spiral ever seen by a large nation in peacetime. It will, and do so long before it is rich. This demographic implosion cannot be reversed quickly.

Dr Kwan says China enjoys a dreadful return on capital

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Here we have 2 companies in a rapidly shrinking industry whose clients have very little faith in their product, and who are saddled with massive liabilities that have generated record losses for 3 consecutive quarters in a row. They have been forced to discountine their highest margin (or so they thought) line of business and have lost over 70% of thier market share in their core business. Ther market has been invaded by larger companies who are better capitalized, better managed, and have none of the toxic waste liabilities that are dragging these two companies down. They both have lost over 80% of their share value in the last year, and are in the mid to high single digits, down from the 80's in '07. They have been forced to the captial market at levels of dilution and interest rates that are not even reserved for those companies that are rated the deepest of junk. They have lost more money for their investors (and now potentially their clients) than any industry since the dot.com bust. Their credit spreads have widened by multiples over the last year. Yet they have been, and continue to be rated AAA. The term "Travesty" is an understatement when describing what used to be the world's most respected financial center.

From Bloomberg: 

 

MBIA, Ambac Losses Elevate Aaa Concern, Moody's Says

 

MBIA Inc. and Ambac Financial Group Inc. had ``meaningfully'' higher losses on home-equity loans and collateralized debt obligations than anticipated, raising concern about their Aaa status, Moody's Investors Service said. This a joke. I saw this coming last year, and with the extent of the housing bubble and the rate of deterioration at that point, I had absolutely no doubt this was going to happen. Take your pick of the myriad ways in which I articulated it:

1. A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton
   
2. Tie-in to the Halloween Story
3. Welcome to the World of Dr. FrankenFinance!
4. Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billi
5. Follow up to the Ambac Analysis
   
6. Monolines swoon, CDOs go boom & I really wonder why the ratings agencies are given any credibili
7. More tidbits on the monolines
   
8. What does Brittany Spears, Snow White and MBIA have in Common?
   
9. Moody's Affirms Ratings of Ambac and MBIA & Loses any CredibiltyThey May Have Had Left
10. My Analyst's Comments on MBIA/Ambac/Moody's Post
    
11. As was warned in this blog, the S&P downgrade of a monoline insurer reverbrated losses through c

 

The first-quarter losses reported by the companies in the past two weeks elevate ``existing concerns about capitalization levels relative to the Aaa benchmark,'' Moody's, unit of Moody's Corp., said in a statement today. Really!!!!??? I don't feel that a company that is rated AAA should be able to generate such concerns. If you are having such concerns now, why wasn't the company downgraded before now? The moniker "AAA" should be beyond reproach, and definitely should not be subject to the ruminations of which you just espoused! These are the characteristics of a BBB company, or mabye a CCC company. Most assuredely, you would not subject your clients to the volatility of opinion that would arise by telling them that a "Moody's rated AAA" company is even remotely at risk of not being able to pay its bills, would you??? Armonk, New York-based MBIA and Ambac, the two largest bond insurers, tumbled in New York Stock Exchange composite trading and their credit-default swaps rose.

While New York-based Moody's stopped short of placing the companies on formal review, analyst Jack Dorer said he will examine whether the slump in mortgages is ``likely to be material for exposed financial guarantors, and will update the market as appropriate.''

MBIA and Ambac retained their top rankings from Moody's and Standard & Poor's less than three months ago. Ambac sold $1.5 billion of stock and equity units and MBIA raised $2.6 billion and the chief executive officers of both companies have said they don't need to raise more. Moody's today indicated future losses on home-equity loans, or second mortgages, may increase their need for more capital.

The slide may ``have material implications for the estimated capital adequacy of financial guarantors most exposed to this risk,'' Dorer said in the report.

Fitch Cuts

Jim McCarthy, a spokesman for MBIA, didn't immediately return a call seeking comment.

``Ambac has met the capital levels laid out by Moody's immediately prior to the capital raise,'' Vandana Sharma, a spokeswoman for Ambac said. ``We will continue to work closely with Moody's to get a better understanding of their revised analytics regarding second liens. The Aaa is extremely important to Ambac.'' Obviously so. They sold the soul of every equity investor they had to the dilution devil to maintain something they really don't deserve and probably would not be able to keep anyway.  Ambac generates capital internally as insurance policies mature, Sharma said. Really, I thought the liabilities expire and frees up the capital unearned capital, which is not the same as generating capital. Then again, what the hell do I know... It's such a complex business, and therein lies the crux of the problem...  

Moody's and S&P put MBIA and Ambac on review for a possible downgrade in January before affirming them with negative outlooks. Fitch Ratings cut both companies to AA earlier this year. Fitch said MBIA needed about $3.8 billion more in capital to justify a AAA rating. S&P, a unit of New York-based McGraw- Hill Cos., yesterday said it will take no action after MBIA reported its first-quarter loss.

`Ongoing Saga'

The prospect of a ratings downgrade by Moody's and S&P earlier this year threw a cloud over the companies and the more than $1 trillion of municipal and asset-backed debt they insure. Markets for everything from the safest municipal securities to bonds backed by home loans and auto loans seized up on concerns that their AAA backing would be removed. Banks also faced losses of $70 billion on the asset-backed debt, according to Oppenheimer & Co. analysts.

``This is an ongoing saga,'' said Andrew Harding, who helps manage $18 billion as chief investment officer for fixed income at Allegiant Asset Management in Cleveland and doesn't hold or have bets against bond-insurer debt.

MBIA, down 87 percent in the past year, dropped 61 cents, or 6.2 percent, and New York-based Ambac declined 36 cents, or 8.3 percent, to $3.97. Ambac slumped 96 percent in 12 months.

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I haven't written much about MBIA lately, primarily because I had closed my bearish position on them at about $9 per share. This was originally initiated in the $60's last year, and really intensified in the $40's and $20's after a decent amount of research . Well, the CEO who over saw the move into structured product insurance (Jay Brown) has returned. He is the guy who said and I quote, "If you don't like structured products, you don't like MBIA" - ain't that a fact! I feel he has been lax in management oversight, judgment and execution. The letter to the shareholders is proof in the pudding. So,  I decided to add a cowboy traded to the mix, buffered by the profits made from the very profitable short earlier this year and last year.

So, MBIA released results this morning. Anlayst consensus estimates (which never, ever seem close to my estimates) was $-0.19, and MBIA reported a loss of  $13.03 per share (it's share price is only $9 and change per share). This is not all mark to market losses, either, operating losses seemed to be significant. According to the news articles $3.58 billion were derivative mark to market losses, hence the balance of the $13.03 was most likely investment and operating losses. This was a company that was literally the dominant underwriter of municipal bond insurance, with a majority market share. As of the last quarter, it had 2.5% market share - exactly as I anticipated. Remember, S&P and Moody's have affirmed its AAA rating. This is a damn shame. This is also an opportune time to review my CDS and counterparty primer as well. Remember, one of my big shorts, Morgan Stanley, has some of the most significant counterparty exposure to this (ahem) "AAA" company. I noticed the media has stopped covering this systemic risk which will be hard for the Fed to plug.

From Bloomberg:

MBIA Inc., the bond insurer that lost 87 percent of its market value in the past year, posted a net loss of $2.4 billion as the slump in mortgage securities deepened.

The first-quarter net loss was $13.03 a share, compared with a profit of $198.6 million, or $1.46 a share, a year earlier, Armonk, New York-based MBIA said in a regulatory filing today. Unrealized losses from derivatives were $3.58 billion.

The loss was MBIA's third straight and comes less than three months after the bond insurer successfully retained its AAA credit rating. MBIA, Ambac Financial Group Inc. and the rest of the industry have posted record losses after misjudging the value of collateralized debt obligations and securities backed by home- equity loans they guaranteed. MBIA, once a dominant provider of municipal bond insurance, had 2.5 percent of the market in the quarter, according to Thomson Financial data.

``We're not out of the woods yet,'' said Richard Larkin, senior vice president at Herbert J. Sims & Co. in Iselin, New Jersey. ``I'm not sure AAA bond insurers will ever be viewed the same way as in the past.''

MBIA raised $2.6 billion in capital to help convince Moody's Investors Service and Standard & Poor's to preserve its AAA rating. Chief Executive Officer Jay Brown said this week the company won't need to raise more.

``We have adequate equity capital to get through this crisis,'' Brown wrote in a letter to shareholders published May 6.

MBIA fell 21 cents to $9.22 in early New York Stock Exchange composite trading. The stock traded above $70 a year ago. MBIA's book value slumped to $8.70 a share on March 31 from $29.16 at Dec. 31, in part because of new shares sold in the capital raising.

`No Longer' AAA

MBIA estimates it will have $827 million of actual losses from paying claims on nine CDO transactions.

``Earnings pressure will remain for several quarters as writedowns continue,'' Peter Plaut, senior vice president at Imperial Capital, wrote in an e-mail today. ``This is no longer a AAA industry for the players that diversified into volatile financial derivatives.''

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 This is a  DRAFT of part 4 of Reggie Middleton on the Asset Securitization Crisis – Why using other people’s money has wrecked the banking system: a comparison to the S&L crisis of 80s and 90s. As was stated in the earlier parts, I periodically have third parties fact check my investment thesis to make sure I am on the right track. This prevents the "hubris" scenario that is prone to cause me to lose my hard earned money. I have decided to release these "fact checks" as periodic reports. This installment covers consumer finance, an aspect at risk in the banking system that is both overlooked and underestimated, in my opinion.

I urge discourse, conversation and debate on this post and the entire series. To me, it is necessary to make sure the world is as I percieve it. 

The Current US Credit Crisis: What went wrong?

1. Intro: The great housing bull run – creation of asset bubble, Declining lending standards, lax underwriting activities increased the bubble – A comparison with the same during the S&L crisis
2. Securitization – dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble – declining home prices and rising foreclosure
3. Counterparty risk analyses – counterparty failure will open up another Pandora’s box
4. You are here => The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue
   
5. To be Published: Credit rating agencies – an overhaul of the rating mechanisms
6. To be Published: An oveview of my personal Regional Bank short prospects

And now, on to the report... 

Reggie Middleton on the Asset Securitization Crisis and Consumer Finance

As with the mortgage market, the consumer lending market reported significant growth since the beginning of this decade largely due to lax lending standards of financial institutions, imprudent lending and poor assessment of payback abilities of customers and more importantly, securitization!!!
 

Consumer credit is generally classified as revolving and non-revolving. Revolving consumer credit includes credit card lending, lines of credit, home equity line of credit (HELOC) and similar products. These types of lending products do not have a fixed number of payments; there is a limit assigned to the borrower up to which he can borrow and pay the principal and interest within a certain period. The method of functioning in this case is very similar to that of a credit card.

On the other hand, non revolving consumer credit includes loans such as automobile loans, loans for mobile homes, education, boats, trailers, vacations, etc. Unlike revolving credit, these require fixed number of payment over a period of time. Over the last 27 years, non revolving credit on an average has constituted 68.8% of the total consumer credit market.

Consumer credit outstanding (US$ bn)

Source: Statistical Releases of the US Federal Reserve

Growth in consumer credit registered its peak during the S&L crisis, as it grew 18.4% y-o-y to US$517.2 billion at the end of 1984. Over the last 20 years (1988 to 2007), total consumer credit outstanding in the US economy has grown at a CAGR of 6.7%, making it a US$2.57 trillion industry at the end of 2007.

The growth proceedings were dominated by revolving consumer credit (CAGR of 9.0%) due to the rising demand for HELOCs over the years, a result of the booming housing market. Moreover, with low interest rates in the earlier years, borrowers found it easy to get their credit limits enhanced. As opposed to this, non revolving credit grew at a lower CAGR of 5.7% over the same period simply due to the dominance of mortgage lending over other lending forms. The faster growth in revolving credit led to a change in the composition of the market. Revolving consumer credit constituted 37.3% of total consumer credit outstanding in 2007, from 25.2% in 1988.

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