Ken Karachi

Ken Karachi

This is the first in a series of articles designed to showcase the historical predictive success of BoomBustBlog and the research team behind it. We will detail several research topics from devastating bank failures to cataclysmic macro events, to unseen monopolies in the making - all to illustrate the value of BoomBustBlog relative to the mainstream media, specialized financial and business media, sell side Wall Street analysts and even think tank and regulatory bodies.

We will kick off this series with our research on what was the 2nd largest commercial REIT in the United States...

GGP abd1c

BoomBustBlog Coverage on General Growth Properties Inc.

Realizing the impending crisis in commercial real estate and the deteriorating economic fundamentals in the US, BoomBustBlog, written by Reggie Middleton, pointed out the trouble General Growth Properties Inc. had and its impact on its stock price in an article (BoomBustBlog.com's answer to GGP's latest press release), early in 2008. According to the article, the possibility of GGP filing bankruptcy was rising with debts payment falling due. The article was published in January 2008, 15 months before GGP filed for Bankruptcy.

Comparison Matrix

Media Houses

First article published on

No. of Articles published

The time lag from BoomBustBlog

The time difference from GGP filing for Bankruptcy

Comments

BoomBustBlog

January 2008

7+ 

  1. Will the commercial real estate market fall? Of course it will.
  2. The Commercial Real Estate Crash Cometh, and I know who is leading the way!
  3. BoomBustBlog.com’s answer to GGP’s latest press release 
  4. Another GGP update coming…

-

Predicted 15 months before GGP's filing for Bankruptcy

Predicted well before filing for Bankruptcy

Bloomberg

-

-

-

-

-

The Wall Street Journal

October 2008

January 2009

2

9 Months

Four months  before (1st article)

Two months before filing for Bankruptcy (2nd article)

Predicted crisis in the commercial property along with GGP

Financial Times

-

-

-

-

-

Forbes

-

-

-

-

-

Reuters

April, 2009

1

15 Months

Zero, as it published on the same day when GGP filed for Bankruptcy

Reacted only after filing for Bankruptcy

The New York Times

April 2009

1

15 Months

Zero, as it published on the same day when GGP filed for Bankruptcy

Reacted only after filing for Bankruptcy

Fortune

-

-

-

-

-

Business Insider

December 2009

1

23 Months

8 months after GGP filed for Bankruptcy

Comparative analysis of fall of GGP

 

Key Highlights:

BoomBustBlog

Reggie Middleton, through his articles, provided comprehensive and some of the earliest warnings about a challenging operating environment for GGP in the wake of deteriorating macroeconomic environment in the US and the Company's substantial financial debt liability. Based on his analysis GGP, a highly leveraged firm was heading into a refinancing-induced liquidity crunch and might have to file for Bankruptcy. Some of the critical points, as highlighted by Reggie, which eventually led to GGP filing for Bankruptcy, includes:

  • Declining rentals of commercial real estate pushed by a slowdown in US consumer spending and a rising unemployment rate
  • Tightening credit market resulting in refinancing challenges for the huge debt liability for GGP
  • The increasing interest burden on the huge debt obligation and inability to outperform in a tight operating environment
  • Low capitalization rates for the properties acquired in 2006-2007 (they simply overpaid by buying at the top of a bubble)
  • Falling Stock prices owing to a slowdown in the commercial real estate sector
  • The distress caused by loose a lending market and sub-prime mortgage crisis
  • Insiders trading activities

The Wall Street Journal

In its first article published in October 2008, WSJ hinted of probable distress in GGP as GGP replaced its chief executive officer and president in a bid to keep its debt load from dragging the Company into Bankruptcy.

In the second article published in January 2009, WSJ pointed the likelihood of a bankruptcy filing for mall giant General Growth Properties Inc., threatening to overlay one of the biggest real-estate bankruptcies ever as GGP was struggling to pay US$2.6 billion credit which was about to mature.

Notably, Reggie had pointed out these facts many months before the article released by WSJ, with his first articles released in the beginning of 2008. At the end of Q4 2007, GGP had US$2.6 billion of debt maturing in 2008. At the end of Q1 2008, GGP had USD2.8 billion due.

Reuters

In its article published in April 2009, right after GGP filing for Bankruptcy, Reuters discussed the reasons leading to Bankruptcy.

Reuters pointed out the failure of GGP to restructure its debt of USD27.29 billion due to the ongoing global financial crisis.

Reuters also pointed out the Bankruptcy of GGP could signal further troubles for other financial institutions who are General Growth creditors.

Notably, Reggie Middleton, in his article in BoomBustBlog, had already pointed this out over a year earlier - that GGP was finding challenges in refinancing its debt obligations due to tightening credit market.

The New York Times

In its article published in April 2009, right after GGP filing for Bankruptcy, The New York Times pointed out the reasons that let GGP file for Bankruptcy.

NYT pointed out that General Growth's Bankruptcy was widely expected as the commercial real estate market was weakening, and GGP was unusually dependent on mortgage financing, as its debts totaled US$27 billion.

NYT also pointed out that GGP could not persuade investors who own more than US$2.25 billion of its bonds to waive payments due in 2009 as debt maturities mounted.

According to NYT, the fall of GGP was seen as a looming crisis in commercial real estate.

Business Insider

In its articles published in December 2009, after 8 months of GGP filing for Bankruptcy, Business Insider pointed out the comparison between the two case studies published by Bill Ackman and Hovde Capital and also stating their facts, that led GGP file for bankruptcy.

Bill Ackman presented the report with its bullish views on the malls and retailers which according to the Hovde Capital are wrong and proved to be wrong. But according to Whitney Tilson’s rebuttal article, the Hovde’s bearish case paints an inaccurate picture of rapidly declining financial performance, then misstates NOI, and then applies an inappropriate capitalization rate a rare trifecta of poor analysis. Also what Whitney Tilson’s said in its article is that, GGP based on their belief that the Company is very likely in the near future to either exit bankruptcy or be acquired.

This is the first in a series of articles designed to showcase the historical predictive success of BoomBustBlog and the research team behind it. We will detail several research topics from devastating bank failures to cataclysmic macro events, to unseen monopolies in the making - all to illustrate the value of BoomBustBlog relative to the mainstream media, specialized financial and business media, sell side Wall Street analysts and even think tank and regulatory bodies.

We will kick off this series with our research on what was the 2nd largest commercial REIT in the United States...

Untitled 79b2f

BoomBustBlog Coverage on General Growth Properties Inc.

Realizing the impending crisis in commercial real estate and the deteriorating economic fundamentals in the US, BoomBustBlog, written by Reggie Middleton, pointed out the trouble General Growth Properties Inc. had and its impact on its stock price in an article (BoomBustBlog.com's answer to GGP's latest press release), early in 2008. According to the article, the possibility of GGP filing bankruptcy was rising with debts payment falling due. The article was published in January 2008, 15 months before GGP filed for Bankruptcy.

Comparison Matrix

Media Houses

First article published on

No. of Articles published

The time lag from BoomBustBlog

The time difference from GGP filing for Bankruptcy

Comments

BoomBustBlog

January 2008

7+ 

  1. Will the commercial real estate market fall? Of course it will.
  2. The Commercial Real Estate Crash Cometh, and I know who is leading the way!
  3. BoomBustBlog.com’s answer to GGP’s latest press release 
  4. Another GGP update coming…

-

Predicted 15 months before GGP's filing for Bankruptcy

Predicted well before filing for Bankruptcy

Bloomberg

-

-

-

-

-

The Wall Street Journal

October 2008

January 2009

2

9 Months

Four months  before (1st article)

Two months before filing for Bankruptcy (2nd article)

Predicted crisis in the commercial property along with GGP

Financial Times

-

-

-

-

-

Forbes

-

-

-

-

-

Reuters

April, 2009

1

15 Months

Zero, as it published on the same day when GGP filed for Bankruptcy

Reacted only after filing for Bankruptcy

The New York Times

April 2009

1

15 Months

Zero, as it published on the same day when GGP filed for Bankruptcy

Reacted only after filing for Bankruptcy

Fortune

-

-

-

-

-

Business Insider

December 2009

1

23 Months

8 months after GGP filed for Bankruptcy

Comparative analysis of fall of GGP

 

Key Highlights:

BoomBustBlog

Reggie Middleton, through his articles, provided comprehensive and some of the earliest warnings about a challenging operating environment for GGP in the wake of deteriorating economic fundamentals in the US and the Company's substantial financial debt liability. Based on his analysis GGP, a highly leveraged firm was heading into a refinancing-induced liquidity crunch and might have to file for Bankruptcy. Some of the critical points, as highlighted by Reggie, which eventually led to GGP filing for Bankruptcy, includes:

  • Declining rentals of commercial real estate pushed by a slowdown in US consumer spending and a rising unemployment rate
  • Tightening credit market resulting in refinancing challenges for the huge debt liability for GGP
  • The increasing interest burden on the huge debt obligation and inability to outperform in a tight operating environment
  • Low capitalization rates for the properties acquired in 2006-2007
  • Falling Stock prices owing to a slowdown in the commercial real estate sector
  • The distress caused by loose lending market and sub-prime mortgage crisis
  • Insiders trading activities

The Wall Street Journal

In its first article published in October 2008, WSJ hinted of probable distress in GGP as GGP replaced its chief executive officer and president in a bid to keep its debt load from dragging the Company into Bankruptcy.

In the second article published in January 2009, WSJ pointed the likelihood of a bankruptcy filing for mall giant General Growth Properties Inc., threatening to overlay one of the biggest real-estate bankruptcies ever as GGP was struggling to pay US$2.6 billion credit which was about to mature.

Notably, Reggie had pointed out these facts much before the article released by WSJ. At the end of Q4 2007, GGP had US$2.6 billion of debt maturing in 2008. At the end of Q1 2008, GGP had USD2.8 billion due.

Reuters

In its article published in April 2009, right after GGP filing for Bankruptcy, Reuters discussed the reasons leading to Bankruptcy.

Reuters pointed out the failure of GGP to restructure its debt of USD27.29 billion due to the ongoing global financial crisis.

Reuters also pointed out the Bankruptcy of GGP could signal further troubles for other financial institutions who are General Growth creditors.

Notably, Reggie Middleton, in his article in BoomBustBlog, had already pointed out that, GGP was finding challenges in refinancing its debt obligations due to tightening credit market.

The New York Times

In its article published in April 2009, right after GGP filing for Bankruptcy, The New York Times pointed out the reasons that let GGP file for Bankruptcy.

NYT pointed out that General Growth's Bankruptcy was widely expected as the commercial real estate market was weakening, and GGP was unusually dependent on mortgage financing, as its debts totalled US$27 billion.

NYT also pointed out that GGP could not persuade investors who own more than US$2.25 billion of its bonds to waive payments due in 2009 as debt maturities mounted.

According to NYT, the fall of GGP was seen as a looming crisis in commercial real estate.

Business Insider

In its articles published in December 2009, after 8 months of GGP filing for Bankruptcy, Business Insider pointed out the comparison between the two case studies published by Bill Ackman and Hovde Capital and also stating their facts, that led GGP file for bankruptcy.

Bill Ackman presented the report with its bullish views on the malls and retailers which according to the Hovde Capital are wrong and proved to be wrong. But according to Whitney Tilson’s rebuttal article, the Hovde’s bearish case paints an inaccurate picture of rapidly declining financial performance, then misstates NOI, and then applies an inappropriate capitalization rate a rare trifecta of poor analysis. Also what Whitney Tilson’s said in its article is that, GGP based on their belief that the Company is very likely in the near future to either exit bankruptcy or be acquired.

 FT.com reports: Central banks flip to gold sales after record rally

Henry Sanderson in London AN HOUR AGO 2 Print this page Central banks became net sellers of gold in August for the first time in a year and a half, in the latest indication that demand for the metal is slowing following a record-setting rally.  Global central banks sold a net 12.3 tonnes of gold over the month, according to estimates published on Wednesday by the World Gold Council, an industry-backed body. The shift came just as the precious metal reached a record high above $2,070 a troy ounce in early August. It has since fallen more than 8 per cent to $1,890 per ounce. The latest data reflect the pullback of some major buyers as countries free up resources to deal with the coronavirus crisis. “All central banks around the world are facing a lot of pressure for liquidity,” said Bernard Dahdah, an analyst at Natixis in Paris. “Now is not the time to hoard gold, the hospitals need the money,” he said. Uzbekistan led the sales, exporting $5.8bn worth of gold in the first eight months of the year, according to government statistics. Central bank purchases have been a lesser factor in this year’s surge in gold, which has been dominated by record demand for gold-backed exchange traded funds. Global investors have poured more than $60bn into such ETFs so far in 2020. But central banks have still bought between 200 and 300 tonnes, according to the WGC’s estimates — worth about $13bn at the lower end, on current prices.

BB19y3dI 8c8f8 

Eurasianet reports: Uzbekistan pins economic fightback on gold sales

The State Statistics Committee revealed on September 21 that the country had exported $5.8 billion of gold in the first eight months of this year. That accounted for half of exports-based revenue.

Just to put that in context, Uzbekistan exported $4.9 billion worth of gold over the whole of 2019 – an amount that then accounted for 27.5 percent of trade turnover.

Uzbekistan became the world’s leading exporter of gold in July, easily outstripping Mongolia’s 6.1 tons with its 11.6 tons of sales. In August alone, it sold $2.5 billion worth of gold. Over the entire duration of 2015, it sold $1.9 billion worth of the metal.

... “The price of gold is at its peak, and economic activity has sunk to its nadir, so I think right now it is necessary to sell gold and foreign exchange reserves, and to use these funds to urgently save the economy from a further decline and to avoid more unemployment,” Nazirov (director of the Capital Markets Development Agency) said.

... Uzbekistan’s external debt burden has surged too. As of July 1, it stood at $17.3 billion, still only equivalent to what is generally deemed a highly manageable 30.3 percent of gross domestic product. It rose by $1.6 billion since the start of the year.

Uzbek economic expert Navruz Melibayev told Eurasianet that while gold is a lifesaver for Uzbekistan in how it generates revenue and helps bridge the trade deficit, reliance on it can only be a time-limited fix.

“We still need to develop industry and other spheres of the economy. Betting on the sale of gold is a temporary measure necessitated by the pandemic and rising prices for this metal,” he said.

The net sale of gold by central banks likely contributed greatly to, if not caused, the 8% drop in the price of gold - which has still risen 30$+ year over year. Of interest will be what happens next. Once the revenues from the gold sales have been used, there is no other ready source of liquid capital for many of the smaller and weaker nations, despite the fact that much of the world is going into a second phase of the COVID disease and related economic contractions. 
gdfg_49c17.png
gdfg1 bb80egdfg12 43efe
 
With the gold reserves gone, what will the countries do to finance their COVID battle efforts? Well, this is what the world's leading economy has done since the pandemic started...

fredgraph 9 5e6b0

They drove interest rates through the floor while spiking the money supply, which drove up the price of gold.  If we were to expand the time series a little, you will see just how egregious this monetary inflation has become....
 fredgraph 10 5153c

 

If I were a gambling man, I would wager the purchase of the gold form these central banks in need may be a worthwhile endeavor...

See what we have recommended central banks in highly inflationary countries do with their gold and our distributed tokenized gold system. It's almost as if we were able to predict this would happen (click a graphic to download and view).

VeGold ARbentina 43759

VeGold Zimbabwe 8682a

VeLend on the cell Phone e5e06

ve assets eea6c

 

NY Mag reports: Citigroup received the most federal funding during the financial crisis for a total of $476.2 billion in cash and guarantees. Next in line for a bailout was Bank of America with $336.1 billion. But between the billions in convenient funding and millions in settlements for failing to disclose risks and losses, the banks have definitely learned their lesson, right? Not according to the panel:

“Very large financial institutions may now rationally decide to take inflated risks because they expect that, if their gamble fails, taxpayers will bear the loss,” the report concluded. “Ironically, these inflated risks may create even greater systemic risk and increase the likelihood of future crises and bailouts. 

 The bank was bailed out in 2008. The article above was published in 2011.It is now 2020. Did Citibank (or for that matter Bank of America, or for that matter any other "Too big to fail" bank) learn their lesson? The answers are "Hell no!" for Citibank (see below), "Absolutely not!" for Bank of America and "Nah!" for JP Morgan and everyone.

Here's a quick four minutes that will walk you through whats going on in 2020. 

Methodology for scrubbing the misleading reporting of Citibank:

  • Step 1: Calculated the average Provision for credit losses quarterly during 2007-2009.
  • Step 2: Calculated the average of Total delinquency quarterly during 2007-2009.
  • Step 3: Calculated the average delinquency as a percentage of Provision for credit losses.
  • Step 4: Calculated the average Provision for credit losses in Q2 2020, using adjusted delinquency in Q2 2020, divided by the average delinquency as a percentage of Provision for credit losses during 2007-2009. 

 

  2007-2009 Q2 2020 - Reported Q2 2020 - Adjusted
Total Delinquency          23,115               2,761           22,853
Provision             7,470               3,885              7,301
Delinquencies as a percent of provisions 309% 71% 313%

 

 The results? Uh Oh! We've seen this movie before, haven't we? Just send this information viral, and remember where you heard it first. We want the credit!

There's a lot more to see in the upcoming weeks. Stay tuned!! See also: Analysis of JP Morgan's Horrible, Terrible, No Good 2nd Quarter and 

 

A list of Reggie Middleton calls from the past....

 Is this the Breaking of the Bear?Joe Lewis on the Bear Stearns buyoutBSC calls are almost free and the JP Morgan Deal is not signed in stoneThis is going to be an exciting, and scary morningAs I anticipated, Bear Stearns is not a done deal

  1. Correction, and further thoughts on the topic and How Far Will US Home Prices Drop?
  2. (not a single sell side analyst that we know of made mention of this very material point in the industry):Lennar, Voodoo Accounting & Other Things of Mystery and Myth!
  3. (2 months before Bear Stearns fell, while trading in the $100s and still had buy ratings and investment grade AA or better from the ratings agencies): Is this the Breaking of the Bear?|Joe Lewis on the Bear Stearns buyout Monday, March 17th, 2008:BSC calls are almost free and the JP Morgan Deal is not signed in stone Monday, March 17th, 2008 |This is going to be an exciting, and scary morning Monday, March 17th, 2008 | As I anticipated, Bear Stearns is not a done dealTuesday, March 18th, 2008 []

  4. :Is Lehman really a lemming in disguise?Thursday, February 21st, 2008 | Web chatter on Lehman Brothers Sunday, March 16th, 2008 (It would appear that Lehman’s hedges are paying off for them. The have the most CMBS and RMBS as a percent of tangible equity on the street following BSC. The question is, “”. I’m curious to see how the options on Lehman will be priced tomorrow. I really don’t have enough. Goes to show you how stingy I am.) |I just got this email on Lehman from my clearing desk Monday, March 17th, 2008| Lehman stock, rumors and anti-rumors that support the rumors Friday, March 28th, 2008 | It appears that I should have dug deeper into Lehman! May 2008
    1. Will the commercial real estate market fall? Of course it will.
    2. Do you remember when I said Commercial Real Estate was sure to fall?
    3. The Commercial Real Estate Crash Cometh, and I know who is leading the way!
    4. Generally Negative Growth in General Growth Properties - GGP Part II
    5. General Growth Properties & the Commercial Real Estate Crash, pt III - The Story Gets Worse
    6. BoomBustBlog.com’s answer to GGP’s latest press releaseandAnother GGP update coming…(among over 700 pages of analysis, review the January 2008 archives or search for “GGP” for more research).
  5. Municipal bond market and the securitization crisis – part 2
  6. The collapse of the regional banks (32 of them, actually) in May 2008:As I see it, these 32 banks and thrifts are in deep doo-doo! as well as
  7. : “Can You Believe There Are Still Analysts Arguing How Undervalued Goldman Sachs Is? Those July 150 Puts Say Otherwise, Let’s Take a Look”,“When the Patina Fades… The Rise and Fall of Goldman Sachs???“andReggie Middleton vs Goldman Sachs, Round 2)
  8. (potentially soon to be the Global Sovereign Debt Crisis) starting in January of 2009 and explicit detail as of January 2010:The Pan-European Sovereign Debt Crisis
  9. I Suggest Those That Dislike Hearing “I Told You So” Divest from Western and Southern European Debt, It’ll Get Worse Before It Get’s Better!
  10. , May 2010: More on the Creatively Destructive Pace of Technology Innovation and the Paradigm Shift known as the Mobile Computing Wars»

Business Insider reports: How 2020 broke the housing market: So many homes are selling that we could run out of new houses in months. Of course, many are likely asking, "But I thought you called this 'The Great Global Real Estate Crash of the 2020s'?".

Well, the Business Insider article depicts a structural shit in real estate preferences - a move form urban apartments to larger urban houses and suburban ans smaller town single family housing. This demand is hitting limited supply, as homebuilders are wary of overbuilding during a market bubble top - as they have learned their lessons from 2008. Add increased demand to limited supply, and record low mortgage rates (which increase demand through greater affordability) and you get higher prices. These higher prices are rising so sharply, that they more than negate the affordability increase gained from lower mortgage rates. I quote the article above:

"as of the end of July, lower mortgage rates had given buyers an extra 6.9% in purchasing power, but house prices were up 8.2% year-over-year at that point — and they've kept going up since.

In fact, the 2% appreciation in national home prices between May and July was the biggest two-month jump since at least 1991, which was when the Federal Housing Finance Authority started tracking those changes in an index."

Regardless, the crash still cometh. Why? Because:

  1. banks are tightening credit standards to brace for pandemic and popping bubble losses See .
  2. Those jobless claims are STILL (yes, even after 25 weeks) the nastiest they've been since records were kept...
  3. As a matter of fact, if we throw in the most recent numbers, and compare everything to the pre-COVID all-time high record in unemployment claims, the point is undeniable. Where will the money come from to pay for all of those new mortgages, nationwide?
  4. fredgraph 7 fecb2
  5. Take note that there has never been a time since the beginning of record keeping that initial unemployment insurance claims, continuous unemployment insurance claims, and the unemployment rate have been this high and/or have spiked nearly as hard. At the same time, there has never been so drastic a drop in GDP, either. Basically, you are quite possible biting off of big chunk of hard times going into debt now for a residential residence, particularly as prices are spiking. This is not just my opinion, as you can see from below...
  6. 55% of Homeowners Regret Taking Out a Mortgage During the Pandemic

Lett's jump straight into this, shall we? This is the state of the US, as of right now versus the comparable period last year...

A quick description of what we see...

  • Unemployment rate very recently peaked at an all-time high, then eventually fell to a level that matched the highest unemployment on record after 21 weeks of damage.
  • Federal debt is at an all-time high, both in nominal terms and real terms, and still climbing at a breakneck, record pace
  • GDP has fallen more, and faster than any time on record, and is still plunging. Real gross domestic product (GDP) decreased at an annual rate of 32.9 percent in the second quarter of 2020, according to the "advance" estimate released by the Bureau of Economic Analysis. In the first quarter, real GDP decreased 5.0 percent.
  • Meanwhile, the US monetary base has spiked both more sharply and farther than at any other time on record. That's right, sharp monetary inflation at the same time that we are having a sharp drop in GDP and productive output - at the same time that we are seeing record government debt, at the same time we are seeing record unemployment.

The stock market should be in the shitter right now, but....

The broad market averages fell, then spiked high, sort of like the unemployment numbers. So, practically every number is bad, GDP, employment, federal debt, monetary  inflation... The only way the stock market could spike in such a situation is through dramatically stronger earnings, right?Well, let's take a look.

In the energy sector, we have Chevron. This is its earnings history leading into the worst depression this country has ever seen....

Yet look at its P/E graphed along time.... What?!?!!?!?

Yeah, I know!

How about Apple, who sells some of the most expensive computer and cell phone equipment available going into a depression....

How about Nvidia, who sells chips into those most expensive cell phones and computing things available going into a depression?

This entire 16 page deck, as well as a host of other insightful analysis and commentary is available to BoomBustBlog subscribers here.

 

 

     Before we get started with my dark missive, let's clarify the title with a few definitions and a brief history lesson:

    Voodoo Accounting - Any form of accounting that does not follow principles of conservatism. While there are many methods by which financial statements can be fudged, it always comes down to inflating revenue or hiding expenses. Any method that boosts profitability through accounting tricks eventually catches up with the company. As soon as it does "poof", past profits disappear like magic. (Hence the name "voodoo accounting"). My calculation of Lennar's fully consolidated financial statements show that about 40% of its full recourse debt lies off balance sheet.

Zombie - Companies that continue to operate even though they are insolvent or near bankruptcy. Zombies often become casualties to the high costs associated with certain operations. Most analysts expect zombie companies to be unable to meet their financial obligations. Also known as the "living dead" or "zombie stocks".

Insolvency - a financial condition experienced by a person or business entity when their assets no longer exceed their liabilities.

Lennar Corporation - a company that I am short that is:

  1. borderline insolvent;;
  2. makes use of voodoo accounting to book profits from assets held off balance (to boost performance metrics) and conceals significant debt off balance sheet as well (to health metrics);
  3. is operating at negative margins;
  4. significantly discounting an exorbitant amount of inventory that is extremely overvalued in a highly unfavorable macro environment that is getting worse, not better.

Enron - The Enron scandal was a financial scandal that was revealed in late 2001. After a series of revelations involving irregular accounting procedures bordering on fraud, perpetrated throughout the 1990s, involving Enron and its accounting firm Arthur Andersen, it stood at the verge of undergoing the largest bankruptcy in history by mid-November 2001. Enron filed for bankruptcy on December 2, 2001.

As the scandal was revealed, Enron shares dropped from over US$90.00 to just pennies. Enron's plunge occurred after it was revealed that much of its profits and revenue were the result of deals with special purpose entities (limited partnerships which it controlled). The result was that many of Enron's debts and the losses that it suffered were not reported in its financial statements. In addition, the scandal caused the dissolution of Arthur Andersen, which at the time was one of the world's top five accounting firms.

Historical dictionary ends here, Dark Missive restarts...

Unfortunately, it appears that I have reached formatting limits of the blogging mechanism that I am leasing, so the charts may be a little difficult to read. Here is a .pdf verstheion of the analysis portion of this blog post (the part without my smart ass opinions) which should be more legible for those who have a problem reading the html blog version below. Feel free to distribute it at will.

Now, to the point - Lennar is leveraged to the hilt. They have a significant amount of debt, a murderous macro environment, a dead business model, and cut throat competition. They also have a lot of secrets hidden off balance sheet. I will leave the research report below untouched, and simply add some highlights here (due to my inability to post the edits).

 Now, after that brief history and vocabulary lesson, I need someone like Stephen Kim from Citibank to issue another fundamentally silly, yet overly bullish report on the homebuilders again so I can strengthen my short position on Lennar. Before the pundits and legal eagles come after me, let it be known that I am not accusing Lennar of fraud or wrongdoing, but I am accusing them of underperformance and the use of off balance sheet vehicles to conceal assets, debt, and risk from investors. What's the difference, you ask? Well, there is reality in the accounting sense, and economic reality. Lennar has $5.5 billion of off balance sheet debt, more than a billion of that fully recourse or otherwise holding the company directly liable. They have not violated GAAP rules, to my knowledge. But, the economic reality is that debt is debt, liabilities are liabilities and ROI and ROA are real measures of performance. Despite the fact that LEN's books are kosher from an accounting perspective belies the fact that they are highly misleading from an economic perspective, which is the perspective that rewards the investor.

To put this into perspective, notice that a proper forensic consolidation of Lennar's full recourse debt (and debt that can attach to the parent company assets through contractual means) shows that Lennar carries about half of its debt, and probably even more of its total liabilities off balance sheet and does not report on it. That is scary for a company that is writing down assets by the billions and is facing sequential quarterly losses in a negative macro environment amongst intense competition. As mentioned in the parenthetical, I have been very, very conservative in this forensic examination. Absolutely no non-recourse debt is involved (I had $3.5 billion of non-recourse to choose from, and it still draws debt service and encumbers assets). My models are flexible enough to granularly segregate the various tranches of debt and include them at will.

Properly including contractually enforceable and full recourse debt shows an extremely high probability of bankruptcy in 8 quarters. The currently published probability is in the high 80% range, though to be conservative the graph states 72%.

Including JV's

In my opinion, and according to some extremely thorough research, Lennar should have been rated as deep junk as far back as 2005. It's debt to enterprise value, debt to equity, debt to capitalization, and practically any other metric that measures debt or earnings quality looks dismal, indeed.

I am sure many of you are saying that they just have to last a few quarter to grow out of this…

 

This graph of gross margins looks more like a Stephen King animated horror graphic than a financial projection, but it is highly justified (see the report below). Lennar will probably not see positive numbers until after 2012.

 Now, on to the formal analysis:

Before we go on, here's a snapshot of Reggie Middleton’s Boom, Bust & Bling Blog Real Estate Analysis that you may find of interest. If you are a regular to the blog, feel free to skip ahead to the analysis:

Home Building Industry: Myths, Markets & Manipulators: The Real Deal on the HomebuildersBubbles, Banks and BuildersBubbles, Banks, and Builders, Pt. DeuxBubbles, Banks & Builders: Pt.III - "Do or Die, Bed Stuy"Bubbles, Bank, & Builders - Pt IV: I can't believe this guyStraight Talk From the Homebuilder CFO: The Coming Land Recession, Pt IStraight Talk From the Homebuilder CFO: The Coming Land Recession, Pt IIStraight Talk From the Homebuilder CFO: The tricks builders use to disguise the true losses on their book valueStraight Talk From the ex-Homebuilder CFO: Yes.. straight from the Lennar CEOs mouth... land has zero value...What does Reggie Middleton and Ryland's upper management have in common? They are both selling shares faster than no doc loans get approved!Thoughts on the US Publicly Traded HomebuildersCorrection, and further thoughts on the topicWho else is in trouble?As was predicted in the homebuilders annual reports, and this blog...The Performance of Centex's Mortgage Originations, or CountryWide Redux, pt IIIIt's approaching "Do or Die" time for the homebuilders - Will desperation tank the US real estate market?Hovnanian Announces Successful Preliminary "Deal of the Century", OR Hey, Our Marketing/PR Team Pulled it Off, and We Finally Got Some Positive Press!!!Credibility is the Key to Success for a CEO – Hovnanian has Lost that Key: A letter to Mr. HovnanianKB Home's Numbers are Horrible, and that's putting it mildly!Apply "COMMON SENSE" when evaluating the home builders!Home builders are up over 20%, housing prices to drop 28% over 4 yrs, inventory > 8%, listings >1.2% - Shorts, Anybody???Potential Home Builder Bankruptcy

Global Macro: Okay, I have just recharged the batteries in my crystal ball: Back tested Home Price Trends - Historical and Forecasted|Quick note on increase in construction spending: not necessarily good economic newsThere is no recession, the economy is in fine shape, and business is strong!!!More than lower interest rates fueled the recent real estate boomNY Housing Trends: Where is NYC Headed?Manhattan Real Estate is Falling. That's Right, I said it!!! And Beware Those with Short Term Memory.Beware, even the strong rental market!The Case-Shiller Index for the Month of JulyProspects for the Stock Market: What Are the Fundamentals?The Unusual Behavior of the Federal Funds and 10-Year Treasury Rates: A Conundrum or Goodhart’s Law?Whaaat!! How much did you cut?Rates are still going up, Mr. BernankeDangerous Times: Where are the Experts?What can the Fed really do to help adjustable rate mortgage holders? Close to nothing...The "Real" Trend in US Housing Prices...For those who feel the world has decoupled from the US economically - and in the financial markets, I bring you “The Great Global Macro Experiment”How Far Will US Home Prices Drop?

Corporate Earnings and Finance A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie MiddletonWashington Mutual get hits hard - you were warned here about this in September!COUNTRYWIDE POSTED its first quarterly loss in 25 years on $2.27 billion in mortgage losses and write-downs and soaring credit-loss reserves. But...Washington Mutuals Mortgage Division Posts 5th Straight Quarterly LossYeah, Countrywide is pretty bad, but it ain’t the only one at the subprime party… Comparing Countrywide to its peersAre the Mortgage Insurers in Serious Trouble?Rampant share buybacks bold ill for future growth

Investment Summary

Lennar's financial performance continues to be thwarted by the continuing slowdown in the US residential housing sector. The company's EPS continued its downward momentum in the sixth consecutive quarter, falling to a loss per share of $3.25 in 3Q2007 from $3.57 in 2Q2006. As declining consumer confidence and tightening credit conditions continue to hamper the housing demand and pricing, the prospects of near-term recovery in the homebuilding sector are currently bleak. Going forward, investor confidence in the sector can only be expected to worsen as disclosures are made of the hitherto concealed off-balance sheet liabilities of homebuilding companies. Lennar's is a case in point with the company's recent 8K filing highlighting the company's exposure to around $1.0 billion of its unconsolidated joint ventures (JV) debt with potential exposure to almost 100% of the latter's additional $4.5 billion liabilities.

Key Points

  • $5.5 billion of hidden debt- As of August 31, 2007, Lennar's hidden debt through JV's stood at a staggering $5.5 billion. Including reimbursement agreement with partners, Lennar's maximum recourse exposure stands at a $1.0 billion. Additionally, Lennar has approximately $0.25 billion of debt in form of recourse through reimbursement agreements and $0.68 billion as joint and several recourse debts. Besides these, the JVs also have $3.7 billion of non-recourse debt. Aptly in response to this mounting debt in November 2007, S&P had lowered Lennar's debt rating as junk to BB+ from BBB- earlier. Earlier in October 2007, Moody's had downgraded Lennar's debt ratings to junk status.
  • Falling backlogs and rising inventory - With declining consumer confidence in the residential housing market and tight credit supply triggering waves of home booking cancellations, homebuilders including Lennar, are facing declining backlogs and rising inventory levels. We expect Lennar's order backlog to decline as new order volumes continue to fall. Lennar's operating days backlog fell to 91 days as on August 31, 2007, from 104 as on August 31, 2006 and we expect this to further decline to 85 days as on February 28, 2008. To lower its inventory levels, the company is offering price incentives on home sales while also doing away with land options in hand. For nine months ended August 31, 2007, the company incurred $343.3 million expense relating to option deposits and pre-acquisition costs on land options it does not intend to purchase, reflecting company's reluctance to build up further inventory. In 3Q2007, Lennar's controlled home-sites and total home-sites declined 42.3% and 32.8%, respectively, over 3Q2006.
  • Pressure on margins – In order to reduce standing inventory, homebuilders across the industry are re-pricing existing home prices to reduce their order backlog. Heavy discounting coupled with use of incentives and incentivized brokerage fees is driving Lennar's realized prices downward. The company's gross margin excluding FAS144 adjustments has declined from 26.0% in 2006 to 18.4% in 2006 and further declined to 14.4% for nine months ending August 2007, while its net margin declined from 14.0% in 2005 to 6% in 2006. For nine months ending August 31, 2007, net margins declined to a negative of 12.3%. As Lennar continues to adjust its pricing to meet current market conditions, we expect a further deterioration of the company's net margins. We expect Lennar's operating margin to decline to turn negative of 16% and 18% in 2007 and 2008, respectively.
  • Higher levels of inventory impairments - To reflect the deteriorating market conditions, Lennar is on land impairment and write-off spree. In 3Q2007, the company reported total valuation adjustments of $856 million related to the valuation adjustments, write-offs of option deposits and pre-acquisition costs, goodwill and notes receivable. As the company adjusts its balance sheet to reflect current market conditions, we expect inventory impairments to continue till 2010 to reflect expected downward trend in prices.
  • High exposure to overheated markets – In 2006 Lennar derived 36.8% of its revenues from Western markets including California and Nevada, and 31.3% from Eastern markets including Florida, Maryland, New Jersey and Virginia. Lennar's high exposure to over-heated markets including Florida and California prove to be a drag on the earnings of the company in the near-to-medium term, in our view.
  • Muted 3QFY2007 results – Lennar reported a net loss of $513.9 million, or $3.25 per diluted share in 3Q2007, compared with net earnings of $206.7 million, or $1.30 per diluted share, in 3Q2006. Revenues from homebuilding declined 44.2% to $2.2 billion in 3Q2007 from $4.0 billion in 3Q2006, primarily off a 41.4% decline in home deliveries and a 5.1% decline in average sales price. As a result of declining consumer confidence and stringent lending standards, Lennar's new home orders declined 47.5% to 5,084 million in 3Q2007 from 11,056 million in 2Q2007 with an order backlog of 6,367 million as of August 31, 2007.

Lennar's homebuilding volumes:

For new orders' estimates, we have used data pertaining to building permits from State of the Cities Data Systems (SOCDS), new housing starts and new home sales from US Census Bureau, and have identified key representative states/ cities in which Lennar operates.

 

Region

Source

Representative states/ cities

East

  • SOCDS – Building permits
  • Maryland, Florida
  • US Census Bureau Housing starts and new home sales
  • Northeast - Florida, Maryland and New Jersey
  • South - Virginia

Central

  • SOCDS – Building permits
  • Texas
  • US Census Bureau Housing starts and new home sales
  • West - Arizona and Colorado
  • South – Texas

West

  • LAECD
  • California
  • SOCDS – Building permits
  • California and Nevada
  • US Census Bureau Housing starts and new home sales
  • West - California and Nevada

Other

  • SOCDS – Building permits
  • Illinois, Minnesota, North Carolina and South Carolina
  • US Census Bureau Housing starts and new home sales
  • Midwest - Illinois, Minnesota
  • South - North Carolina, South Carolina, Alamba
  • Northeast - Pennsylvania, New York, Delaware and Massachusetts

 

The above sources have been assigned weights; higher weights assigned to SOCDS building permits data since it tracks the trend state-wise and reflects the expected new construction activity, in turn indicating the new orders received.

We expect Lennar's Western regions to experience the steepest decline in new orders followed by Eastern and Central regions. Overall we expect Lennar to post a decline in new orders by approximately 35% and 19% for 2007 and 2008, respectively. However from 2009 onwards, we expect new orders growth to pickup in all the regions except west which would continue to be a drag on overall volume growth till 2010.

Lennar's homebuilding price:

To forecast average price for building, we have used key US home prices indices - Home Price Index (HPI) sourced from Office of Federal Housing Enterprise Oversight (OFHEO), S&P/Case-Shiller Home Price Index reported by Standard and Poor's (S&P), Home Asking Prices from Housing Tracker and Condor Prices from Radar Logic. For each region, we have identified states/ cities, whose price indices are available, as follows -

 

Region

Source

Representative states/ cities

East

OFHEO

Florida, New Jersey, Maryland, Virginia

S&P

Florida – Miami, Tampa

Housing tracker

Florida – Miami, Tampa

Radar Logic

Florida – Miami, Tampa

Central

OFHEO

Arizona, Colorado, Texas

S&P

Arizona - Phoenix, San Diego, San Francisco

Colorado – Denver

Texas – Dallas

Housing tracker

Arizona – Phoenix, San Diego

Texas – Dallas

Radar Logic

Arizona - San Diego, San Francisco

Colorado – Denver

West

OFHEO

California, Nevada

S&P

California - Los Angeles

Nevada - Las Vegas

Housing tracker

California - Los Angeles

Nevada - Las Vegas

Radar Logic

California - Los Angeles

Nevada - Las Vegas

Other

OFHEO

Illinois, Minnesota, New York, North Carolina, South Carolina, Alabama, Pennsylvania , Delaware and Massachusetts

S&P

Illinois - Chicago

Minnesota - Minneapolis

North Carolina - Charlotte

Massachusetts - Boston

Housing tracker

Illinois - Chicago

Minnesota - Minneapolis

Radar Logic

Illinois - Chicago

Massachusetts - Boston

 

The above sources have been assigned weights to forecast pricing growth at each of Lennar's operating regions. For S&P/Case-Shiller Home Price Index we have used forecasted values from S&P. We have computed historical spread for Housing tracker and Radar Logic with Case-Shiller Home Price Index to computed forecasted values for Housing tracker and Radar Logic. Currently we have assigned higher weights to S&P/Case-Shiller Home Price Index since they represent forecasted values.

Housing price in US continues to deteriorate owing to excess supply as there is a very big push to reduce standing inventory across the industry. Existing home builders are re-pricing their existing inventory in order to sell their order backlog. Excess supply situation further fuelled by flat to down housing demand coupled with use of incentives, price reductions, and incentivized brokerage fees is putting downward pricing pressure. Overall we expect average home price to decline 5.1% and 5.2% in 2007 and 2008, respectively. We expect Lennar's home price to continue to decline till 2010.

Lennar's Homebuilding revenues:

We expect Lennar's homebuilding revenues to witness a decline of 39.3% and 32.9% in 2007 and 2008, respectively, to reach $9.49 billion and $6.37 billion in 2007 and 2008. We expect revenues to continue to decline till 2009 (8.6%). For 2010 we expect revenues to remain nearly flat. For 2011 and 2012, we expect Lennar's homebuilding revenues to increase by 3.3% and 6.3%, respectively.

Lennar's Homebuilding cost of sales:

We expect Lennar's per cost of sales excluding impairment to grow at a modest pace of 1.9% and 2.3%, in 2007 and 2008, respectively. To reflect the deteriorating market conditions, Lennar is on land impairment and write-off spree. For nine-months ending August 31, 2007, Lennar reported valuation adjustment of $1.2 billion. We expect Lennar to write-down its inventory till 2010 as we expect home prices to continue to fall till 2010. However, we believe Lennar to write-down most of its inventory in 2007. Resultantly, we expect Lennar's unit cost of sales including impairment to increase by 8.1% in 2007. However owing to significant decline in deliveries, Lennar's total cost of sales are expected to decline by 28.8% and 30.3% in 2007 and 2008, respectively.

Lennar Financial service revenues:

In addition to increasing interest liabilities on warehouse lines of credit increase, growing disability to re-sell their mortgages in the secondary market is posing a challenge for most homebuilders in the US who offer mortgage financing to its buyers. This should have an adverse effect on Lennar's financial services segment as well as on its loan originations.

During 2006, Lennar originated approximately 41,800 mortgage loans of approximately $10.5 billion. Substantially all of the loans the Financial Services segment originates are sold in the secondary mortgage market on a servicing released, non-recourse basis; however, the Company remains liable for certain limited representations and warranties related to loan sales.

We believe that difficult conditions in the credit market will impact the spreads for Lennar. Consequentially, we expect Lennar's margins in the financial segment to further deteriorate from the existing levels. We expect Lennar's gross margin in the financial segment to decline from 4.4% in 2007 to a negative of 10.6% in 2009. However with pick-up in new orders starting 2009 and a consequential increase in mortgage origination, we expect margins to stabilize. Going forward for 2011 and 2012, we expect Lennar's margins for Financial services at 3.9% and 7.3%, respectively.

Lennar's share price vis-à-vis U.S housing index

Lennar's share price has shown a high degree of correlation with the US housing prices. Lennar's share price has immensely benefited during the boom in the US housing market driven by significant growth in housing prices. Between January 2000-2007 Lennar's share price has yielded 598% returns to its shareholders. During the corresponding period housing prices increased 807%. However with decline in land prices starting mid-2006,and expected to continue into next few years, we envisage Lennar's share price to remain under pressure.

Owing to declining trend in US home price, Lennar's operating margin has declined from a peak of 10% in 2005 to 4% in 2006 and is expected to turn to a negative of 13% and 12% in 2007 and 2008, respectively. Lennar's Z-score has declined from 3.73 in 2004 to 3.03 in 2006 and we expect it to decline further to 2.24 in 2007 and 2.02 in 2008, indicating warning signals towards bankruptcy. However, 2009 onwards we expect Lennar to be in serious financial trouble with high probability of bankruptcy with its Z-score falling to 1.76.

Impact of housing price on Lennar's solvency

Deterioration of Lennar's revenues and gross margins:

Lennar's homebuilding revenues witnessed an increase of 33.0% and 17.4%, in 2005 and 2006. However for nine-months ended August 31, 2007, Lennar's revenues declined 33.7% owing to deterioration in U.S housing markets. Consequentially for 2007, we expect Lennar's homebuilding revenues to decline 39.3% to $9.5 billion owing to 34.1% decline in deliveries and 5.1% decline in average home price. We expect revenues to continue to decline in 2008 (32.9%) and 2009 (8.6%). However post 2009, we expect slowdown in US housing markets to ease off and resultantly we expect a nominal 0.1%, 3.3% and 6.3% increase in homebuilding revenues for 2010, 2011 and 2012, respectively. Lennar's west and east markets which include operations in California and Florida, respectively, are expected to be the worst effected regions and hence we expect Lennar's homebuilding revenues in west and east markets to fall 41.6% and 43.5%, respectively in 2007. Further in 2008 we expect revenues from these two regions to fall further by 37.4% and 31.6%, respectively.

To accurately reflect the current market conditions, Lennar wrote-off significant impairments in its inventory. For 2Q2007 and 3Q2007, Lennar reported a total valuation adjustment of $857 million including $303 million valuation adjustment relating to finished homes, CIP and land on which the Company intends to build homes, and $242 million pertaining to option write-offs and pre-acquisition costs on land options. Lennar's homebuilding gross margin including impairment charges declined from 15.7% in 2005 to 6.1% in 2006 and is expected to decline further to a negative 14.6% in 2007 and a negative 16.3% in 2008.

Historical trends in revenues and gross margin:

During the US housing boom, Lennar's revenues increased more than three folds to $16.3 billion in 2006 from $4.7 billion in 2000. However following the recent slowdown in US housing markets, revenues for nine months ended August 31, 2007 declined 33.3% to $8.0 billion from $12.0 billion over corresponding period last year. We expect the decline in Lennar's revenues to persist in 2008 and 2009 with 2007 and 2008 revenues falling significantly by an expected 38.8% and 32.7%, respectively, to $10.0 billion and $6.7 billion. This represents a realistic 4.5% long-term CAGR 2000-2008, against the growth trajectory witnessed during 2000-2006 at a CAGR of 23.0%, which is highly unsustainable.

Hidden liabilities via consolidated JV's:

According to recent 8-K filed by Lennar on November 6, 2007, total debt of unconsolidated JV's stood at $5.5 billion. Out of this $1.2 billion is in the Lennar's maximum recourse exposure. Including a $0.26 billion reimbursement agreements with partners, Lennar's net recourse exposure is approximately $1.0 billion. We believe that since this debt is recourse in nature, the Company is directly accountable in case of default. As a result, we have consolidated the entire debt of $1.0 billion including effect of interest payments on financial statements of Lennar.

In addition to this, Lennar also has $0.67 billion in form of partner's several recourse and $3.7 billion of non-recourse debt. Since this debt is non-recourse in nature, we have currently excluded the impact of non-recourse debt on Lennar's financial statement.

Lennar's balance sheet including JV's debt (including recourse debt and 0% of non-recourse debt)

Even with the most conservative approach after considering only the recourse debt of $1 billion (to which the company remains liable by way of recourse debt) out of total debt from JV's worth about $5.5 billion, Lennar's 2007 debt to capitalization jumps to 83.7%. For 2010, Lennar's debt to capitalization would be 152.2% which is further expected to worsen to 199.1% by 2011.

Drop in credit ratings:

On standalone basis excluding the impact of JV's debt, Lennar's Z-score is expected to worsen with further deterioration in the housing sector. While the company's Z-score (excluding the impact of debt from unconsolidated JVs) declined from 3.73 in 2004 to 3.03 in 2006, we expect this to further fall to 2.24 in 2007 indicating warning signals about potential financial problems. The company's Z-score may worsen to 1.76 in 2009 with industry conditions remaining unfavorable and in the absence of any committed initiatives by the company to recover from its current problems.

Considering the full impact of recourse debt with 0% non-recourse debt, Lennar's Z-score further falls to 2.02 for 2007 and to 1.77 in 2008, Indicates serious financial trouble and a high probability of bankruptcy.

In November 2007, S&P had lowered Lennar's debt rating as junk to BB+ with a negative outlook from BBB- earlier. As per S&P, the prime reason for the rate cut was "weakened credit measures, Lennar's concentration in highly competitive and oversupplied housing markets, and the company's considerable investment in off-balance-sheet joint ventures." In October 2007, Moody's had downgraded Lennar's debt ratings to junk status.

Valuation:

Relative:

Earnings approach:

We believe that owing to volatility of earnings, earnings based valuation, including DCF and EP, is not appropriate for the housing sector. Based on relative valuation using P/B multiple we expect Lennar's share price is at $20.43 against current share price of $16.02. This is a valuation based solely upon the comparable adjusted book value. It, unfortunately, has its flaws. The primary flaw being the inability to factor in earnings quality (like DCF and economic profit which can't be used here, or more accurately stated, produce valuations in the deep negatives – as in less than zero without some fancy financial tinkering) and more importantly the risk associated with the massive debt carried by the subject company. Factor in the risk, earnings volatility, and the macro environment, and one will be hard pressed to value Lennar above the single digits.

Key Metrics:

Lennar's order backlog is expected to decline from 11,608 million at the end of 2006 to 6,415 million by 2007-end from continued decline in new orders. Lennar's new orders are expected to decline by 35.0% and 18.9%, in 2007 and 2008, respectively. We expect volumes to stabilize 2009 onwards with new orders growth of 0.8%, 2.6% and 3.0% in 2009, 2010 and 2011, respectively.

At the 4Q2007 delivery rate, Lennar's operating backlog days stood at 95 against 104 as on 3Q2006-end indicating declining cash flows.

 

Bloomberg reports "New York Homebuyers Are Searching Everywhere But Manhattan": Contracts to buy (demand) Manhattan co-op apartments declined 26% in August from a year earlier, while pending condo deals plummeted 38%, while new listings (supply) in the borough surged -- by 68% for co-ops and 30% for condos.

 I warned of this months ago. First of all, this is a real deal depression, not a mere recession...

This real estate crash is exacerbated by dense metro areas such as Manhattan, but it will be truly global in nature... 

And it will encompass much more than just residential real estate....

This will hit NYC particularly hard, and no, there will not be a material recovery near term - V-shaped or otherwise, and the malaise will be here past the invention or a COVID vaccine.

The unemployment problem is real, and persistent...

Which easily reveals the Anatomy of the Nastiest Real Estate Crash Ever...
 

The metrics behind this real estate crash are not only undeniable, they are truly unprecedented!

 If you don't believe me, simply look at the lengths the nation's largest bank has gone through to hide its true credit debacle, already!

 No, it's not just JP Morgan, either. Look at Bank of America, the nations largest mortgage lender....

Forensic Review of Bank of America's 2Q2020 Earnings - It's Ugly!

 

Figure 13: 30+ Day Delinquency Rate w/COVID Emergency Deferrals, As Adjusted by Veritaseum Research (in %)

Now, back to the Bloomberg story: 

The story was different outside Manhattan. Shoppers fanning out from the city’s business core, in search of more space for working and learning from home, pushed up demand pretty much everywhere else last month (except Manhattan).

  • Contracts to buy single-family houses in Greenwich, Connecticut, almost tripled from a year earlier to 136 deals. The greatest increase in demand was in the range of $1 million to $1.99 million, with 50 contracts, up from 13 in August 2019.
  • In Westchester, single-family contracts jumped 57% to 780. Even condos fared well, with deals climbing 24%.
  • In the Hamptons, there were 278 signed deals for single-family homes, more than double last August’s rate.
  • Brooklyn saw a near tripling of co-op deals, with 138. Most were for properties priced under $1 million. Condo contracts jumped 33% to 200.

Now, what's wrong with this story? That boom is short term and transient in nature. Those videos and articles I included above clearly make that evident, but there are two portions in particular that should really stand out. Unemployment is truly out of control...

fredgraph 2 6b3ea

In 2007, housing prices started falling precipitously, and unemployment spiked as a result of financial markets crashing in sympathy, liquidity drying up and financial institutions locking up. Now, unemployment and unemployment claims have spiked 1.5x to 7x that of 2008, and it is employment that allows buyers to pay mortgages and put down payments in for housing, not to mention pay rents. 

The effects are already very evident. Look at Bank of America, when we rejigger their reported numbers for the economic truth.

 BOA's actual 30+ day consumer loans delinquency amount stood at USD31.2 billion in Q2 2020 compared to reported 30+ day delinquency amount of USD1.4 billion. More alarming is that BOA's allowance for loan losses in Q2 2020 is USD9.2 billion, which is only 30% of the actual delinquent amount. Figure 10: 30+ Day Delinquency Rate w/COVID Emergency Deferrals, As Adjusted by Veritaseum Research (in USD billions) Source: Veritaseum Research

 Source: Veritaseum Research

 

Look at JP Morgan, when we do the same.

 asdfadf e58a3

In both big bank cases, not only are the true credit metrics dramatically (I mean many multiples) worse than the banks are reporting, but they are dramatically and woefully under provisioning for these losses as well - dramatically and woefully. 

Do you think it is just Reggie Middleton et. al being pessimistic? Well, look at what Bank of America reported for their 30 day delinquencies, compared to what we calculated...

Figure 12: 90+ Days or More Delinquency Rate – As Reported (in USD millions)

Source: Bank of America Earnings Release, 2Q 2020

The above data is as reported in BofA’s earnings release. But if we delve in, we can see a completely different picture of the delinquency rates of credit cards. The actual, economic delinquency rates have a considerable difference than the reported one. On March 16th 2020, BOA enacted the Client Assistance Program where it offers assistance to 66 million consumers and small business clients in response to the unprecedented challenges of COVID-19, allowing the clients to defer payments. BOA has processed approximately 1.8 million total deferrals, and as of July 9th, the Bank still has 1.7 million deferrals. The deferrals represent USD29.8 billion of consumer balances. If we add back this deferral amount to the reported delinquency amount of credit cards a completely different, and in our professional opinion – a considerably more revealing, honest and informational, scenario in delinquency rates comes out. The actual 30+ days and delinquency rate is 37.1% compared to the reported 30+ days delinquency rate of 1.7%. That is a difference of nearly 2,200%! Misleading, to put it lightly. Figure 13: 30+ Day Delinquency Rate w/COVID

Emergency Deferrals, As Adjusted by Veritaseum Research (in %)

Source: Veritaseum Research

One of us are lying, no? If you had to guess which one, who would you choose? Here's and experiment. Let's look at the numbers of a not-for-profit entity that has no incentive to use prestidigitation to makes it's numbers look something other than they are and see who it agrees with. Bloomberg reports: FHA Mortgage Delinquencies Reach a Record, Led by New Jersey

Federal Housing Administrationmortgages -- the affordable path to homeownership for many first-time buyers, minorities and low-income Americans -- now have the highest delinquency rate in at least four decades. 

That's about how we see it as well.

The share of late FHA loans rose to almost 16% in the second quarter, up from about 9.7% in the previous three months and the highest level in records dating back to 1979, theMortgage Bankers Associationsaid Monday. The delinquency rate for conventional loans, by comparison, was 6.7%.

 Sounds about right. Actually, it's a but below the big banks numbers, but hey...
 

Millions of Americans stopped paying their mortgages after losing jobs in the coronavirus crisis. Those on the lower end of the income scale are most likely to have FHA loans, which allow borrowers with shaky credit to buy homes with small down payments.

For now, most of them are protected from foreclosure by the federal forbearance program, in which borrowers with pandemic-related hardships can delay payments for as much as a year without penalty. As of Aug. 9, about 3.6 million homeowners were in forbearance, representing 7.2% of loans, the MBA said in a separate report. The share has decreased for nine straight weeks.

Housing has held up better than expected in an otherwise shaky economy, with record-low mortgage rates fueling sales of both new and previously owned houses. With job losses mounting and Congress slow to act on a fresh stimulus package, that momentum could be threatened.

How long do you think that will last with unemployment STILL at a level unseen in the history of this country and a government that can't consistently agree on bailout packages, that will (if agreed upon) inflate the USD to unforeseen levels AND indebt this country to a level that even world wars haven't caused.

New Jersey had the highest FHA delinquency rate, at 20%. The state also had the biggest increase in the overall late-payment rate, jumping to 11% in the second quarter from 4.7%. Following were Nevada, New York, Florida and Hawaii -- all states with a high proportion of leisure and hospitality jobs that were especially hard-hit by the pandemic, the MBA said.

Yep!

But the current spike in delinquencies is different from the Great Recession, thanks in part to years of home-price gains and equity accumulation, according to Marina Walsh, vice president of industry analysis for the bankers group.

But she represents the banking industry, hence she would say that wouldn't she? Just like the bank accounts said that they have <1% 30 day delinquency rates. It's called "the new truth", or was that "fake news"? I simply can't keep track anymore. Oh, and to put this localized NY thing into perspective: In 2017: New York State's GDP was over $1.5 trillion, 8 percent of the U.S. total.

For those who are interested, explore our tokenized gold and silver products along with out associated research - designed to assist you in weathering that dollar inflation thingy.

See Panic-Driven Monetary Inflation and It's Effect on Tokenized Gold, then enter here https://dapp.veritaseum.com/. Find relevant research here https://dapp.veritaseum.com/#/research

 

  1. Introduction

Bank of America ("BOA or the Bank"), the 2nd largest Bank in the US by asset size, has exceeded its earnings expectation and reported a net income of USD3.53 billion in Q2 2020. However, the net revenues reported for Q2 2020 is USD22.5 billion, barely edged out analysts' estimates of USD22 billion. Net income of the Consumer Banking segment is reported at USD71 million in the 2Q 2020, which has drastically declined from USD1.8 billion recorded in Q1 2020. Federal Governments' emergency rate reductions have curbed the Bank's net interest income. The Bank has reported a net interest income of USD10.85 billion in Q2 2020, which has declined from its previous quarter as well as last year's period value. However, the non-interest income has increased and reported an income of USD11.48 billion compared to USD10.64 billion in Q1 2020 and USD10.90 billion in Q2 2020. Net interest yield rate stood at 1.87% in Q2 2020 compared to 2.33% in Q1 2020. The Bank has maintained a provision of USD5.12 billion for credit losses in Q2 2020.

BOA is feeling the effects of COVID-19 more acutely as its business is more consumer-focused. The plunge in “real” economic activity” and “actual” economic value of BOA has placed downward pressure on the Bank's consumer banking segment, which is tied to the health and financials of millions of American consumers and borrowers. Hence, BOA is considered as the most sensitive of the large banks by analysts when it comes to fluctuation in interest rates.

Let us get a detailed view of its earnings.

Net Income

BOA has reported a net income of USD3.5 billion in Q2 2020 compared to a net income of USD7.3 billion in Q2 2019. Net income of the Bank's major segment, i.e., Consumer Banking, has declined drastically in Q2 2020 and reported a net income of USD71 million compared to USD3.3 billion in Q2 2019. This is primarily due to Federal Governments emergency cut in interest rates as well as rising unemployment. The Global Wealth & Investment Management segment reported a net income of USD624 million in Q2 2020, which has also declined from the USD1.08 billion in Q2 2019. The Global Banking and Global Market segment's net income in Q2 2020 have declined from the same quarter previous year but has increased from the previous quarter's income. Net income of Global Banking and Global Market segments reported at USD726 million and USD1.90 billion in Q2 2020 compared to USD136 million and USD1.71 billion in Q1 2019. Other net income has increased to USD216 million in Q2 2020, from a net loss of USD493 million in Q1 2020 and USD9 million in Q2 2019.

Figure 1: Bof A Segment-wise Net Income Trend (in USD millions)

 

Source: Bank of America Earnings Release, 2Q 2020

Net Interest Income & Non-Interest Income

BOA reported a net interest income of USD10.85 billion in Q2 2020 compared to USD12.19 billion in Q2 2019. The net interest income has declined with interest rate cuts by the Federal Reserve. However, non-interest income has increased to USD11.48 billion in Q2 2020 from USD10.90 billion in Q2 2019, primarily because of an increase in underwriting income and financial advisory services.

Figure 2: B of A Net Interest Income & Non-Interest Income (in USD millions)

Source: Bank of America Earnings Release, 2Q 2020

Profit Provisioned for Credit Losses

BOA reserved 72% of its pre-provision profit as a provision for credit losses. The Bank has provisioned 97% of total Consumer Banking segment profit for credit losses followed by Global Banking segment with a provision of 65.3% of the pre-provision profit. The Bank has reserved 14.1%, 3.9% and 3.7% pre-provision profit of Global Wealth & Investment Management, Global markets and other segments, respectively.

Figure 3: B of A Profit Provisioned for Credit Losses (in %)

 

Source: Bank of America Earnings Release, 2Q 2020

Return-on-Equity (ROE)

BOA's ROE has declined to 5.3% in the Q2 2020 from 11.0% in Q2 2019. The drastic decline in the Consumer Banking profit has impacted the ROE of the Bank.

Figure 4: B of A Return-on-Equity(in %)

 

Source: Bank of America Earnings Release, 2Q 2020

Net Interest Margin

The net interest margins is an indicator of the Bank's ability to lend money at an interest rate higher than the interest rate it pays on its deposits. The emergency cut of interest rate by the Fed has put downward pressure on its net interest margins. Notably, net interest rate margin of BOA has declined from 2.4% in Q2 2019 to 1.9% in Q2 2020.

 

Figure 5: BofA Net Interest Margin (in %)

Source: Bank of America Earnings Release, 2Q 2020

Balance Sheet Interest Rate Analysis

Earning Assets

The interest rate of BOA declined in Q2 2020. The interest rate of trading assets declined primarily because of a significant decline in the interest rates of Federal deposits, time deposits and short-term investments and Federal securities borrowed under the agreement of reselling in Q2 2020. The interest rate of commercial assets has declined primarily because of a decline in interest rates of the commercial real estate sector. The interest rate of the Consumer Banking segment declined with the decline in the interest rates of home equity sector.

Figure 6: Earning Assets Interest Rate Analysis (in %)

Source: Bank of America Earnings Release, 2Q 2020

 

Interest-bearing liabilities

The rates of interest-bearing deposits of BOA have also declined in Q2 2020. The interest rates of short-term borrowings and other interest-bearing liabilities have significantly declined and reached -10% in Q2 2020. The interest rates of total interest-bearing liabilities have declined to 1.61% in Q2 2020 from 0.41% in Q2 2019.

Bank of America is, in real time, refuting the erroneous assumption that inter-bank interest rates cannot go below zero because a lender would prefer to hold on to its money and receive no return rather than pay someone to borrow the money. This may be true for uncollateralized loans, but a lender may be willing to pay interest if the securities offered as collateral on a loan allow it to meet a delivery obligation (D’Avolio 2002; Jones and Lamont 2002), i.e. treasuries or certain equities. These are the treasury FTDs (fail-to-delivers) for the month of June. Which bank do you think is proximal to these FTDs on the 11th of June?

Figure 7: Interest Rate Analysis of Interest Bearing Deposits (in %)

Source: Bank of America Earnings Release, 2Q 2020

Funding and Liquidity

BOA's liquidity position in Q2 2020 has improved from Q2 2019. In Q2 2020, the Bank's liquidity position stood at USD2,776 billion.

Figure 8: Funding and Liquidity (in USD billion)

Source: Bank of America Earnings Release, 2Q 2020

 

Global Liquidity Sources include cash and high-quality, liquid, unencumbered securities, inclusive of US government securities, US agency securities, US agency MBS, and a select group of non-US government and supranational securities, and other investment-grade securities, and are readily available to meet funding requirements as they arise. Federal Reserve Discount Window or Federal Home Loan Bank borrowing capacity is excluded from the source.

Commercial Credit Exposure by Company

Credit exposure is the measurement of the maximum potential loss to a lender if the borrower defaults on payment. It is a calculated risk to doing business as a bank. The global pandemic has significantly affected industries, resulting in lost revenues and disrupted supply chains on account of lockdown measures and there residual effects. Industries such as real-estate, retailing, consumer services, food beverage and tobacco, transportation, consumer durables and apparels, vehicle dealers and automobile and components are highly susceptible due to lockdowns and restriction measures. BOA has a significant amount of credit exposures to these sectors.

 

 

Particulars

Commercial Utilized

Total Commercial Committed

June 30th 
2020

March 31st 
2020

June 30th 
2019

June 30th 
2020

March 31st 
2020

June 30th 
2019

In USD billions

           

Asset managers and funds

64.2

75.6

70.2

100.8

111.5

108.0

Real estate

74.2

76.0

66.9

96.1

95.8

89.7

Capital goods

47.7

48.3

39.6

85.7

85.5

75.1

Finance companies

40.7

46.1

39.1

63.8

66.6

62.9

Healthcare equipment and services

39.7

40.7

35.4

63.8

58.7

57.1

Government and public education

43.8

45.2

42.4

56.0

56.3

54.4

Materials

28.8

30.7

27.9

52.4

53.3

52.3

Retailing

29.6

33.5

26.5

49.8

49.5

47.9

Consumer services

34.2

34.8

25.8

48.3

46.3

47.2

Food, beverage and tobacco

24.6

28.0

25.4

46.2

47.8

45.6

Commercial services and supplies

24.7

25.6

22.2

38.1

36.8

37.8

Energy

17.0

18.3

15.0

37.4

38.0

37.4

Transportation

26.3

28.2

24.8

35.5

36.5

34.5

Utilities

13.3

14.5

12.1

30.0

31.7

31.3

Individuals and trusts

20.5

20.1

18.9

28.4

28.7

25.8

Global commercial banks

25.1

31.3

28.4

27.5

33.5

31.4

Media

14.5

13.6

12.1

26.4

24.5

24.8

Technology hardware and equipment

10.3

12.8

9.4

22.5

23.8

21.7

Consumer durables and apparel

10.9

12.6

10.3

21.1

20.5

20.0

Software and services

11.7

11.3

10.4

21.0

19.8

19.7

Vehicle dealers

15.4

18.3

17.7

19.8

21.2

20.8

Automobiles and components

12.4

11.8

7.8

18.6

17.3

15.0

Pharmaceuticals and biotechnology

6.8

6.3

6.1

17.6

19.6

16.5

Insurance

6.8

7.9

6.1

14.2

15.3

13.2

Telecommunication services

7.9

10.1

8.9

13.6

15.9

15.3

Food and staples retailing

6.4

6.8

5.9

10.6

10.7

9.8

Financial markets infrastructure (clearinghouses)

4.9

7.1

9.7

7.3

9.5

11.4

Religious and social organizations

5.4

4.4

4.0

7.2

6.1

5.9

Total commercial credit exposure by industry

667.7

719.9

628.8

1,059.5

1,080.7

1,032.5

 

BOA's total committed commercial credit exposure as on June 30, 2020 stood at USD1,060 billion, and total utilized commercial credit exposure stood at USD668 billion. BOA has the highest credit exposure in ‘asset managers and funds’ segment (expect this to get drawn upon when leveraged long or short positions go awry), followed by the ‘real estate’ sector (‘nuff said) and ‘capital goods’ market (straight consumer exposure during and economic depression).

As of June 30 2020, the total committed credit exposure of ‘asset management’ sector stood at USD101 billion out of which USD64.2 billion credit has been utilized. BOA's total committed credit exposure in the real estate sector (the hardest hit sector by the pandemic) stood at USD96.1 billion in Q2 2020 out of which USD74.2 billion is utilized.

Non-Performing Loans (NPLs)

BOA reported total non-performing loans of USD4.4 billion in Q2 2020 compared to NPLs of USD4.2 billion in Q2 2019. The Bank’s NPLs has increased with an increase in the NPLs of commercial loans.

Total NPLs in the consumer loan segment has declined in Q2 2020 and reached USD2.2 billion from USD3.0 billion in Q2 2019. The NPLs declined primarily because of a decline in NPLs of home equity loans as the Bank has charged-off a significant portion of loans during the one-year period.

Figure 9: Non-Performing Loans – Consumer Loans  (in USD billion)

Source: Bank of America Earnings Release, 2Q 2020

 

However, Commercial sector NPLs increased in Q2 2020. The total commercial NPLs in Q2 2020 stood at USD2.2 billion compared USD1.2 billion in Q2 2019 (an 83.3% YoY increase). The Commercial sector NPLs increased with the increase in the US commercial, Non-US commercial and commercial real estate sector. The NPL related to commercial, Non-US commercial and commercial real estate sector stood at USD1.2 billion, USD387 million and USD474 million in Q2 2020 compared to USD820 million, USD122 million and USD112 million in Q2 2019 respectively.

 

 

Figure 10: Non-Performing Loans – Commercial Loans  (in USD billion)

Source: Bank of America Earnings Release, 2Q 2020

 

Loan Delinquency rate and Charge-off

BOA, in its 2Q 2020 results reported 30+ days loan delinquency rate of 1.7% in the Consumer Banking segment (credit cards). The delinquency rate of credit card loans have not changed much throughout the last five quarters and even declined in Q2 2020.

Figure 11: 30+ Days or More Loan Delinquency Rate – As Reported (in %)

 

Source: Bank of America Earnings Release, 2Q 2020

A similar scenario is seen in the 90+ days or more credit card delinquency rates also. The loan delinquency rate of 90+ days or more has also declined in Q2 2020 from its previous quarter's level. In Q2 2020, the Bank has reported 90+ days or more delinquency rate of 0.93%.

 

 

Figure 12: 90+ Days or More Delinquency Rate – As Reported (in USD millions)

 

Source: Bank of America Earnings Release, 2Q 2020

 

The above data is as reported in BofA’s earnings release. But if we delve in, we can see a completely different picture of the delinquency rates of credit cards. The actual, economic delinquency rates have a considerable difference than the reported one.

On March 16th 2020, BOA enacted the Client Assistance Program where it offers assistance to 66 million consumers and small business clients in response to the unprecedented challenges of COVID-19, allowing the clients to defer payments. BOA has processed approximately 1.8 million total deferrals, and as of July 9th, the Bank still has 1.7 million deferrals. The deferrals represent USD29.8 billion of consumer balances.

If we add back this deferral amount to the reported delinquency amount of credit cards a completely different, and in our professional opinion – a considerably more revealing, honest and informational, scenario in delinquency rates comes out. The actual 30+ days and delinquency rate is 37.1% compared to the reported 30+ days delinquency rate of 1.7%. That is a difference of nearly 2,200%! Misleading, to put it lightly.

Figure 13: 30+ Day Delinquency Rate w/COVID Emergency Deferrals, As Adjusted by Veritaseum Research (in %)

Source: Veritaseum Research

 

BOA's actual 30+ day consumer loans delinquency amount stood at USD31.2 billion in Q2 2020 compared to reported 30+ day delinquency amount of USD1.4 billion. More alarming is that BOA's allowance for loan losses in Q2 2020 is USD9.2 billion, which is only 30% of the actual delinquent amount.  

Figure 10: 30+ Day Delinquency Rate w/COVID Emergency Deferrals, As Adjusted by Veritaseum Research (in USD billions)

Source: Veritaseum Research

  1. Conclusion

The US economy has been experiencing a significant and unprecedent material slowdown over the past few quarters due to the global pandemic, COVID-19 in combination with the deflation of a drawn out bubble that’s been blowing for over a decade. The pandemic has affected businesses with lost revenue and disrupted supply chains on account of lockdown measures. Industries such as Retailing, Consumer Services, Food Beverage and Tobacco, Transportations etc. are the worst affected and are highly susceptible. BOA has a significant amount of credit exposures in these sectors, signifying a huge impact on its earnings.

However, BOA in its Q2 2020 earnings has surpassed the earnings expectations and reported a net income of USD3.5 billion. The Bank's Consumer banking segment was hugely affected by the emergency interest rate cuts by the Federal Government and reported a net income of USD71 million. The Bank has reported USD11.5 billion non-interest income which has increased in this quarter primarily because of an increase in underwriting income and financial advisory services. However, the ROE and the net interest margin of BOA has declined in Q2 2020.

BOA has a provisioned 72% of its pre-provision GAAP earnings for credit losses in Q2 2020. The Bank's liquidity position has improved from the previous quarter and stood at USD2,776 billion. The Bank's NPLs were reported at USD4.4 billion.

The Bank's delinquency rates have declined and have reported a delinquency rate of 1.7% in Q2 2020. This is mainly because the Bank has enacted the Client Assistance Program under which it has allowed its clients to defer payments and excluded the total deferral amount of USD29.8 billion. Although this may adhere to GAAP (generally accepted accounting principles) guidelines, it is tantamount to prestidigitation and misdirection. This provides a misleading picture of the Bank’s financials. When we add back the amount set under the program, the delinquency rate increases to 37.06%. This indicates a big wave of defaults expected to come in the next few quarters, of which BofA is woefully under-provisioned for. Although BofA is in particularly bad shape in the is regard, it is not alone. JP Morgan, the largest bank in the US by assets, and arguably one of the better managed banks, is in the exact same predicament, using the exact same parlour tricks to hide the credit quality damage to tis balance sheet. Reference “Analysis of JP Morgan's Terrible, Horrible, No Good 2nd Quarter of 2020 - Why Am I the Only One?

I never got a chance to perform a full forensic analysis of Lehman, but did put a fair size short on them a few months back due to their "smoke and mirrors" PR (oops), I mean financial reporting. There were just too many inconsistencies, and too much exposure. I was familiar with the game that some I banks play, for I did get a chance to do a deep dive on Morgan Stanley, and did not like what I found. As usual, I am significantly short those companies that I issue negative reports on, MS and LEH included. I urge all who have an economic interest in these companies to read through the PDF's below and my MS updated report linked later on in this post. In January, it was worth reviewing Is this the Breaking of the Bear?", for just two months later we all know what happened.

I came across this speech by David Eihorn and he has clearly delineated not only all of the financial shenanigans that I mentioned in my blog, but a few more as well. Very well articulated and researched.


Here are a few choice excerpts:

"The issue of the proper use of fair value accounting isn’t about strict versus permissive accounting. The issue is that some entities have made investments that they believed would generate smooth returns. Some of these entities, like Allied, promised investors
smoother earnings than the investments could deliver. The cycle has exposed the investments to be more volatile and in many cases less valuable than they thought. The decline in current market values has forced these institutions to make a tough decision. Do they follow the rules, take the write-downs and suffer the consequences whatever they may be? Or worse, do they take the view that they can’t really value the investments in order to avoid writing them down? Or, even worse, do they claim to follow the accounting
rules, but simply lie about the values?

The turn of the cycle has created some tough choices. Warren Buffett has said, “You don’t know who is swimming naked until the tide goes out.” I do not believe the accounting is the problem. The creation of FAS 157 and other fair value measures has improved disclosure, including the disclosure of Level 3 assets – those valued based upon non-observable – and in many cases subjective – inputs. This has helped investors better understand the financial positions of many companies. For entities that are not over-levered and have not promised smoother results than they can deliver, when the assets have fallen in market value, they can take the pain and mark them down. It doesn’t force them to sell in a “fire-sale.” If the market proves to have been wrong, the loss can be reversed when market values improve. For levered players, the effect of reducing values to actual market levels is that the pain is more extreme and the incentive to fudge is greater. With this in mind, I’d like to review Lehman Brothers’ last quarter. Presently, Greenlight is short Lehman. Lehman was due to report its quarter two days after JP Morgan and the Fed bailed out Bear Stearns. At the time, there were a lot of concerns about Lehman, as demonstrated by its almost 20% stock price decline the previous day with more than 40% of its shares changing hands. In the quarter, bond risk spreads had widened considerably and equity values had fallen sharply. Lehman held a large and very levered portfolio.

With that as the background, Lehman announced a $489 million profit in the quarter. On the conference call that day, Lehman CFO Erin Callan used the word “great” 14 times, “challenging” 6 times; “strong” 24 times, and “tough” once. She used the word “incredibly” 8 times. I would use “incredible” in a different way to describe the report. The Wall Street Journal reported that she received high fives on the Lehman trading floor when she finished her presentation.

Twenty-two days after the conference call, Lehman filed its 10-Q for the quarter. In the intervening time, I had made a speech at the Grant’s Spring Investment Conference where I observed that Lehman did not seem to have large exposure to CDOs. This was true
inasmuch as Lehman had not disclosed significant CDO exposure.

Let’s look at the Lehman earnings press release (Table 1). Focus on the line “other asset backed-securities.” You can see from the table that Lehman took a $200 million gross write-down and has $6.5 billion of exposure...

... Now let's
look at the footnote 1 of the table, explaining
Other
asset-backed securities
:

The Company
purchases interests in and enters into derivatives with collateralized debt
obligation securitization entities ("
CDOs"). The CDOs to
which the Company has exposure are primarily structured and underwritten by
third parties. The collateralized asset or lending obligations held by the CDOs
are generally related to franchise lending, small business finance lending, or
consumer lending.
Approximately 25% of the positions held
at February 29, 2008 and November 30, 2007 were rated BB+ or lower (or
equivalent ratings) by recognized credit rating agencies...
[emphasis added]

Last week, Lehman's
CFO and corporate controller confirmed that the whole $6.5 billion consisted of
CDOs or synthetic CDOs. Ms. Callan also confirmed that the 10-Q presentation was
the first time that Lehman had disclosed the existence of this CDO exposure.
This is after Wall Street spent the last half year asking, "Who has CDOs?"
Incidentally, I haven't seen any Wall Street analysts or the media discuss this
new disclosure.

I asked them how
they could justify only a $200 million write-down on any $6.5 billion pool of
CDOs that included $1.6 billion of below investment grade pieces. Even though
there are no residential mortgages in these CDOs, market prices of comparable
structured products fell much further in the quarter. Ms. Callan said she
understood my point and would have to get back to me. In a follow-up e-mail, Ms.
Callan declined to provide an explanation for the modest write-down and instead
stated that based on current price action, Lehman "would expect to recognize
further losses" in the second quarter. Why wasn't there a bigger mark in the
first quarter?

Now, I'd like to
put up Lehman's table of Level 3 assets (Table 3). I want you to look at the
column to the far right while I read to you what Ms. Callan said about this
during the Q&A on the earnings conference call on March 17.

[A]t the end of the
year, we were about 38.8 [billion] in total Level 3 assets. In terms of what
happened in Level 3 asset changes this quarter, we had net sort of payments,
purchases, or sales of 1.8 billion. We had net transfers in of

1.1 billion. So stuff
that was really moved in or recharacterized from Level 2. And then there was
about 875 million of write-downs. So that gives you a balance of 38,682 as of
February 29.

As you can see, the
table in the 10-Q does not match the conference call. There is no reasonable
explanation as to how the numbers could move like this between the conference
call and the 10-Q. The values should be the same. If there was an accounting
error, I don't see how Lehman avoided filing an 8-K announcing the mistake.
Notably, the 10-Q changes somehow did not affect the income statement, as there
must have been other offsetting adjustments somewhere in the financials....

... When I asked them
about this, Lehman said that between the conference call and the 10-Q they did a
detailed analysis and found, "the facts were a little different."

I want to
concentrate on the $228 million of realized and unrealized gains Lehman
recognized in the quarter on its Level 3 assets. There is a $1.1 billion
discrepancy between what Ms. Callan said on the conference call - an $875
million loss - and the table in the 10-Q, which shows a $228 million gain.

I asked
Lehman, "My point blank question is: Did you write-up the Level 3 assets by over
a billion dollars sometime between the press release and the filing of the
10-Q?" They responded, "No, absolutely not!"

However, they could
not provide another plausible explanation. Instead, they said they would review
the piece of paper Ms. Callan used on the call and compare it to the 10-Q and
get back to me. In a follow-up e-mail, Lehman offers that the movement between
the conference call and the 10-Q is "typical" and the change reflects
"re-categorization of certain assets between Level 2 and Level 3." I don't
understand how such transfers could have created over a $1.1 billion swing in
gains and losses...


I would like to add that Morgan Stanley is guilty of much of what Lehman is being accused of, and with much more net counterparty exposure and leverage to boot. See The Riskiest Bank on the Street and particularly Reggie Middleton on the Street's Riskiest Bank - Update. I would like to excerpt page 4 of that report here to see how similar the marketing (er, sorry about that again), I mean "financial reporting" of these two companies are:

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, toApril 2, 2008)Source: Marki.comtAlthough 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 - Morgan Stanley ABS Inventory (1.65 MB).
"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. These research reports were initially done in January and April, and I never got the chance to publicly release my thoughts on this hedging billions of dollars of specific risks with broad mathematical indices, marginal (at best) counterparties, and potentially litigous swap agreements, and such. Unfortunately, it looks like other investors/analysts may have beat me to the punch. Just remember, you heard it here first! </span
The US housing markets are yet to stabilize and housing prices are still way 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
Page 3 of 10