Displaying items by tag: Banking

We actually had a modern day run on the bank in the UK and the equity markets shrugged it off.

It is a mistake, plain and simple. I normally don't like to tell people who specialize in a business how to run it, since they probably know more about their business than I do - but sometimes the mistakes are just so glaring. I don't care how many analysts are poring over how many books at Countrywide. BAC's error is not misjudging the value of Countrywide now, but misjudging the macro environment in which Countrywide operates.

My experience has been primarily understanding and evaluating companies from the equity perspective, but that definitely doesn't mean that I ignore the fxed income side. I am just not better at it than the other guys. What I have been noticing of late is that credit markets have been screaming murder for some time now, and the equity markets have been humming along new bullish highs and trading runs as if nothing is truly wrong. This is a strong indicator that momentum trading has again taken control of the markets. It is an environment where price trumps value. The last time this came to a head was the dot com bust. It took many institutional and individual investors 5 to 6 years to break even. Some never recouped their losses. Well, my gut has been telling me for about a year and change now that we are back there again. 2008 thus far has done nothing but confirm that we have come to a head. The pic above was an actual shot (one of very many at various locations) of the run on Northern Rock Bank in the U.K. This was real, and it was indicative of a real problem.

Well, we had a very recent run on the bank here in the states as well. There were pictures all over the web when it occurred, and now mysteriously, they are all gone. All I was able to retrieve was this screen capture of a thumbnail from Blownmortgage.com. Just as the pictorial remnants of the run have somehow disappeared, so has the equity markets prudence in the face of such a run. You can guess which bank got ran on.

This is an introduction and precursor to the work being done over at Reggie's laboratory concerning Bear Stearns, who has seen its share price halved since the credit market melee kicked off. A melee that many say the Bear is responsible for igniting. I don't know how fair a comment that is, but I do know one thing, though. In terms of equity devaluation for the bear, you probably ain't seen nothin' yet. Bear Stearns will soon be, if not already, in a fight for its life. It is beset with the possibility of a criminal indictment (no Wall Street firm has ever survived a criminal indictment), additional civil litigation, and client defection and aliention. Despite all of these, the biggest issues don't seem all that prevalent in the media though. Bear Stearns is in a real financial bind due to the assets that it specialized in, and it is not in it by itself, either. It's excessive reliance on highly "modeled" and real asset/mortgage backed products in its portfolio may potentially be its undoing. See Banks, Brokers and Bullsh1+ part one for a run down on model risk and part two for my take on counterparty credit risk as a backgrounder before reading this piece.

I thought of sharing with you some of the key observations that we've made while doing the valuation model for Bear Stearns, which admittedely is quite late. I first took interest in Bear Stearns in June, but only recently got around to addressing the investment banking sector in a matter suitable for the blog over the last month. During that month, BSC has seen aggressive adverse price action. My research tells me that this price action is not only justified, but will have to continue in order for BSC to be adequately priced. There will be details that support this assessment in the final report.

Bear Stearns first caught my interest at around $130. When we started with the original shortlist of the investment banks for formal analysis on December 13, 2007, Bear Stearns stock price stood at $98.39. The stock price has fallen by more than 27% since then and now trades at $71.17.

External fundamentals behind my call for additional adverse price reaction

The company's exposure to the asset and mortgage backed securities is as follows:

Mortgage and Asset backed inventories of $43.6 billion

A thorough forensic analysis of Goldman Sachs, Bear Stearns, Citigroup, Morgan Stanley, and Lehman Brothers has uncovered...

Last week, Morgan Stanley called Citibank the “short play of the year for 2008”. That is rather rare – an investment bank not only issuing a plainly worded sell recommendation, but an actual short recommendation? And on a fellow bank??? I read it and said, “Hmmm!” Morgan Stanley has some damn nerve calling another bank a short. They are the RISKIEST bank on the street. Let’s take a quick visual overview, and then let’s go over how I came to that conclusion.

Capital One, Citibank and HSBC Holdings have some explaining to do. Click the chart for an enlarged version. Capital One has a lot of explaining to do.

Warning: this is an opinionated blog article that may offend those employed by large rating's agencies or monoline insurers. Recommend reading as a backgrounder:

1. A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton.
2. Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion Market Cap
3. Follow up to the Ambac Analysis
4. Bill Ackman of Pershing Square - How to save the Monolines

From Bloomberg news:

MBIA Inc. fell the most in more than 20 years in New York trading after Moody's Investors Service said the biggest bond insurer is ``somewhat likely'' to face a shortage of capital that threatens its AAA credit rating.

A review of MBIA and six other AAA rated guarantors will be completed within two weeks, Moody's said in a statement today. Moody's revised its assessment from last month that MBIA was unlikely to need more capital after additional scrutiny of the Armonk, New York-based bond insurer's mortgage-backed securities portfolio.

``The guarantor is at greater risk of exhibiting a capital shortfall than previously communicated, (about a week and a half ago - my, aren't we fickle with our opinions) New York-based Moody's said. ``We now consider this somewhat likely.''

This is content from another blog that I thought my constituency would appreciate... Yes, it has an alarmist tone, and many of us already know much of what he states, but does make a compelling story when all put together. He also includes two very well known companies that I am probably going to put a concentrated short position on once I have finished my research.

With credit markets sinking into deeper turmoil ...

With more severe losses spreading to a wider range of financial institutions ...

And with the Fed's rate cuts thus far failing to stem the crisis ...

We are coming dangerously close to a money panic.

Few Wall Street analysts are talking about this in public. Fewer still understand its potential consequences. Many don't even know what a money panic is. But historians do. They realize that ...

A money panic is a stampede from greed to fear, risk to safety, buying to selling. Once set into motion, it can spin out of control, feeding on itself, wrecking havoc in financial markets.

Moreover, the data I'll share with you in this in-depth issue shows that, if not averted, a money panic could ...

• Threaten the solvency of major Wall Street firms like Bear Sterns, Goldman Sachs, Lehman Brothers, Merrill Lynch or Morgan Stanley.

• Increase the risk of future failure among large banks like Bank of America, Citibank, HSBC, JPMorgan Chase or Wachovia.
• Even force certain kinds of money market funds to break their solemn process of preserving your capital.

----- EXTENDED BODY:

No one can predict the future. But right now, the panic is already spreading from big brokers and banks to local governments and a few money market funds. Just last week, for example:

• Florida's Local Government Investment Pool, a fund for local Florida governments, was frozen to stop a rush of withdrawals by panicked investors. Until recently, the fund had $27 billion. Last month, it fell to $15 billion due to mortgage-related losses and mass withdrawals. And on Thursday morning alone, before Florida slapped the freeze on withdrawals, the fund lost $3.5 billion!

• Montana's school districts, cities and counties withdrew $247 million from the state's $2.4 billion investment fund after officials said the rating on one of the pool's holdings was lowered to "default" level.
• Countrywide Financial caused more shock waves. One week ago, I explained why I believe the company is on a collision course with bankruptcy. (Click here for the details.) Now, we learn that state funds like Florida's may have substantial investments in the company's banking subsidiary, downgraded in August and likely to be downgraded again.

Even certain money funds, thought to be safe from the turmoil, have felt repercussions. Bloomberg's David Evans puts it this way:

"Unbeknownst to most investors, some of the largest money market funds today are putting part of their cash into one of the riskiest debt instruments in the world: collaterized debt obligations (CDOs) backed by subprime mortgage loans ...

"U.S. money market funds run by Bank of America Corp., Credit Suisse Group, Fidelity Investments and Morgan Stanley held more than $6 billion of CDOs with subprime debt in June, according to fund managers and filings with the U.S. Securities and Exchange Commission. Money market funds with total assets of $300 billion have invested in subprime debt this year."

Some examples cited by Bloomberg:

• The Credit Suisse Group Institutional Money Market Fund Prime Portfolio held 8% of its $22.8 billion of assets in commercial paper secured by subprime home loans as of June 30.

• Two AIM money market funds owned $2.64 billion of CDO commercial paper that was invested in subprime debt, also in June.

• Fidelity Investments, the world's biggest mutual fund company, owned $2.3 billion in CDO-issued commercial paper in two money market funds as of May 31.

• Fidelity Cash Reserves Fund, the biggest money market fund in the U.S., had 1.5% of its $98.2 billion of assets invested in CDO commercial paper backed by subprime debt.

• The Fidelity Institutional Money Market Portfolio had 2.3% of its $32.3 billion in assets such as commercial paper.

• Federated Investors, the third-largest U.S. manager of money market funds, had seven money market funds with a total of more than $1 billion of commercial paper issued by Bear Stearns-managed CDOs at the end of June.

• Bank of America's Columbia Cash Reserves and Columbia Money Market Reserves funds owned more than $600 million of Bear Stearns' CDOs. And ...

• Wells Fargo runs three money market funds which held a total of $1.5 billion in CDO commercial paper, also on June 30.

To their credit, some of these funds have since trimmed their riskier holdings. But the above list barely scratches the surface. Looking ahead, money funds like these will either ...

(a) have to dump their mortgage-backed securities, driving down the market value of those investments even further. Or worse ...

(b) get stuck with these sinking investments and let their own shares break below the $1-per-share price that's mandatory for a money fund's survival.

Right now, the companies that manage the money funds are stepping in to inject capital and prevent this potentially disastrous break-the-buck scenario. But they are under no legal obligation to do so. And if they don't ... that's when you could see a full-fledged money panic unfold.

In a moment, I'll name some money funds that are not vulnerable. But first, let me explain why I believe this particular panic is so unique.

Close Encounters with a
Panic of the Third Kind

I first began studying the history of financial panics nearly four decades ago, when I was an undergraduate at New York University.

I learned about the panics of 1833, 1837 and 1857, which were the result of speculative land booms stimulated by the westward advance of the nation's first railroads.

I studied the panic of 1901, the outcome of a battle to corner the stock market and take over the Northern Pacific Railroad.

I delved into the "rich man's panic" of 1907, which followed a boom in corporate mergers ... the 1920-21 panic precipitated by the liquidation of excess business inventories ... plus the 1929 panic that came with the unraveling of a huge stock market pyramid built by brokers, banks, industrial tycoons and speculators.

And from my graduate student dorm at Columbia University, I even published a book dedicated to this subject.

I found that history has brought us two kinds of panics:

1. Panics brought on by a collapse of assets with liquid markets — such as stocks, bonds and certain commodities.

2. Panics caused mostly by the collapse of assets without liquid markets — such as business inventories, land or locomotives.

Today, there's no evidence that these 19th or 20th century-type panics will be repeated. Too much — especially the active intervention of central banks — has changed since then. But there is abundant evidence that we are now experiencing close encounters with a money panic of a third kind.

Indeed, according to banking regulators, there are three kinds of assets in the world:

Level One assets are actively traded. You can know exactly how much they're worth based simply on their price in the open market.

Level Two assets are not actively traded. But they're similar enough to actively traded assets to give you a reasonable estimate of their value.

Level Three assets are the most slippery. In addition to having no active market, they're so unique, there's no reliable way to estimate their true value. Instead, all that banks and regulators can do is guess. And the only tools they have to support their guesswork are unproven mathematical formulas.

Here's the key:

The money panic brewing today is driven largely by this third kind of asset — derivatives of questionable value that were artificially created by Wall Street brokers, officially sanctioned by Washington regulators, and falsely rated by Wall Street rating agencies.

These are the sinking assets that are hitting the big Wall Street firms ... panicking investors in Florida and Montana ... even threatening some money market funds.

The irony:

Everyone finally recognizes that these assets are collapsing. But since there's no way of measuring their value until after they're dumped on the market, no one can possibly know how bad that collapse really is until it's too late.

Think of it this way: You own General Motors. You check its share price daily. And you see it's sinking in value. You may decide to tolerate the loss and continue to monitor the situation closely. Or you may decide to cut your loss and get out. Either way, at least you know how much damage it's doing to your portfolio.

That's the situation investors are facing with level three assets right now:

Thousands of local governments, banks and individuals have no idea of exactly when, where or how much they're losing. And it is this unusual level of uncertainty that's creating the conditions for a money panic.

What about the Treasury's efforts to freeze that rate of interest on these investments in order to help millions of homeowners avoid foreclosure? That just adds still more uncertainty, throwing not only the value but also the yield on these securities into question.

Look. I've been screaming "Bloody murder!" about these assets since they were first created. My father did the same before me. But no one would listen. And now, I'm concerned that it could be too late.

Some of Wall Street's Largest Firms Have More
Level Three Assets Than They Have Capital

Specifically, according to data compiled by the Financial Times:

Merrill Lynch has $27.2 billion in level three assets, the equivalent of 70% of its stockholders' equity. In other words, for each $1 of its capital, Merrill has 70 cents in assets of questionable and uncertain value.

Goldman Sachs has $51 billion in level three assets, or 130% of its equity.

Bear Sterns has sunk its balance sheet even deeper into the level-three-asset hole, with $20.2 billion, 155% of its equity.

Lehman Brothers is in a similar situation — $34.7 billion, or 160% of its equity. And ...

Morgan Stanley tops them all with $88.2 billion in level three assets, or 250% of its capital. That's an unwieldy $2.50 cents in level three assets for each dollar of capital. It implies that, in the absence of new capital infusions, all it would take is a 40% loss — and Morgan Stanley's capital could be 100% wiped out.

Bottom line: The huge Wall Street write-downs you've heard about to date — among the largest in history — could be just the tip of the iceberg.

Major U.S. Banks Are Also
Overloaded With Derivatives

Derivatives are bets — sometimes good bets, sometimes bad ones. And the mortgage-backed securities that are ground zero of this crisis are also derivatives. But they're not the only derivatives that could be vulnerable.

My forecast: There are two kinds of derivatives that I believe could be directly impacted by a money panic:

• Interest-rate derivatives. If you think interest rates are going down, you could use these to take one side of the bet. If you think rates are going up, you could use them to take the other side.

• Credit-swap derivatives. If you think a particular borrower is relatively secure, you'd use these to take one side of the bet. Or if you think the borrower is likely to default, you'd take the other side.

The worrisome reality, according to the U.S. Office of the Comptroller of the Currency (OCC):

The rate of growth in these derivatives has been explosive.

At the end of 1994, the total "notional" value of interest-rate and credit derivatives held by U.S. banks was $9.9 trillion. And at the time, I thought that was a lot.

But as of the latest reckoning (June 30, 2007), it was $135.1 trillion, or 13.6 times more!

That's a growth of 1,260% in a huge-but-esoteric investment area that I think could be at the core of a money panic.

And it gets worse:

All told, there are 968 U.S. commercial banks that invest in derivatives. But among them, 963 banks hold a meager 1.5% of all the interest-rate and credit derivatives in America.

In contrast, just five banks hold an amazingly large 98.5% of all the interest-rate and credit derivatives.

From all my studies of history, I find that to be the worst concentration of risk of all time.

The five banks: JPMorgan Chase, Bank of America, Citibank, Wachovia and HSBC. How much risk are they taking? No one knows for sure. But therein lies one of the primary problems.

Yes, we know that not all derivatives are risky.

And yes, we know that the huge "notional" values of the derivatives can overstate their size.

But we also know that the formulas and models used to evaluate their risk levels may not hold up under panicky market conditions.

So although most derivatives can be accurately priced right now, they may be impossible to price in a money panic, much like level three assets.

Huge Exposures
To Credit Risk

Helping to cut through some of the uncertainty, the OCC evaluates the credit exposure of each U.S. bank holding derivatives. In other words, it asks the question:

Regardless of whether the bet is a win or a loss, what happens if the investor on the other side of the bet doesn't pay up?

In normal times, such payment defaults are rare. So this is largely a theoretical question. But in a money panic, when markets can go haywire and available cash financing can suddenly dry up, a chain reaction of defaults could make this a very urgent and practical question.

Here are the answers, according to OCC data:

Overall, including all types of derivatives ...

Wachovia has credit exposure that's equivalent to 89% of its capital. In other words, if all of its counterparties defaulted on their bets with Wachovia, nearly nine-tenths of its capital would be wiped out.

Bank of America is exposed to the tune of 99% of its capital. Assuming no capital infusions, it could be virtually wiped out in an extreme money panic scenario.

And at three banks, the panic would not have to be quite that extreme:

• Citibank has 292% of its capital exposed to this kind of credit risk.

• JPMorgan Chase has 387% of its capital exposed.

• HSBC beats them all with an exposure of 388% of its capital. That means that even if its counterparties defaulted on just 26% of their bets, its capital could be wiped out.

Now, remember what I told you about level three assets — that they don't have a regular place to trade.

Well, we could say something similar about the overwhelming majority of derivatives: They are not traded on regulated exchanges. Rather, they are traded over the counter, based on individually negotiated contracts.

In other words, if there's a default, the parties have to work through it directly, one on one. Exchange authorities are not going to step in to help manage the crisis for them.

And currently, four of the five U.S. banks I named earlier trade over 90% of their derivatives in this way — outside of regulated exchanges.

At JPMorgan Chase, Bank of America, Citibank and HSBC, the derivatives they trade outside of exchanges represent 94%, 93%, 97% and 97% of their total, respectively. Only Wachovia has a somewhat lesser amount in this category — 77%.

End result: Still more uncertainty, still more vulnerability to a money panic.

Coming Tuesday, December 11:
The Fed's Next Belated Response

Fed Chairman Bernanke and his colleagues don't talk about a panic in plain daylight. They dare not even utter the word. But I have little doubt that, behind closed doors, they're talking — and thinking — about it long past the bedtime of most investors.

They know all about last week's panic withdrawals from the Florida and Montana funds.

They know about the surprisingly large losses at some money funds.

They are aware of the collapsing and uncertain value of level three assets ... the big exposure to these assets at major Wall Street firms ... and the grave uncertainty revolving around trillions of dollars in derivatives.

They're not going to let the financial markets slide into a money panic without a fight. Quite the contrary, next Tuesday, December 11, the Fed is going to:

• Slash the discount rate by a quarter or even a half point ...

• Cut their target rate for short-term interbank borrowings (Fed funds), also by a quarter or a half point ...

• Restate, even more firmly, their readiness to do whatever it takes to avert a money panic, and ...

• Even come up with some new, creative ways to pump desperately needed cash into institutions likely to suffer the brunt of a money panic.

For the U.S. economy, already sinking into recession, I think it will be too little, too late.

But for the U.S. dollar, it will be too much, too soon. Its value will plunge anew. Foreign currencies — especially crisis currencies like the Japanese yen — will surge still further.

Three Ways to Escape
A Money Panic

There is no investment that is absolutely safe from all dangers. But in this flammable environment, there are three you should consider very seriously:

Money Panic Escape Vehicle #1. Treasury-only money funds such as:

• American Century's Capital Preservation Fund,

• U.S. Global's U.S. Treasury Securities Cash Fund, or

• Our affiliate's Weiss Treasury Only Money Market Fund.

These funds have never owned — and never will own — level three or even level two assets. They invest exclusively in the highest level, most secure assets in the world — short-term U.S. Treasury securities or equivalent.

When my father, J. Irving Weiss, founded the precursor to today's money funds in the early 1960s, this is precisely the kind of money fund he had in mind. And today, I'm pleased to see there are quite a few still following that model.

The only risk, as I see it: The sinking value of the dollar itself. But you can offset that risk with ...

Money Panic Escape Vehicle #2. As Jack and I explain in our free 50-minute video online right now, the world's paramount "crisis currency" is the Japanese yen. And now, you can conveniently buy Japanese yen through ETFs or even options, aiming for returns of as much as 28 to 1.

Money Panic Escape Vehicle #3. Gold. The daily market price is bound to fluctuate sharply. But with the threat of a money panic ... and with central banks rushing to counter that threat by printing more paper money ... the yellow metal is likely to make the $800-per-ounce level a floor and head for much higher levels.

Good luck and God bless!

Martin

About Money and Markets

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Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Sean Brodrick, Larry Edelson, Michael Larson, Nilus Mattive, Tony Sagami, and Jack Crooks. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include John Burke, Amber Dakar, Adam Shafer, Andrea Baumwald, Kristen Adams, Maryellen Murphy, Red Morgan, Jennifer Newman-Amos, Julie Trudeau, and Dinesh Kalera.

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WaMu is having a bad day (see news on WaMu). I rang the alarms on WaMu twice -most recently in early October - Washington Mutuals Mortgage Division Posts 5th Straight Quarterly Loss and initially in early September - Yeah, Countrywide is pretty bad, but it ain't the only one at the subprime party... Comparing Countrywide to its peers. You see, you don't even have to be a client to like me:-) This upcoming quarter marks the 6th consecutive quarterly loss for their mortgage division. They saw this coming more than a year and a half ago, and so did I. Unfortunately, I covered that short on WaMu a few weeks ago to raise cash, but luckily reinstated it just in time to catch the big drop. I need to write a piece on handling extreme market volatility and holding on to positions. Many of the stocks that I am bearish on have become volatile momentum plays and have detached significantly from their fundamentals. This makes them more than twice as risky, and quite expensive to hold on to - but also offers significant profit opportunity when traders push a proximal bankruptcy candidate up to $30 per share on the call of someone like Stephen Kim from Citibank. I digress (especially since WaMu hasn't been that volatile), and back to the point - I believe that WaMu, like Countrywide, are not the only banks at the subprime underwriting party (the problem is not subprime loans, but subprime underwriting - which spreads the effects throughout the lending industry that includes consumer, corporate, retail and wholesale - and fails to confine it to any one sector of low FICO mortgages), but we will cross that bridge when we get to it.

As for the severity of the situation, peruse:

1. Bubbles, Banks and Builders
2. Bubbles, Banks, and Builders, Pt. Deux
3. Bubbles, Banks & Builders: Pt.III - "Do or Die, Bed Stuy" and
4. Bubbles, Bank, & Builders - Pt IV: I can't believe this guy

Ramble off, 'nuff said!

I have taken the liberty to annotate this well done article from the NY Times to illustrate a few points on the alternative lenders in the news. Since this is a lot of work, I will complete the analysis piecemeal, and post it as it is done as italics in the article. Don't forget to download the attached spreadsheet and follow the links. They are illuminating... For instance, one big bank specialized in no doc, interest only, negative amortization, 90%+ LTV, 40 year amortization, one month adjustable ARM loans that sold mostly at the very top of the real estate bubble (2004 - 2006: meaning collateral going nowhere but down) at just about the lowest point in the interest rate cycle (meaning rates going nowhere but up), aimed primarily at newbie residential investors (read destined for failure) and owner-occupants who had to stretch to get into a house (read shouldn't be getting a loan). This is not subprime, either. Sounds interesting??? Well, it wasn't CountryWide...

On its way to becoming the nation's largest mortgage lender, the Countrywide Financial Corporation encouraged its sales force to court customers over the telephone with a seductive pitch that seldom varied. ''I want to be sure you are getting the best loan possible,'' the sales representatives would say.

But providing ''the best loan possible'' to customers wasn't always the bank's main goal, say some former employees. Instead, potential borrowers were often led to high-cost and sometimes unfavorable loans that resulted in richer commissions for Countrywide's smooth-talking sales force, outsize fees to company affiliates providing services on the loans, and a roaring stock price that made Countrywide executives among the highest paid in America.

Countrywide's entire operation, from its computer system to its incentive pay structure and financing arrangements, is intended to wring maximum profits out of the mortgage lending boom no matter what it costs borrowers, according to interviews with former employees and brokers who worked in different units of the company and internal documents they provided.

One document, for instance, shows that until last September the computer system in the company's subprime unit excluded borrowers' cash reserves, which had the effect of steering them away from lower-cost loans to those that were more expensive to homeowners and more profitable to Countrywide.

From my experience, there is evidence of this from Lehman Brothers, Washington Mutual and potentially IndyMac Bank as well. I am fairly sure that there are surprises to be had from all three of these banks as well in the upcoming quarters, big surprises. These practices were supported indirectly by Citibank, Lehman Brothers and Wamu through their warehouse credit lines to subprime mortgage banks, most of which have gone out of business or scaled down operations. Citibank is no longer giving out new credit lines, and Wamu is now the largest warehouse, and they have been aggressively curtailing their mortgage products, shrinking their asset base (most thrifts seek to increase their asset base) and expanding their deposit business and retail branches (up until last year they were aggressively expanding their retail mortgage only branches). Lehman has also shuttered operations the majority of subprime operations, while JPMorgan Chase has just offered Centex a line with extreme covenants that force repurchase and dictate what products could be underwritten (no non-conforming).

Now, with the entire mortgage business on tenterhooks and industry practices under scrutiny by securities regulators and banking industry overseers, Countrywide's money machine is sputtering. So far this year, fearful investors have cut its stock in half. About two weeks ago, the company was forced to draw down its entire $11.5 billion credit line from a consortium of banks because it could no longer sell or borrow against home loans it has made. And last week, Bank of America invested $2 billion for a 16 percent stake in Countrywide, a move that came amid speculation that Countrywide's survival was in question and that it had become a takeover target - notions that Countrywide publicly disputed.

Homeowners, meanwhile, drawn in by Countrywide sales scripts assuring ''the best loan possible,'' are behind on their mortgages in record numbers. As of June 30, almost one in four subprime loans that Countrywide services was delinquent, up from 15 percent in the same period last year, according to company filings. Almost 10 percent were delinquent by 90 days or more, compared with last year's rate of 5.35 percent.

Wamu's nonperforming loans have doubled from the June 30^th quarter of ‘06 to the most recent quarter, from .62% to 1.29%, but excludes "Excludes nonaccrual loans held for sale" (whatever the hell that means). My best guess is that these are the loans that have not been earmarked for the investment portfolio, and are being held for sale, thus are not held under the accrual accounting rules. If this is the case, these numbers were delivered just before the massive upheaval in the markets where investors totally shunned the MBS products. If my hunch is correct, then "Excludes nonaccrual loans held for sale" category will be forced into the investment portfolio, and this may look bad. The banks tried to sell off the garbage, and Wamu wrote its fair share of it. Reference their option arm product which was not only an annual (and monthly) arm product, but gave the payer the option to go negative amortization (pay a portion of the interest and allow the rest to get tacked onto the principal). This product was aimed at newbie investors and owner occupants who had to stretch to get into a house. Because this had more lax underwriting rules, it offered much, much higher loan to value ratios, to my recollection at least 90%. It's heyday was 2005 and 2006, the height of the housing boom, which means that 90 LTV loan is either underwater already or soon to be. Think about it, negative AM on inadequate collateral using an adjustable rate mortgage during one of the lowest interest rate periods in history. Even in reclaiming the property through foreclosure, Wamu will take a BIG loss on these. Wells Fargo shows a large amount of Level 3 gains in their latest earnings report. Level 3 gains are those market to myth (I mean model) profits that are derived from modeling a price in lieu of obtaining it from the market place. They may be force to keep these on the books for a long time and/or take significant losses on them. More on Wells Fargo later...

I think Wamu got stuck with a lot of this stuff. Reference the footnotes in the attached spreadsheet. We will see come next reporting period, which will put the bank diversification of cash flows mantra to the ultimate test. Their provision for loan losses went up over 60% during the same period from 224 million to 372 million and net charge offs are up 133%. I expect much worse in the upcoming quarter. Unlike Countrywide, Wamu appears to have adequate liquidity due to a larger and more diversified thrift business, but that doesn't mean that they ain't going to lose a lot of money on their less than prudent lending practices. Their tangible equity to total capital is 6.07%, but includes the footnote "Excludes unrealized net gain/loss on available-for-sale securities and derivatives, goodwill and intangible assets (except MSR) and the impact from the adoption and application of FASB Statement No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, as of December 31, 2006. Minority interests of $2.94 billion for June 30, 2007, $2.45 billion for March 31, 2007 and December 31, 2006 and $1.96 billion for September 30, 2006 and June 30, 2006 are included in the numerator." Now this is scary, for these are most likely the derivatives that have no credible bid, thus cannot be priced and/or marked to market. Exactly what is the unrealized net gain/loss and how is it derived? We're talking 20.1 billion in subprime, and almost 30 billion in multi-family loans with a total of 206.7 billion dollars of loans in their portfolio. Wamu does not want high defaults or the impairment of their collateral. I think both are a forgone conclusion due to the aggressive underwriting to obtain these loans, specifically through the Option ARM product. How much so is the question. The Home Loans group within Wamu has taken consistent losses for the last 4 quarters, primarily due to provisions for losses and non-interest expenses.

or click here for a copy.

Many of these loans had interest rates that recently reset from low teaser levels to double digits; others carry prohibitive prepayment penalties that have made refinancing impossibly expensive, even before this month's upheaval in the mortgage markets.

To be sure, Countrywide was not the only lender that sold questionable loans with enormous fees during the housing bubble. And as real estate prices soared, borrowers themselves proved all too eager to participate, even if it meant paying high costs or signing up for a loan with an interest rate that would jump in coming years.

But few companies benefited more from the mortgage mania than Countrywide, among the most aggressive home lenders in the nation. As such, the company is Exhibit A for the lax and, until recently, highly lucrative lending that has turned a once-hot business ice cold and has touched off a housing crisis of historic proportions.

''In terms of being unresponsive to what was happening, to sticking it out the longest, and continuing to justify the garbage they were selling, Countrywide was the worst lender,'' said Ira Rheingold, executive director of the National Association of Consumer Advocates. ''And anytime states tried to pass responsible lending laws, Countrywide was fighting it tooth and nail.''

Started as Countrywide Credit Industries in New York 38 years ago by Angelo R. Mozilo, a butcher's son from the Bronx, and David Loeb, a founder of a mortgage banking firm in New York, who died in 2003, the company has become a $500 billion home loan machine with 62,000 employees, 900 offices and assets of $200 billion. Countrywide's stock price was up 561 percent over the 10 years ended last December.

Mr. Mozilo has ridden this remarkable wave to immense riches, thanks to generous annual stock option grants. Rarely a buyer of Countrywide shares - he has not bought a share since 1987, according to Securities and Exchange Commission filings - he has been a huge seller in recent years. Since the company listed its shares on the New York Stock Exchange in 1984, he has reaped $406 million selling Countrywide stock.

As the subprime mortgage debacle began to unfold this year, Mr. Mozilo's selling accelerated. Filings show that he made $129 million from stock sales during the last 12 months, or almost one-third of the entire amount he has reaped over the last 23 years. He still holds 1.4 million shares in Countrywide, a 0.24 percent stake that is worth $29.4 million.

''Mr. Mozilo has stated publicly that his current plan recognizes his personal need to diversify some of his assets as he approaches retirement,'' said Rick Simon, a Countrywide spokesman. ''His personal wealth remains heavily weighted in Countrywide shares, and he is, by far, the leading individual shareholder in the company.''

Mr. Simon said that Mr. Mozilo and other top Countrywide executives were not available for interviews. The spokesman declined to answer a list of questions, saying that he and his staff were too busy.

A former sales representative and several brokers interviewed for this article were granted anonymity because they feared retribution from Countrywide.

Among Countrywide's operations are a bank, overseen by the Office of Thrift Supervision; a broker-dealer that trades United States government securities and sells mortgage-backed securities; a mortgage servicing arm; a real estate closing services company; an insurance company; and three special-purpose vehicles that issue short-term commercial paper backed by Countrywide mortgages.

Last year, Countrywide had revenue of $11.4 billion and pretax income of $4.3 billion. Mortgage banking contributed mightily in 2006, generating $2.06 billion before taxes. In the last 12 months, Countrywide financed almost $500 billion in loans, or around $41 billion a month. It financed 177,000 to 240,000 loans a month during the last 12 months.

Countrywide lends to both prime borrowers - those with sterling credit - and so-called subprime, or riskier, borrowers. Among the $470 billion in loans that Countrywide made last year, 45 percent were conventional nonconforming loans, those that are too big to be sold to government-sponsored enterprises like Fannie Mae or Freddie Mac. Home equity lines of credit given to prime borrowers accounted for 10.2 percent of the total, while subprime loans were 8.7 percent.

Regulatory filings show that, as of last year, 45 percent of Countrywide's loans carried adjustable rates - the kind of loans that are set to reprice this fall and later, and which are causing so much anxiety among borrowers and investors alike. Countrywide has a huge presence in California: 46 percent of the loans it holds on its books were made there, and 28 percent of the loans it services are there. Countrywide packages most of its loans into securities pools that it sells to investors.

Another big business for Countrywide is loan servicing, the collection of monthly principal and interest payments from borrowers and the disbursement of them to investors. Countrywide serviced 8.2 million loans as of the end of the year; in June the portfolio totaled $1.4 trillion. In addition to the enormous profits this business generates - $660 million in 2006, or 25 percent of its overall earnings - customers of the Countrywide servicing unit are a huge source of leads for its mortgage sales staff, say former employees.

In a mid-March interview on CNBC, Mr. Mozilo said Countrywide was poised to benefit from the spreading crisis in the mortgage lending industry. ''This will be great for Countrywide,'' he said, ''because at the end of the day, all of the irrational competitors will be gone.''

But Countrywide documents show that it, too, was a lax lender. For example, it wasn't until March 16 that Countrywide eliminated so-called piggyback loans from its product list, loans that permitted borrowers to buy a house without putting down any of their own money. And Countrywide waited until Feb. 23 to stop peddling another risky product, loans that were worth more than 95 percent of a home's appraised value and required no documentation of a borrower's income.

Wamu still has their option arm product on their site.

As recently as July 27, Countrywide's product list showed that it would lend $500,000 to a borrower rated C-minus, the second-riskiest grade. As long as the loan represented no more than 70 percent of the underlying property's value, Countrywide would lend to a borrower even if the person had a credit score as low as 500. (The top score is 850.)

The company would lend even if the borrower had been 90 days late on a current mortgage payment twice in the last 12 months, if the borrower had filed for personal bankruptcy protection, or if the borrower had faced foreclosure or default notices on his or her property.

Such loans were made, former employees say, because they were so lucrative - to Countrywide. The company harvested a steady stream of fees or payments on such loans and busily repackaged them as securities to sell to investors. As long as housing prices kept rising, everyone - borrowers, lenders and investors - appeared to be winners.

One former employee provided documents indicating Countrywide's minimum profit margins on subprime loans of different sizes. These ranged from 5 percent on small loans of $100,000 to $200,000 to 3 percent on loans of $350,000 to $500,000. But on subprime loans that imposed heavy burdens on borrowers, like high prepayment penalties that persisted for three years, Countrywide's margins could reach 15 percent of the loan, the former employee said.

Regulatory filings show how much more profitable subprime loans are for Countrywide than higher-quality prime loans. Last year, for example, the profit margins Countrywide generated on subprime loans that it sold to investors were 1.84 percent, versus 1.07 percent on prime loans. A year earlier, when the subprime machine was really cranking, sales of these mortgages produced profits of 2 percent, versus 0.82 percent from prime mortgages. And in 2004, subprime loans produced gains of 3.64 percent, versus 0.93 percent for prime loans.

One reason these loans were so lucrative for Countrywide is that investors who bought securities backed by the mortgages were willing to pay more for loans with prepayment penalties and those whose interest rates were going to reset at higher levels. Investors ponied up because pools of subprime loans were likely to generate a larger cash flow than prime loans that carried lower fixed rates.

As a result, former employees said, the company's commission structure rewarded sales representatives for making risky, high-cost loans. For example, according to another mortgage sales representative affiliated with Countrywide, adding a three-year prepayment penalty to a loan would generate an extra 1 percent of the loan's value in a commission. While mortgage brokers' commissions would vary on loans that reset after a short period with a low teaser rate, the higher the rate at reset, the greater the commission earned, these people said.

Persuading someone to add a home equity line of credit to a loan carried extra commissions of 0.25 percent, according to a former sales representative.

''The whole commission structure in both prime and subprime was designed to reward salespeople for pushing whatever programs Countrywide made the most money on in the secondary market,'' the former sales representative said.

Consider an example provided by a former mortgage broker. Say that a borrower was persuaded to take on a $1 million adjustable-rate loan that required the person to pay only a tiny fraction of the real interest rate and no principal during the first year - a loan known in the trade as a pay option adjustable-rate mortgage. If the loan carried a three-year prepayment penalty requiring the borrower to pay six months' worth of interest at the much higher reset rate of 3 percentage points over the prevailing market rate, Countrywide would pay the broker a $30,000 commission.

When borrowers tried to reduce their mortgage debt, Countrywide cashed in: prepayment penalties generated significant revenue for the company - $268 million last year, up from $212 million in 2005. When borrowers had difficulty making payments, Countrywide cashed in again: late charges produced even more in 2006 - some $285 million.

The company's incentive system also encouraged brokers and sales representatives to move borrowers into the subprime category, even if their financial position meant that they belonged higher up the loan spectrum. Brokers who peddled subprime loans received commissions of 0.50 percent of the loan's value, versus 0.20 percent on loans one step up the quality ladder, known as Alternate-A, former brokers said. For years, a software system in Countrywide's subprime unit that sales representatives used to calculate the loan type that a borrower qualified for did not allow the input of a borrower's cash reserves, a former employee said.

A borrower who has more assets poses less risk to a lender, and will typically get a better rate on a loan as a result. But, this sales representative said, Countrywide's software prevented the input of cash reserves so borrowers would have to be pitched on pricier loans. It was not until last September that the company changed this practice, as part of what was called in an internal memo the ''Do the Right Thing'' campaign.

According to the former sales representative, Countrywide's big subprime unit also avoided offering borrowers Federal Housing Administration loans, which are backed by the United States government and are less risky. But these loans, well suited to low-income or first-time home buyers, do not generate the high fees that Countrywide encouraged its sales force to pursue.

A few weeks ago, the former sales representative priced a $275,000 loan with a 30-year term and a fixed rate for a borrower putting down 10 percent, with fully documented income, and a credit score of 620. While a F.H.A. loan on the same terms would have carried a 7 percent rate and 0.125 percentage points, Countrywide's subprime loan for the same borrower carried a rate of 9.875 percent and three additional percentage points.

The monthly payment on the F.H.A. loan would have been $1,829, while Countrywide's subprime loan generated a $2,387 monthly payment. That amounts to a difference of $558 a month, or $6,696 a year - no small sum for a low-income homeowner.

''F.H.A. loans are the best source of financing for low-income borrowers,'' the former sales representative said. So Countrywide's subprime lending program ''is not living up to the promise of providing the best loan programs to its clients,'' he said.

Mr. Simon of Countrywide said that Federal Housing Administration loans were becoming a bigger part of the company's business.

''While they are very useful to some borrowers, F.H.A./V.A. mortgages are extremely difficult to originate in markets with above-average home prices, because the maximum loan amount is so low,'' he said. ''Countrywide believes F.H.A./V.A. loans are an increasingly important part of its product menu, particularly for the homeownership hopes of low-to moderate-income and minority borrowers we have concentrated on reaching and serving.''

Workdays at Countrywide's mortgage lending units centered on an intense telemarketing effort, former employees said. It involved chasing down sales leads and hewing to carefully prepared scripts during telephone calls with prospects.

One marketing manual used in Countrywide's subprime unit during 2005, for example, walks sales representatives through the steps of a successful call. ''Step 3, Borrower Information, is where the Account Executive gets on the Oasis of Rapport,'' the manual states. ''The Oasis of Rapport is the time spent with the client building rapport and gathering information. At this point in the sales cycle, rates, points, and fees are not discussed. The immediate objective is for the Account Executive to get to know the client and look for points of common interest. Use first names with clients as it facilitates a friendly, helpful tone.''

If clients proved to be uninterested, the script provided ways for sales representatives to be more persuasive. Account executives encountering prospective customers who said their mortgage had been paid off, for instance, were advised to ask about a home equity loan. ''Don't you want the equity in your home to work for you?'' the script said. ''You can use your equity for your advantage and pay bills or get cash out. How does that sound?''

Other documents from the subprime unit also show that Countrywide was willing to underwrite loans that left little disposable income for borrowers' food, clothing and other living expenses. A different manual states that loans could be written for borrowers even if, in a family of four, they had just $1,000 in disposable income after paying their mortgage bill. A loan to a single borrower could be made even if the person had just $550 left each month to live on, the manual said.

Independent brokers who have worked with Countrywide also say the company does not provide records of their compensation to the Internal Revenue Service on a Form 1099, as the law requires. These brokers say that all other home lenders they have worked with submitted 1099s disclosing income earned from their associations.

One broker who worked with Countrywide for seven years said she never got a 1099.

''When I got ready to do my first year's taxes I had received 1099s from everybody but Countrywide,'' she said. ''I called my rep and he said, 'We're too big. There's too many. We don't do it.' ''

A different broker supplied an e-mail message from a Countrywide official stating that it was not company practice to submit 1099s. It is unclear why Countrywide apparently chooses not to provide the documents. Countrywide boasts that it is the No. 1 lender to minorities, providing those borrowers with their piece of the American homeownership dream. But it has run into problems with state regulators in New York, who contended that the company overcharged such borrowers for loans. Last December, Countrywide struck an agreement with Eliot Spitzer, then the state attorney general, to compensate black and Latino borrowers to whom it had improperly given high-cost loans in 2004. Under the agreement, Countrywide, which cooperated with the attorney general, agreed to improve its fair-lending monitoring activities and set up a $3 million consumer education program.

But few borrowers of any sort, even the most creditworthy, appear to escape Countrywide's fee machine. When borrowers close on their loans, they pay fees for flood and tax certifications, appraisals, document preparation, even charges associated with e-mailing documents or using FedEx to send or receive paperwork, according to Countrywide documents. It's a big business: During the last 12 months, Countrywide did 3.5 million flood certifications, conducted 10.8 million credit checks and 1.3 million appraisals, its filings show. Many of the fees go to its loan closing services subsidiary, LandSafe Inc.

According to dozens of loan documents, LandSafe routinely charges tax service fees of $60, far above what other lenders charge, for information about any outstanding tax obligations of the borrowers. Credit checks can cost $36 at LandSafe, double what others levy. Some Countrywide loans even included fees of $100 to e-mail documents or $45 to ship them overnight. LandSafe also charges borrowers $26 for flood certifications, for which other companies typically charge $12 to $14, according to sales representatives and brokers familiar with the fees.

Last April, Countrywide customers in Los Angeles filed suit against the company in California state court, contending that it overcharged borrowers by collecting unearned fees in relation to tax service fees and flood certification charges. These markups were not disclosed to borrowers, the lawsuit said.

Appraisals are another profit center for Countrywide, brokers said, because it often requires more than one appraisal on properties, especially if borrowers initially choose not to use the company's own internal firm. Appraisal fees at Countrywide totaled $137 million in 2006, up from $110 million in the previous year. Credit report fees were $74 million last year, down slightly from 2005.

All of those fees may soon be part of what Countrywide comes to consider the good old days. The mortgage market has cooled, and so have the company's fortunes. Mr. Mozilo remains undaunted, however.

In an interview with CNBC on Thursday, he conceded that Countrywide's balance sheet had to be strengthened. ''But at the end of the day we could be doing very substantial volumes for high-quality loans,'' he said, ''because there is nobody else in town.''

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