Credit Suisse has a note out urging caution on Citigroup shares due to regulatory hurdles.  Their logic bears noting as it can be useful for other U.S.-based banks.

On Monday the CS analysts met with Citi management, who were somewhat cautious. The CS note indicates that regulatory changes in the U.S. are likely to mandate higher capital ratios and this necessarily will constrain returns on capital, not just at Citigroup but elsewhere in banking.

Another question involved deferred tax assets (DTAs), which I brought up last week. Citi said only $13 billion of the $38 billion in DTAs were counted against Tier 1 capital, meaning any writedowns to capital will have much less affect on Tier 1 capital. About $14 billion in DTAs were related to Citi’s burgeoning loan loss reserves; so the tax losses have not yet been triggered. This may give Citi time to earn money in order to use the DTAs. Again, the key with Citi’s DTAs has to do with how much it earns going forward. If it does not earn enough money, the deferred assets will have to be written down.

In general, banks are now entering a less favourable regulatory environment.  Moreover, in March, many bank stocks were trading below tangible book for the first time since 1990, at the height of the last major credit crunch in the U.S.. After a more than doubling in bank stocks from March lows, this is no longer the case and it will be harder to beat now elevated earnings estimates.

Meredith Whitney has said she expects the large cap bank stocks to underperform due to some of these hurdles and sees a relative value play in regionals.  However, a lot of CRE and loan construction exposure remains at regionals and the continued seizure of 3 or 4 banks every week by the FDIC points to distress.

I continue to believe upside in bank shares is limited all around.

Related posts:

• How well capitalized is Citigroup?
• How is Citi going to deal with $38 billion in deferred tax assets?
• The Citigroup Bailout: a blogosphere post-mortem
• Citigroup and Redecard: shedding international assets
• Rubin resigns from Citigroup

There are a lot of threads to tie together in today’s reporting of news in the auto sector.

General Motors has reported a third-quarter loss of $1.15 billion. But all indications are that car sales continue to outpace expectations in the United States.  Meanwhile, there are conflicting stories that GM both plans to pay back its bailout money, and to use it to help its ailing European operations. I will try to tie all these stories into a common thread.

First are the earnings. This is the first report by General Motors since leaving bankruptcy.  The results are decidedly mixed showing increasing sales, but a large loss and declining liquidity.

The video above points to losses and negative cash flow. But Bloomberg has reported that GM had significantly positive cash flow in Q3: $3.3 billion worth. Irrespective, sales are up.

The New York Times’ Deal Book says:

Excluding taxes and one-time items like the costs related to restructuring its dealership network, G.M. said its operations lost $261 million from July 10 and September 30. The loss in North America was $651 million.

For the entire third quarter, including the final 10 days of G.M.’s bankruptcy, the company said its revenue was $28 billion, up 21 percent from the second quarter.

In addition, retail sales have revealed that car sales in the U.S. are still relatively brisk for October despite the expiration of cash for clunkers. So, GM is benefitting from more sales, but is still not making money and still seeing cash go out the door. Obviously, they are going to need to cut costs even more, unless they count on sales returning to pre-crisis levels.  However, all indications are that they do, as CEO Fritz Henderson says revenue growth is their number one priority.

“We have significantly more work to do, but today’s results provide evidence of the solid foundation we’re building for the new G.M.,” the chief executive, Fritz Henderson, said in a statement. “With a healthier balance sheet and a competitive cost structure, our focus is on driving top line performance.”

See the Bloomberg video below for my comments by Henderson.

Meanwhile, in what should be seen as a PR move, General Motors has also announced it will begin repaying government money. The first $1 billion to be repaid in December. The company will make $1 billion payments to the U.S. government and $200 million payments to the Canadian government every quarter. It has said it could repay all the aid money by 2011, four years ahead of schedule. Presumably, this does not include the equity government stakes which can be sold on in the open market in an I.P.O.

Given the fact that General Motors is still losing money, it would make sense for them to delay repayment. However, I reckon they are going to repay early in order to tamp down criticism about their government-funded bailout.

The same is true in Germany as well as GM has also announced it will repay ALL German state aid before month’s close.  That is big. It significantly reduces the German government’s leverage over GM plans for restructuring in Germany.

This makes the recent statements about using bailout funds to bolster European operations seem inexplicable. If GM is losing money and needs to use bailout funds to plug up holes in Europe because it has decided to renege on an agreement to sell operations, why is it paying back bailout funds?  Is it not obvious the company needs the money?

My interpretation of GM’s actions is this: they are still a loss-making company and their cost basis is unprofitable at present sales levels. In order to return to profitability, they will need to further reduce costs or increase sales. At present, management have opted to grow the top line – and this makes retaining the European operations vital as the auto technology at Opel is considered first class.

So, GM has reneged on the Opel sale, risking the political backlash, because it is flush with bailout cash.  However, it knows that its desire to use these funds to stabilize the European business is likely to invite populist outcries in North America. This is why they have announced the repayment schedule today; it is purely a public relations maneuver to quell any anti-bailout sentiment. They are repaying German state aid for similar reasons, but also because it gives them greater flexibility in making operating decisions about job cuts and plant closures.

As GM is not publicly traded, we do not have stock prices as a gauge of how receptive investors are to these latest moves. But, according to Bloomberg, GM 8 3/8 bonds maturing 2033 jumped significantly, adding $2.63 to move to $20.3 on $100 par value.

You can expect to see GM as a topic in both the business and political press for some time to come.

Related posts:

• GM looks to use US and Canadian tax money to bailout Opel
• GM and Chrysler to get more bailout money
• GM headed for bankruptcy
• GM considers keeping Opel, raising capital
• Chrysler: bulls make money, bears make money, pigs get slaughtered

In a recent post, “How is Citi going to deal with $38 billion in deferred tax assets?,” I pointed to a Reuters article which called into question Citigroup’s ability to earn enough money to prevent its having to take a charge for an incredibly large deferred tax asset. That post generated a response from a Citi representative who emphatically defended Citi’s capital position with a chart comparing Citigroup to other large global financial institutions.

Below is that chart:

As you can see from the chart, based on Citi’s reported public accounts, the company is well-capitalized. Moreover, even hedge fund operators like John Paulson who maid a mint on shorting financials in 2007 and 2008 now think Citi is in much better condition. Paulson was known to be buying shares in August.

You could agree or disagree with Paulson about whether Citigroup is a buy at its present share price. And you could argue that Citi should be taking the charge that Willens suggests. But the fact is, Citi has been recapitalized – at taxpayer expense. And that’s more the point here. 

Citigroup has received more money from the government ($45 billion) than any other bank in the U.S., none of which has been paid back. Moreover, the government was forced to not just forgo dividends on its preferreds but also convert these into common equity and provide debt guarantees for the company. Absent government money, Citigroup is the worst capitalized big bank. Absent government money, Citigroup would not exist.

Even still, Citigroup cannot be nearly as profitable as it once was because it has been forced to sell assets in order to achieve its ratios. Yet, it is an organization with almost $1.9 trillion in assets and is certainly still too big to fail.

I see Citigroup as emblematic of the problems we face in dealing with large systemically dangerous institutions. They insist that we return to some semblance of business as usual after they have received massive bailouts without any clear timeline when those monies will be repaid – if ever. Meanwhile, it is far from clear what these institutions would look like if the collateral they put up for loans received from the Federal Reserve and the rest of their assets were marked to market.

I, for one, think the big banks have made it. I said so as far back as April. I may not like the way they have been recapitalized, but I am in little doubt that they have been.

But Citigroup and Bank of America in particular have gotten there with great help from taxpayers. All of the too-big-to-fail financial behemoths exist because of government largesse. That high-level executives of these organizations show little contrition or remorse for having cost our economy tremendously is the saddest part of this crisis.

Disclosure: I have no financial positions in Citigroup or any other financial services company.

Related posts:

• My take on the latest Citigroup bailout
• The Citigroup Bailout: a blogosphere post-mortem
• Rubin resigns from Citigroup
• Credit Suisse cautious on Citigroup due to regulatory hurdles
• Citigroup and Redecard: shedding international assets

Citigroup has been losing tens of billions of dollars over the past two years as the financial crisis has unfolded. If one considers the government capital that Citi has not paid back, the bank is clearly the weakest of the four largest legacy banking behemoths in the United States. Earnings results this year demonstrate that their raw earnings power is no match for the likes of JPMorgan Chase or Wells Fargo. Moreover, their capital base has been impaired, causing them to have to sell assets, reducing their earnings power further still.

Unless something miraculous happens over the next few years, they are not going back to the glory days of $20 billion yearly net income. That’s why their mountainous $38 billion deferred tax asset is a problem.

Reuters explains:

Citigroup has a roughly $38 billion deferred tax asset, which essentially represents expected cash flow from future tax benefits. Accounting expert Robert Willens said on a conference call late last month that he expects the bank to write the asset down by about $10 billion in the fourth quarter. That would represent about 7 percent of the bank’s net worth as measured by the reported value of the company’s shareholder equity.

What is going on here is a result of the fact that companies keep two sets of books – one for the taxman and one for public statements.  On the tax books, they pay more taxes upfront than we see in their public accounts (I know it sounds dodgy but I am sure a tax accountant can explain). By deferring the tax liability, companies reduce the net present value of the tax charges. Everybody wins except the taxman, right? 

Well, not exactly.  If Citigroup cannot make enough taxable income in future periods to cover these deferred tax assets, they are going to have to take a charge and write down the asset immediately. That is what Robert Willens is pointing to. If he is right, Citigroup would have $10 billion less capital as soon as Jan.1, 2010. And given they are perhaps the least well-capitalized of the stress test 19 except GMAC, that’s a problem.  It would certainly constrain their lending capacity.

But, of course, Citi officials have already come out to put any fears to rest.

"We are comfortable with the valuation," Kelly said, adding that the bank looks at its deferred tax asset at the end of each quarter. About $16 billion of the deferred tax asset must be realized by around 2016, and the rest has a much longer time frame, Kelly added.

Whew. For a second there, I was starting to think Citi needed another bailout.

By the way, Bank of America has a similar problem.  They have a huge net operating loss (NOL) carry-forward from their acquisitions of Merrill Lynch and Countrywide Financial. If BofA cannot make enough taxable income to use all of their NOLs which are now assets on their balance sheet, they too will have to take a ‘valuation allowance’ a.k.a a hit to earnings.  The net deferred tax assets at BofA (incl. NOLs) were $19.6 billion according to their 3Q 10-Q filing.  See the note below (click to expand).

As you would suspect, “The Corporation has concluded that no valuation allowance is required.”

Source

Bank of America SEC filings – BofA website

Related posts:

• Credit Suisse cautious on Citigroup due to regulatory hurdles
• How well capitalized is Citigroup?
• JPMorgan has record revenue and $2.7 billion in profit
• Is Citi being forced to downsize by Obama?
• Are Citi and BofA gaming the Geithner Plan already?

The positive earnings announcement by Wells Fargo on Wednesday was marred by a sell recommendation from Dick Bove and a lot of chatter about credit writedowns and mortgage servicing rights (MSRs). I wanted to add a few words about the report, MSRs, and bank stocks more generally.

First of all, this has been a very good quarter for bank earnings. Many of the big names globally have surprised to the upside. this includes Goldman Sachs, Morgan Stanley, JPMorgan Chase, Wells Fargo, US Bancorp, SEB in Sweden, Credit Suisse in Switzerland and on down the line. As one would expect, most banks are profiting from record low interest rates.

The question for the big banks is whether the huge writedowns they are still taking and the run-up in their stock prices since march limits any upside in valuation. For smaller banks, we should expect weaker results as they are more leveraged to the sectors of the economy like commercial real estate and construction loans which are still suffering.  Goldman and Morgan Stanley should do relatively better as they are really broker-dealers and both investment banking and sales & trading are doing well right now. On the whole, I have said I think upside is limited for the sector, but downside is vast. Hence I am bearish on bank stocks.

Let’s look at Wells Fargo (WFC) as an example of what is happening.

Wells reports record profits

Wells reported net income of $32 billion, a robust operating pre-tax profit of $10.8 billion, and record net income of $3.2 billion. Sounds wonderful. What’s not to like?  That was bank analysts Dick Bove’s initial impression as well. Live on-air at CNBC, he said Wells Fargo “is proving itself to be a standout.”

But, once Bove got a peek under the hood and started to crunch the numbers at Wells, he was significantly less impressed – so much so that he issued a sell rating literally nine hours later. And he took a lot of flak for this about-face.

The Wall Street Journal’s Market Beat reports:

Prominent banking analyst Dick Bove, who caused a stir Wednesday with seemingly contradictory remarks on Wells Fargo, has decided he’ll no longer provide immediate earnings commentary on air.

“I’m not going to do it anymore. I’m going to have to see the numbers before I go on air,” Bove told Dow Jones Newswires Thursday. “It creates an untenable situation.”

Appearing on CNBC immediately after the San Francisco bank’s 8:00 a.m. EDT Wednesday earnings release, the Rochdale Securities analyst included Wells among “standout” banks when asked to name a few. Bove, who appears regularly on business news programs, said the earnings news suggested Wells had its loan losses “under control.” The comments left many with the impression that Bove
favored the bank.

Later in the day, Bove made waves when he downgraded Wells to “sell” from “neutral.” In an interview Wednesday with Dow Jones Newswires immediately after the downgrade, Bove called the bank’s earnings “pretty poor,” and said mortgage hedging and unsustainable tax cuts inflated earnings.

The downgrade sent Wells shares sharply lower, and weighed on the broader stock market. The Dow Jones Industrial Average finished the session lower after spending most of the day in positive territory.

So, what caused Bove to go from calling Wells a standout to telling us to sell? FT Alphaville’s Tracy Alloway has the goods:

Wells Fargo reported earnings of $0.56 per share for the third quarter. This was well above my estimate of $0.41 per share and in line with second quarter results. The earnings forecast for 2009 has been increased to $2.08 per share from $1.94 per share. The estimates for 2010 and 2011 remain unchanged at $1.93 per share and $2.67 per share, respectively. The target price on the stock is being maintained at $25 per share. The rating is reduced to Sell.

• While the quarterly number was higher than the expected, the increase seems to be due to two factors. The servicing fees on mortgages (MSR) jumped by $1.1 billion or $0.15 per share, and the tax rate fell by 2.2% adding another $0.02 per share to earnings.
• The volatility in the mortgage servicing fee is impossible to explain. In the past five quarters this fee has moved around as follows: $525 million, negative $40 million, $843 million, $753 million, and $1.9 billion. Mortgage rates in these five quarters have been as follows: 6.31%, 5.87%, 5.06%, 5.03%, and 5.15%. These rates would argue for a constant decline in the value of mortgage servicing until the third quarter this year.
• This is not what is depicted in the Wells Fargo numbers. The reason is that Wells hedges its servicing portfolio. These hedges are very large. For example in the second quarter, the bank lost $1.3 billion on its MSR hedges. In the third quarter, it made $3.6 billion on these hedges. The swing from quarter to quarter was $4.9 billion. The earnings per share impact was $0.68 per share. This is more money than the bank earned, overall, including the hedge profit, in the third quarter.
• Despite the fact that this is the most compelling earnings event in each quarter, the bank never spends much more than 5 seconds discussing it. It is an unsustainable profit but MSR hedges keep coming through for the company when it needs to bolster earnings.
• The remaining businesses of the bank were very mixed in the quarter. Most disturbing is that loan losses seem to be accelerating on the negative side.

At issue is mortgage servicing rights (MSRs) not to mention loan losses. Let’s concentrate on the MSRs. Wells Fargo has all of its financial statements dating back to 2001 on its website.  I found an explanation of its reporting of MSRs from the Q3 2003 10Q useful (I have highlighted the key points).

The Company originates, funds and services mortgage loans. These activities subject the Company to a number of risks, including credit, liquidity and interest rate risks. The Company manages credit and liquidity risk by selling or securitizing most of the loans it originates. Changes in interest rates, however, may have a potentially large impact on mortgage banking income in any calendar quarter and over time. The Company manages both the risk to net income over time from all sources as well as the risk to an immediate reduction in the fair value of its mortgage servicing rights. The Company relies on mortgage loans held on its balance sheet and derivative instruments to maintain these risks within Corporate ALCO parameters.

At September 30, 2003, the Company had mortgage servicing rights (MSRs) of $5.8 billion, net of a valuation allowance of $1.8 billion. The Company’s MSRs were valued at 1.03% of mortgage loans serviced for others at September 30, 2003, up from .92% at December 31, 2002 and .89% at September 30, 2002. The increase in MSRs was predominantly due to the growth in the servicing portfolio resulting from originations and purchases.

The value of the MSRs is influenced by prepayment speed assumptions affecting the duration of the mortgage loans to which the MSRs relate. Changes in long-term interest rates affect these prepayment speed assumptions. For example, a decrease in long-term rates would accelerate prepayment speed assumptions as borrowers refinance their existing mortgage loans and decrease the value of the MSRs. In contrast, prepayment speed assumptions would tend to slow in a rising interest rate environment and increase the value of the MSRs.

The Company mitigates mortgage banking interest rate risk in two ways. First, a significant portion of the MSRs are hedged against a change in interest rates with derivative contracts. The principal source of risk in this hedging process is the risk that changes in the value of the hedging contracts may not match changes in the value of the hedged portion of the MSRs for any given change in long-term interest rates.

Second, a portion of the potential reduction in the value of the MSRs for a given decline in interest rates is offset by estimated increases in origination and servicing fees over time from new mortgage activity or refinancing associated with that decline in interest rates. In a scenario of much lower long-term interest rates, the decline in the value of the MSRs and its impact on net income would be immediate whereas the additional fee income accrues over time.

Under GAAP, impairment of the MSRs, due to a decrease in long-term rates or other reasons, is reflected as a charge to earnings through an increase to the valuation allowance.

In scenarios of sustained increases in long-term interest rates, origination fees may eventually decline as refinancing activity slows. In such higher interest rate scenarios the duration of the servicing portfolio may extend. In such circumstances, periodic amortization of servicing costs may be reduced, and some or all of the valuation allowance may be released.

What Wells Fargo is saying is that a decrease in interest rates as we have seen recently should lower net income immediately as the loss in revenue flows through the income statement.  Yet, this is not happening according to the latest earnings report.  the question is why? Dick Bove’s answer is the temporary gains from the hedging contracts have more than offset the more permanent loss in MSR income, that is for now. I certainly think Wells will be making boatloads of money on refinancing fees. But, this fee income “accrues over time.” What will happen with these massive hedges is unclear.  What is clear is that the MSR value will have to be written down and that will be a drag to income. So, on the whole, if you strip out the hedges, the earnings level at Wells is misleadingly high.

The troubling thing about this is that these hedges are marked to market and because there are no actively-traded contracts for comparison, there are no reliable marks to mark-to-market. Let’s call these marks mark-to-make believe then.  And Wells is not the only one benefitting from this. Wells, BofA, JPMorgan and Citi, the four largest mortgage servicers, all are benefitting from this.

The four banks wrote up the value of their MSRs by about $11 billion in the second quarter, according to regulatory filings. Mortgage rates climbed by 0.35 percentage point in that period, according to Freddie Mac.

The four banks control 56 percent of the market for the contracts, according to Inside Mortgage Finance, a Bethesda, Maryland-based newsletter that has covered the industry since 1984. Servicers collect payments from borrowers and pass them on to mortgage lenders or investors, less fees. They also keep records, manage escrow accounts and contact delinquent debtors.

Under U.S. accounting rules in place since 1995, banks should report the value of mortgage-servicing rights on a fair- market basis, or roughly what they would fetch in a sale. A bank must record a loss whenever it sells MSRs for a price below where they’re marked on the books.

Because there’s no active trading in the contracts, there are no reliable prices to gauge whether banks are valuing the rights accurately, analysts said.

Bank of America held the largest amount of MSRs as of Sept. 30, with $17.5 billion. JPMorgan had $13.6 billion, while Wells Fargo owned $14.5 billion and Citigroup $6.2 billion.

Let’s see where this leads for the next quarters.  Right now it looks a lot like big bank earnings are inflated artificially by hedges. How well regional banks fare on loan losses should give us a better picture of the underlying fundamentals in the sector.

Sources

Wells Fargo 2003 Q3 10-Q (pdf) – Wells Fargo website

Wells Fargo, JPMorgan Benefit From Servicing Hedging – Bloomberg

Related posts:

• Wells Fargo to buy Wachovia
• How refinancing helps the likes of Bank of America and Wells Fargo
• On Meredith Whitney’s Goldman downgrade
• Wells profit forecast is a clear bullish sign
• Goldman crushes earnings estimates

Meredith Whitney downgraded Goldman Sachs from ‘buy’ to ‘neutral’ today.  Previously, Goldman had been her only buy recommended stock, all of the others rated neutral or ‘sell.’  Why did she do it?

FT Alphaville has the answer:

We are downgrading shares of Goldman Sachs to Neutral from Buy after over a 34% run in price since their second quarter results. At $190, shares have exceeded our $ 186 12-month price target, and we believe upside could be limited over the medium term. Specifically, we invoke a "why be greedy" rationale with such a stunning move in shares over such a short period of time. From here, we believe upside to GS’ shares is more of a "market call" and that shares should trade more or less in line with moves in the market.

In essence, Whitney is making a call based on valuation more than fundamentals.  She believes Goldman’s fundamentals still remain good. After all, Lehman and Bear Stearns are gone – so competition is less. But, the stock has run up too much to warrant buying at these levels.  This makes sense if you look at how Goldman’s stock has fared over the last two years.

Goldman Sachs is trading at its highest level since May 2008, well before Lehman failed.  So I do think taking profits is warranted. That said, should you sell now or wait for the price action to dictate when you sell? I am saying cut exposure now but Jeffrey Saut of Raymond James uses a quote to make a compelling case for waiting for the stock to roll over so as to not sell early (hat tip Barry Ritholtz).

“The absolute price of a stock is unimportant. It is the direction of price movement which counts.”

“During major sustained advances in stock prices, which usually occupy from five to seven years of each decade, the investor can complacently hold a list of stocks which are currently unpredictable. He doesn’t worry about the top because he knows he is never going to sell at the top. He knows that the chances are overwhelming in favor of the assumption that he will get far better prices by waiting until after the top is passed and a probable reversal in trend can be identified than he will ever get by attempting to anticipate the top, and get out on the nose.

In my own experience the largest profits we have ever taken have come from stocks purchased while they were making a new high in a market which was also momentarily expecting the top. As I have already pointed out the absolute price of a stock is unimportant. It is the direction of the price movement that counts. It is always probable, but never certain, that the direction of the price movement will continue. Soon after it reverses is time enough to sell. You should sell when you wish you had sold sooner, never when you think the top has arrived. That way you will never get the very best price – by hindsight your individual transactions will never look daring. But some of your profits will be large; and your losses should be quite small. That is all that is necessary for a satisfactory, enriching investment performance.”

“Stock Profits Without Forecasting,” by Edgar S. Genstein

This makes sense if you don’t have a price target for the stock you buy. But, on the whole, I say pick an exit point when you buy a stock and stick to that target. This is what Whitney is doing. And this is essentially what I have recommended for selling equities based on a Jeremy Grantham S&P target.

As for banks stocks, the whole sector is through the roof and I certainly do not believe the fundamentals warrant this as I laid out last week.  Goldman is a broker-dealer and a bank in name-only. Its model has not changed, so it is operating in an environment far more inviting than its big bank cousins like Bank of America and Wells Fargo.

So while Goldman and Morgan Stanley are looking at better prospects there are numerous obstacles to for banks.  Two articles I linked to yesterday point out some of the headwinds.

First, from the Financial Times:

A surge in fixed-income underwriting opportunities during the quarter is expected to boost revenues not just at Goldman, but also the investment banking divisions of JPMorgan Chase, which reports on Wednesday, and Bank of America, which announces results on Friday.

However, the non-investment bank operations of JPMorgan and BofA will be hit by loan losses in the commercial area as well as the consumer area, says Richard Bove, an analyst at Rochdale Securities.

“They will have to go back to increasing the size of their reserves,” Mr Bove adds.

“This could result in losses for the quarter and into next year.”

Notice how this article distinguishes between proprietary trading and broker-dealer activities on the one hand and traditional banking operations on the other. The credit cycle is still in a downswing and this will hurt banks.  But there are also other forces at work.  Marshall Auerback pointed out a Bloomberg article to me regarding the huge book of business the big banks do as mortgage servicers and how accounting rules there look unfavorable going forward.

The four biggest U.S. banks by assets may have to take writedowns on $55 billion of mortgage- collection contracts after marking them up by $11 billion in the second quarter, casting a shadow over earnings.

Bank of America Corp., JPMorgan Chase & Co., Citigroup Inc. and Wells Fargo & Co. wrote up the value of the contracts, known as mortgage-servicing rights or MSRs, by 26 percent in the quarter as mortgage rates climbed by about 0.35 percentage point. Net gains on the contracts added more than $1 billion to Wells Fargo’s record earnings in the quarter and $1 billion to JPMorgan’s first-quarter profit.

Mortgage rates fell about 0.26 percentage point in the third quarter, according to Freddie Mac, and servicing costs are rising, meaning the four banks, which handle collections on more than $5.9 trillion of U.S. mortgages, may face writedowns.

“We’re very bearish on MSR valuations,” said Paul Miller, a banking analyst at FBR Capital Markets in Arlington, Virginia. “They are overvalued. There are higher costs associated with the servicing, and we’re very concerned about it.”

Add these to my other concerns in commercial real estate, deposit insurance payments, credit card losses, loss of government subsidies, the need to keep higher levels of capital, and a flattening yield curve and you see an environment in which bank stocks should underperform the market.

The long and short is bank stocks have run up too much too quickly. Now is the time to lighten up on them. This is true whether you are talking about Goldman, which is going to earn a lot of money, or the likes of Bank of America, which faces a more challenging environment.

Related posts:

• Goldman crushes earnings estimates
• Bill Miller and Meredith Whitney: The Bull and the Bear
• Is Meredith Whitney bullish now?
• Goldman loses $2.1 in the third quarter
• Warren Buffett backs Goldman

I think it should be abundantly clear that I am bearish on financials given my sell equities call two weeks ago.  After all, it was the banking sector which I was most bullish on in April – August. They are also the stocks that have run up the most as well.  But now is the time to sell.  Why?  The conditions which created the bull run are effectively over.  Here was the notice that put me over into the bearish camp. It came last week:

US banks will have to pay $45bn in up-front fees to the Federal Deposit Insurance Corporation under a plan presented on Tuesday to shore up the FDIC’s depleted deposit insurance fund. The agency warned it will run out of liquid funds early next year due to bank failures, and said the estimated cost of expected failures from 2009 to 2013 had increased to about $100bn from an earlier estimate of $70bn. Most failures are expected this year and next.

Paying $45 billion in capital is an enormous impediment to increases in capital for the financial sector and the worst-case scenario for credit growth. This is very bearish for bank stocks and the broader economy as well.

I see it as a tad ironic that the agency tasked with seizing insolvent banks has run out of money and must tap the very pool of institutions for accelerated payments.

The FDIC chose this option for political purposes as their options were limited.

1. Borrow from the banks. Their was a leak by the New York Times last week that the FDIC was considering borrowing from the very companies it regulated in order to recoup lost funds. I criticized this proposal harshly because it could only lead to regulatory capture at the FDIC – the least captured of America’s regulators. The general public reaction was wildly negative to the leaked information. This is a crazy but legal idea that Sheila Bair was forced to defend – but reject as not ‘serious in the same breath (see my comments here).
2. Borrow from the Treasury. The Obama Administration was able to get Congress to authorize the FDIC a $500 billion line of credit back in May. This seemed like a great fallback then.  But, with the Federal deficit spiraling out of control and people yelling about government intervention in the healthcare debate, no one in Washington wants to be seen tapping what could be construed as taxpayer money. Bair said “I think there’s some recognition that . . . everyone’s got bail-out fatigue and should be extricating themselves from government support, not getting in deeper.”
3. Tax the banks in a special assessment. I say ‘tax’ because the special assessment idea which was being considered was bad for optics.  Banks are not lending because they ostensibly have a weak capital position. So, you want to go in and weaken that base further by ‘taxing’ them?  OK, now we know who to blame when the double dip recession happens.
4. Get the banks to pre-pay. This is the option chosen. Let’s be honest, there is zero difference between this option and the third option above except this is couched as money the banks will have to pay anyway. Not a very good option, really.  But, are there other choices?

Now, if you are running a bank and still expecting a decent number of writedowns in commercial property, residential mortgages, and credit cards, you are not too thrilled to have to pre-pay your FDIC insurance premiums. Then you hear Dick Fisher of the Dallas Fed and Don Kohn the Fed Vice Chairman jawboning in a hawkish way like they are going to raise rates. Not that you believe them, but still.  If Sheila Bair comes around asking for a pound of flesh, you are already feeling a bit beaten down.  I guarantee you this is not going to be good for lending.

But of course, there’s always the government spin:

John Dugan, an FDIC board member and the comptroller of the currency, said he supported the “thoughtful” proposal.

The only downside, he said, was that the cash provided to the FDIC would not then be used by the banking industry to provide loans. “This may not be likely to have a material effect on credit availability . . . but I think this is an important question,” he said.

OK. Keep telling yourself this won’t affect lending. But, owners of bank shares have to look at the situation a bit more dispassionately.   Back in April, I said:

Despite obvious problems with the bailout packages provided by the U.S. government and a huge amount of writedowns still coming due, I now fully anticipate that 2009 will surprise to the upside in financial services… I see financial services companies shedding troubled assets, not marking other assets to market and having an enormous margin spread due to ridiculously low interest rates. To me, this is a huge buy signal.

And the rally has been MUCH more than I expected.

Amongst larger banks, Bank of America (BAC) is at $16 and change from $2.53, up over 600%. JPMorgan Chase (JPM) is up almost 400% from March lows. Wells Fargo (WFC) is up over 300% from the lows. Even Citi is up over 400% –and I thought they were dead money.

Amongst large regionals, you have Fifth Third (FITB) up over 900% from a near bankruptcy valuation. Zions (ZION) is up nearly 300%. SunTrust is up more than 300% too. 

I think you get the point. There has been the mother of all rallies for bank stocks. But, this is going to change.  The low-hanging fruit (government bailouts, subsidized borrowing, low interest rates, huge spread margins, bonus payments for lending) has been picked. 

Prepare for tough headwinds:

1. A flattening yield curve
2. FDIC pre-payments
3. A withdrawal of subsidized borrowing
4. Larger commercial mortgage losses

I expect the momentum born of upside earnings surprises to turn to the dread of earnings warnings.

Update 2009 10 05: Goldman is singing a different tune and has upgraded the big banks in the sector today.  I agree that the TBTF institutions will outperform, but can or will they rise further from here? Credit Suisse is cutting earnings estimates. Stay tuned.

More update: Chris Whalen is apoplectic that Goldman is upgrading the too-big-to-fail banks and has given his own downbeat assessment, a view I shared on Credit Writedowns just yesterday. See his comments and video here.

Related posts:

• Bank stocks under $10 a share
• Bank failures to surge in coming years
• Are European banks sitting on 16.3 trillion in toxic assets?
• Bank consolidation and getting positive about the credit crisis
• Bank bankruptcy or bailout?

Fannie Mae has the luxury of marking its accounts more accurately because they have no fear of being nationalized or going bust since they already have hit the wall.  So, when we read the latest quarterly results from Fannie Mae, we are not just seeing a glimpse of Fannie’s reckless financing, but of the American financial system as a whole.

From Fannie Mae’s Q2 press release (note the emphasis added):

Fannie Mae… reported a loss of $14.8 billion, or ($2.67) per diluted share, in the second quarter of 2009, compared with a loss of $23.2 billion, or ($4.09) per diluted share, in the first quarter of 2009. Second-quarter results were driven primarily by $18.8 billion of credit-related expenses, reflecting the ongoing impact of adverse conditions in the housing market, as well as the economic recession and rising unemployment. Credit-related expenses were partially offset by fair value gains. The company also reported a substantial decrease in impairment losses on investment securities, which was due in part to the adoption of new accounting guidance…

Combined loss reserves were $55.1 billion on June 30, 2009, up from $41.7 billion on March 31, 2009, and $24.8 billion on December 31, 2008. The combined loss reserves were 1.80 percent of our guaranty book of business on June 30, 2009, compared with 1.38 percent on March 31, 2009, and 0.83 percent on December 31, 2008.

Translation: we lost over $40 billion and our loss reserve rate has more than doubled in 6 months.  We are a financial bottomless pit.

How about this statement on page three:

Total nonperforming loans in our guaranty book of business were $171.0 billion on June 30, 2009, compared with $144.9 billion on March 31, 2009, and $119.2 billion on December 31, 2008.

That’s $171.0 billion in NPLs, not million.  Breathtaking.  Needless to say, Fannie has its hands out for more taxpayer money – $10.7 billion to cover their net worth deficit from this quarter alone to be exact.

But, the reported net worth deficit of $10.6 billion does not represent figures according to fair value. That is covered on page six (emphasis added):

Our estimated fair value net asset deficit was $102.0 billion as of June 30, 2009, compared with $110.3 billion as of March 31, 2009.

Is Fannie far worse off than, say, Citi or BofA, or are they reporting their numbers somewhat closer to mark-to-market? The scale of the losses seem astronomical.

More here.

Related posts:

• Question: How is Fannie Mae a AAA company?
• BofA carrying loans on books for $44 billion above fair value
• Gateway Financial and Midwest Banc have one-third of capital in Fannie and Freddie Preferreds
• Everyone’s talking about Fannie and Freddie
• RBS reports a record loss of 24 billion pounds

Earnings season is upon us and the Swedish banks have begun reporting earnings. Their results have seen huge writedowns that demonstrate large and continued exposure to souring loans in the Baltics.

Handelsbanken and Nordea reported today. Despite the writedowns, you do get the sense that things are going better than expected as the banks beat expectations. Nordea even raised its guidance. But SEB and Swedbank, major lenders to the Baltics, are still on the ropes as previous earnings from those banks attest.

Nordea

The Danish daily Berlingske Tidene calls the first six months of 2009 “one of the best in Nordea’s history.” It notes that “despite the crisis atmosphere net income was almost a record, and management will need to revise full-year guidance upwards.”  Net income was 616 million Euros against expectations of only 421 million. That’s pretty spectacular.

But what about loans to the Baltics? Berlingske Tidene reports.

Impaired loans in the Baltic region as a whole – including both non-performing and performing – have run up to 418 million Euros, equivalent to 550 basis points of total loans and receivables.

The total writedowns for the Baltic countries was 202 million Euros…

Long story short, Nordea faces the same problems with loans in the Baltics that JPMorgan faces with credit cards and residential property in the U.S. i.e. rising losses.  In both cases, these losses have been offset by large profits due to a favorable interest rate environment.  Whether this continues is the question.

Handelsbanken

It was the same story at Handelsbanken, with the company bating expectations. The bank reported an operating profit of 3.445 billion krona, which was slightly more than last year and well above the 2.924 billion krona consensus. The Swedish krona is trading at 7.69 to the dollar, so we’re talking about $450 million in profit.

Loan losses were up to 939 million krona from 571 million last year. There was no initial report of exposure to the Baltics as Handelsbanken was not one of the biggest lenders amongst the Swedish banks. All in all, this was a good report.

SEB

SEB reported yesterday and they showed a large loss of 193 million krona, compared to the 2.8 billion profit of 2008.  This huge swing is due to large credit losses, he majority of it in the Baltics. SEB had 3.6 billion krona in credit losses, 74% of which came from the Baltics.  This forced them to write down 2.4 billion in loans in the Baltics and Russia.

The contrast is striking and its all due to the reckless lending in the Baltics.  Expect more of the same going forward.

Swedbank

Swedbank is the other big lender in the Baltics with SEB.  SO they had dismal earnings as well in a report from last Thursday.  The FT reports:

Swedbank, the largest lender in the Baltics, posted net losses of SKr2.01bn ($257m), compared with net profits of SKr3.6bn a year earlier.

It was the bank’s second consecutive quarterly loss and much worse than the SKr1.27bn deficit forecast by analysts.

Loan losses soared from SKr423m a year ago to SKr6.67bn, with about two-thirds of the amount in the Baltics and a third in Ukraine.

In response, the bank said it planned to reduce staff by 3,600, about 16 per cent of its workforce, by this time next year, with most of the cutbacks in the Baltic states.

Shares were up on the announcement, but I expect more of the same going forward.  Whether Swedbank needs more capital remains to be seen.

Now, Just two weeks ago I mentioned a plan by Swedbank and SEB to write down personal loans in Latvia, the hardest hit country in the Baltics, by 10% in exchange for a Latvian government guarantee against further losses (see Transferring Swedish bank risk onto Latvian taxpayers). It is unclear whether these writedowns were taken or even if this proposal has gotten a green light, especially given the problems Latvia is now having getting more money from the IMF.  But, clearly, this would mitigate any losses at Swedbank and SEB.

The difference in profitability between the four banks does show that the banking system in Sweden is doing just fine outside of the problems with Baltic exposure.  I take that as an encouraging economic sign in Sweden that may be indicative of other countries in Northern Europe as well.

Sources

Nordea overrasker positivt – Berlingske Tidene

Nordeas vinst klart över förväntan – Dagens Nyheter

Handelsbanken överträffar prognoser – Dagens Nyheter

Baltic exposure hits Swedish bank – BBC News

Related posts:

• Why is Swedbank doing a second rights issue?
• Estonia and Latvia: headed for the rails
• Event risk in the Baltics is critically high
• Transferring Swedish bank risk onto Latvian taxpayers
• European banks have hands out for more capital

Every country has a problem child or two in the financial services sector. America has Citigroup and Bank of America. Britain has RBS and HBOS/Lloyds.  And Germany has Hypo Real Estate. 

I have been chronicling problems at the real estate lender on this blog for some time now and last posted on HRE in April (“HRE: defusing the German financial time bomb”).  Back then, the German government was looking to step in and effectively nationalize the company.  Subsequently, on June 23rd, Hypo Real Estate warned of heavy future losses. Having already received €100 billion in support from the government, you could be forgiven for thinking HRE is a bottomless pit. 

Now that the company is a ward of the state, taxpayers are on the hook for another 10 billion. But, Hypo Real Estate’s plight reveals stresses in Spain as well. Ambrose Evans-Pritchard reports.

"The bank clearly has a solvency problem," said Michael Endres, head of the board in an interview with Welt am Sonntag. "It wouldn’t surprise me if a capital injection of €10bn proved insufficient."

Meanwhile, the extent of credit damage in Spain is becoming clearer after America’s GMAC revealed that it had been selling Spanish mortgage assets at 14.5 cents on the dollar as it withdraws from global ventures to focus on the US home market.

Until now, it has been hard to measure the extent of the "haircuts" being suffered on Spanish mortgage securities since there is no obvious gauge such as the ABX Index used to track sales prices on US subprime and Alt-A debt.

The GMAC sales suggest that Spain’s property crash will inflict large losses on foreign creditors, mostly from Germany and France. The Spanish government has long insisted that higher credit standards in Spain have spared the country the sort of debacle seen in the US.

Hypo Real’s Mr Endres said earlier management had expanded at breakneck speed in foreign markets that they never understood, wading cluelessly into US housing through its Dublin operations. "The property market is like farming: you don’t buy a field until you have walked around it a few times," he said.

First of all, I would love to know what GMAC is doing in the Spanish mortgage market. Considering GMAC just got a second bailout in May, American taxpayers have the right to know what GMAC is doing and where. 

The revelation of GMAC’s involvement also makes clear how intertwined the global financial system is – an American auto lender gets a bailout and then dumps Spanish mortgage assets for a ridiculously low price. These losses make clear that a reckless German real estate company speculated away billions in the same foreign market, turning it into a government-owned company and requiring yet more money from German taxpayers.

But, I should also add that 14.5 cents on the dollar is extremely low given the fact that Spanish house prices have only fallen 13% to date (see my post “House price declines accelerate in Spain”).  What does that tell you about likely losses in the Spanish banking system going forward?

Related posts:

• Hypo Real Estate: 600 billion in off-balance sheet assets
• Germany: banking system collapse possible due to Hypo Real Estate
• Spain: Bleak forecast puts unemployment at 22% in 2010
• House price declines accelerate in Spain
• More problems at three European financial institutions

While Citi and BofA are getting taken to the woodshed for double secret probation, JPMorgan Chase is showing record revenue of $25.6 billion and a large profit of $2.7 billion.  As profit is up 36% from a year earlier and 27% from just last quarter, you can see that JPM is now firing on all cylinders.

The contrast between the performance at JPMorgan Chase and Goldman, who reported Tuesday and the beating that BofA and Citi are taking at the hands of regulators demonstrates which big banks are weak and which are doing better.  Goldman and JPMorgan have already returned their TARP funds and are free to return to business as usual.  Goldman has increased risk to pre-crisis levels according to Value at Risk (VaR) measurements and are due to give out record bonuses.  Meanwhile, JPMorgan Chase saw its loan loss reserves fall 2% from Q1 to Q2.

Citi is up tomorrow. Expect a huge contrast to what we have seen from Goldman and JPMorgan Chase. 

Also expect some serious regulatory steps as well. As I indicated in April’s post “Stress tests reveal Citi and BofA need more capital, but you knew that already,” some banks were going to pass the stress test while others would fail. I also said then that debt for equity swaps, nationalization or FDIC seizure were going to be on the table, if the failing banks didn’t get the necessary capital from the private market. Citi and BofA have both failed the stress tests and have not gotten enough capital.  So the Feds are going to move in and take action- and we’ll get a sense of what kind of action tomorrow.

The only remaining question is Wells Fargo.  They have not paid back their TARP money but I still suspect they are doing better than Citi and BofA.

Related posts:

• JPMorgan: Beats expectations despite writedowns
• Is Citi being forced to downsize by Obama?
• Ten big banks receive approval to repay TARP funds
• Will banks exiting TARP take back their toxic waste now?
• How is Citi going to deal with $38 billion in deferred tax assets?

I got a tip from a friend Andrew about a sale of assets by Wells Fargo (WFC) which raises a number of interesting questions.  He sent me the following 14 July article from the Milwaukee Business Journal.

Wells Fargo sold $600 million in mostly non-performing subprime loans to Irvine, Calif.-based Arch Bay Capital, National Mortgage News reported, citing sources familiar with the sale.

The industry publication said the loans sold for 35 cents on the dollar, about double what most hedge funds were offering.

Most of the subprime loans San Francisco-based Wells Fargo (NYSE: WFC) sold were originated by once-high flying Accredited Home Loans and NovaStar Financial, both of which originated subprime loans in the Milwaukee area.

No one involved in the recent sale is talking on the record, which may be a key reason lenders will look to private transactions to unload bad assets rather than turn to a government-sponsored program, National Mortgage News said.

Now, this transaction has not received a lot of coverage.  But the OC Register’s Matthew Padilla covered it as well as the buyer Arch Bay is based there. And they ask some interesting question based on the piece from the original source, National Mortgage News.

National Mortgage News reports Wells Fargo recently sold $600 million in distressed subprime loans to Irvine-based Arch Bay Capital.

Paul Muolo of NMN says the loans were originally funded by two mid-sized subprime lenders: Accredited Home Loans and NovaStar Financial.

Arch Bay co-founder Steven Davis declined to comment on the purported sale to his firm, referring calls to his partner Shawn Miller who serves as Arch Bay’s CEO. Mr. Davis didn’t deny that the sale took place but he wouldn’t confirm it either. Mr. Miller could not be reached for comment.

Meanwhile, one question the sale raises is this: How exactly did the publicly traded Wells wind up with so many crummy non-prime loans from these once highflying firms? Answer: I don’t know and Wells isn’t talking. A company spokesman said the bank’s corporate policy is to not discuss its loan auctions.
…
The nice thing about the private non-performing loan market is that none of these messy details have to see the light of day, including the price paid. One banker told me that the 35 cents on the dollar that Arch Bay reportedly paid was twice what some hedge fund bidders were offering.

I have calls into Wells and Arch Bay and will update the post if and when I hear back.

Does such a sizable deal signal we really don’t need PPIP? Or, looking at it another way, if paying 35 cents on the dollar is a high bid, then I don’t see how PPIP could help banks’ books.

The last question is a good one, but I have others.  Here is what I wonder:

• Why does Wells have this exposure to Milwaukee-based loans to begin with?  If these were part of an MBS, the loan pool would be more dispersed. Were they out buying NovaStar and Accredited Home loans back in 2007 when these companies’ subprime operations went to the wall?  (See my list of bank writedown news by lender for the 2007 events at NovaStar and Accredited Home.)
• Do they even own these loans or are they the ‘asset manager?’  They could be selling on behalf of a third party.  But, as they are not talking, we have to assume this is their own exposure.
• How much more Midwestern exposure does Wells have?  I have to assume they bought these loans to hold on their books if these are not part of a broader MBS pool.  I know they have operations in the Midwest because of Norwest. But, the fact that they probably bought loans outright to hold on their books would suggest that they have a lot of exposure in the Midwest.
• As The OC Register says: is 35 cents a high bid?  That would suggest massive writedowns waiting to be taken on other assets of  similar quality in the Midwest. Think Ohio and Michigan.  Where are these assets marked on the books?  At 35 cents, higher, or lower?  I’m betting much higher. Will we learn more in the WFC Q2 conference call next Wednesday on 22 July?
• Who else is doing deals like this?  And does that mean they are bypassing the PPIP program because they can do these deals privately?

Finally, as the OC Register suggests, a 35 cents on the dollar bid means huge writedowns that banks do not want to take – especially banks still on government TARP life support like WFC.  To me, this explains very well why the PPIP program was a failure: if banks can sell distressed assets quietly over time to private bidders, they might be able to delay taking writedowns.  But, the price discovery involved in the PPIP program would be a blood bath for banks already capital-constrained.  This is why the program has failed.

Related posts:

• Wells profit forecast is a clear bullish sign
• Creditors paid in full? No – try 6 cents on the dollar
• Quality financials are out there
• Wells Fargo to buy Wachovia
• Regionals are exposed to credit crisis

This comes via Bloomberg:

Goldman Sachs Group Inc.’s second- quarter profit exceeded analysts’ estimates as record trading and stock underwriting led the company to its highest quarterly profit.

Net income in the three months ended June 26 was $3.44 billion, or $4.93 a share, the New York-based bank said today in a statement. That surpassed the $3.65 per-share average estimate of 22 analysts surveyed by Bloomberg and compared with $2.09 billion, or $4.58 per share, in last year’s second quarter.

This number includes a charge that if excluded would put us up well into the $5 per share range – very much in line with Meredith Whitney’s bullish call. Here’s what the Wall Street journal said.

Goldman posted income of $3.44 billion, or $4.93 a share, up from $2.09 billion, or $4.58 a share, a year earlier. The latest results included a $426 million dividend related to the company’s paying back its TARP funds. Excluding that, earnings were $5.71 a share. Net revenue jumped 46% to $13.76 billion.

The stock was down $2 in pre-market trading at 830AM ET. MarketWatch also notes a huge uptick in revenue.

Net revenues at the firm were $13.76 billion in the second quarter, compared to $9.42 billion last year. Goldman switched from a fiscal reporting schedule to a calendar schedule last year, and this year’s second quarter ended in June, while the year ago data is for the period ended May 31, 2008.

The Goldman press release is here.  What I find notable is the order in which the press release presents the earnings, with a statement on the advisory business first, followed by equities and then fixed income even though fixed income was where the most revenue and profit came.  That is revealing – ad shows Goldman execs still consider the advisory business of relatively more importance from a reputational perspective.

Related posts:

• Goldman loses $2.1 in the third quarter
• Let Goldman fail next time
• On Meredith Whitney’s Goldman downgrade
• Is Meredith Whitney bullish now?
• Bill Miller and Meredith Whitney: The Bull and the Bear

Just when I was wondering where Meredith Whitney had gone, she’s back.  But she has a whole new tone to her.  In this interview on CNBC, she says she is expecting a monster number from Goldman (GS) tomorrow morning, in 2010 and in 2011. She is well above the street on Goldman. She even uses the word ‘cheap’ when referring to the stock.  Is Meredith Whitney a bull now? Have a listen – she also talks about other names and sees Bank of America (BAC) as the one to watch.  I like her reference to ‘junk in the trunk’ when talking about JPMorgan Chase (JPM) in the 2nd video below.

Her comments seem a far cry from the bearish Meredith Whitney of yore.  What happened to that woman?  Maybe she read my post “Marc Faber: “it’s very tough for a forecaster who was ultra-bearish to stay bearish.”

For a view of what Whitney sounded like just a few months ago, see my May post “Meredith Whitney seems onboard with the fake recovery” or my April post “Meredith Whitney: Regardless of stress tests, banks will still need more capital.” She sounds very different today and is singing a tune I first got onboard with in April (“Wells profit forecast is a clear bullish sign”).  But, given the huge run up in shares, I do question how much more upside there is to bank shares now despite what are likely to be very good earnings.  Let’s see how Goldman’s earnings and shares do and that should be a good test.

You will notice that in the first video she suggests that the disappearance of the likes of Lehman and Bear are good for the surviving behemoths (which increases banking concentration, a point I just made).

UPDATE 1230ET: Whitney makes a point regarding loan modifications that I first made on May 26th (“How refinancing helps the likes of Bank of America and Wells Fargo”) i.e. that the big banks are getting a HUGE incentive to do refis and this will goose their earnings short-term in three ways: a. they get a refinancing fee that goes straight to current income. b. they get an incentive fee due to rules the government made on May 21st, the subject of my May 26th post. c. the banks get to at least delay writedowns because past due mortgages become current and this will decrease their loan loss provisions over the short-term.  Nevertheless, home mortgage default recidivism means that re-default likelihood is high and that the writedowns will eventually have to be taken.  Whitney seems to be saying this makes banks a good trading play, not a good holding play.

Related posts:

• Meredith Whitney: “I haven’t been this bearish in a year”
• Bill Miller and Meredith Whitney: The Bull and the Bear
• On Meredith Whitney’s Goldman downgrade
• Meredith Whitney seems onboard with the fake recovery
• Meredith Whitney: more bearish than ever, but…

The Online Merriam-Webster Dictionary describes alchemy as “a power or process of transforming something common into something special” or “aiming to achieve the transmutation of the base metals into gold.”  Well, it seems Morgan Stanley is engaging in some financial alchemy because it is about to trade near-junk rated paper for Aaa gold-standard bonds (hat tip Max Keiser and Stacy Herbert).

Morgan Stanley plans to repackage a downgraded collateralized debt obligation backed by leveraged loans into new securities with AAA ratings in the first transaction of its kind, said two people familiar with the sale.

Morgan Stanley is selling $87.1 million of securities that it expects to receive top AAA ratings and $42.9 million of notes graded Baa2, the second-lowest investment grade by Moody’s Investors Service, according to marketing documents obtained by Bloomberg News. The bonds were created from Greywolf CLO I Ltd., a CDO arranged in January 2007 by Goldman Sachs Group Inc. and managed by Greywolf Capital Management LP, an investment firm based in Purchase, New York.

Here’s the problem.  In June, Moody’s downgraded the Aaa tranche of this CDO six notches to A3 because the default rate for loans in the tranche soared to 7 percent.  So, now, Morgan Stanley has been able to re-package this paper, and…voila this debt is Aaa again.  Everybody’s doing this repackaging.  Goldman plans to sell over $200 million of repackaged Commercial mortgage-backed paper very soon.

So, when earnings start coming in this quarter and you are wondering how these banks aren’t writing down huge losses due to events like this and this, you now have one more reason why.  Here are two more reasons here and here.   The question is whether investors will be fooled.

ps. – I am sure Morgan Stanley added credit enhancement, collateral, reduced the poorly performing assets, etc, etc.  But, nevertheless, you have to wonder how this stuff gets a Aaa rating when substantially the same loan pool was just downgraded six notches.

Source

Morgan Stanley Plans to Turn Downgraded Loan CDO Into AAA Bonds – Bloomberg

Related posts:

• Goldman and Morgan Stanley are now banks
• Morgan Stanley’s writedowns bring us to a cool $1 trillion
• Are covered bonds really the solution?
• Quote of the day: Investment Bank Leverage
• Morgan Stanley: rogue trader goes missing

I have been looking forward to the Alcoa (AA) earnings report, due out later today, because of what it suggests about the economy.  As the economy bottoms, the fortunes of cyclical companies that are leveraged to the overall state of the economy turn up.  As Alcoa is the first company to report every earnings season and it is an cyclical basic industries company, its earnings report have been seen as an economic bellwether for some time. But is this set to change?

Alcoa Inc, whose results are traditionally viewed as an indicator of the country’s economic health, is expected to post a third consecutive quarterly loss this week.

But many on Wall Street no longer see the aluminum producer’s numbers as a bellwether portending either a deeper recession or an easing of the global downturn.

"It’s a large company in a major industry and it is the first to report, so it gets special recognition," said Joseph Battipaglia, a market strategist at Stifel Nicolaus & Co in Yardley, Pennsylvania.

"But it’s only telling you about the health of the aluminum industry and that’s not very good right now.

"FedEx and UPS are better signs of a change in direction," he added, referring to the two largest U.S. shipping or package-delivery companies. "I wouldn’t take what Alcoa says as a significant indication of how the American or global economy is faring."

Battipaglia said that even if Alcoa — the first member of the Dow Jones industrial average to release earnings — reported an upsurge of orders on Wednesday, it was no real sign of a turnaround. Most customers let their inventories go down in recent months, he noted, and were now restocking while aluminum prices are relatively low.

Battipaglia’s comments are significant for two reasons.  First, there is the fact that we may well be seeing an inventory-induced uptick in the economy right now.  It is far from clear that the economy has bottomed in a sustainable way.  I made this point in my recent post, “ISM: Is this the mother of all inventory corrections?.”To be sure, I do think the economy is bottoming and that a technical recovery will ensue late this year or early next year. However, I am willing to entertain the notion that a balance sheet recession for U.S. consumers has created conditions in which this view could turn out to be optimistic.

The second reason I believe Battipaglia is on to something is that UPS and FedEx (FDX) are more representative of overall economic conditions these days. In my post “If FedEx is losing money, you know the economy is in bad shape” I said we should worry about what FedEx’s numbers are saying about economic growth in America.

Last month I said that June was significant for two reasons.  First, we are going to get our first test of data that could disappoint, which would spell trouble for an overbought market. But, just as important, we need to watch the industrials because there is going to be no sustainable recovery unless these cyclical companies are leading the way.  If the recent awful earnings report from FedEx is any indication, this sector is still in a world of hurt.  The Globe & Mail has a good take on how this is shaping up.

So, certainly look toward the Alcoa earnings report today for signs of economic direction.  However, keep in mind that we have already seen FedEx’s numbers and they are not good. UPS reports on 23 Jul 2009.  Let’s have a look at what those numbers are telling us as well.

Source

What does Alcoa’s expected loss mean for the economy? – Reuters

Related posts:

• Earnings results at Swedish banks show large writedowns in Baltics
• Are European banks sitting on 16.3 trillion in toxic assets?
• If FedEx is losing money, you know the economy is in bad shape
• Goldman crushes earnings estimates
• Lehman Brothers earnings: loss of $3.9 billion

This comes from Reuters:

Fallout from a still deteriorating housing market caused the rate of consumer loan payments at least 30 days late to rise to 3.23 percent in the January-to-March period from 3.22 percent in the 2008 fourth quarter, the American Bankers Association said.

Delinquencies were the highest since the ABA began tracking the data in 1974. Late payments on home equity borrowings set records, rising to 3.52 percent from 3.03 percent on loans and to 1.89 percent from 1.46 percent on lines of credit.

The overall delinquency rate actually understates consumer pain because it excludes bank-issued credit cards, where credit deterioration was severe.

Remember, 2008 was all about a financial crisis.  What we are seeing now in consumer and commercial mortgage delinquencies, credit card and other consumer loan delinquencies is what one would expect  see in a normal recession. Normally we would expect this record level of delinquency to hit the bottom line at banks, especially those with large asset-backed loan exposure.  However, accounting rule guidance may distort the reporting of writedowns.  JPM releases on the 16th, BofA (BAC) and Citi (C) on the 17th.  So, we should get a good indication how things are reported then.

Related posts:

• Consumer credit down a massive 33% in Spain
• What Home-Loan Banks reveal about the effects of mark-to-market
• New Crisis Threatens Healthy Banks
• More warnings on regional banks
• Extend and pretend and the growing divide between delinquencies and foreclosures

This morning, stock markets are down in Asia and Europe.  And Futures show a likely decline in the U.S.

What’s happening?  I think we are seeing the March rally hitting the wall as the technical recovery everyone is anticipating looks to come later and to be less robust. As a result, commodities are selling off horribly.  Crude has traded under $65 and is down over 3%.

For me, Alcoa’s Wednesday report will give a good sign of how robust the economy is as basic material stocks should do well in an upturn.  In a post in late May Consumers ‘do believe in the green shoot story’, I indicated that June and early July would be key for this overbought market.

Let’s remember that confidence does not translate into consumption, especially as most of the uptick here was in consumer expectations.  Nevertheless, this has grabbed the market’s attention and U.S. stocks are up well over 2% as I write this.  If you were wondering whether the powerful market rally from March has legs, this should come as proof that it does.  The S&P 500 is now above its 20-day average trendline again.

I should caution that an uptick in expectations of this magnitude has a dark side.  If the economic data disappoint in June, we could see a sharp selloff.  That makes the June data and the early July earnings reports very crucial data points.

And I still believe this is true.  The June economic data was not nearly as good as market experts expected and the market has sold off as a result.  he employment data last week was truly dreadful.  If we get poor earnings here in July, this bear market rally is going to get cut down to size.

Key sectors to watch are financials and basic materials.

Sources

Commodity Futures – Bloomberg
CNN Money Pre-Market Data – CNN Money

Related posts:

• Dow 4,000 still in the cards?
• Kass: Bearish on equities
• Rosenberg: Market rally is just multiple expansion
• Are the markets set for a pullback?
• Getting bearish again

FT Alphaville is reporting that the credit rating agency Fitch puts credit card losses at 10.4% of outstanding loans.  This is a record.  Bad news if you are a credit card company.  So, what does one do in that situation?  You raise rates on customers that are paying, silly.

Citi’s rate increases emerged on the day the government proposed legislation to create a new regulator with sweeping powers on consumer protection and a week after the bank was attacked by some politicians for raising employees’ salaries.

Holders of co-branded cards who failed to pay their balance in full at the end of the month saw their rates rise by an average 24 per cent – or nearly 3 percentage points – between January and April, according to a Credit Suisse analysis of data from the consultancy Lightspeed Research.

Now, remember, insurance companies do the same thing- jack up rates for those that can pay to make up for the losses on those that can’t pay.  But, the optics here are not good – with Citi being bailed out by government and Obama calling for consumer protection at the same time as Citi is piling on interest.  It should be interesting to see if the Obama people have anything to say about this.

The Alphaville post by Stacy-Marie Ishmael is interesting because it does suggest that off-balance sheet losses are going to be an issue here.

I have two thoughts on the larger issue of credit cards.

1. The banks to watch are Citi, JPM and BofA, and Capital One as they all have huge credit card outfits.  My eyes are on JPM because they are the bellwether of the industry now.  Back in November, I warned that they were highly leveraged to the real economy. So, while they have escaped fairly well to date, let’s see what kind of beating they take going forward.  This will be instructive to the health of U.S.banking.
2. One would normally expect a slew of writedowns.  After all, it was writedowns on marketable securities which blew up the credit crisis in 2007 and 2008.  But FASB has fixed this problem.  So, let’s see how many writedowns result.  In truth, credit card debt used to be discharged in consumer bankruptcy.  But, the credit card lobby fixed that problem in 2005.  Now, the credit card companies may still be able to get their pound of flesh even if one files for bankruptcy. The key is whether you have a job or not due to a new bankruptcy means test.  The long and short for me is this: in the real world, since a high percentage of people defaulting on credit cards have lost jobs, we should expect the recovery rate to be much lower due to debt discharge in bankruptcy.  This should lead to a lot of writedowns at the likes of Citi, PM and BofA.  But, given recent FASB guidance on accounting for mark-to-market, it is anyone’s guess at this point.

Any way you look at it, though, higher loan losses mean less revenue.  How this gets reported over the near term is another matter altogether.

Related posts:

• Consumer loan delinquencies paint bleak picture
• More credit card writedowns are coming
• Amex: paying cardholders to close accounts
• Citi close to selling German unit
• $35 billion in missing writedowns

Last month I said that June was significant for two reasons.  First, we are going to get our first test of data that could disappoint, which would spell trouble for an overbought market. But, just as important, we need to watch the industrials because there is going to be no sustainable recovery unless these cyclical companies are leading the way.  If the recent awful earnings report from FedEx is any indication, this sector is still in a world of hurt.  The Globe & Mail has a good take on how this is shaping up.

FedEx’s forecast yesterday was certainly no green stalk. During the rally that began in March, its shares surged 80 per cent by early May as investors bet that a full financial meltdown and economic depression were not in the works. That’s about double the move of the broad S&P 500 over the same period, and it reinforced the belief that freight haulers are barometers for the global economy.

"They are a reflection of consumer conditions," said Morgan McGowan, assistant economist at Moody’s Economy.com. "The companies involved operate with a combination of air and ground, and even rail shipping as well. So they give a broad range of the different types of shipments that are going out.”

Now, though, the barometric reading has changed as investors lose patience over the lack of hard evidence of an economic recovery. FedEx shares have fallen 17.8 per cent over the past month – worse than the broader market – and have sent some strategists to the Dow Theory, a technical indicator that gets some respect from those who sneer at technical analysis.

According to the theory, an upward move by the 30-member Dow Jones industrial average means nothing unless the 20-member DJ transportation average also moves up. The reason? The industrials make the stuff that the transportation companies haul. If there’s no hauling, then there probably isn’t a lot of demand for the stuff being made.

Lo and behold, the transportation average – which includes Burlington Northern Santa Fe Corp., Union Pacific Corp. and FedEx – has hit hard times, tumbling 6.6 per cent since last Thursday.

The industrials are now playing catch-up: The index began its descent on Monday and has since fallen 3.4 per cent – and the Dow Theory hints at more trouble ahead unless the economic news starts pointing toward sunnier days.

"Until now, ‘less bad than expected’ has been enough for investors," John Hussman of Hussman Funds, said in his weekly letter to clients. "At this point, however, stocks are priced to require an economic recovery."

In short, this market has risen to seriously overbought levels that has priced in imminent recovery.  But, the FedEx news should give you pause in regards to an imminent recovery. Even a delay in recovery until the fourth or first quarter would be a huge disappointment in this market.  Continued recession beyond that time would be catastrophic.

Related posts:

• Alcoa earnings on deck, but focus on FedEx and UPS
• Unemployment numbers still point to partial recovery
• James Montier sees “deep value” in markets – he is bullish
• Irish banks have unreported bad debt
• The House defeats the bailout plan and shares plunge

On the face of it, Nationwide’s earnings report looks extremely good: 15% Tier 1 Capital, Pre-tax profit of nearly £400 million.  Given this financial institution’s leverage to the residential housing market, their results stand in stark contrast to the likes of Chelsea, which was downgraded by Fitch last week with four other U.K. building societies.  The Nationwide shows performance that also stands in stark contrast to HBOS, the erstwhile king of residential property in U.K. bank lending.  Clearly, one must understand the stark contrast demonstrates that reckless risk-taking has been a major factor in the downfall of both HBOS and RBS.  I should also note that Nationwide is not a public company.  It never demutualised as did the Halifax, a prime reason for the dichotomy in risk profiles.

Here is the press release below. Take the self-congratulatory statements (“Nationwide is the largest UK banking institution not to have raised capital during the year”) with a pinch of salt:

Nationwide Building Society today announced its results for the year ended 4 April 2009. This set of results demonstrates a resilient performance in an exceptionally difficult market place. During the period, the Society has remained free from government support, has not needed to raise additional capital and its assets have increased organically in addition to the integration of three regional brands. Nationwide continues to hold high levels of liquidity and remains well capitalised with a Tier 1 ratio of 15.1% and a high quality balance sheet. Whilst the levies payable under the Financial Services Compensation Scheme (FSCS) have had a significant impact on statutory profit, the Society remains profitable and is here for the long-term providing consumers with a real and attractive alternative to the banks.

Nationwide has performed well in unprecedented and challenging market conditions:

• Underlying profit before tax of £393 million (2008: £781 million). The reduction of 50% reflects the cost of carrying additional liquidity and margin compression in a low interest rate environment, together with an increase in impairment provisions in the current recessionary conditions.
• Reported profit before tax for the year of £212 million (2008: £686 million).
• Reported profit is after an exceptional charge of £241 million in respect of FSCS levies covering the Group’s share of interest for the full three year period of the HM Treasury loan to FSCS. These levies account for more than half of the fall in reported profit.
• Despite the challenging environment, an estimated £680 million benefit has been provided to members in the year through competitive interest rates and lower fees and charges.
• Total assets, including the impact of the mergers with The Derbyshire and The Cheshire Building Societies and acquisition of certain assets and liabilities of Dunfermline Building Society, increased by 13% to £202.4 billion (2008: £179.0 billion).

Prudent and robust balance sheet:

• Strong capital ratios with a Tier 1 ratio of 15.1% and Core Tier 1 ratio of 12.1% (Basel II, IRB basis). Nationwide is the largest UK banking institution not to have raised capital during the year.
• Balance sheet funded predominantly by retail savings, with our wholesale funding ratio of 28.6% (4 April 2008: 31.0%) being one of the lowest levels within UK banking institutions.
• Loans originated by Nationwide continue to perform strongly, with the proportion of residential mortgage accounts more than 3 months in arrears of 0.60%, compared with the CML industry average of 2.39% as at 31 March 2009. The CML industry average has deteriorated at twice the rate of Nationwide’s arrears on originated loans in the year to 31 March 2009.
• Mortgage assets acquired through mergers with Derbyshire and Cheshire and the purchase of Dunfermline’s prime residential assets have been fair valued on a basis which makes allowance for anticipated losses over the remaining life of the loans. As a result of this fair valuation exercise, Group profits should be protected from future losses.
• The recession has impacted the commercial property market particularly in the second half of the year and has resulted in a significant increase in the number and value of commercial arrears cases, albeit from a very low base. The number of Nationwide originated commercial cases 3 or more months in arrears is 179 (4 April 2008: 66).
• The proportion of unsecured personal loan balances over 30 days in arrears increased to 7.15% (2008: 5.88%), but remains significantly less than the industry average of 17.0%.
• The Society’s core liquidity ratio at 4 April 2009 was 12.8% (4 April 2008: 8.9%).
• The AFS reserve has increased to £2.0 billion negative, net of tax (4 April 2008: £0.4 billion negative). The Available for Sale (AFS) assets have been carefully reviewed based upon latest performance data and no significant additional impairment has been booked in the second half of the year. The majority of these assets were purchased with the intention of holding them to maturity and we continue to expect to recover full value for substantially all of them over their residual life.

Proactive response to market conditions:

• Merger transactions with The Derbyshire and The Cheshire Building Societies were successfully completed in December 2008, three months after announcement.
• Acquisition of prime residential loans, retail liabilities and other selected assets and liabilities of Dunfermline Building Society completed in March 2009.
• Portman integration was completed ahead of schedule, with total merger synergies of £90 million to be delivered by the end of 2009/10.
• Retail savings franchise expanded into the Republic of Ireland with the opening of a branch in Dublin.

Nationwide’s chief executive, Graham Beale, said,
“History will record 2008 as a year of fundamental change to banks and financial institutions across the world. Nationwide has remained strong in the midst of all this turbulence and has been the only major UK banking institution not to raise capital or seek access to Government sponsored capital enhancing schemes. This reflects a combination of our naturally high capital and prudent lending practices which are the hallmark features of a strong building society.

“Profitability has been adversely affected by the low interest rate environment and increased provisions as a result of the current recession. Our reported profit is 53% lower than it would otherwise have been because there is an exceptional charge of £241 million relating to the levies payable to the FSCS.

“We regard the fact that the FSCS charge is not linked to the level of risk posed to the financial system by individual institutions, but instead is allocated by share of the retail savings market, as illogical and unfair, producing a disproportionate outcome for the low risk retail funded institutions, particularly building societies. This view is shared by 173 cross party MPs. We have also lobbied for an increase in the FSCS limit from £50,000 to at least £100,000 which would reassure savers with independent institutions that they have similar protection as those with Government owned, nationalised and part-nationalised banks.

“During the year we played our part in promoting financial stability by merging with the Derbyshire and Cheshire building societies in December 2008 and by acquiring selected assets and liabilities of Dunfermline Building Society in March 2009. In addition, the Group also expanded its retail savings franchise by opening a branch in Ireland in March 2009.

“The size of the mortgage and savings market has contracted significantly in the year as a result of the extreme economic conditions. In addition, aggressive deposit taking by state owned institutions such as NS&I and Northern Rock effectively took in excess of 70% of the savings market in the second half of 2008. Against this background we maintained our competitive position with healthy market shares of over 8% for mortgages and 10% for savings deposit growth.

“Market conditions will remain challenging throughout 2009 and beyond. In particular, the low interest rate environment will continue to depress margin and higher levels of unemployment and business failures will inevitably lead to increased loan loss provisions. However, we remain confident that Nationwide’s high quality balance sheet and robust capital ratios will continue to underpin our financial strength and place us in a strong position to trade through these conditions and remain a real and attractive alternative to the banks.”

Source

Nationwide Building Society Results Press Release – Nationwide site

Related posts:

• Nationwide: example of how UK recap scheme matters
• Nationwide: Press release on Dunfermline acquisition
• Nationwide looking to buy targets in UK mortgage market
• UK consumers don’t save
• Nationwide: U.K. house prices resume their descent

Earlier today I posted an article about how accounting was favourable to banks in that it could help them weather the storm and appear well-capitalized until a recovery is underway.  Afterwards, a buoyant economy would increase earnings enough to allow the massive writedowns that need to flow through the income statement to be taken in stride.  As an addendum to the previous post, I added a note regarding how this turn-of-events can take place even though the housing market is considerably worse than most pundits felt it would be.

Calculated Risk has a story out (Revisiting the JPMorgan / WaMu Acquisition) which suggests that JPMorgan, if anything, under-provisioned for the eventual WaMu losses.  That would suggest a lot of writedowns over the life of the WaMu loans. This is an account that I would tend to believe as the housing market is worse than the baseline case JPMorgan presented after the acquisition (see my post "JP Morgan Chase buys WaMu out").  Again, I see WaMu as a bankrupt organization that was destined to fail.  Nevertheless, over the short-term, accounting from the transaction can be favourable to JPMorgan’s earnings – and I see that as a net positive for JPM.

I have another tack regarding bank earnings to share.  Feel free to express your agreement or doubt in the comments regarding this line of argument.  As a result of the securitization model of mortgage finance having replaced the traditional model, banks with large retail customer bases are geared to transactions and volume as a way of making money.  This means banks like high mortgage transaction volumes, whether through actual purchases or refinancing.  Some of the the banks geared in that direction include Wells Fargo and Wachovia, Bank of America and Countrywide Financial, and JPMorgan and Washington Mutual. All of these banks will benefit from having bought other bankrupt organizations with large mortgage operations. 

For example, say you buy a house in 2004 that is not underwater. Having seen your 5-year ARM reach the end of the ARM period, you are looking to refinance now in 2009.  Using some of the homeowner-oriented bailout schemes, your bank can lower your monthly payment but in return they get an incentive payment:

• A straight out cash incentive payment of say $1000 for doing a loan modification on a still current loan as the lender (say Wells Fargo) AND another cash payment as a servicer (say, Countrywide, now BofA).
• A amortized payment equal to half of the savings you just received (as long as you stay current, which 40% of loan-mods are not doing). So you save $100, but the bank gets $50 a month for the next five years as a lender. The servicer will get annual payments here as well.

Nice, huh?  Well read this from the Mortgage Bankers Association from last week’s Weekly Mortgage Applications Survey.  I have highlighted the points you should pay attention to.

The Mortgage Bankers Association (MBA) today released its Weekly Mortgage Applications Survey for the week ending May 15, 2009.  The Market Composite Index, a measure of mortgage loan application volume, was 915.9, an increase of 2.3 percent on a seasonally adjusted basis from 895.6 one week earlier.  On an unadjusted basis, the Index increased 2.0 percent compared with the previous week and increased 42.0 percent compared with the same week one year earlier.

The Refinance Index increased 4.5 percent to 4794.4 from 4588.6 the previous week and the seasonally adjusted Purchase Index decreased 4.4 percent to 254.0 from 265.7 one week earlier. 

The four week moving average for the seasonally adjusted Market Index is down 6.4 percent.  The four week moving average is up 0.1 percent for the seasonally adjusted Purchase Index, while this average is down 8.2 percent for the Refinance Index.

The refinance share of mortgage activity increased to 73.6 percent of total applications from 71.9 percent the previous week. The adjustable-rate mortgage (ARM) share of activity increased to 2.4 percent from 2.3 percent of total applications from the previous week.

The fact is bankers are looking to get A LOT of refinancing volume because both servicers and lenders stand to increase current net income significantly if refinancing volumes are high.  An increased refinancing transaction volume is a backdoor way of re-capitalizing banks.  Now, just in case you are interested, here is what the same MBA Weekly report looked like on Oct 8th, just after Lehman filed for bankruptcy.

The Mortgage Bankers Association (MBA) today released its Weekly Mortgage Applications Survey for the week ending October 3, 2008.  The Market Composite Index, a measure of mortgage loan application volume, was 465.5, an increase of 2.2 percent on a seasonally adjusted basis from 455.4 one week earlier.  On an unadjusted basis, the Index increased 2.2 percent compared with the previous week and was down 28.6 percent compared with the same week one year earlier.

The Refinance Index increased 0.9 percent to 1345.8 from the previous week and the seasonally adjusted Purchase Index increased 3.2 percent to 314.5 from one week earlier.  The Conventional Purchase Index increased 0.7 percent while the Government Purchase Index (largely FHA) increased 9.9 percent.
The four week moving average for the seasonally adjusted Market Index is down 1.4 percent.  The four week moving average for the seasonally adjusted Purchase Index is down 4.1 percent, while this average is up 1.8 percent for the Refinance Index.

The refinance share of mortgage activity decreased to 43.4 percent of total applications from 44.0 percent the previous week. The adjustable-rate mortgage (ARM) share of activity decreased to 2.3 percent from 2.5 percent of total applications from the previous week.

Clearly refinancing volume is through the roof as zero percent interest rates are an incentive for all mortgage-holders to refinance.  This increased volume of transactions will be very helpful to banks’ earnings over the near-term.  Notice that I haven’t mentioned Citigroup anywhere here because they lost out in the Wachovia transaction and they have a fairly small retail operation domestically.

Source

Mortgage Applications Increase in Latest MBA Weekly Survey: 20 May 2009 – MBA website

Mortgage Applications Increase Slightly In Latest MBA Weekly Survey: 8 Oct 2008 – MBA website

Related posts:

• More on Fannie and Freddie – Signs of life in the Refi Market?
• How much money is Wells Fargo really making?
• Fixed rate mortgages at a nine-month high
• Merrill – Bank of America deal
• WaMu: Mr. Smith goes to Washington and turns predatory

The following Bloomberg article points out why I have repeatedly argued that banks will be earning a lot of money, Meredith Whitney’s counter-arguments notwithstanding. It also points out why the likes of John Hempton believe that the FDIC ‘stole’ Washington Mutual from shareholders and awarded it to JPMorgan, a view I have not supported (hat tip Marshall Auerback).  For those of you who don’t think accounting matters tremendously in why banks are going to fare much better than anticipated, you need to read this article.  I have bolded the most significant parts

JPMorgan Chase & Co. stands to reap a $29 billion windfall thanks to an accounting rule that lets the second-biggest U.S. bank transform bad loans it purchased from Washington Mutual Inc. into income.

Wells Fargo & Co., Bank of America Corp. and PNC Financial Services Group Inc. are also poised to benefit from taking over home lenders Wachovia Corp., Countrywide Financial Corp. and National City Corp., regulatory filings show. The deals provide a combined $56 billion in so-called accretable yield, the difference between the value of the loans on the banks’ balance sheets and the cash flow they’re expected to produce.

Faced with the highest U.S. unemployment in 25 years and a surging foreclosure rate, the lenders are seizing on a four- year-old rule aimed at standardizing how they book acquired loans that have deteriorated in credit quality. By applying the measure to mortgages and commercial loans that lost value during the worst financial crisis since the Great Depression, the banks will wring revenue from the wreckage, said Robert Willens, a former Lehman Brothers Holdings Inc. executive who runs a tax and accounting consulting firm in New York.

“It will benefit these guys dramatically,” Willens said. “There’s a great chance they’ll be able to record very substantial gains going forward.”

When JPMorgan bought WaMu out of receivership last September for $1.9 billion, the New York-based bank used purchase accounting, which allows it to record impaired loans at fair value, marking down $118.2 billion of assets by 25 percent. Now, as borrowers pay their debts, the bank says it may gain $29.1 billion over the life of the loans in pretax income before taxes and expenses.

Basically, all of these banks acquired loan books that were marked down tremendously before they went on the books.  Now, they are going to use this to their advantage and run the ‘excess’ cash flow from these assets through the income statement.  John Hempton has been particularly vociferous about the purchase accounting in the WaMu deal.  Because I had puts on WaMu through August 2007, I tend to see Washington Mutual as a bankrupt organization that was destined to fail.  If you read Hempton’s account, he makes an argument for the opposite. It all boils down to purchase accounting.

Purchase Accounting

The purchase-accounting rule, known as Statement of Position 03-3, provides banks with an incentive to mark down loans they acquire as aggressively as possible, said Gerard Cassidy, an analyst at RBC Capital Markets in Portland, Maine.

“One of the beauties of purchase accounting is after you mark down your assets, you accrete them back in,” Cassidy said. “Those transactions should be favorable over the long run.”

JPMorgan bought WaMu’s deposits and loans after regulators seized the Seattle-based thrift in the biggest bank failure in U.S. history. JPMorgan took a $29.4 billion writedown on WaMu’s holdings, mostly for option adjustable-rate mortgages and home- equity loans.

“We marked the portfolio based on a number of factors, including housing-price judgment at the time,” said JPMorgan spokesman Thomas Kelly. “The accretion is driven by prevailing interest rates.”

What about the other transactions: Wachovia, Lehman, Countrywide, Merrill?  I am sure you will find the same dynamic at work.  The article goes on to mention how many of these deals will also be favourable: at least over the short-term – and that  is what matters.  If the big banks can re-capitalize during this recession and we get a recovery, they are going to be able to take the eventual writedowns in stride as recovery will buoy their earnings potential.

Watch Q2 earnings at the banks, because Meredith Whitney and others are expecting a horrendous quarter.  I am not.  I think this accounting swag is going to be a positive for banks and may cause their shares, now under pressure to stabilize or rally.  Key names to watch: BAC, JPM, PNC, WFC, and COF, all of whom have benefitted from purchase accounting.  You should notice that Citigroup is not amongst these names.

The full story is linked below.

UPDATE 3:40PM: Calculated Risk has a story out (Revisiting the JPMorgan / WaMu Acquisition) which suggests that JPMorgan, if anything, under-provisioned for the eventual WaMu losses.  That would suggest a lot of writedowns over the life of the WaMu loans. This is an account that I would tend to believe as the housing market is worse than the baseline case JPMorgan presented after the acquisition (see my post “JP Morgan Chase buys WaMu out“).  Again, I see WaMu as a bankrupt organization that was destined to fail.  Nevertheless, over the short-term, accounting from the transaction can be favourable to JPMorgan’s earnings – and I see that as a net positive for JPM.

Update 540PM: Here is the associated viedo clip.

Source

JPMorgan $29 Billion WaMu Windfall Turned Bad Loans Into Income – Bloomberg.com

Related posts:

• JPMorgan: Beats expectations despite writedowns
• How refinancing helps the likes of Bank of America and Wells Fargo
• JPMorgan has record revenue and $2.7 billion in profit
• Regionals options suffer due to accounting rules
• WaMu on the brink of disaster: has agreement with regulators

Kyle, a long-time reader, recently asked why I think mark-to-market accounting actually matters.  After alI, savvy investors know that accounting does not necessarily change cash flows.  I think his question has a lot to do with not just accounting, but also with the stress tests.

Kyle writes:

My point is that it has really NOT changed, and people are trying to make it seem like it did. To be honest, I’m glad most people do feel that way, because it means those idiots in Congress will hopefully leave well alone. The capital raising that just occurred due to stress test mumbo jumbo has no connection to FSP 157-4. It is a requirement of GAAP to disclose when an accounting change has affected reporting, in order to explain the change. Out of the probably fifty different financial institution 10-Q’s that I’ve looked at, only one, Wells Fargo, indicated that 157-4 had a material impact on their reporting, which it did to the tune of 4B. The other 49 explicitly state, “157-4 had no material impact on our reporting, and we do not expect it to in the future.” It’s in the notes for anyone to read. I just do not understand how an accounting change which explicitly has had no impact on reporting (this is the ultimate point I am trying to make, the rule change was and has been almost completely meaningless), could lead to changes in whether or not a bank is undercapitalized.

Here is my thinking on that issue. I understand what Kyle is saying: FAS 157 guidelines will have no impact on reported earnings. I think it will and that this will alter behaviour. Wells and the Home Loan banks are just two early uses of the 157-4 alterations. Others may follow.

But more important is the affect on future writedowns.  A bank only has to attribute its actions to 157-4 if it is amending prior accounting to reflect a change in asset designation to ‘holding to maturity.’ However, if it marks assets today as ‘holding to maturity’ and then is later forced to write down those assets, these writedowns will not be attributed to changes in the FAS 157 guidelines. So, anticipated future writedowns that would have gone through the income statement from marking to market will now be accounted for as held to maturity. This means the guidelines are affecting accounting and causing the company to report differently. In short: future writedowns for 2009 will be less because of FAS 157.

In my view, it is future credit card, jumbo loan and CRE exposure which will be most affected by this. These are areas where you should expect heavy pressure from securitized assets on bank balance sheets due to deterioration in income from credit card receivables,prime mortgage loans, and commercial real estate loans. What mark-to-market guidelines effectively mean is that banks will not have to reduce capital by nearly as much as had they not marked these assets as hold to maturity.

That is where the stress tests come into play. The stress tests are seen as the make or break for banks i.e. banks that don’t raise enough capital to meet the TCE requirements will be seized by the FDIC and treated to a BankUnited outcome. So the stress tests tell investors what the likely outcome is to be in regards to nationalization. Translation: if you raise enough capital or are well-capitalized enough already to pass the stress test, we’ll leave you alone. You might even be able to pay back your TARP funds. But, if you can’t make the grade in a few months, you will be seized, cleansed, management thrown out, equity reduced to zero, and we will sell you on to private equity concerns or another bank or chop you up into little pieces. This is the IndyMac/BankUnited solution.  Notice that bondholders did not lose any money here.

So, the stress tests and the capital raising exercise have revealed that no one is going to be nationalized unless they can’t come up with the capital.  But since even Citi and Bank of America have been raising capital, few big banks are going to be seized.  You probably saw Huntington (HBAN) and Fifth Third (FITB) coming to market and their shares coming under pressure as a result. But, HBAN said it was going to repurchase $470 million in preferreds immediately after it raised the common equity capital.  Why?  Tangible Common Equity.  This is the measure by which the stress tests are being conducted.  Preferred shares don’t count, so why not issue common and retire preferreds in order to boost your TCE? Remember, pass the stress test and you’re good to go.  Fail and Sheila Bair plays the Grim Reaper on you, your management team, and your shareholders.

My conclusion from all of this building from March on was that bank shares would pop and I said so in April.  Now, the rally has been way over the top and shares have come under pressure as these companies have gone to market for capital.  However, if writedowns from CRE, Prime and Credit Card loans turn out to be less horrible in Q2 and Q3 as I anticipate, shares can rally again and again.  Note, Meredith Whitney takes the opposite view i.e. that major losses are coming for banks – so I am aware of the other side of this argument.

I am left concluding that accounting alters behaviour and has an appreciable impact on share prices, especially when it dictates government intervention.  This is why mark-to-market, tangible common equity, and the stress tests are all significant for the financial services industry.

Related posts:

• What Home-Loan Banks reveal about the effects of mark-to-market
• At least six banks need more capital under stress tests
• BofA, Citi, Wells and GMAC biggest losers in stress test leaks
• Stress tests reveal Citi and BofA need more capital, but you knew that already
• Black: Stress tests and the Big Lie

Back on the 16th, I posted a link to a Wall Street Journal article by James Hagerty which detailed how the Federal Home Loan Banks were able to prevent asset writedowns because of guideline changes to mark-to-market accounting.  I think the implications will be significant.  Here is what the article said (emphasis added):

A change in accounting policies allowed some of the Federal Home Loan Banks to avoid taking big hits to earnings for the first quarter.

Several of the 12 regional home-loan banks recorded losses and eliminated dividends in recent quarters because of write-downs on their investments in private-label mortgage securities. Such securities, packaged by Wall Street firms, don’t carry a government guarantee.

Now, the home-loan banks are benefiting from new guidance from the Financial Accounting Standards Board, or FASB, on the treatment of securities that companies intend to hold until maturity. That guidance allows companies to make a distinction between the portion of any decline in the value of a security they attribute to deteriorated credit quality and the portion blamed on other factors, such as distressed conditions in the market.

Only the part blamed on credit quality needs to be reflected in the income statement; the rest can be put into an account known as "other comprehensive income," which doesn’t affect earnings or calculations of regulatory capital.

The home loan banks say the new guidance allows them to give a more accurate picture of the losses they expect.

The long and short of this rule change is that financial companies will have much greater discretion in how they account for writedowns in asset-backed securities of credit cards, auto loans and commercial real estate (for more on this, see my post “A few comments about mark-to-market”).  In the end, this will bring accounting of asset-backed securities more in line with the accounting for loans.   To the degree that banks believe market prices reflect temporary impairments of assets they intend to hold to maturity, they can decide not to write down these assets.  Moreover, even if those assets wind up permanently impaired and must eventually be marked down, the banks can benefit from earnings in the intervening period between the likely original markdown under previous guidelines and the eventual new markdown under new guidelines.

Therefore, it should now be clear that many writedowns which would have occurred in 2009 will be delayed indefinitely.  In my view, this is a large reason why the financials had rallied so much from the beginning of March.  Moreover, banks are getting new capital from private investors now.  In the Fall and Winter this was unheard of.  Only the best banks had access to equity capital markets.

What this means is threefold:

1. Writedowns will be fewer in 2009 and 2010 as a result of marking assets as held to maturity.
2. With interest margins high, banks are likely to increase large amounts of capital from earned income.
3. Banks also have access to private equity capital and are likely to raise large amounts of capital through those markets.

So, for any given firm with large commercial real estate, jumbo residential real estate or credit card asset-backed security exposure, the stress to raise capital has been greatly diminished.  Overall, this will be a net plus to credit availability.  To be sure, large writedowns are likely to continue.  However, for most banks these writedowns are not going to exceed the capital raised and earned.

Source

Home-Loan Banks Avoid Some Hits – WSJ

Related posts:

• What the stress tests reveal about Obama’s thinking on banks
• A few comments about mark-to-market
• $35 billion in missing writedowns
• The regionals versus money center banks
• Consumer loan delinquencies paint bleak picture