Tuesday, 27 May 2008 01:00

A little more on HELOCs, 2nd liens and rose colored glasses

I syndicate my work across various sites on the web and occasionally go through the comments to see what people think. I get viewers of all types, from first time investors and the curious to multi-billion dollar portfolio managers and directors of analytical departments of the bulge brackets. It is the guy in the middle, the arm chair investor that seems to throw some of the wierdest comments, though. One of which was, "banks are more complicated than HELOC exposure and LTVs and it will take more than that to determine a bank short". Well, that comment is partially true. Today's banks are much more complex than LTVs and 2nd liens, but when these risky products on the downturn are multiples of your tangible capital, it really doesn't take more than that to start causing some severe solvency issues. You can have a trillion dollars in assets, but if you have $20 billion in equity with $100 billion in investments that will take a 50% loss, you are underwater by $30 billion. You can talk about these banks using terms such as "complicated", "complex", "fancy" and all of the other high falutin' adjectives that you can think of, but at the end of the day, if you lose more than you own you are insolvent. Now, that's a simple concept and it works quite well for my investment pursuits. This is coming from a guy who use to design offshore, option embedded structured products to fund illiquid private sector liabilities for things such retiree health care risks. Having some experience in the structured product arena, being an entrepreneur, and simply having to balance the family budget, I have come to learn - without a doubt - that complicated usually means less valuable. Either that, or it means an opportunity to charge the client more through lack of transparency in the pricing and profit structure.

The Asset Securitization Crisis Analysis roadmap to date:

  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, PNC addendum Posts One and Two
  7. Reggie Middleton says don't believe Paulson: S&L crisis 2.0, bank failure redux
  8. More on the banking backdrop, we've never had so many loans!
  9. As I see it, these 32 banks and thrfts are in deep doo-doo!

On the aforementioned note, let's take a quick recap of the HELOC and 2nd lien markets before we move on to the rest of the banking series. I may take a quick detour after this post to update my homebuilder and monoline perspectives, so please bear with me. To avoid redundancy, please read the 32 Banks in Deep Doo-Doo post that I made and the associated links that walk through the entire Asset Securitization Crisis series.

Following the geographic default graph for HELOCs reproduced from the last posting, you see the two states that have been in the news the most lately have big spikes in my pretty little graph.

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Now, if we drill down into those two big stalks we see above and observe who has the most concentrated exposure there, we see the following...

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And in Florida, the condo capital of world, we have...

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Remember, concentration is a very risky thing in investing. You can hit a homerun short term, but long term the odds will catch up to you and hurt a lot. These banks rolled the die, and crapped out. Below I put a FICO score chart in just for the fun of it. FICO scores are a lot less relevant than many believe. They are still useful, but far from the be all and end all that they were marketed as.

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Now, the bank at the lower and of the 2nd lien FICO graph is trying to buy what is probably the most troubled large mortgage lender in the world in what is probably the worst macro environment in the last 7 decades. Hmmmm... Is that smart???

As someone with direct experience in the residential lending arena can tell you, there is a big difference in the quality of loans written directly versus those sourced from a third party, ex. a broker. The reason, obviously, is that the brokers don't have any skin in the game in terms of risk retention, and have significant incentive to "fudge" the numbers in order to push loans through (that is how they are paid). Then we have glorified brokers who post margin, got a warehouse credit line and call themselvers "mortgage banks". These guys are just brokers with a fancy credit card that they parked loans on till they could sell them off to investors. The problem is, this forced minimum risk retention, but enough to drive 100's out of business when the market collapsed last year. Long story short, it is much more dangerous to rely on prudent underwriting from a brokered loan than from a direct channel loan. Amazingly enough, we had the exact same problem with brokers in the S&L crisis. I guess 1,200+ lending institution failures wasn't enough to teach a lesson that lasted more than 15 years. For more on this, see A comparison with the same during the S&L crisis.

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Well, you see who has been relying on the brokers. "Nuff said. Don't be fooled by large asset bases and big brand names either. Bear Stearns was a big brand name, and Citigroup had the largest asset base out there.

So, all of this stuff ultimately leads to loans not getting paid. How many loans and whose holding them? Well, let's take a look.

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Now, those delinquincies ultimately lead to charge-offs - basically writing off the value of the loan. Remember, in earlier postings, many of these loans will result in 100% losses with no recovery due to 2nd lien status, high LTVs, and high home price depreciation. Now, I don't know about your, but I think that charge offs at the rates depicted below is definitely bad news. On top of that, it gets worse. These delinquincies are understated for many banks. Those who are feeling too much heat are doing dastardly things such as purposely under-reporting delinquincies and charge offs, preferring instead to let people live in their houses without paying rather than take the accounting hit of reporting the bad news, exstending the period in which accounts are qualified as charge offs, knowingly allowing servicing companies to operating at a decided lag in reporting delinquincies, etc. There are big, brand name banks guilty of some (and all) of the above. This fools the average retail investor as well as the institutional investor that relies on sell side research, or does not have staff, expertise or resources to really dig deep down into the nitty gritty. No need to fear though, Reggie Middleton is here. I have teams of very smart analysts and forensic accountants whose task it is to find bulls1t and bring it to the surface. I'm the type of guy that works around the clock to put food on the table myself, so between all of us we're bound to find something. After this installment we will review leverage and risk and then pursue which banks are playing these games. This very valuable information I wll disseminate for free.

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The next post in this series on banks and thrifts will go through leverage, which will tell us how equity is eaten up by these numbers. After the bank short list drill down, I will put up a sensitivity analysis chart that will show exactly how much equity is destroyed and where in my ultimate bank short. After all, to many, a 1.5% charge off or loss doesn't mean much - unless it is from several multiples of your equity capital. Then things really start to heat up - especially if it is understated and joined by similar charge offs with minimum recoveries from several other risky lending pools assets. The series installment two posts after this (dealing strictly with banking) will drill down a bit deeper into each lender on my short list. Then, finally, a full forensic report of another one of my utlimate shorts, very similar to the PNC analysis. Peppered in between these will be my update on the last Lennar analysis (the first one on the street to take them to terms on off balance sheet debt and JVs) and the homebuilders and the continuation to the state of the muni bond sector and its effect on the CDS market post. So much to do, so little time. If you are with an investment institution or boutique and you find this research of value, have them contact me. I'm looking for outlets for this stuff, which will allow me to put more time and resources into it. If you are just an individual investor or simply a curious web surfer that enjoys my work, pass the word around with the "invite tool" and bookmark the articles with your favorite social bookmarking tool below.

Last modified on Tuesday, 27 May 2008 01:00

2 comments

  • Comment Link Reggie Middleton Saturday, 20 March 2010 15:59 posted by Reggie Middleton

    It's good to have you here, and that was a welcome, rational and well thought out comment.

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  • Comment Link Dan Stephens Saturday, 20 March 2010 12:23 posted by Dan Stephens

    Reggie, I love your work in general, which I usually access in Seeking Alpha, however, I followed a link to this site. You are brilliant, a great writer, and so hard working.

    I totally agree with your conclusions about the dire straights of lenders as a result of the housing downturn. The credit and banking crises are now firmly rooted in the situation with home equity loans, which gets way too little attention in any form of public press and discussion. I have a couple of points about the above posting.

    CitiMortgage has been one of my favorite lenders for conforming loans for years. They were also one of the biggest and best for home equity loans and HELOCs in the broker channel. Of course, they, and virtually all of the big lenders, except Wells Fargo are completely out of the home equity lending business in the broker channel, if not in direct lending. Most equity lenders limit their loans to 80% CLTV, and even 75% CLTV in CA, AZ, NV, FL, and perhaps WA. I notice that none of your charts and graphs show anything about Citi, and I'll bet they are actually at or near the top of the list of lenders holding equity loans.

    Of course, Bank of America bought Countrywide, so the data for those could be combined. Same with WAMU being acquired by Chase. No doubt these were shotgun marriages at the behest of financial and political kingpins, since no investor in their right mind would have been acquiring those "assets" at the time they did in the midst of financial and housing collapse.

    As a native of Minneapolis, the home base of US Bank, I also wonder if they too should make your list. I believe they have exposure as big as some of the other major regionals you present.

    I was disappointed with one of your comments, echoing a persistent mantra in discussions of the mortgage problem, and that's the suggestion that mortgage brokers fudging data played some significant role in the mortgage crisis. No doubt there were, and possibly are, some who did that, but I assure you it could not have been a statisticaly significant factor in the scope of the crisis, and to the extent that it was, it could only have existed with the deliberate complicity of mortgage underwriters risking their jobs, a highly unlikely scenario. The truth is, most mortgage brokers had so much genuine business in the 2002-2006 stretch, that fraud was unncessary. Further, if you had actually experience originating mortgages, whether as a broker or an employee of a lender, you'd know that the toughest part of originating any loan is getting over all of the very specific and difficult hurdles of the guidelines in underwriting. Of course, those hurdles were much lower for certain loans when there was credit/asset lending in the form of stated income, no ratio and no doc loans, none of which exist anywhere any longer in the mass markets for mortgages, but were very popular among the large crowd of underemployed and unemployed with excellent credit who were trying to refinane for a lower rate or to gain access to new equity.

    Looking the future of housing, we have the following immediate, significant, adverse developments in the mortgage market: (1) the USDA Rurual Housing Program just ran out of funds and lenders have suspended all applications for the same in the last two weeks; (2)at the end of March the Fed will stop buying debt of the government sponsored mortgage agencies, Fannie and Freddie, and Ginnie; (3) HARP was due to expire end of March, but got extended through the end of June. Barring reversals of the foregoing, that's going to prevent prevent a lot of immedate and potential purhases and refinances, that might have occurred either soon or when the economy recovers enough to employ significant numbers of those who are unemployed now (no loans available now without a regular job o with two years tax returns for self-employed). Foreclosures were projected for another 3-4 million in 2010, but with 14% of mortgages in default, and still rising, and the unemployment dragging on, I bet it turns out to be more than 3 million. I don't see how housing values cannot fall 10-20% more in absence of significant job growth in the very near futre.

    It seems to me that the only things holding up, or pushing up the bank stocks, for that matter stocks in general, could be high velocity trading, hedged buy programs by well-heeled entities (including the Fed?), and short covering by many investors who are rationally short.

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