Friday, 16 May 2008 01:00

Reggie Middleton says, "Don't believe Paulson": S&L 2.0 - bank failure redux

 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 I do not publish my research until after I have established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

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.


This graph should speak for itself. To put it in a few short words, "You ain't seen nuthin' yet!"


We are overbuilt, not just in residential but commercial as well. Construction and development loans have always been a high risk/high reward endeavor, well the risk part is coming home to roost. We are at a historical high in the riskiest classes of bank loans, at a time when supply is excessive, the macro environment is downright destructive, and bank capital levels are at all time lows.


It appears as if the banks believe Henry Paulson's bullshi,, excuse me, "assertions" that the worst is behind us, for they appear to be explicitly under-reserving for what I see as a historically high level of RE loan concentrations. This is not even taking into consideration the performance trend of those loans over the last few quarters.


More to the point, look at the last two times real estate has gotten into trouble. Both times really hurt the US, with the earlier one (the S&L crisis) probably costing the US citizen and the banking system the most since the Great Depression. Despite this, the banking industry was much more prepared (in terms of loan loss provisions) to whether the storm then they are now. If you have read through my Asset Securitization Crisis primer and you are a reasonable man/woman, you should gather that we are in a much worse position now than we were in either of the last two downturns. This means that loan loss provisions are going to spike up sharply, and along with it capital requirements increase dramatically (spell the word D-I-L-U-T-I-O-N slowly, for we will be seeing a lot more of it) while earnings plummet. But then again, if the worse is behind us, it doesn't really matter, does it???


I have screeched many times on my blog that some very smart people who should really know better are definitely overestimating the power of the Fed to get us out of this situation. Those guys over at CNBC say, "but we are getting rate cuts, margins are improving, yada, yada." Yes, we did get rate cuts. Yes, margins are improving. But from what level. As you can see, regional CRE lending institutions had it better during the S&L crisis, and you see what happened to over a thousand of them .


Wikipedia excerpt:

The U.S. Savings and Loan crisis of the 1980s and 1990s was the failure of several savings and loan associations in the United States. More than 1,000 savings and loan institutions (S&Ls) failed in what economist John Kenneth Galbraith called "the largest and costliest venture in public misfeasance, malfeasance and larceny of all time."[1]
The ultimate cost of the crisis is estimated to have totaled around
USD$160.1 billion, about $124.6 billion of which was directly paid for
by the U.S. government -- that is, the U.S. taxpayer, either directly
or through charges on their savings and loan accounts-- [2], which contributed to the large budget deficits of the early 1990s. The resulting taxpayer bailout ended up being even larger than it would have been because moral hazard and adverse-selection incentives compounded the system’s losses. [3] The concomitant slowdown in the finance industry and the real estate
market may have been a contributing cause of the 1990-1991 economic recession.
Between 1986 and 1991, the number of new homes constructed per year
dropped from 1.8 million to 1 million, the lowest rate since World War II.
For the record, we are on track to easily break that housing starts record. Why would anyone bid up the homebuilders??? Study balance sheets and history, people!!!

As a matter of fact, the current environment shows the weakest net interest margins for the last 30 years! To make matters worse, I believe that sooner or later (probably sooner) the government is going to be forced to stop thier core inflation charade as energy, food, housing, and the materials used to produce these commodities, skyrocket through the clouds and into outer space. Of course inflation is under control as long as you don't have to eat, drink, drive or sleep in warm shelter! If real inflation forces the feds hands into raising rates, even just a little, the banks are toast. That little dip in NIMs at 1985 in the graph was probably the straw that broke the camel's back in the S&L crisis. Yes, Mr. Bernanke --- Conundrum! Or maybe not. Mr. Paulson said the worst is behind us!

Below, you can see where we have a whole lot more loans to default on than we did in the S&L crisis, even after adjusting for inflation (not reflected in the chart).


So, after taking all of this into consideration, you can see why I don't think the worst is behind us. As a matter of fact, many focus on subprime, and more recently HELOCs (for good reason). Here is an interesting article on Calculated Risk regarding the losses on HELOC's being understated because the servicers are too busy to get timely information out. But (I know, never start a sentence with a conjuntion, but this is my blog - Enlgish teachers are not allowed here), if one simply takes a gander at what is really going on, you will find there is a broad field to choose from when selecting banks to short.


I think I'll end this here. My next research post will be on muni losses affecting credit default swaps, charge offs in the banking sector, more bank short candidates that I chose to bypass, and a homebuilder update. I will also be hosting a high net worth and institutional investor pow wow on the Hudson River leaving from Chelsea Piers in Manhattan, for anyone of the aforementioned interested in my opinions and outlooks. Stay tuned.

Last modified on Friday, 16 May 2008 01:00


  • Comment Link Shannon Saturday, 24 May 2008 14:03 posted by Shannon

    Actually, I think that the housing prices were driven up by cheap money (low rates, exotics, etc.), which, in turn, created an upward, unsustainable spiral.

    People saw housing prices climb, figured they could get a loan, dove in... Banks saw housing prices rise, figured they could make money either way (fees, or increased value of house if the borrower defaulted), they offered more and more exotic loans.

    And so on. Thus, those who saved money and knew that the housing prices exceeded their economic value (purchase cost / month higher than rent), will be footing the bill. That's why, after this is all over and everything settles down here and abroad (because I don't think there will be a true decoupling), I'm keeping all of my investments in foreign securities.

  • Comment Link Reggie Middleton Tuesday, 20 May 2008 08:56 posted by Reggie Middleton

    You're right in that it probably should not be referred to as a "spread", but more so a correlation. The rampant pile up of loans were fueled by increasing housing prices which justified the loan build up from the business decision level. As housing prices decline, these loans become riskier and eventually unprofitable as LTVs breach 100%+ and foreclosures mount, reducing recovery rates, and in the case of many high LTV 2nd lien loans, eliminating recovery all together.

  • Comment Link ken Monday, 19 May 2008 23:34 posted by ken

  • Comment Link Alex N Monday, 19 May 2008 11:31 posted by Alex N

    Interesting charts, but in fairness, I do not quite understand how you can measure spread between per cent values of gross loans and housing price index. Having them on the same chart is more or less ok to show the dynamics of the process, but subtracting values measured in different units is a bit over the top, even if the overall conclusion is plausible.

  • Comment Link Anonymous Sunday, 18 May 2008 07:15 posted by Anonymous

    The Penny King predicts that at least 2,000 financial institutions, that includes banks, savings and loans, bank holding companies, investment banks, mortgage brokers, mortgage companies, real estate investment trusts and any other financial services related company, will collapse, fail, disappear, go out of business between now and the end of 2009. That inlcudes more than 100,000 additional layoffs across this troubled global industry.


  • Comment Link curious george Saturday, 17 May 2008 15:14 posted by curious george

    Reggie, from what I've read the only major difference between you and some of the smarter WS quants is your conviction, honesty to the trade, and, apparently, paymaster.

  • Comment Link JO Friday, 16 May 2008 21:50 posted by JO

    Hey Reggie, great blog. I have been following markets since 12 and trading since 18..since 2004, I have focussed on this developing crisis. Have to say your blog is outstanding and I spend a lot of time on many good ones..Your blog fits in the contrarian philosophy I value so much. I believe that on average, if 80 % or more of the public/pros believe in something, they will almost certainly be I follow the guys like you who tell a different tale..I work in financial services for a coop/CU and often come across commentary from MF companies, etc. In the first comment above talking about inflation, etc, I have to say the only way our world will survive and prosper on a sustainable basis in the long run is to get off the fiat money system..I have held this opinion for a long time...hence i appreciate your straightforward writing and education of the public/blog readers. At the most fundametnal level, the underlying cause of our societal ills and current crisis is the most hedious monetary experiement in inflation / bubble that has created a false sense of "wealth", punished savers and those who follow the rules (payoff the home, save for retirement, build a pension, etc)and allowed for an extraordinary confiscation of wealth through inflation and taxes. So I encourage you to continue the excellent work in covering tis crisis...the day will come when people finally realize the scam that is this system and call for the end of fractional reserve banking and abolishment of the Fed.
    Regards from Canada

  • Comment Link Reggie Middleton Friday, 16 May 2008 20:55 posted by Reggie Middleton

    I don't believe that there are any (current) alternatives to the US dollar as a reserve currency.

  • Comment Link Sam Goody Friday, 16 May 2008 20:43 posted by Sam Goody


    IS the answer to your riddle "Commodities?" or is it that capital can not take flight from dollar assets because the alternatives are worse....

  • Comment Link Reggie Middleton Friday, 16 May 2008 12:40 posted by Reggie Middleton

    Thanks for the supportive words. I hope you get a lot out of the learning process. As for your questions, you are asking the same ones everyone else is asking. Let me pose this question to you, though. If there was a run out of the dollar and US treasuries, where would that capital run to? Certainly not the pound, who is soon to be worse off than the US. Not the untested and unstable Asian currencies. Not the Euro, who may face the temptation of a break up due to the mish mash of economies being forced to live in the same economic house. Spain and Italy's economies are tanking, yet Germany et. al. is doing well, hence Trichet says their is no need to drop rates with inflation at the door. Tell that to the coastal Spanish homeowners.

    It will be interesting to see how they get these myriad and diverse economies to all walk under the same tiny umbrella during a torrential downpour. Someone(s) is going to get pushed out into the rain.

  • Comment Link jana madan Friday, 16 May 2008 12:26 posted by jana madan

    Hi Reggie,

    Thanks for sharing your valuable thoughts. I love your blog. It's my addiction after my morning coffee. I am totally agreed with you on your investment thesis. I also have short( thru puts) vested interest. Basically I bet on my positions, predicting that there could be black swan event within six months. I may be wrong, but in the long run, you have better chances to win!

    The only thing in my strategy, I under estimated is 'BERNANKE PUT'. I do not want to attribute this to one person, I can call it as FED PUT. FED is doing right thing(to improve short term economy) to stabilize the credit markets using its tools. It is taking time to stabilize the markets. It might win in the short run. I predicted this will happen. But biggest shock so for to me is how contained is dollar crisis, yen carry trade, long term yields and confidence on GSE's and IB MBS holdings. I know GSE's are backed by Gov. If that is the case why there is no run on dollar and US treasuries.
    Regarding the fundamentals I know you are exactly right about the whole securitization fraud. On the economy front it is scary to think about the depression kind of situation, if you really think that Greenspan PUT has created this worst Housing bubble, which has created the uneven economy, I mean some parts of the economy like housing related(RE agents, brokers, insurance, health, builders, retailers) expanded lot and Technology and R&D investments lagged during this period. It will have huge impact on this coming recession(depression).
    Think about my own situation, I am an R&D Engineer was having high paid and rewarded job during the tech bubble( I am not supporting the tech bubble, but Technology leaded the USA as number one in the world economy) , but your morale will go down when average Joe make a million on a wild ride speculative real estate investment, which is guaranteed and backed my US Government. So I can say Gov. Policy has created this bubble and has to face 'moral hazard'. Since I am techie, I am not that expressive. But I have learned lot about the economic fundamentals from your blog, especially the whole Securitization process. I really appreciate your fundamental thoughts.

  • Comment Link Reggie Middleton Friday, 16 May 2008 11:51 posted by Reggie Middleton

    You can register [url=,com_eventlist/Itemid,/func,details/did,1/]here [/url]. The date is tentative, but I will firm it up by next week. I have to get the boat back to NYC. Just to clarify, this is just a meet and greet for like minded financial folk to share ideas and enjoy themselves. I'll have space on the boat for about 10 t0 15 people.

  • Comment Link Chris Marshall Friday, 16 May 2008 11:32 posted by Chris Marshall

    Reggie, Could you let me know a date for your pow wow, ASAP, so that I can arrange to be in the US.

  • Comment Link Reggie Middleton Friday, 16 May 2008 10:12 posted by Reggie Middleton

    I thought I would paste two comments over here, since they are so aligned with my investment thesis and articulately stated:

    - Reggie you have done some good research putting this altogether. I agree, that things are still quite dangerous. Spreads have come down, but the Fed and BOE are still active and advocating for banks to strengthen their balance sheets. One can't fault Pualson for "talking his book". It is part of the job.

    My own concern is CDS netting in the event of a few failures or a midsize counterparty failure. The relative illiquidity and slowish netting facilities means that a few days delay on a "EOD" agreement could send some pretty large shocks through various netting nodes on the CDS network of relationships.

    Herstatt type risk cascades rapidly through a tightly coupled system. One could argue that the relative lack of liquidity and thin balance sheets increases the "coupling" in the system.

    - Thanks for one of the most intelligent articles on these subjects I have read. I was as a CPA in the Northeast and my contention is that this crisis is not a subprime mortgage mess at all that it is in fact unnanounced inflation and the corrosion in wages/benefits for the working class that is leading to all these problems we are seeing.

    Just in the last few days the Govt announced inflation was 2.4% and gas prices FELL last month!

    In a nutshell, inflation has been running rampant. It is the additional costs layered on by inflation that have left people unable to pay their bills, not their mortgage. Between 1978-1986 the Govt indexed social security 75% to keep up with inflation. In the last 8 years that number has been 25%.

    So lets find the 2-3% inflation. Here are some real numbers that people are paying in my area.

    Heating oil up 350% in 10 years
    Gas up 300% in 10 years
    Medical insurance, family coverage up 500% in ten years
    Taxes in my town up on average 86%
    Electricity in much of CT up as much as 74% in the last few years alone!
    Food inflation, heck we have things that went up 30% in a month but most food items are at highs except for meats because they are killing the animals as the feed is too expensive, wait til fall.

    Thus with technology and outsourcing putting a lid in wages ,there is no pressure to raise wages. Real income is declining much faster than the Govt states. 2 days ago they said it declined 1 % based on 2.4% inflation. If inflation is 10% real income is declining by 9%.

    People are making less, not more, have less benefits, and less pensions than in prior years. Good paying jobs have been replaced by jobs with lower pay and less benefits. Please note the recent statistics in BusinessWeek in the differences between men and women in the job crisis and how women have less job losses because they are working in those service jobs which often pay less.

    In my client base I do not see any problems with subprime loans. I see a lot of people cutting their spending, trying to keep their businesses running.

    The ultimate irony is the same Govt that told you the economy was doing well, the jobs market was strong and inflation tame, is now handing out money telling you to spend it.

    This is way worse than people think. Student loans might not fund. Those auction rate securities have 320 billion in peoples funds frozen, some earmarked for college. Inflation/foreclosures/economic pullback is now entering round two. In NJ they have to raise tolls because people are driving LESS and paying less tolls!!!! Driving is way down yet fuel prices soar.

    Only the super rich are making it this time and they will watch their saved dollars depreciate right along with eveyrone else.

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