Displaying items by tag: Mortgage Banking

The mortgage market has not even started to "really" fall apart yet. The "worst is behind us", indeed!

U.S. Mulls Future of Fannie, Freddie

The Bush administration has held talks about what to do in the event mortgage giants Fannie Mae and Freddie Mac falter, according to three people familiar with the matter, as the stock prices of both companies continue to fall sharply.

These were two of the most obvious shorts to make in the mortgage crisis -pure mortgage lenders and insurers!

From Bloomberg: Fannie Mae, Freddie Losses Make Them `Insolvent,' Poole Says :

Chances are increasing that the U.S. may need to bail out
Fannie Mae and the smaller Freddie Mac, former St. Louis Federal
Reserve President William Poole said in an interview. Freddie
Mac owed $5.2 billion more than its assets were worth in the
first quarter, making it insolvent under fair value accounting
rules, he said. The fair value of Fannie Mae's assets fell 66
percent to $12.2 billion, data provided by the Washington-based
company show, and may be negative next quarter, Poole said.

``Congress ought to recognize that these firms are
insolvent, that it is allowing these firms to continue to exist
as bastions of privilege, financed by the taxpayer,'' Poole, 71,
who left the Fed in March, said in the interview yesterday.

Published in BoomBustBlog
Wednesday, 09 July 2008 05:00

GE and the Uber Bank Forensic Analysis

Published in BoomBustBlog
Thursday, 03 July 2008 05:00

CDS stands for Credit Default Suckers...

I've been preaching about the risks the CDS market poses to the
financial system for some time now. Since the monolines faux business
model has been laid bare, we will start seeing some real action in this
arena. For those who don't want to take my anecdotal quips as gospel, I
actual go in depth through Reggie Middleton on the Asset Securitization
Crisis Series - The Next Shoe to Drop: Credit Default Swaps (CDS) and Counterparty Risk - Beware what lies beneath!. A worth read for those not familiar with the Credit Default Sucker's market.

Now, to the point of the post. UBS is in a lot of hot water these
days. Despite being eyeballs deep in rapidly disintegrating, highly
leveraged trash assets they are also often in hot water. Reference the
financial times:

In depth: UBS - Apr-01

UBS faces civil charges over securities sales - Jun-26

Published in BoomBustBlog
Monday, 30 June 2008 05:00

The BIS Conference in Europe

This was contributed by ChrisM regarding the recent banking meeting in Europe and my comments:

The meeting here in Basel has been very interesting, the main points are:

1) they don't expect the economy to slow much further in the second half.

In regards to the US and UK, I don't see much evidence to support this.

2) they are concentrating on fighting inflation first, before growth.

This should have been number one
priority from the beginning. Inflation is still woefully understated by
government numbers. On the boat ride, I shared with the fellow
boombustbloggers my observation that effective housing price inflation
is still rampant. Nominal prices have dropped sharply across the
country, but affordability is actually way down in many areas, due
primarily to the tightening of credit. The largest barrier for home
purchasers for the middle and working class is the down payment. This
barrier has increased significantly after the mortgage markets came
back to reality, thus even though prices may have drop by 20% or so,
required down payments on those houses have increased as much as 100%
to 400% (think from 5% down piggyback 2nd mortgages to 10% to 20%
conventional mortgages with PMI).

In addition, interest rates have
moved up sharply and maintenance costs have skyrocketed with the cost
of commodity inflation. This does not take into account the cost of
heating homes, which may have effectively doubled in the past year.

Fuel,
housing and food are still stripped from the core rate reading, yet
they are the most ubiquitous of consumer purchases and all have
advanced nearly or more than 100% in the past year or so (sans food,
which still went up a lot).

3) they have suggested that "parking" bad debts, by the central banks, to assist commercial/investment banks is a bad idea.

I agree wholeheartedly.

4) they have further suggested that the institutions should sell these instruments at market rates, to establish a true value, to hopefully achieve a bottom to valuations.

Without doing so, no serious
investors will ever trust them. They must swallow the short term pain
in order to gain long term clarity. Then again, foreign investors have
agreed to pour good money after bad. I theorize that petrodollars and
SE Asian manufacturing money are attempting to get monetized through the major financial systems of the US and the UK,
but they are only willing to take but so big a loss in the "legitimate
laundering" of their monies into these developed nations financial systems. After a while, they should grow weary. Remember, I stated that the introduction of foreign monies purchasing assets en masse tends to denote a sharp drop in asset value. Think back to US acquisition of foreign automobile companies, the Asian acquisition of overheated US real estate in 80's (Japan was supposed to take over the world back then), and the Japanese investment in consulting companies (ex. Deloitte and Touche).


Obviously the FED does not have to heed these suggestions, but the warning by the Chinese today to stabilise the dollar, is a veiled threat that they may stop buying US debt.

Points 3 and 4 will see the banks tank (again), the next 3 months should be interesting.

Published in BoomBustBlog

Nouriel Roubini, global macro Uber-Bear, has posted an interesting commentary on his blog - "The delusional complacency that the “worst is behind us” is rapidly melting away…and the risk of another run against systemically important broker dealers" which I am excerpting below with my comments in red:

The deleveraging process for the financial system has barely started as most of the writedowns have been for subprime mortgages; the writedowns and/or provisioning for the additional losses have barely started. Thus, hundreds of banks in the U.S. are at risk of collapse. The typical small U.S. Bank (with assets less of $4 billion has 67% of its assets related to real estate; for large banks the figure is 48%. Thus, hundreds of small banks will go belly up as the typical local bank financed the housing, the commercial real estate, the retail boom, the office building of communities where housing is now going bust. Even large regional banks massively exposed to real estate in California, Arizona, Nevada, Florida and other states with a housing boom and now bust will go belly up. This is true, and the risk is borne not only by the smaller and regional banks, but the big brokers and the entire US economy as well. This is a snapshot from the Asset Securitization Crisis Series - A very significant part of our GDP is now tied up in this mess! In the decade from 1988-1997, residential loans have expanded at a CAGR of 10.1% as compared to 3.5% for commercial loans. However, in the following decade i.e. 1998-2007, residential loans grew at a lower CAGR of 11.2% as compared to 12.4% for commercial loans, mainly because of small and mid-size banks lent more in commercial real estate during the period. Although commercial real estate loans were higher paying, they also bore higher risk in the form of liquidity, valuation, market risk - which affected the risk profile of these banks that were incapable of bearing such a level of complexity in risk in the first place.

image008.gif

Source: FDIC

Shift from traditional banking activities

With major opportunities of revenue generation being offered by trading and other investment activities, as well as the lifting of the Glass-Steagal Act in the US (which allowed commercial banks and investment banks to compete directely), banks across the globe shifted from traditional banking activities to other sources of income, leading to better revenue diversification. The ratio of non-interest income to a bank’s total income has more than doubled from 20% in 1980 to approximately 44% in 2006.

image009.gif

Source: FDIC

Back to the Roubini Excerpt...

And even large banks and broker dealers are now at risk. After the bailout of Bear Stearns’ creditor and the extension of lender of last resort liquidity support the tail risk of an immediate financial meltdown was reduced as that liquidity support stopped the run on the shadow banking system. Indeed in March we were an epsilon away from such meltdown as – without the Fed actions – you would have had a run not only on Bear but also on Lehman, JP Morgan, Merrill and most of the shadow banking system. This system of non-banks looked in most ways like banks (borrow short/liquid, leverage a lot and lend longer term and illiquid). So the risk of a bank-like run on non-bank (whose base of uninsured wholesale short term creditors/lenders is much more fickle and run trigger-happy – as the Bear episode showed - than the stable base of insured depositors of banks) became massive. Thus, the Fed made its most radical change of monetary policy since the Great Depression extending both lender of last resort support to non-bank systemically important broker dealers (via the PDCF) and becoming a market maker of last resort to banks and non-banks (via the TAF and the TSLF) to avoid a full scale sudden run on the shadow banking system and a sure meltdown of the financial system.

While the tail risk of such a meltdown has now been reduced the view that systemically important broker dealers - that have now access to the TSLF and the PDCF – now don’t risk a panic-triggered run on their liabilities is false; several of them can still collapse and not be rescued. The reasons are as follows: liquidity support by the Fed is warranted for illiquid but solvent institutions but not for insolvent ones; and the risks that some of the major broker dealers may face is not just of illiquidity but also insolvency (Lehman had as much exposure to toxic MBS, CDOs and other risky assets as Bear did). The Fed already tested the limits of legality (as argued by Volcker) in its bailout of Bear’s creditors.

I have a lot of respect of Professor Roubini's predictive success over the last few years, but he (like most) appear to have not taken a close look at these banker's books. Reference my original research on MS form December of last year. Once it comes to the truly illiquid stuff, Morgan has Bear beat by about 25% and Lehman beat by a large margin as well. As a matter of fact the only one's that come close are the media and Street's golden darling boys, Goldman Sachs. Surprise, Surprise!!! It always pays to go through the numbers. Is GS reyling on risky prop trading to keep up this pristine facade? Curious minds want to know.

The riskiest bank on Wall Street – High exposure to Level 3 assets despite significant write-downs

image001.png

Unconsolidated VIEs could aggravate woes

VIEs have tormented most Wall Street financial majors—several of them have had to consolidate their VIEs to increase liquidity and limit losses. These innovative, structured entities were introduced to boost earnings without transferring actual risk into the balance sheets of banks.

Morgan Stanley has significant exposure to VIEs, with the maximum loss ratio averaging roughly 50% in recent years. The large exposure ($37.7 billion in 4Q 07), high loss ratio and adverse market conditions could force the company out of business if its maximum loss assumptions become reality. Morgan Stanley’s unconsolidated VIEs comprise the most troublesome asset categories – MBS & ABS portfolios (worth $6.3 billion), credit & real estate portfolios ($26.6 billion) and some structured finance products ($8.6 billion). Loss exposure in the credit & real estate portfolio is not expected to be lower than 70% considering the slump in housing demand, falling home prices and rising foreclosures. The growing housing inventory across the U.S. has also raised concerns about the disposal of these assets. Home prices across the U.S. declined 7% (on average), while foreclosures increased 20% during the past year alone. This scenario reflects the bleak prospects of the housing industry and the securities linked to it.

Unconsolidated VIEs, Exposure to loss (in $ mn) and loss ratio (in %)

image004.png

Source: Company data

And back to Roubini...

Suppose that a run – triggered by concerns about illiquidity and solvency – occurs against a major broker dealer (say Lehman) would the Fed come to the rescue again? The answer is not sure: such broker dealer has access to the PDCF but sharply borrowing from this facility would signal that the institution may be bleeding liquidity and be in trouble; thus large access to the Fed facility may cause the run on the liabilities of such financial institutions to accelerate rather than ebb. The reason is as follows: if creditors of the broker dealers knew with certainty that the Fed liquidity tab is open and unlimited the existence of the facility would stop the run. But if there is any meaningful probability that the amount that the Fed would be willing to lend to an institutions using that facility is not unlimited and is not unconditional then use of the facility may accelerate the run – as those first in line would have access to the liquidity provided by the Fed lending to the broker dealer in trouble while those waiting may be stuck once the lending stops. This is akin to a currency crisis in a pegged exchange rate regime triggered by a run on the forex reserves of a central bank. Once the reserves are running down and investors expect that the central bank will run out of reserves the run accelerated and the collapse of the peg occurs faster.

I tend not to build too high a concentration in any one position (risk managment guidelines), but I have been allowing certain broker banks to tilt the scale a little. I hear whispers of potential runs, and the logic is there as Dr. Roubini has illustrated and as I have pointed out in earlier posts. This combined with the fact that a couple of these brokers are quite exposed to risk and the media/pundits haves not their homework in regards to exactly who is weak and why portends another Bear Stearns-like catastrophe/profit oppurtunity.

Published in BoomBustBlog

I am going to release the draft of the Sun Trust analysis in pdf form for registered users. It hasn't been reviewed, but since STI is moving so fast, and I am short on time I decided to offer it to the blog early. I started my position in the mid fifties, and it has dropped precipitously, just like nearly the entire Doo Doo 32 list. One of the things that took my time was the BoomBustBlog Boat ride up the Hudson to the Pallisades. Sorry I was so late fellas, lots of fog and safety first (and I'm always lateCool). Below is Cap'n Vic, who takes the credit for shepherding us safely through the condo ridden waters of NYC's Hudson River.

capn_vic.jpg

I was able to show the BoomBustBloggers, most of which flew in from out of the country and out of state for the financial brainstorming and chit chat, how the myth of NYC's immunity to a real estate downturn was just that, a myth - or at least that was what was communciated by the big blogger himself. See "On the NYC Real Estate Front" then look at the West Side Highway which is the street that leads up to where we met to board the boat.

Cranes in the background building more condos...

061.jpg

And here we have even more condos...

062.jpg

Oh no! What do we have here, more condos!!!

064.jpg

Look closely, can you see what banks are financing these???

These are all within viewing distance of the docks, and there are many, many, many more. Guess what we will have an oversupply of in the bulletproof home of the world's financial center that is laying off tens of thousands of financial execs and back office support. Go ahead, I bet you can't guess. Its expensive, the most expensive in the country, and there is more of it than jobs to go around to pay for it, and it takes gobs and gobs of bank money to build. Go ahead, guess...

And here are some of those handsome, debonair BoomBustBloggers who didn't even know that their BoomBustBlog researched accounts were being heavily fortified by the market facing reality via 30 point plus drop in the broad market and the psychological significant but empirically irrelavent near 400 point drop in the Dow - as they cruised up the Hudson... Even the shy ones...

dsc01764.jpg

We discussed politics, Obama vs McCain (you know what that brought about), peak oil, pharma and biotech, true and effective housing price inflation vs nominal, options and strategies, banking and finance, builders, gentrification and hard work. All in all, an enjoyable and fruitful day, fellas. I will be scheduling another trip for approximately this time next month.

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???


Here is the full Sun Trust Forensic Analysis (17 pages) icon Sun Trust Bank Report (391.89 kB 2008-06-27 08:09:31), and the following is an excerpt:


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I.
INVESTMENT SUMMARY

Banks
continue to reel amid rising loan delinquencies and foreclosures in the US,
which reached record levels in the first three months of 2008, and difficult
operating environment. Housing sector woes are not showing any signs of abating
and witnessed the steepest ever price decline of 15.3% y-o-y in April 2008. Unemployment
levels, which increased the highest in last 22 years, soaring commodity and
energy prices, and high inflationary conditions have dampened consumer
confidence and caused serious slow-down in economic activities. The problem in
the housing sector has spilled over to other sectors and credit spreads
continue to widen off risk aversion caused by inflationary conditions and fear
of US
recession.

SunTrust
Bank (SunTrust), having almost 60% of its loan portfolio in real estate, with
large concentrations in troubled geographies like Florida and Georgia, has
witnessed a significant increase in loan losses and charge-offs in the recent
quarters. The problem is expected to hurt the bank the most among its peer
group as SunTrust is plagued with one of the lowest capital ratios and
continues to maintain a higher dividend pay-out ratio than most of its peers.
Amid continuing expectations of higher loan losses and mark-to-market losses
off widening of credit spreads in the coming quarters, we expect bank to raise
funds in the near-to-medium, which might result in dilution of its equity, and to
sell its investment in Coca-Cola. Further, we expect the bank to witness
compressed net interest margin (NIM) in 2008 and 2009 over the 2007 levels off
expectations of interest rate increases by Fed towards the second half of 2008.
These combined with slow-down in non-interest income, higher charge-offs and
mark-to-market losses will drag SunTrust's valuation to $28.5 per share from
the present level of $37.40 (as of June 24, 2008), in our view.

II.
Key points

Razor-thin
capital ratios:
At the
end of 1Q2008, SunTrust had one of the lowest regulatory ratios in the
industry, with tier 1 capital ratio and total capital ratio of 7.25% and 11.0%,
respectively. With an increase in charge-offs caused by higher loan
delinquencies due to declining housing prices, the current capital ratio
doesn't seem to provide adequate cushion for the bank to sustain losses. As the
bank embarks on measures to raise additional capital, dilutive effect could
drag its valuation to lower levels.

Exposure
to troubled sectors:
SunTrust
has nearly 60% of its loan portfolio in the real estate sector which is being
plagued by rising delinquencies amidst falling housing prices. Charge-off on
real estate loans witnessed a remarkable surge to 1.25% in 1Q2008 from 0.18% in
1Q2007 and 0.07% in 1Q2006. As housing problems are expected to continue to
persist in the near-to-medium term, we expect charge-offs to continue to rise
and peak-off in 2Q2009. As a result we expect the bank's earnings to remain
under considerable pressure.

Higher
provisions to put a strain on banks earnings:
As a result of rising NPAs and charge-offs, SunTrust
has increased its provisions to cover its expected loan losses nearly 10 times
to $560 mn in 1Q2008 from $56 mn in 1Q2007.

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SunTrust's rising
provisions are eroding its earnings. In 1Q2008 SunTrust's net interest income (after
provision for loan losses) declined 47.7% y-o-y to $0.58 bn primarily due to an
increase in provisions. However, despite higher provisions in the recent
quarters, total allowances at 1.25% of the total loans as against 1.88% of NPAs
seem inadequate. We expect SunTrust's provision for losses to increase in the
coming quarters due to increased charge-offs on home equity, and residential
and construction loans.

Growing
proportion of NPAs a cause of concern:
SunTrust's NPAs increased to $2.3 bn (or 12.6% of
shareholder's equity) at the end of 1Q2008 from $0.75 bn (or 4.2% of
shareholder's equity) at the end of 1Q2007, with residential mortgages NPAs
witnessing the steepest rise to $1.3 bn from $0.4 bn. However, despite a rise
in NPAs, reserves-to-NPAs declined to 0.67x from 1.39x in 1Q2007 implying that
the bank has not been able to create adequate provisions to the corresponding
rise in NPAs.

Contracting
net interest income margins:
As Fed responds to rising inflation through rate
hikes, banks' NIMs are expected to contract from the present levels. SunTrust's
NIM had declined to 2.83% in 1Q2008 from 2.97% in 1Q2007. In addition to margin
contraction, lower growth of high yielding riskier assets compared to deposit
growth would be a double whammy on the bank's net interest income. SunTrust's net interest income declined 2.1% to
$1.1 bn in 1Q2008. We expect the bank's
net interest income to continue to decline 2.0% and 0.1% in 2008 and 2009,
respectively.

Higher mark-to-market write-downs
to continue to be a drag on the bank's earnings:
SunTrust's hard
to value level 3 assets, which are the most illiquid securities, grew 495% over
1Q2007 to $4.5 bn at the end of 1Q2008 partly off purchases of level 3 assets
and transfer of assets from level 2 to level 3 due to unobservable market
inputs. As the liquidity in the credit markets dries up and spreads widen due
to increased risk aversion, banks could see further write-downs in their loan
portfolio. In 2007, SunTrust recorded a $700 mn valuation adjustment, with
4Q2007 alone contributing $555 mn of valuation adjustment. As Fed raises rates
and economic problems worsen, SunTrust's credit spreads will widen off
increased write-downs with an estimated valuation loss of $1,345 mn and $442 mn
in 2008 and 2009, respectively

Noisy
quarter for SunTrust to start 2008 performance:
SunTrust's net income declined 46.2% to $269 mn from
$499 mn in 1Q2007 with a reported EPS of $0.81 in 1Q2008 compared to $1.40 in
1Q2007. However, the 1Q2008 EPS included several non-recurring items including
$86 mn of visa IPO gain, a $89 mn gain on sale of lighthouse, $37 mn gain on corporate
real estate and $18 mn gain on mortgage production income, impacting the banks
post tax EPS positively by $0.50 in 1Q2008. On the other hand, 1Q2007 EPS was
impacted by a $32.3 mn gain on lighthouse and a charge of $13.8 mn related to implementation
costs associated with E2, impacting banks 1Q2007 EPS by $0.04. Overall,
SunTrust's EPS (adjusted for non-recurring gains) for 1Q2008 declined significantly
to $0.31 compared with $1.36 in 1Q2007.


III.
Valuation

We have valued SunTrust based on
a weighted average of price-to-adjusted book value (P/B) excluding intangible
assets, price/sales (P/S) multiple and DCF approach with weights of 0.85, 0.05
and 0.10, respectively. SunTrust's
valuation based on price-to-adjusted book value (P/B), price/sales (P/S)
multiple and DCF approach is $34.3, $34.1 and $18.6, respectively, translating
into a weighted average share price of $32.72 implying a downward risk of 12.5%
from the current market price of $37.40 (as of June 24, 2008). However,
including the dilution impact considering an increase in tier 1 capital of $0.5
bn and $2.7 bn to maintain tier 1 capital of 6.0% and 7.5%, respectively, SunTrust's
valuation per share based on adjusted book value per share comes to $32.2 and
$28.5, respectively representing a downward potential of 10.5% and 20.8%,
respectively....

Download the pdf to see why we think that STI is full of it in regards to their not having to cut their dividend. The way I see it, there is no prudent way around it (emphasis on the word, "Prudent").

I am on the road now, but when I am stationary I will add highlights from the proprietary model to this post in order to illuminate the fact that the market has yet to fully price in STI's woes.

Published in BoomBustBlog

I hate to pick on these guys, but I just can't help it. From Bloomberg :

Analysts Backtrack on Banking Stocks After Saying Worst Is Over

Wall
Street analysts who only weeks ago were telling investors to buy bank
stocks because the worst of the credit crisis was over are now
flip-flopping.

Goldman Sachs Group Inc. reversed a call on financial stocks, saying on June 23 that its May 5 recommendation was ``clearly wrong.'' Merrill Lynch & Co. on June 17 cut its rating on Lehman Brothers Holdings Inc.
to ``neutral,'' just a week after telling clients to buy. Barron's, the
financial newspaper, said this week that its February advice to buy American International Group Inc. was a ``mistake.''

``Analysts probably have less credibility than they did 10 years ago,'' said Charles Geisst,
the author of ``100 Years on Wall Street'' who teaches finance at
Manhattan College in New York. ``This has just eroded it a little bit
more.'

Published in BoomBustBlog

Here is a comparison of more banks and thrifts. In looking over this, I continue to doubt the wisdom of BAC's acquiring CFC. The upside does not seem to justify risking the downside. The spreadsheet below compares the five banks I have looked closely at over the last few months – WFC, STI, BAC, MTB and ZION across various parameters, primarily with respect to their asset quality. Please note our observations on the same and be aware that this is backwards looking from research I commissioned some time ago:

1. STI has high real estate exposure, higher NPA and 90+ days loan delinquent as proportion of tangible shareholders’ equity, lower allowance as a percent of NPAs, higher Texas ratio, higher ET shortfall to tangible equity, and lower NIM. Though STI does not report the geographic distribution of its operations, its primary markets include Florida, Georgia, Maryland, North and South Carolina among others. High exposure to Florida could make the bank highly susceptible to rising risk of loan losses. However, a noteworthy factor is that the stock has already gone down by around 50% over the last year.

2. BAC has the lowest tier 1 leverage and NIM among the group and relatively higher gross charge-offs and NPAs to tangible equity. We believe that BAC prospects should be considered together with the probable impact of the impending CFC takeover. This requires a detailed analysis of CFC’s state of affairs, which is horrible from the anecdotal research that I have gathered. Since I am in a rush, I will simply post the spreadsheet and comment on it throughout the day.

3. M&T also has a high real estate exposure and high NPA and 90+ days delinquent loans to tangible equity. However, it seems better provisioned that STI and has higher NIM than STI.

4. WFC also seems vulnerable primarily owing to high exposure to California and Florida, higher proportion of gross charge-offs and poorer capitalization.

Comparison of banks
Wells Fargo SunTrust Bank of America M&T Bank Zions Banc
WFC STI BAC MTB ZION
Stock price (last close) As on June 6, 2008 25.42 46.32 30.50 81.18 39.45
Price Performance (Absolute)
1 months -13.48% -16.16% -18.30% -11.26% -12.08%
3 months -9.57% -15.89% -16.98% 5.03% 12.33%
12 months -29.33% -47.48% -39.06% -25.91% -50.84%
Market cap 84.75 bn 16.28 bn 136.26 bn 8.94 bn 4.24 bn
1Q08
Wells Fargo SunTrust Bank of America M&T Bank Zions Bank
WFC STI BAC MTB ZION
Total loans ($ mn) 386,333 123,713 873,870 49,279 40,064
Loan composition:
Commercial (other than real estate) 24.0% 30.2% 30.5% 27.4% 46.0%
Commercial real estate 16.6% 10.4% 7.2% 37.0% 34.8%
Residential real estate (including home equity) 38.4% 49.5% 44.0% 23.6% 16.0%
Consumer loans 19.2% 9.9% 18.3% 12.0% 1.9%
Total real estate exposure 55.0% 59.9% 51.2% 60.6% 50.8%
Growth in total loans (q-o-q) 1.1% 1.1% -0.3% 2.6% 2.1%
Commercial (other than real estate) 2.3% 3.8% 1.0% 6.0% 3.2%
Commercial real estate 2.9% 2.3% 2.4% 9.3% 2.1%
Residential real estate (including home equity) 0.8% -0.4% -1.3% NA -0.1%
Consumer loans -1.0% -0.1% -0.8% NA -6.1%
Shareholders' equity 48,159 18,431 156,309 6,488 5,328
Goodwill and intangibles 13,148 8,353 87,693 3,422 2,150
Tangible shareholders' equity 35,011 10,078 68,616 3,066 3,178
Total NPAs 4,495 2,320 7,827 548 434
NPAs as per cent of total loans 1.2% 1.9% 0.9% 1.1% 1.1%
Growth in NPAs (q-o-q) 16.2% 40.1% 31.6% 12.4% 53.0%
NPA composition (as % of respective loans):
Commercial (other than real estate) 0.6% 0.3% 0.5% 0.6% NA
Commercial real estate 1.0% 0.5% 2.6% 0.8% NA
Residential real estate (including home equity) 1.2% 3.0% 1.1% 3.3% NA
Consumer loans 0.3% 0.4% 0.3% 0.6% NA
Loans 90 days or more delinquent still accruing 1,631 744 4,160 81 85
As % of total loans 0.4% 0.6% 0.5% 0.2% 0.2%
NPAs and 90+ days delinquent loans as % of total loans 1.6% 2.5% 1.4% 1.3% 1.3%
NPAs and 90+ days delinquent loans as % of shareholders' equity 12.7% 16.6% 7.7% 9.7% 9.7%
NPAs and 90+ days delinquent loans as % of tangible shareholders' equity 17.5% 30.4% 17.5% 20.5% 16.3%
Gross Charge offs 1,764 323 3,180 56 54
Gross charge-offs as per cent of total loans 0.5% 0.3% 0.4% 0.1% 0.1%
Growth in gross charge-offs (q-o-q) 23.62% 68.60% 39.17% -12.58% 79.03%
Gross charge-off compisition (as % of respective loans):
Commercial (other than real estate) 0.28% 0.10% 0.19% NA 0.01%
Commercial real estate 0.07% 0.00% 0.17% NA 0.22%
Residential real estate (including home equity) 0.36% 0.38% 0.17% NA NA
Consumer loans 1.15% 0.43% 1.19% NA NA
Gross charge-offs as % of shareholders' equity 3.7% 1.8% 2.0% 0.9% 1.0%
Gross charge-offs as % of tangible shareholders' equity 5.04% 3.2% 4.63% 1.8% 1.7%
Provision for loan loss charge 2,028 560 6,021 60 92
As per cent of total loans 0.5% 0.5% 0.7% 0.1% 0.2%
As per cent of NPAs 45.1% 24.1% 76.9% 11.0% 21.2%
As per cent of gross charge-offs 114.97% 173.54% 189.34% 107.52% 171.68%
Reserve for loan losss (EOP) 6,013 1,545 14,891 774 501
As per cent of total loans 1.6% 1.2% 1.7% 1.6% 1.3%
As per cent of NPAs 133.8% 66.6% 190.3% 141.2% 115.4%
As per cent of gross charge-offs 340.87% 478.88% 468.27% 1386.27% 932.60%
Texas ratio 14.9% 26.4% 14.4% 16.4% 14.1%
Change in Texas ratio from preceding quarter (bps) 1.38 5.85 2.26 1.53 4.05
Eyles Test reserve for loan loss 8,606 3,688 22,182 841 825
Shortfall as a % of tangible book value 7.4% 21.3% 10.6% 2.2% 10.2%
NIM 4.7% 3.1% 2.7% 3.4% 4.2%
Leverage ratio (Tier 1 capital / average assets) 7.04 7.20 5.61 7.04 7.18
High-risk geographic exposure
Commercial real estate loans in California & Florida 37%
Home equity loans in California and Florida 41%
Residential real estate loans in California, Florida and Nevada 40%
Residential mortgage loans in California and Florida 39%
Home equity loans in California and Florida 40%
Credit card loans in California and Florida 19%
Commercial real estate loans in California & Florida 24%
Published in BoomBustBlog
Wednesday, 25 June 2008 05:00

More on Bank of Amercia and Countrywide

The more I think about this transaction, the more it stinks. I am trying my best to give BAC's management the benefit of the doubt since banking is their profession, after all. Then again, my profession is ferreting out profitable opportunities, and methinks a shorting is in the air if they close on this deal. Most know how bad off Countrywide is, but let's waltz through and overview of Bank of America...

1Q-2008 4Q-2007 3Q-2007 2Q-2007 1Q-2007
Total Allowances at EOP 14,891 11,588 9,535 9,060 8,732
Gross Charge off's as % of Loans
Residential mortgage 0.03% 0.01% 0.01% 0.01% 0.01%
Credit card - domestic 1.57% 1.25% 1.36% 1.56% 1.65%
Credit card - foreign 0.87% 0.86% 0.89% 0.88% 0.89%
Home equity 0.49% 0.16% 0.05% 0.03% 0.02%
Direct/Indirect consumer 0.89% 0.96% 0.62% 0.54% 0.57%
Other consumer 2.75% -0.96% 1.84% 1.50% 1.45%
Total consumer 0.47% 0.34% 0.30% 0.30% 0.31%
Commercial - domestic 0.05% 0.05% 0.02% 0.03% 0.13%
Commercial real estate 0.17% 0.03% 0.07% 0.01% 0.01%
Commercial lease financing 0.09% 0.09% 0.07% 0.05% 0.05%
Commercial - foreign 0.02% 0.02% 0.03% 0.03% 0.04%
Small business commercial - domestic 1.83% 1.46% 1.51% 1.35% NA
Total commercial 0.18% 0.13% 0.12% 0.11% 0.10%
Total Gross Charge offs as % of Loans 0.36% 0.26% 0.24% 0.24% 0.24%
Provision as % of Loans 0.69% 0.38% 0.25% 0.24% 0.17%
Provision as % of NPA's 77% 56% 60% 76% 60%
Gross Charge off to Loans 0.36% 0.26% 0.24% 0.24% 0.24%
Gross Charge off to NPA's 41% 38% 56% 75% 85%
Allowances as % of Loans 1.70% 1.32% 1.20% 1.19% 1.21%
Allowances as % of NPA's 190% 195% 283% 379% 424%
NPA's to Loans 0.90% 0.68% 0.42% 0.32% 0.28%
Shareholder's equity 156,309 156,309 138,510 135,751 134,856
Goodwill 77,872 77,530 67,433 65,845 65,696
Intangible assets 9,821 10,296 9,635 8,720 9,217
Adjusted Equity 68,616 68,483 61,442 61,186 59,943
Diluted shares outstanding 4,461 4,497 4,476 4,477 4,497
BVPS 35.0 34.8 30.9 30.3 30.0
Adj BVPS 15.4 15.2 13.7 13.7 13.3
NPAs as a % of shareholders' equity 5.0% 3.8% 2.4% 1.8% 1.5%
NPAs as a % of adjusted shareholders' equity 11.4% 8.7% 5.5% 3.9% 3.4%
More than 11% of shareholder's value is in non performing assets, and this is before buying the worst bankn in the country!!!
Texas Ratio 14.4% 12.1% 8.9% 7.4% 7.2%
The Texase (insolvency) ratio has doubled in the last year
Eyles Test 22,181.8 19,324.2 15,120.4 14,017.9 13,570.1
Shortfall from current reserve for loan loss 7,290.8 7,736.2 5,585.4 4,957.9 4,838.1
Shortfall as % of tangible shareholders' equity 10.6% 11.3% 9.1% 8.1% 8.1%
The Eyles Test shows that reserves are sparse
NIM 2.73% 2.61% 2.61% 2.59% 2.61%

Leverage is increasing even as margins will freeze or reverse as the US Banks

Tier 1 leverage ratio 5.61 5.04 6.20 6.33 6.25

This what the portfolio looks like. They are heaviest in the things that are hurting the industry the most!

Loan
Portfolio (March, 2008)
Loan Portfolio % of Total NPA % of Total NPA NPA/ Loans Charge-offs % of NPA % of Loans
Consumer
Residential mortgage 266,145 30.6% 2,576 35.1% 0.97% 85 3% 0.03%
Credit card – domestic 60,393 7.0% NA NA NA 950 NA
Credit card – foreign 15,518 1.8% NA NA NA 135 NA
Home equity 118,381 13.6% 1,786 24.4% 1.51% 582 33% 0.49%
Direct/Indirect consumer 80,446 9.3% 6 0.1% 0.01% 719 11983% 0.89%
Other consumer 3,746 0.4% 91 1.2% 2.43% 103 113% 2.75%
Total consumer 544,629 62.7% 4,459 60.8% 0.82% 2,574 58% 0.47%
Commercial – domestic 188,089 21.6% 996 13.6% 0.53% 102 10%
Commercial real estate 62,739 7.2% 1,627 22.2% 2.59% 108 7% 0.17%
Commercial lease financing 22,132 2.5% 44 0.6% 0.20% 21 48% 0.09%
Commercial – foreign 31,101 3.6% 54 0.7% 0.17% 7 13% 0.02%
Small business commercial –
domestic
20,123 2.3% 153 2.1% 0.76% 368 241% 1.83%
Total commercial at
historical cost
324,184 37.3% 2,874 39.2% 0.89% 606 21% 0.19%
Total Loans 868,813 100% 7,333 100% 0.84% 3,180 43% 0.37%

Level 3 Assets are present in a decent amount

Level 1 Level 2 Level 3 Nettings Assets/Liabilities at Fair Value
Federal funds sold and
securities purchased under agreements to resell
0 2,661 0 0 2,661
Trading account assets 54,062 106,109 5,522 0 165,693
Derivative assets 1,082 782,438 10,834 (743,429) 50,925
Available-for-sale debt
securities
2,221 209,981 9,658 0 221,860
Loans and leases(2) 0 0 5,057 0 5,057
Mortgage servicing rights 0 0 3,163 0 3,163
Other assets(3) 19,019 12,411 5,496 0 36,926
Total 76,384 1,113,600 39,730 (743,429) 486,285

Check out Geographic Concentrations amongst troubled lending products!

1Q-2008 4Q-2007
Consumer
Loan State Concentration – Managed Basis
Residential Mortgage
California 87,815 88,703
Florida 16,588 16,497
New York 16,889 15,333
Texas 12,990 13,193
New Jersey 10,184 10,346
Virginia 11,355 11,535
Other U.S./Foreign 113,904 123,126
Total 269,725 278,733
Credit Card
California 22,645 22,231
Florida 12,639 12,503
New York 9,368 9,420
Texas 10,032 10,098
New Jersey 5,952 5,937
Virginia 4,605 4,669
Other U.S./Foreign 118,517 118,833
Total 183,758 183,691
Home Equity
California 31,646 29,891
Florida 16,035 15,442
New York 7,666 7,439
Texas 2,269 2,231
New Jersey 7,921 7,779
Virginia 4,007 3,861
Other U.S./Foreign 48,961 48,352
Total 118,505 114,995
Direct/Indirect
California 10,180 9,743
Florida 6,627 6,244
New York 4,483 3,275
Texas 6,334 6,050
New Jersey 2,116 1,911
Virginia 1,932 1,784
Other U.S./Foreign 50,014 49,571
Total 81,686 78,578
Other
California 115 121
Florida 195 203
New York 63 67
Texas 224 231
New Jersey 12 13
Virginia 51 54
Other U.S./Foreign 3,086 3,161
Total 3,746 3,850
Commercial real estate loan
concentration
California 10,073 9,369
Northeast 9,113 8,951
Midwest 8,230 7,832
Illinois 6,830 6,731
Southeast 6,756 6,472
Southwest 5,798 5,400
Florida 4,828 4,870
Midsouth 3,014 2,843
Northwest 2,755 2,417
Other 1,932 3,370
Geographically diversified 2,357 2,282
Non-U.S. 1,293 1,065
Total 62,979 61,602

Now if I were to overlay a similar chart of Countrywide on top of this, it would stop your heart. Can I hold myself back from a long term bearish play on this company if they buy CFC without subsidies? Does BAC management know something that I don't? I'd like to hear from readers who know more about this deal and the players than I do.

Published in BoomBustBlog
Friday, 20 June 2008 05:00

Now, they're all holding the bag!

From CNBC: Moody's Cuts MBIA, Ambac Top Insurance Ratings

Moody's
stripped the insurance arms of Ambac Financial Group and MBIA of their
AAA ratings, citing their impaired ability to raise capital and write
new business... Demand for their insurance wraps has also
effectively dried up on concerns over losses the companies will take
from insuring risky residential mortgage-backed debt.

Standard & Poor's stripped both insurance arms of their top ratings on June 5.

Moody's
cut Ambac Assurance three notches to "Aa3," the fourth highest
investment grade, and downgraded Ambac Financial three notches to "A3,"
the seventh highest investment grade, from "Aa3."

MBIA
Insurance was cut five notches to "A2," the sixth highest investment
grade, and MBIA Inc was cut five notches to "Baa1," three steps above
junk, from "Aa2."...

MBIA said Moody's action will give some holders of guaranteed
investment contracts the right to terminate the contracts or to require
that additional collateral be posted. The company said it has "more
than sufficient" liquid assets to meet those requirements. Yeah, okay. Everything that has come out of Management's mount in the last year has been false - practically every defensive public statement. They can't even spell credibility at this point.

This is a Turning Point Ladies and Gentlemen!

IMO, MBIA's management is the lack of wisdom in action. I know it is easy to kick someone whent they are down, and that is something that I definitely do not aim to do. Yet, I have questioned management's competency for some time, way before it was popular to do so.

This is the dilemma. Everybody and their grandaunt's cousin knew the monoline wraps weren''t worth the toilet tissue their were contracted on, but they all played along with the triple ratings agency game. Realistically, in terms of perception of risk, we are in the same place we were in two months ago.

And to think, there is no clearing house, no guarantee of settlement, no standardized credit or counterparty rating. Who knows who the hell will pay up and who will not! I have already bet my money that the monolines wouldn't be able to pay up, and I made a penny or two on that wager. The game is now afoot.

The growth in CDS market in the last few years has
outstripped that of the US
equity and bond markets

The credit
derivatives market has grown at a remarkable pace as reflected from the
tremendous increase in total notional amount outstanding over the last few
years. The total notional amount of credit derivatives as of June 2007 increased
to US$42.6 trillion, an increase of 109% over the US$20.4 trillion reported in
June 2006. This has been driven by both the rise in single name CDS and the multi
name CDS instruments. The significant rise in the multi name CDS (traded
indices) has notably surpassed the growth in single name CDS. Single name CDS’ total notional amount
outstanding has increased from US$7.31 trillion in June 2005 to US$24.2
trillion in June 2007 while the multi name CDS has grown from US$2.9 trillion
in June 2005 to US$18.3 trillion in June 2007.

image002.jpg

Source: Thomson Research

From an accounting perspective, we should see big things happening though. Now, some real transparency should be coming to light. Banks and other entities will have to start marking things down significantly, contracts that will get called will bankrupt the monolines, who will either refuse or be unable to pay. Level 3 asset concentrations and counterparty risk will be the poisons du jour. Who is the most toxitic? The CDS market will show the cracks that I have been predicting for some time as the dominoes go horizontal at a hastened pace. Even the speculators, re: Ackman, et. al. may have problems. Not everyone is going to get paid on their CDS exposure, because many guys on the other side (this is read as the counterparty risk that I have been crowing about for one year) just won't have the money to pay up. Trust me. If you haven't unwound already, God Bless the side pocket clause!

... for my next prediction, a lot of people may benefit from revisiting my "I know who's holding the bag" and "The Next Shoe to Drop: The CDS market, beware what lies beneath " articles... We will be testing the Fed's ability to rescue these banks, for although they have bandaged the liquidity wound, what's killing the banks is the insolvency disease - something the Fed is powerless to mitigate. This is why Paulson was on TV yesterday pushing to hasten the Fed's regulatory power increase.

We very well soon see where I got the moniker, "The Riskiest Bank on the Street" from. See icon Morgan Stanley_final_040408 (1.38 MB). I received some notoriety after successfuly calling the Bear Stearns collapse (Is this the Breaking of the Bear?). Many who don't follow me closely may not realize how similar I consider Bear Stearns and Morgan Stanley. Morgan Stanley's net credit, counterparty, and level 3 exposure was the reason why I did the deep dive on it instead of Lehman, despite the fact that Lehman had more CRE exposure in proportion to its equity. Methinks the street may be looking at the wrong bank to fail. I may be wrong, we shall see. I made a decent profit off of Lehman anyway since those who follow the blog realized that we discovered Lehman's foibles way before most took notice. I wrote the following in April, right after the Bear debacle:

Morgan Stanley’s significant level 3 exposure and high leverage remain a cause for extreme concern

Large write-downs likely due to level 3 assets exposure: Morgan
Stanley’s level 3 asset exposure, which stood at 261% of its equity as
of February 29, 2008, is likely to cause a significant drag on its
valuation in the near future. These assets, for which the bank uses
proprietary models to gauge their value, will witness the largest
write-downs of all asset categories amid the current credit market
turmoil. When compared with other leading investment banks, Morgan
Stanley clearly stands out to be the most vulnerable to falling values
in these hard-to-value assets. It is worthwhile to mention that Bear
Stearns, which last month witnessed significant erosion in its market
capitalization, had level 3 assets equal to 239% of its equity, next
only to Morgan Stanley. Although the Fed has mitigated liquidity
concerns of investment banks in significant part, the balance sheet
solvency is a far more difficult problem to address – and one in which
Morgan Stanley leads the pack.

Just so no one thinks I am following the crowd, I wrote this the 2nd week of February:

Failure of bond insurers increases counterparty credit risk

Bond insurers have guaranteed a monstrous $2.4 trillion of outstanding
debt besides providing insurance coverage to troubled structured
finance products such as CDOs. Banks active in the ABS RMBS and CMBS
real estate markets have more than one reason to worry having bought
protection through credit-default swaps (CDS) from bond insurance
companies. Since the CDS market is not regulated, it is difficult to
assess the amount of exposure banks have to bond insurer counterparty
risk. ACA Capital Holdings is facing difficulties in paying claims due
to its exposure in the CDO sector and subprime market. This prompted
Merrill Lynch to write down its exposure to ACA by $1.9 billion. Sell
side analysts such as Meredith Whitney of Oppenheimer, estimate that
banks may have to write off securities (worth $10.1 billion) insured
with ACA. Morgan Stanley’s exposure to net counterparty credit
aggregates $51 billion. Nearly 27% of this was rated BBB and lower as
of 30 November 2007. This reflects the $10 billion increase since
August 31, 2007.

Morgan Stanley Issued Securities with Exposure to Ambac and MBIA

Morgan Stanley has exposure to bond insurers through bonds insured by
them and their status as counterparties to derivative contracts. The
inability of bond insurers to pay claims has become a serious concern
for parties exposed to such firms.

The significant concentration in subprime home equity lines, who are subject to playing 2nd
fiddle to the primary lender in first position in terms of claim on the
what is increasingly highly encumbered property, leaves MS open to
unprecedented losses - losses that can extend significantly past the next two quarters.

Deal Type

Min Rating

Sum of Par Amount

Sum of Potential Losses

CDO

A

$37,800,000

$0

AA

$15,000,000

$0

BB

$4,000,000

$0

BBB

$8,000,000

$0

CDO Total

$64,800,000

$0

CMBS

A

$238,297,455

$0

AA

$166,048,000

$0

AAA

$700,924,635

$0

B

$21,323,450

$0

BB

$79,302,500

$0

BBB

$629,817,177

$0

CMBS Total

$1,835,713,216

$0

Home Equity

A

$3,734,303,697

$1,679,091,758

AA

$3,045,402,787

$779,963,597

AAA

$398,260,933

$0

BB

$5,144,130

$5,144,130

BBB

$11,919,038,778

$9,239,733,896

CCC

$704,192

$225,201

Home Equity Total

$19,102,854,518

$11,704,158,582

RMBS

A

$251,756,751

$106,291,080

AA

$487,871,361

$98,398,644

AAA

$886,227,100

$0

BB

$6,442,461

$0

BBB

$254,936,389

$79,764,450

RMBS Total

$1,887,234,062

$284,454,174

(Other)

A

$20,000,000

$0

AA

$45,500,000

$0

(Other) Total

$65,500,000

$0

Grand Total

$22,956,101,796

$11,988,612,756

Counterparty credit exposure (in $ million)

image005.png

Source: Company data


So, where is all of this exposure and risk hidden?

Unconsolidated VIEs could aggravate woes

VIEs have tormented most Wall Street financial majors—several of them
have had to consolidate their VIEs to increase liquidity and limit
losses. These innovative, structured entities were introduced to boost
earnings without transferring actual risk into the balance sheets of
banks.

Morgan Stanley has significant exposure to VIEs, with the maximum loss
ratio averaging roughly 50% in recent years. The large exposure ($37.7
billion in 4Q 07), high loss ratio and adverse market conditions could
force the company out of business if its maximum loss assumptions
become reality. Morgan Stanley’s unconsolidated VIEs comprise the most
troublesome asset categories – MBS & ABS portfolios (worth $6.3
billion), credit & real estate portfolios ($26.6 billion) and some
structured finance products ($8.6 billion). Loss exposure in the credit
& real estate portfolio is not expected to be lower than 70%
considering the slump in housing demand, falling home prices and rising
foreclosures. The growing housing inventory across the U.S. has also
raised concerns about the disposal of these assets. Home prices across
the U.S. declined 7% (on average), while foreclosures increased 20%
during the past year alone. This scenario reflects the bleak prospects
of the housing industry and the securities linked to it.

Unconsolidated VIEs, Exposure to loss (in $ mn) and loss ratio (in %)

image004.png

Source: Company data

Unconsolidated VIE's

FY 2007

$ mn

Unconsolidated VIE assets

Maximum exposure to loss

Loss ratio %

MBS & ABS

7,234

280

3.9%

Credit & real estate

20,265

13,255

65.4%

Structured transactions

10,218

2,441

23.9%

Total

37,717

15,976

42.4%

To forecast these loss ratios, we
have used the maximum exposure to loss as the worst case scenario. For
the base case, we expect the loss ratio to be lower than the maximum
exposure to loss.

Base Case

Optimistic Case

Worst Case

Mortgage and asset-backed securitizations

2%

1%

4%

Credit and real estate

50%

30%

65%

Structured transactions

15%

10%

24%

Base Case

Optimistic Case

Worst Case

Mortgage and asset-backed securitizations

109

54

217

Credit and real estate

6,080

3,648

7,953

Structured transactions

613

409

976

Total Losses in $ million

6,801

4,111

9,146


This is the "Riskiest Bank on the Street", as updated in April right after I liquidated the largest position in my proprietary portfolio, Bear Stearns puts from the year before:

Morgan Stanley’s significant level 3 exposure and high leverage remain a cause for extreme concern

Large write-downs likely due to level 3 assets exposure: Morgan
Stanley’s level 3 asset exposure, which stood at 261% of its equity as
of February 29, 2008, is likely to cause a significant drag on its
valuation in the near future. These assets, for which the bank uses
proprietary models to gauge their value, will witness the largest
write-downs of all asset categories amid the current credit market
turmoil. When compared with other leading investment banks, Morgan
Stanley clearly stands out to be the most vulnerable to falling values
in these hard-to-value assets. It is worthwhile to mention that Bear
Stearns, which last month witnessed significant erosion in its market
capitalization, had level 3 assets equal to 239% of its equity, next
only to Morgan Stanley. Although the Fed has mitigated liquidity
concerns of investment banks in significant part, the balance sheet
solvency is a far more difficult problem to address – and one in which
Morgan Stanley leads the pack.

Bank Level 1 Assets Level 2 Assets Level 3 Assets Shareholder Equity Total Assets Level 1 Assets-to-Total Assets Level 2 Assets-to-Equity Level 3 Assets-to-Equity Leverage (X)
Citigroup $223 $934 $133 $114 $2,183 10.2% 822% 117% 19.21
Merrill Lynch $122 $768 $41 $32 $1,020 12.0% 2405% 130% 31.94
Lehman Brothers $73 $177 $39 $26 $786 9.2% 687% 152% 30.59
Goldman Sachs $122 $277 $72 $47 $1,120 10.9% 586% 153% 23.71
Morgan Stanley $115 $226 $74 $31 $1,045 11.0% 723% 236% 33.43
Bear Stearns $29 227 $28 $12 $96 30.7% 1926% 239% 8.15
Based on latest quarterly filings and transcripts
Also,
the growing proportion of level 3 assets in Morgan Stanley’s total
asset exposure is raising investors’ concerns over expected write downs
in the coming quarters. The bank’s level 3 assets have increased partly
due to re-classification of assets from level 2 to level 3 on account
of unobservable inputs for the fair value measurement. During 4Q2007,
Morgan Stanley re-classified $7.0 bn of funded assets and $279 mn of
net derivative contracts from level 2 to level 3. Morgan Stanley’s
level 2 assets-to-total assets ratio declined to 5.2% in 4Q2007 from
8.9% in 1Q2007 while its level 3 assets-to-total assets increased to
7.0% in 4Q2007 from 4.3% in 1Q2007 indicating growing uncertainty
associated with valuation of assets not readily marketable. The trend
can be expected to continue in the coming quarters as uncertainty
associated with realizing values from illiquid assets continues to grow.
image0121x.gif
image014x.gif
High leveraging could hinder capital raising abilities: While
expected asset write-downs could continue eroding Morgan Stanley’s
equity at least for the next few quarters, the company’s
higher-than-peers leverage levels could prove to be an impediment in
raising additional capital to maintain its statutory capital levels.
Morgan Stanley’s leverage (computed as total tangible assets over
tangible shareholders’ equity) stood at 37.3X as of February 29, 2008,
while the bank’s balance sheet size had been reduced to $1,091 bn as of
that date from $1,182 bn on November 30, 2007. The bank’s leverage is
the highest among its peers which could be a cause of concern amid
falling income levels and tight liquidity conditions in the financial
markets.
image0121.gif
* Adjusted assets / adjusted shareholder's equity
Morgan Stanley taking initiatives to “de-risk” its balance sheet: In
the wake of issues underpinning the current crisis in the markets,
Morgan Stanley is making continued efforts to “de-risk” its balance
sheet by reducing its exposure to risky credit positions. Morgan
Stanley’s total non-investment grade loans decreased to $26 bn in
1Q2008 from $30.9 bn in 4Q2007. In addition Morgan Stanley reduced its
gross exposure towards CMBS and RMBS securities to $23.5 bn and $14.5
bn, respectively, in 1Q2008 from $31.5 bn and $16.5 bn, respectively,
in 4Q2007.

5

Significant counter-party risks from monoline downgrades to result in further write-downs

While
hedging does function as an effective tool in minimizing loses from
write-downs of dubious assets, hedging in the form of protection from
monolines/bond insurers carries associated counterparty credit risks
which cannot be ignored in the current environment of continued
weakening of monolines. An increasing probability of counterparty risks
materializing for investment banks from the deteriorating financial
position of the monolines could contribute to further asset write-downs
by the banks. It is estimated that the top five US investment-banks
have a combined $23 bn in uncollateralized exposures to triple-A rated
counterparties part of which is with the monocline bond insurers
including AMBAC, MBIA (may face downgrade from Fitch, same with Ambac),
and FGIC (is now rated as junk), which have been a subject of
downgrades in the last few months. Merrill Lynch’s total
uncollateralized exposure to triple-A counterparties stood at $7.1 bn
as of August 31, 2007, while that of Morgan Stanley was $7 bn as of
that date. The corresponding figures for GS, Lehman and Bear Sterns
were $4.7 bn, $4 bn and $330 mn, respectively. Merrill Lynch has
reported that around 50% of its total hedging is in the form of
monoline insurance, giving a fair indication of the possible
write-downs resulting from downgrades of monolines. Merrill Lynch also
reported a $3.1 bn asset write-down in 4QFY07 in response to a
downgrade of ACA Capital (to which it had an exposure) to junk status.
As
of February 29, 2008, Morgan Stanley had $4.7 bn aggregate exposure
towards monolines with a $1.3 bn exposure in ABS bonds, $2.6 bn in
municipal bond securities and $0.8 bn in net counter party exposure.
The deterioration of credit market coupled with significant losses
suffered by monolines had caused downgrades of monolines. Any further
downgrades of monolines could result in additional write-downs by
financial institutions and adversely affect the financial markets.
Morgan Stanley recorded approximately $600 mn write-down in 1Q2008 on
account of its exposure from monolines.
S&P
estimates that the total hedges to CDO exposures by bond insurers are
currently around $125 bn, though the location of these hedges is not
entirely known. A separate report by Oppenheimer & Co estimates
that the total write-down by the financial institutions resulting from
potential rating downgrades of monolines could range between $40 bn to
as high as $70 bn, with Citigroup, ML, and UBS being the most
vulnerable as they together hold a large chunk of the credit market
risk associated with bond insurers. The coming quarters could thus
witness more significant assets write-downs if monolines are
downgraded.
The
possible relief comes from the recent developments whereby monolines
have been successful in raising capital to maintain their AAA ratings. Earlier,
in March 2008, both S&P and Moody’s affirmed AAA and Aaa ratings,
respectively, to AMBAC after it raised $1.5 bn through sale of common
stock and convertible units.
Another
factor which may reinforce the banks’ counter party risks on monocline
exposure are the recent developments which indicate that the monolines
may be looking for means to terminate their guarantee contracts with
the banks to evade their liabilities. A case in point is the legal
battle initiated between Merrill Lynch and Security Capital Assurance
(SCA) wherein Merrill Lynch sued SCA’s XL Capital Assurance unit on the
ground that the latter refused to honor the commitments arising on the
bank’s CDS worth $3.1 bn. SCA has in turn alleged that Merrill Lynch
had not honored the contractual terms by transferring the control
rights on the CDOs to a third party. More such legal battles could
follow creating increased uncertainty on the true extent of hedging
exercisable on monocline exposure.

5

Hidden losses from unconsolidated VIE’s a cause of concern for Morgan Stanley

image016t.gif
Morgan
Stanley has a significant exposure to MBS, ABS, credit and real estate
assets and other structured transactions through VIEs. As at November
30, 2007 Morgan Stanley consolidated $22.4 bn of assets from VIEs, with
a maximum loss exposure of $17.6 bn. In addition, the bank also has
$37.7 bn in exposure through unconsolidated VIEs with a maximum loss
exposure of $15.9 bn, yielding a maximum loss-to-total exposure at
42.4%. Morgan Stanley’s total exposure towards unconsolidated VIEs is
in some of the riskiest asset class categories, including a $7.2 bn
exposure towards MBS and ABS securities (maximum loss-to-exposure of
3.9%), $20.3 bn towards credit and real estate (maximum
loss-to-exposure of 65.4%) and $10.2 bn towards structured transactions
(maximum loss-to-exposure of 23.9%).
Consolidated VIE's ($ mn) 30-Nov-07
US$ mn VIE
assets consolidated
Maximum exposure to loss
Mortgage and asset-backed securitizations 5,916 1,750
Municipal bond trusts 828 828
Credit and real estate 5,130 5,835
Commodities financing 1,170 328
Structured transactions 9,403 8,877
Total 22,447 17,618
78.49%
Unconsolidated VIE's ($ mn) 30-Nov-07
US$ mn VIE
assets not consolidated
Maximum exposure to loss
Mortgage and asset-backed securitizations 7,234 280
Credit and real estate 20,265 13,255
Structured transactions 10,218 2,441
Total 37,717 15,976
42.36%
Net losses Optimistic Case Base Case Worst Case
Mortgage and asset-backed securitizations 28 42 84
Credit and real estate 2,187 3,314 6,628
Structured transactions 564 854 1,709
Total
in US$mn
2,779 4,210 8,420

As
can be ascertained from its high maximum loss-to-exposure ratio of
65.4%, the credit and real estate product is the most vulnerable of all
the products in respect of a probability of defaults considering that
most of the US housing problem is linked to loans originated with poor
underwriting standards to marginal buyers at the peak of the housing
bubble. Falling housing prices coupled with stringent lending standards
are making it increasingly difficult for borrowers to refinance
existing loans resulting in higher delinquency and foreclosures for
these loans. Under our base case scenario we have estimated total
losses of $4.2 bn from unconsolidated VIEs primarily off losses from
the credit and real estate sectors.
Also
it is worth mentioning that some investment baking firms (prominently
UBS and Lehman) are spinning off or considering a spinoff of their
riskier assets into separate subsidiaries, CLOs and SIVs as an
off-balance sheet exposure in an attempt to shrink their balance sheet
through accounting shenanigans designed to deceive investors by
presenting a rosy picture of their financial affairs.

Worsening credit market to impact Morgan Stanley’s financial position

The
current gridlock in the credit market has drastically pulled down the
mark-to-market valuation of mortgage-backed structured finance
products, resulting in significant asset write-downs of banks and
financial institutions. It is estimated that further write-downs by
investment banks could touch $75 bn in 2008 after an estimated $230 bn
already written off since the start of 2007. With the situation not
expected to improve in the near-to-medium term, investment banks are
likely to face a sizeable erosion of their equity from large
write-downs in the coming periods. Though the recent mark-down
revelations by UBS and Deutsche Bank have injected some positive
sentiment in the global capital markets with the hope that the credit
crisis has reached an inflection point, it is overly optimistic to
believe that the beginning of the end of the current turmoil is at hand
before the causes of the turmoil, tumbling real asset prices and
spiking credit defaults, cease to act as catalysts.
image013x.gif
* expected
Morgan
Stanley wrote off a significant $9.4 bn of its assets in 4Q2007.
However, the write down in 1Q2008 was much lower with $1.2 bn mortgage
related write-down and $1.1 bn leveraged loan write-down, partly offset
by $0.80 bn gains from credit widening under FAS159 adjustments. One of
the factors which the bank considers while estimating asset write-downs
is the movement in the ABX index which tracks different tranches of CDS
based on subprime backed securities. Nearly all tranches of ABX index
have witnessed a significant decline over the last six months. While
Morgan Stanley’s 4Q2007 write-down of $9.4 bn appeared in line with a
considerable fall in the ABX index during the quarter, a similar nexus
is not evident for 1Q2008. Morgan Stanley recorded a gross write-down
of $2.3 bn in 1Q2008 though the decline in ABX indices seemed
relatively severe (however not as steep as in the preceding quarter).
The disparity raises a concern that Morgan Stanley might report more
losses in the coming periods.
image015y.jpg
ABX BBB indices (September 26, 2007, to April 2, 2008) Source: Marki.comt Although
the ABX indices showed a slight recovery in March 2008, this is
expected to be a temporary turnaround before the indices resume their
downward movement owing to expected continuing deterioration in the US
housing sector and mortgage markets. The following is a detailed, yet
not exhaustive, example of Morgan Stanley's "hedged" ABS portfolio -
icon Morgan Stanley ABS Inventory (1.65 MB)6.
"Hedged"
is a parenthetical because we believe that large scale investment bank
hedges are far from perfect. We discuss this later on in the report.
The
US housing markets are yet to stabilize and housing prices are still
above their long-term historical median levels, leaving scope for a
further downside in prices. Between October 2007 and January 2008, the
S&P Case Shiller index declined nearly 6.5% (with 2.3% decline in
January 2008 alone). We would like to make it clear that although the
CS index is an econometric marvel, it does not remotely capture the
entire universe of depreciating housing assets. It purposely excludes
those sectors of the housing market that are hardest hit by declines,
namely: new construction (ex. home builder finished inventory), condos
and co-ops, investor properties and “flips”, multi-family properties,
and portable homes (ex. trailers). Investor properties and condos lead
the way in defaults due to excess speculation while new construction
faces the largest discounts, second only to possibly repossessed homes
such as REOs. A decline in this expanded definition of housing stock’s
pricing could result in increased defaults and delinquencies,
significantly beyond that which is represented by the Case Shiller
index, which itself portends dire consequences.
As
credit spreads continue to widen over the next few quarters, the assets
would need to be devalued in line with risk re-pricing. Morgan Stanley
and the financial sector in general, are expected to continue with
their balance sheet cleansing exercise, recording further asset
write-downs till stability is restored in the financial markets.
While
it is believe the expected continuing fall in the security market
values would indicate more write-downs in the coming quarters, a part
of this could be set-off under FAS159 by implied gains from write-down
of financial liabilities off an expected widening of credit spreads.
Morgan Stanley is expected to record assets write-down losses of $16.5
bn and $7.6 bn in 2008 and 2009, respectively, considering the bank’s
increasing proportion of level 3 assets amid falling security values.
This would be partially off-set by FAS159 gains of $930.8 mn and$116.1
mn in the two years off revaluation of its financial liabilities. It is
important to note the fact that FAS 159 gains are primarily accounting
gains, and not economic gains and they do not truly reflect the
economic condition of Morgan Stanley. Of the $18.3 bn of total
liabilities for which the bank makes adjustments relating to FAS159,
$14.2 bn and $3.1 bn of liabilities relate to long-term borrowings and
deposits.
Since
most of these securities are traded in the secondary market, it would
be difficult for Morgan Stanley to translate these accounting gains
into economic gains by purchasing them at a discount to par during a
widening credit spreads scenario.
To
explain
in simpler terms, marketable securities can be purchased at a
discount to par if credit spreads increase as MS debt is devalued.
Thus, theoretically, MS can retire this debt for less than par by
purchasing this debt outright in the market, and FAS 159 allows MS to
take this spread between market values and par as an accounting profit,
presumably to match and offset the logic in forcing companies to market
assets to market via FAS 157. In reality, only marketable securities
can yield such results in an economic fashion, though companies that
would be stressed enough to experience such spreads probably would not
be in the condition to retire debt. In Morgan Stanley’s case, these
spreads represent non-marketable debt such as bank loans, negotiated
borrowings and deposits. These cannot be purchased at less than par by
the borrower, thus any accounting gain had through FAS 159 will lead to
phantom economic gains that don’t exist in reality. For instance, a $1
billion bank loan will always be a loan for the same principle amount,
regardless of MS’s credit spreads, unless the bank itself decides to
forgive principal, which is highly unlikely. It should be noted that
Lehman Brothers actually experienced an economic loss for the latest
quarter of about $100 million, but benefitted by the accounting gain
stemming from FAS 159, that led to an accounting profit of
approximately $500 million. This profit, which sparked a broker rally,
was purely accounting fiction. Similarly, Morgan Stanley (in economic
profit, ex. “real” terms) overstated its Q1 ’08 profit by approximately
50%. This overstatement apparently induced a similarly rally for the
brokers. Quite frankly, we feel the industry as a whole is in a
precarious predicament due to dwindling value drivers, a cyclical
industry downturn, a credit crisis and a deluge of overvalued,
unmarketable and quickly depreciating assets stuck on their balance
sheets. Their true economic performance is revealing such, but is
masked by clever, yet allowable accounting shenanigans.
Morgan Stanley Write-down -2008 Level 1 Level 2 Level 3 Total
(In US$ mn)
Financial
instruments owned
U.S.
government and agency securities
- 12 2 14
Other
sovereign government obligations
- 9 0 9
Corporate
and other debt
2 2,761 2,223 4,986
Corporate
equities
413 71 62 546
Derivative
contracts
226 7,252 3,240 10,719
Investments 1 1 196 198
Physical
commodities
- 12 - 12
Total
financial instruments owned
642 10,120 5,723 16,485

Published in BoomBustBlog
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