Thursday, 02 October 2008 06:00

Continued Deterioration in Global Lending, Government Intervention in Free Markets

The Asset Securitization Crisis: Part 26

This is part 26 (and we're not even finished) of the macro updates that drive my ever-developing investment thesis. Click here for the current performance of this thesis as applied through a public research model.

Fannie Mae & Freddie Mac - Who will finance their future?

Mae and Freddie Mac were formed as government agencies to expand home
ownership and provide stability and liquidity to the secondary mortgage
market. The continued decline in housing prices in the US has resulted
in huge write downs in the residential mortgage backed securities
market. The S&P Case Shiller home price index has been declining
consecutively for the last 23 months; it fell 0.5% in July 2008. The
imminent threat to Fannie Mae's and Freddie Mac's combined debt of
US$1.59 trillion, and lack of financing options have raised doubts
about the viability of mortgage companies. Their net worth has been
eroded significantly due to huge losses. It stood at US$54 billion as
of June 30, 2008. The underwritten or owned mortgages by these two
entities comprise about 50% of the US mortgage industry (worth US$12
trillion). These two large mortgage giants faced a liquidity crunch,
due to large write downs that amounted to US$14.9 billion in the last
one year. Fannie Mae has raised more than US$14 billion in capital
since November 2007, while Freddie Mac raised US$6 billion in the same
period to offset write downs on mortgages it owns or guarantees.
Consequently, to avoid a severe mortgage market crisis if they failed,
they were taken over by the US government on September 7, 2008. The
government has decided to take charge of the beleaguered mortgage
companies through Federal Housing Finance Agency (FHFA), a government conservatorship,
and rescue them from the current situation. The government would back
the debt underwritten by these two companies. FHFA, formed by the
merger of Federal Housing Finance Board (FHFB) and the Office of
Federal Housing Enterprise Oversight (OFHEO), would supervise the two
mortgage giants and have the powers of the Board and management. The
Chief Executive Officers for both companies have been replaced. Mr.
Herb Allison and Mr. David M. Moffett are the current CEOs of Fannie
Mae and Freddie Mac, respectively.

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Under the government conservatorship, Fannie and Freddie would continue to guarantee mortgage-backed securities without limit, as the government supports

The Asset Securitization Crisis Analysis road-map 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 - counter-party failure will open up another Pandora's box (must read for anyone who is not a CDS specialist)
  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. Municipal bond market and the securitization crisis - part 2 (should be read by whoever is not a muni expert - this newsbyte may be worth reading as well)
  7. 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
  8. Reggie Middleton says don't believe Paulson: S&L crisis 2.0, bank failure redux
  9. More on the banking backdrop, we've never had so many loans!
  10. As I see it, these 32 banks and thrifts are in deep doo-doo!
  11. A little more on HELOCs, 2nd lien loans and rose colored glasses
  12. Will Countywide cause the next shoe to drop?
  13. Capital, Leverage and Loss in the Banking System
  14. Doo-Doo bank drill down, part 1 - Wells Fargo
  15. Doo-Doo Bank 32 drill down: Part 2 - Popular
  16. Doo-Doo Bank 32 drill down: Part 3 - SunTrust Bank
  17. The Anatomy of a Sick Bank!
  18. Doo Doo Bank 32 Drill Down 1.5: Wells Fargo Bank
  19. GE: The Uber Bank???
  20. Sun Trust Forensic Analysis
  21. Goldman Sachs Snapshot: Risk vs. Reward vs. Reputations on the Street
  22. Goldman Sachs Forensic Analysis
  23. American Express: When the best of the best start with the shenanigans, what does that mean for the rest..
  24. Pt one of three of my opinion of HSBC and the macro factors affecting it

25. The Big Bank Bust

the mortgage market. However, there is restriction on the capital raised to refinance securities, which is fixed at US$20 billion per month. Besides, the buyout of the mortgage giants by the government has not offered any support to equity shareholders. Shares of Fannie Mae and Freddie Mac fell 90% and 83%, respectively, on September 8, 2008, the first day of trading after it was taken over by the government. Under FHFA, there would be no dividends issued on either common stocks or preferred shares, thereby saving about $2 billion per year for these firms. Furthermore, the mortgage companies' political lobbying activities would be discontinued and charitable activities are likely to be reviewed. The Treasury, along with FHFA, would buy preferred stock worth US$1 billion each in Fannie and Freddie to provide assurance to the companies' debt holders. This move could strengthen the conforming housing mortgage market (actually, a subset of the actual mortgage market), although it is highly doubtful it will support housing prices which are suffering and extreme inbalance between supply and demand. The US government is expected to have the right to own 79.9% in each company due to the effects of the government conservatorship. The US government is now, in effect, one of the largest financial institutional trading companies in the world!


Source: Bloomberg

Fannie Mae's and Freddie Mac's debt worth US$223 billion (of the total US$1.59 trillion) matures on September 30, 2008. This factor was a prime concern for these companies. The rolling of t debt is an essential phenomenon in the mortgage industry, and with the government backing they would be able to refinance these debts. The 30-year mortgage rate, which stood at 6.35%, is expected to decline as the government would act as a guarantor, and to date has dropped about 60 basis points already. On September 7, 2008, the government's attempt to bailout the mortgage giants received support from all quarters. The Federal Reserve and the US Treasury evaluated the process of bailing out the two companies, and estimated an investment of around US$200 billion for the same.

  • Banks raise equity and sell-off toxic assets to strengthen and deleverage balance sheet

Banks continue to raise equity to compensate the large write downs, which has affected their

Relevant links in today's news that were handily predicted on the at least 6 to 12 months before hand - with specificity

Washington Mutual May Be Forced to Sell Deposits, Branches to Stay Afloat

Fed Direct Loans Lose Stigma as Commercial Banks Push Borrowing to Record

China Expects U.S. Financial Crisis to Spill Over, Its GDP Growth to Slow

balance sheets. The decline in value of mortgage-backed securities has forced large investments banks to write-off huge losses. In the current credit turmoil, the total losses stood at US$508.4 billion as of September 8, 2008. Banks raised US$362.3 billion, representing around 71% of the losses, in capital to refurbish their balance sheets. Furthermore, decrease in value of these assets and high default rate across all categories of mortgage-backed assets has encouraged banks to sell their toxic assets. Companies would have us believe that once these toxic assets are sold-off, the balance sheet would strengthen due to better quality assets. Though this thesis may be acceptable to some very limited degree, it has led to a huge supply of toxic assets (as most large banks are facing the same situation), and significant decline in their value of such assets which leads to an overall unprecedented decline in corporate value. A mere increase in the quality of assets will not offset an aggregate (and significant) decrease in asset value and shareholder equity - which is exactly what the financial sector is experiencing now.


Source: Bloomberg

Banks have been raising equity to strengthen their balance sheet in light of the huge losses and asset writedowns in the last few quarters. Citigroup Inc, which has incurred the highest loss of US$55.1 billion, raised US$49.1 billion in capital. Merrill Lynch recorded a loss of US$51.8 billion, but was able to raise US$29.9 billion. The company sold toxic assets worth US$30.6 billion to private equity fund, Lone Star Funds. Merrill Lynch recovered just 22% of the entire amount (US$6.7 billion), which demonstrates the significant losses suffered by the company - reinforcing the thesis busting statement espoused in the paragraph above. Furthermore, Merrill Lynch planned to sell its controlling stake in a unit of Financial Data Services Inc for a consideration of US$3.5 billion. Lehman Brothers, which owns US$65 billion mortgage-related portfolio, has been in talks with potential buyers, including BlackRock Inc., Korea Development Bank and several private equity firms, to sell its toxic assets worth US$30 billion. In addition, Lehman Brothers intends to transfer the commercial mortgages and real estate business to a new company and then spin-off that company rather than selling all the assets. Again, I fail to see how that creates shareholder value. It is basically a shell game where the company places bad assets here or there and finances the shift with an equity seed by selling the only thing of recognizable value - the Neuberger and Berman asset management group.


Source: Bloomberg

  • Lax underwriting/financing activities being replaced by stricter lending norms, thereby restricting credit growth

The roots for the credit turmoil were laid in 2002-03 in the aftermath of dot com crash. There was an increasing interest for investment in the real estate sector, which laid the foundation for the current crisis. As demand grew, prices also increased as illustrated by the S&P Case Shiller home price index, which rose to 206.52 as of July 31, 2006 from 112.39 at the start of 2001. Rising prices of real estate properties boosted underwriting practices as bankers loosened the legal procedures. According to the Association of Community Organizations for Reform Now (ACORN), the mortgage denial rate, which highlights the loans denied, fell from 44.57% in 1998 to 14% in 2003 due to lax underwriting. The decline in denial rate for mortgages provided an opportunity for subprime borrowers to attain loans. The share of subprime mortgages in total originations rose to 20% (or approximately US$600 billion) in 2006 from 13% in 1999. However, the housing bubble crash in mid 2007 led banks to resort to stricter lending norms as the mortgage denial rate increased to around 29% in 2007. In July 2008, a survey conducted on Bank Lending Practices by Senior Loan Officer Opinion covering 52 domestic banks and 21 branches and agencies of foreign banks in the US, indicated that more than 60% of the banks have tightened the lending standards across all categories. The stricter norms include tightened selected price terms and increasing spreads on loan rates, thereby making the loans expensive. Furthermore, about 55% of the domestic respondents and 45% of foreign respondents expect further tightening of the lending norms in the second half of 2008, while 45% of the domestic and 30% of the foreign respondents expect the lending norms to be tightened in the first half of 2009. The Federal Reserve reduced the bank lending rate to the current 2.25% from 6.25% at the start of 2007, through a series of rate cuts, due to slowdown in the economy and the fallout of the mortgage crisis (see The Anatomy of a Sick Bank!). However, the conventional mortgage rate increased during the same period to 6.48% from 6.14% at the start of 2007. Stringent lending norms have already affected consumer credit, which grew at a lower rate of 5.7% as of March 31, 2008 compared to 8.1% as of September 30, 2007. Going forward, as credit losses increase, the norms for lending would be tightened further, thereby hampering credit growth.

  • Worsening default scenario across all consumer loan segments to result in higher losses

The rising default rate indicates the deteriorating credit situation across all loan segments. In 3Q 08 (until date), asset writedowns amounted to US$9.8 billion as total losses due to the credit crisis aggregated US$508.4 billion. Moody's Investors Service has predicted that the global debt default across categories would reach 4.98% by the end of 2008, while in the US it would be 5.7%. The current default rate stands at 2.5%. Furthermore, if the US enters into recession, Moody's expects the default rate to reach 10% in 2009. The corporate default rate stood at 10.4% in 2002. It reached an all-time high of 11.9% in 1991. In Europe, the current corporate default rate is 0.7%. In the case of real estate loans, the delinquency rate for the one-to-four-unit residential properties has risen by 6 basis points to 6.41% since 2Q 08. The rate for residential real estate loans increased to 4.33% in 2Q 08 from 1.37% in 1Q 06. The delinquency rate for commercial real estate loans moved up to 4.24% in 2Q 08 from 1.02% in 1Q 06 (see GGP and the type of investigative analysis you will not get from your brokerage house for my deep dive on commercial real estate and General Growth Properties). According to the International Monetary Fund (IMF), total losses are likely to reach US$1 trillion due to higher delinquency and default rates. The rate at which the default has increased in the last year across all categories of loans segments is likely to result in higher losses in the coming period.


Source: Federal Reserve

The default rate in corporate bonds issued by companies with different rating has been rising significantly. Moody's Bond Indices Corporate bond with BAA rating, which exhibits the default rate of bonds issued by BAA rated companies, increased to 7.01% as of August 31, 2008 from 6.59% a year ago. Similar trends were also witnessed in companies with other ratings. As a result, the credit rating for these companies is likely to be affected, thereby increasing the interest rates paid and debt service.


Source: Bloomberg

The credit card default rate is expected to rise with increasing interest rates across all categories of loans, higher unemployment and slowdown in the global economy (see The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue). Rising inflation has accentuated the probability of rising default rate. The unemployment rate in the US moved up to 6.1% as of August 31, 2008 from 4.7% as of August 31, 2007. The increase is likely to create further repayment problems. The largest US retail bank, Bank of America Corp's managed credit card loan losses rate rose to 5.96% in 2Q 08 from 4.75% in 2Q 07. JPMorgan Chase & Co, exhibited similar trends as its net credit cards charge-off rate jumped to 4.98% in 2Q 08 from 3.62% in 2Q 07. This nations number one charge card company, and the company with perceived premier customer base has also seen significant spikes in delinquencies, as well as resorting to financial shenanigans in the form of changing accounting standards in an attempt to conceal spiking default rates (see When the best of the best start with the shenanigans, what does that mean for the rest... ). The overall delinquency rate for the US banks increased by 88 basis points to 4.9% in 2Q 08 from 4.02% in 2Q 07. Furthermore, the charge-off in credit cards grew by 162 basis points to 5.47% in 2Q 08 from 3.85% in 2Q 07. According to James Ellman, President at Seacliff Capital (a hedge fund), a deep recession in the US is expected to increase the credit card default rate by 11-12%.

Even prominent and well respected banks such as Wells Fargo have started taking measures to deal with the rising default rate, such as changing the accounting standards for the delinquency and charge-off (see Doo-Doo bank drill down, part 1 - Wells Fargo and Doo Doo 32 Bank Drill Down 1.5: The Forensic Analysis of Wells Fargo). To discerning eyes (such as mine), this simply accentuates the problem as in due course the delinquencies, hence the economic damage, will rise while the accounting earnings will remain relatively unscathed, thus failing to give a true picture of the companies' health, at least to those who don't subscribe to the BoomBustBlog! Further, the increases in unemployment coupled with net effective increases in commodities, food, energy and housing (as compared to bubble times) are bound to lead to a decrease in disposal income, thereby hurting consumer-led growth.


Source: Federal Reserve

Loans offered to the commercial and industrial sectors form a major chunk of the total loans offered by banks, particularly regional banks (see More on the banking backdrop, we've never had so many loans! and As I see it, these 32 banks and thrfts are in deep doo-doo!). The loans provided to commercial and industrial sector leads to production activities which is essential for economic growth. Increase in interest rates on loans provided to this segment has escalated the interest cost, which led to the increased delinquency rate. The default rate in commercial and industrial sector increased by 49 basis points to 1.67% in 2Q 08, the highest since 2005, from 1.18% in 2Q 07. Higher cost of borrowing has led to a contraction in margins of companies. I have started releasing individual corporate research reports based upon this occurrence. The manufacturing and industrial failure rate will make the financial bust look like a session of romper room. See the following for actionable intelligence on the industrial and manufacturing space affected by the recent turn of events:

The natural progression of my investment thesis ,

Is the GGP saga over? ,

The first of several shortlists for my industrial shorts

Navistar update,

Navistar's results analysis

An analytical view of the Navistar surprise

What to make of GE, the Uber Bank?

I have found the first of many highly likely bankruptcy candidates

Preview of analysis on tap, USG Corp.

Moreover, the charge-off in commercial and industrial sector doubled to 0.82% in 2Q 08 from 0.42% in 2Q 07. The financial credit crisis has exerted pressure on the real economy (manufacturing/production), where the total capacity utilization in the industry has declined to 79.9% in July 2008 from 81.4% a year ago. The continuous slowdown in the capacity utilization of industries could exert additional pressure on economic growth.

The delinquency rate in agriculture loans improved by 7 basis points to 1.1% in 2Q 08 from 1.17% in 1Q 07. At first blush, one would think this would indicate marginal relief but non-standard (and apparently misleading reporting) is rampant in the industry (see Wells Fargo Q2 2008 Highlights).


Source: Federal Reserve

o Rise in losses and NPAs to hinder credit expansion, despite attempts by the US government to manipulate the free Markets

Losses continue to rise in the current credit crisis scenario, with additional write downs of US$9.8 billion in 3Q 08 (as of date). The accumulated losses now stand at US$508.4 billion and are likely to rise further with an increase in the delinquency and charge-off rates. Banks have written down large parts of their toxic assets to strengthen balance sheets. They have also raised additional capital to maintain the capital adequacy rate in light of growing write downs.

Most of the banking players have recorded significant losses and their NPAs have increased significantly in the last few quarters. The overall deterioration in credit quality from subprime assets to prime asset category has accentuated the losses for the banks. Bank of America has asset writedowns worth US$21.2 billion as of September 9, 2008, of which US$5.2 billion were in 2Q 08. Furthermore, the bank's non-performing assets rose 307.6% to US$9.8 billion in 2Q 08 from US$2.4 billion in 1Q 08. The acquisitions of troubled institutions (largest in their class) Countrywide and Merrill Lynch, are bound to weight further on asset quality. Similar trends were witnessed in other banks, where non-performing assets increased significantly. JP Morgan Chase & Co's non-performing assets grew 157.2% to US$6.2 billion in 2Q 08 from US$2.4 billion in 1Q 08. Rising losses and higher non-performing assets have reduced the net worth of banks. This factor has also affected their credit expansion initiatives. Growth in consumer credit in the US fell 15.3% to US$62.7 billion in 1H 08 from US$74.01 billion in 2H 07. In the last one year, losses have increased substantially in each quarter. As a result, credit expansion is likely to be affected. Rising delinquency and charge-off rates have forced banks to tighten their lending practices, thereby resulting in decline in credit growth.

  • Junk bond and leverage loans will witness higher defaults

Junk bond and leverage loans are high-yield products issued by financial institutions. The junk bond market has become less lucrative due to rising defaults. Higher defaults in the junk bond and leverage loans markets are expected to render a lot of companies insolvent. Mr. Edward Altman, who has developed the Z-Score model for predicting bankruptcy, believes the default rate in junk bonds would be 4.64% of the US$1.1 trillion junk bonds outstanding. The total leverage loans stood at US$197.02 billion with the largest investor being JP Morgan amounting to US$26.40 billion as on December 31, 2008. The rise in the default rate of these junk bond and leverage loans, would lead to further write down by these firms. Standard and Poors has highlighted that if the recessionary fears persist, then the default rate in junk bonds could rise to 8.5%. The historical average for junk bonds stands at 5%. As the leading investors in the junk bonds are the leading banks, the concomitant pressure on lending will be even more severe.


Source: Bloomberg

Furthermore, the junk bonds issued by companies have reduced significantly as demand has declined. Sale of junk bonds dipped 46% y-o-y to US$58.4 billion as of date. Lower demand and lack of liquidity increased the spread rates. Currently, the JPMorgan Credit Index High Yield spread has moved up to 515.22 points from 351.36 points at the start of the year. A higher yield bond is more likely to default, widening the credit crisis.

There is more to come in this extension to the Asset Securitization Crisis. Lookout for:

B) The ending could be very painful...

Will industrial / manufacturing be the next casualty?

  • Industrial / Manufacturing companies in for hard times ahead
  • Debt refinancing gets costlier for industries owing to higher interest rates and perceived risks
  • Industrial companies squeezed on both sides - dwindling sales and rising costs
  • Credit availability dries up as the leverage loan market is in distress
  • Default risk of companies continues to rise as depicted by the rising CDS spreads
  • Rise in raw material prices to further squeeze the margins of manufacturing companies

Recession no more a possibility - it is certain!

  • Housing prices in the US - still searching for a bottom
  • Fallout of the credit crisis - Problems in the financial sector spreads into manufacturing
  • Rise in defaults (consumer and corporate) to result in lower credit growth
  • Declining consumer spending to negatively impact overall aggregate demand growth

Rising inflation and economic slowdown - a global phenomenon

  • Globally inflation rising driven by food and fuel prices
  • Economic growth has taken a backseat across developed and emerging markets
  • Slowdown in the Euro zone - UK, Germany, France, Spain and Italy - following the US' footprints
  • Japan - Lower export earnings indicate tough times ahead
  • China and India - Decoupling is passé

More bankruptcies to come?

  • Number of banking institutions in distress continues to increase - Check out the FDIC watch list

Last modified on Thursday, 02 October 2008 06:00