There is a lot of rhetoric to strip away from this debate. “Cram downs” imply that bankruptcy judges have total free reign to modify mortgages to suit the interests of borrowers without any regard to the interests of the lenders. Bankruptcy judges will automatically lower principal to the current value of the underlying homes or the borrowers’ ability to pay, again without regard to a net present value (NPV) comparison with foreclosure. The sanctity of contracts and the effect of cram downs on mortgage costs in the future are arguments that have been endlessly reiterated. And finally JP Morgan (JPM) CEO Jamie Dimon does not want to write down any principal that he is entitled to get back.
Now for some truth: Congress is only opening mortgage contract modification to a limited portion of the bankruptcy code and judges would be obligated to consider modifications versus foreclosure in a way that mitigates losses to the lenders. The threat of cram downs should lead to more conservative lending. Also, Congress has been considering implementing judicial mortgage modification for only a limited time period.
Everything I have read says that mortgage servicers are supposed to decide mortgage modifications based on a NPV comparison with foreclosure. The trouble is they are risk adverse in interpreting their on contracts with the securitization trusts, and they don’t have the incentives to step out on the limb. The numbers to plug into the NPV calculations and risk of re-default are open to endless argument. Therefore all parties will actually benefit from having bankruptcy judges as their arbitrator.
Once the judge decides that modification is more beneficial to creditors than foreclosure, he or she will have to determine how to move the various mortgage levers to make the mortgage sustainable. The judge will have to arbitrate the borrower’s and lender’s proposals for the most sustainable combination of interest, principal, term, deferrals and fees. Most modifications have failed to date because lenders and servicers have not taken a realistic approach to sustainability.
Former Treasury Secretary Paulson and Federal Reserve Chairman Bernanke have told us endlessly that we need price discovery to unclog the movement of toxic assets. Forget the mark-to-market CDO and MBS prices based on models, indexes, and credit default swaps. Each of these is used for the benefit of individual players, and the self-interests of these players negate a transaction price.
My guess is that bankruptcy judges will only hear borrowers with the least desirable collateral and that are the deepest under water. Banks will eagerly use the bankruptcy threat to facilitate short sales for their better collateral. This combination will quickly bring real price discovery from the bottom up. Once loans are made current (with sustainable payments) their value can be uniformly calculated, and trading of CDO and MBS easily facilitated.
Valuing mortgages based on the greater value of foreclosure or the borrowers’ ability to pay is the true free-market price. Have the Treasury or Fed determine the value of mortgages if held to maturity or the value booked at financial institutions is arbitrary and will not facilitate free-market transactions.
I would even take it one step further. The government should create a temporary mortgage court that would rapidly arbitrate all delinquent mortgages based on standardized filings. Parties unsatisfied with the judge’s ruling would then be able to appeal in a regular bankruptcy proceeding.
No disclosures.
Mortgage “Cram Downs” Quickest Route to CDO & MBS Price Discovery
Fed talks interest rates UP!
Bloomberg reports “Treasuries Drop as Fed Offers Little Guidance on Debt Purchases”. Just like I wrote previously in “Fed Losing Control of Mortgage Rates”, Bernanke’s Federal Reserve has no more fire power. Chairman Bernanke is left with only rhetoric and confusion to sell. Bloomberg wrote that traders were disappointed that today’s Fed statement did not actually state that the Fed would begin buying longer-term treasuries. The Fed is going in baby steps from “evaluating” to “preparing,” but not actually executing the new policy.
Why the sudden slow motion? Because the Fed does not really have the fire power to move the Treasury bond market given the volume new issuance required to fund the TARP, as well as, President Obama’s stimulus and anticipate “Bad Bank” initiatives. $40B 2-year and $30B 5-year notes are set to be auctioned next week alone. It does not matter whether it's former Treasury Secretary Paulson’s TARP investments in banks, Federal Reserve Chairman Bernanke’s liquidity facilities, or President Obama’s reckless spending on what’s called the stimulus – it all needs to be financed. The bond market does not distinguish between investments and reckless spending, only supply and demand. Didn’t Paulson have to sell treasuries to deposit money into the Fed to keep Bernanke operating?
The 30-year rates rose 21BP to 3.46%, the 10-year rates rose 15B to 2.69% and the 5-year rates rose 12BP to 1.69%. With over $2T in new Treasury financing, few investors would be willing to risk intermediate or long-term inflation, and the absorption risk of that volume. Now that treasury bills carry basically zero interest, the Fed should concentrate on providing liquidity – a job it has done reasonably well.
I believe that starting next week the stock market will trade in concert with the intermediate term treasury bonds. And I see Treasury bond prices falling (their interest rates move up) as the supply accelerates. After all the Fed stated in no uncertain terms that it is pro inflation.
The Shock and Awe of Government Raising Citigroup Warrants Strike Price to $20
Bloomberg reports “Summers Says TARP to Be ‘Very Different’ Under Obama.” The director of the White House’s National Economic Council stressed transparency, accountability; and the push for banks to leverage TARP funds into consumer mortgages and car loans. Larry Summers said that the Obama Administration was not out to benefit financial institutions, but “of course we need to stabilize financial institutions -- without a stable financial system the economy can’t work.” Summers refused to provide any detail on President Obama’s plan or even philosophy for strengthening financial institutions until after New York Federal Reserve President Timothy Geithner is sworn in as Treasury Secretary. I guess with Geithner the Senate will be voting on a "pig in a poke".
While the Administration is getting its lipstick ready, I would like to suggest dramatic policy change that would jumpstart private investment in our banking and insurance systems. The Treasury, FDIC and Federal Reserve should raise the strike prices on the warrants they received for TARP and other programs to the estimated value of these companies in normal times. If a conservative estimate of a shrunken Citigroup (C) in normal times would be $20 per common share, investors would know the government would not dilute until the shares reach that level. Above that level it would be an opportunity for Citigroup to raise capital from whoever bought the warrants from the government. This would end the fears of nationalization and cause a short squeeze as the shorts attempt to cover. Moral hazard on the shorts – what a concept!
Raising the government’s strike price would do more to prevent short raids and build investor confidence than restoring the uptick rule and temporary bans on short selling. I think that it would be even more powerful than the mortgage loss backstops that were provided to Bank of America (BAC), Citigroup and to a lesser extent JP Morgan (JPM).
The Treasury, Fed and FDIC did consider open market common stock purchases to raise Citicorp’s stock price and improve confidence during the last rescue. But they determined that the amount required to move the market would be equivalent to nationalizing the company. Raising their warrant strike would be far less disruptive and far cheaper.
I know there is tremendous political pressure to squeeze harder for taxpayer upside in these deals. Warren Buffett got a better deal than the government on his Goldman Sachs (GS) investment could often be heard in Congress. But the government’s shortsightedness has actually aided the shorts in squeezing their prey to death or near death, causing the government to actually increase its risk participation. How many small banks have failed or suffered severe capital losses because the Treasury killed the value of the Fannie Mae (FNM) and Freddie Mac (FRE) preferreds? Think of the lost leverage. President Obama does not appear to be garnering the political will to restore the financial system in the most efficient, but politically unpopular means.
The controversial and often maligned former American International Group (AIG) CEO Hank Greenberg has often said the government’s role in rescues should be to save jobs and return companies to strong taxpaying entities, not maximize the government’s profit. I won’t pass judgment as to whether Greenberg was responsible for AIG’s venture into more risk than it could manage or conversely is the messiah that has the answers to AIG’s rescue. But, the irony is that the government is on a path of squeezing so hard that they are winding up minimizing their profits.
Along with warrant repricing, the government should consider reducing the number of warrants outstanding to reward good behavior. For a government that actively manages all sorts of behavior through the Internal Revenue Code, this would not be a step very far out on the limb.
Let’s not forget that we cannot have a private enterprise banking system without equity capital. And we cannot have equity capital without common stock shareholders. Scaring away common stock shareholders just can’t be the solution, encouraging them must be. Even the Chinese Communists understand that, so our communist Larry Summers should too.
Disclosures: Author is long AIG, BAC, C, FNM and FRE.
Fed Losing Control of Mortgage Rates
With much fanfare, the Federal Reserve started buying Fannie Mae (FNM), Freddie Mac (FRE) and FHLB debt and MBS. Conforming 30-year mortgages rates dropped to an average 4.96 according to Freddie’s last report. The Fed was hailed for its accomplishment, and predictions came from all corners that 4.5% or even 4% mortgages were not far off. All that was needed was for Fannie and Freddie to stop charge fees commensurate with the risks they are incurring for the crowds to start rushing back into the housing market. Thankfully, FHFA Director James Lockhart does not want to run his conservatorships at a loss. GSE fees will remain as is for now.
Now Bloomberg is reporting that euphoria has been short lived with “Freddie Mac Says Fixed Mortgages Rose to 5.12 Percent”. Freddie reported that 30-year fixed rate mortgages rose from an average 4.96% to 5.12% this week and 15-year fixed from 4.65% to 4.8%. Even worse Bankrate.com reported that in its broader survey that 30-year fixed mortgages rose from an average 5.28% to 5.59%. (Bankrate.com sited slightly different rates on its website than Bloomberg quoted for it.)
Apparently, Bernanke’s $500B is just not enough to take control of the mortgage market. He is even losing control of the conforming mortgage market. The patriotic banks stuck their toes in the lower rate water, but soon realized it’s still winter. Frost bite on that toe and hypothermia on the rest of the mortgage body set back in. FTN Financial chief economist Christopher Low said, ``The move back above 5% this week is an indication that while the Fed's program is helpful it is still very difficult to securitize mortgages and for that reason banks are still discouraging homebuyers to a certain extent.''
Higher rates are being driven by fears of unemployment and falling home prices as well as stricter lending standards. Investors could never be satisfied with even a 5% return for incurring either or both of the credit and interest rate risks. Add to this the collateral and political risks, and you have a market that the Fed will never have enough fire power to control. Even Treasury Secretary Paulson said in his closing speech that driving mortgage rates down to the 4% to 4.5% range would take an astronomical amount of cash. This hasn’t stopped Bernanke and the new Administration from talking in that direction.
With a $2T balance sheet and 0% Fed Funds, the Fed has run out of bullets – silver or otherwise. At this point fiscal and monetary policy can only raise mortgage rates through reckless government indebtedness. Just like government interventions have had little long term effect on currency exchange rates, they are also too small to control mortgage interest rates for anything but very short term periods. One week in this case.
The government should not fret. 5% mortgage rates are aggressively low by any historic standard. Any lower rates would artificially inflate the housing collateral to the detriment of mortgage investors. The best thing the government can do to promote housing stability is to eliminate all ARMs on primary residences.
Disclosures: Author is long FNM and FRE.
Messages from the Large Regional Banks
Several large regional banks reported today and gave consistent messages. Cost of funds is increasing as they more conservatively shift from overnight borrowing to 90 day and longer paper, and their customers shift to higher cost CDs from money market accounts. Interest margins continue to be squeezed as asset rates fall more quickly than liability rates. Credit costs continue to rise along with unemployment. They are aggressively marking down real estate owned down to as low as 33% of loan values.
Careening common stock prices has forced them to take major non-cash write downs of goodwill on their acquisitions, further eroding their capital. The banks are not looking to pursue any new large acquisitions. When asked about FDIC pressure to acquire troubled banks and the possibility of the FDIC stripping their prey clean of toxic assets, BB&T (BBT) said that the deposits left are fast money. Troubled banks have had to pay up for deposits and when the rates are “rationalized”, the fast money leaves, and the acquired branches would be unprofitable until the business is rebuilt. Thus a cheap bank becomes a costly investment.
Competition for deposits, while still intense, has eased somewhat with the Washington Mutual and Wachovia mergers into JP Morgan (JPM) and Well Fargo (WFC). Some of the regionals were able to cut their CD rates in half. The regionals are optimistic about gaining customers disgruntled by these difficult megabank integrations.
BB&T saw the trend of non-bank lending via securitizations beginning to reverse. Originating and holding loans could bring steady profits in traditional banking over the next 10 years. But none of the regionals indicated that they wanted to hold any of the residential mortgages they were originating.
Most of the regionals talked about deteriorating conditions over the next year or two and the stock market has not taken the news well. The Microsoft (MSFT) scare today could not have helped.
Disclosure: Author is long WFC.
From Strong Treasury Secretary to Technocrat
Listening to New York Federal Reserve President Geithner’s confirmation hearing for Treasury Secretary, I got the impression that the country desperately needed this man. Yet he admitted that the Obama administration has not formulated any plans for restoring the credit markets, and constantly referred to the “smartest guy in the room” Larry Summers. While head of the National Economic Council Summers has not been elected and was not required to be confirmed, he has clearly replaced former Treasury Secretary Paulson as the most powerful man in financial Washington. Summers has become the only visible spokesman for Obama Administration.
Our technocrat Timothy Franz Geithner cried that no one would listen to his dire warnings over the last two years, but did not even present a theory on how to proceed when he gets in power. A leader he is not. Geithner took no responsibility for any of the failed policies that he participated in, only his personal tax indiscretions. He offered nothing learned from the Lehman failure and the destruction of bank shareholder equity. Geithner’s only theme was read Larry Summers letters to Congress. He basically said it will take Larry Summers at least a few more weeks to develop a plan.
Not even Federal Reserve Chairman Bernanke stood up in the power vacuum that Paulson left. While Geithner admitted all did not go well during his subornation to Paulson and Bernanke, he was either too loyal or confused to give us any details.
The question that the stock market wants to ask President Obama’s team is how do you recapitalize the banks if you kill the common shareholders? True bank capital is nothing more than common equity. No solace when Summers preaches an end to common dividends. Beware, an end to preferred dividends might not be far behind.
The Senators that President Obama is trying to appease continue to beg for credit to be extended to consumers and businesses, while still insisting that the banks that would extend the credit and their shareholders be punished. These Senators also want to maximize the government’s profit in any bank investments. Despite all the rhetoric about change, everything seems to be same.
Mortgage Collateral Bears an Interest Rate Risk
President Obama’s economic pitchman Larry Summers is preaching for every possible way to reflate the economy. Federal Reserve Chairman Bernanke is saying the world can’t be saved until housing prices stabilize. Even Federal Reserve Bank of San Francisco President Janet Yellen warns it’s “not acceptable” to let inflation fall. All hands are on deck to lower mortgage interest rates further, if at all possible, and make our savings worthless. JP Morgan (JPM) CEO Jamie Dimon summed it up best by saying consumers only care about the monthly payments, so I’ll lower rates and extend terms, but don’t touch my equity in your home. Dimon wants to pull out his equity in your home when the politicians reflate its value again.
Good luck, Mr. Dimon. I hope JP Morgan’s future mortgage originations are no longer based on the assumption collateral values only rise. Economic conditions and the housing bubble aside, house values should float inversely with interest rates. In general, rising interest rates lower housing values and falling interest rates raise housing values. Therefore, shouldn’t banks and other mortgage investors demand a higher equity cushion (down payment) when interest rates are far below the norm?
It can be argued when housing payments (mortgage, taxes, insurance, etc.) are between 30% and 40% of the borrowers’ income, the lender’s risk is minimal. So lower mortgage interest rates get more people safely into homes. That logic only works when the collateral value of the home is not a factor in the loan approval process, when only the borrowers’ ability to pay (income) and willingness to pay (credit score) count.
If the home’s collateral value is truly a factor in the mortgage loan approval process, the home’s value must be stress tested under both normalized and outlier interest rates as well as economic conditions. What would the home be worth if prevailing mortgage interest rates doubled or tripled in five years, if unemployment reached 10% or higher, or if the type of housing or location becomes undesirable? Are McMansions as popular today as they were a few years ago? How about Miami condos?
I’ll take the contrarian point of view. When unemployment is low, credit easy and interest rates are low, housing generally has a higher value and is more vulnerable to lose value. Think about former Federal Reserve Chairman Paul Volcker inflicting extraordinary high interest rates or the economic black swan we’re living through now. Good times definitely call for higher down payments than bad times.
Conversely, housing is depressed during bad times, providing a greater opportunity for equity to rise during the subsequent recovery. Therefore a lower down payment is needed to shield against further loss. In today’s conundrum of economic stress and low interest rates, I believe that higher future interest rates will dampen home values even with an economic recovery.
While ability to pay and willingness to pay are judged for each individual, the collateral value of a property cannot be appraised outside of the future economic and interest environment for the country as a whole. From a collateral perspective, it does not matter whether the borrower is paying a 4% or 12% interest rate, what matters is that interest rates will surely be a lot higher than 4% in 5 years.
The flat 20% down rule seems as outdated as the rest of Wall Street’s failed financial models. To coin the conservative phrase, we have had quite an activist Fed over the last 4 decades, especially in the last 20 years. Bernanke may appear to be a black swan, but he is just the long tail of former Federal Reserve Chairman Greenspan’s dragon.
No disclosures.
Citi Holdings in a Growth Phase
Let’s have some fun. To paraphrase what The Marines say, we will visualize all that Citi Holdings can be. After all, Citigroup is in no hurry to divest this fine set of assets according to CEO Vikram Pandit. Why be just Citicorp when you could be Citigroup with all the toys. Some analysts and reporters have implied that the government prodded Citigroup to create Citi Holdings as a first step toward massive divestitures, but I believe Citi Holdings was created as a place for Treasury Secretary Paulson to dump the often uncooperative FDIC Chairwoman Sheila Bair.
No need to stop there. Federal Reserve Chairman Bernanke could throw in his American International Group (AIG) holdings, Fannie Mae (FNM) and Freddie Mac (FRE) mortgage paper and other assorted goodies. Bair could throw in some General Electric (GE) debt guarantees, and even Paulson could include TARP warrants that are losing value. All we need is for JP Morgan (JPM) to add legacy Bear Stearns (at least part of which CEO Jamie Dimon said is not pretty), and Bank of America (BAC) to contribute its reluctantly merged Merrill Lynch into the soup. Now that would be a tasty concoction.
There has been speculation the government is going to form the mother of all bad banks to absorb massive amounts of toxic assets as a path toward encouraging lending. Alternate speculation is that all major banks are on their way to separating, or ringing as they like to say, assets for government loss protection. It’s just a matter of time before JP Morgan and Wells Fargo (WFC) get in the game with the fine mortgages obtained through Washington Mutual and Wachovia. (Holy Warren Buffett!) And PNC Financial (PNC) would be bringing up the rear with their National City mortgages. Visualize all these CEOs trying to throw their mortgage footballs through Bernanke’s tire as in the “dysfunction” commercial.
Wouldn’t it be easier for Paulson just to buy Citi Holdings before Asia opens on Sunday? Paulson’s time is rapidly running out, but he surely can do a quick make versus buy analysis. Citi Holdings is a great base to build upon.
One serious note: Every time the government tries to instill confidence by cordoning off the riskiest assets, it kills confidence by further diluting common shareholders. The government cannot be successful until it decides whether it wants to build or destroy banks. Punishment has proven inconsistent with instilling confidence in investors to fund and repair the nation’s most crucial financial institutions. Perhaps a government super bad bank could work, but don’t suck equity out of the good banks that you want to survive.
Disclosure: Author is long AIG, BAC, C, FNM, FRE, GE and WFC.
The Investment Case for Bank of America and Citigroup
The investment case for Bank of America (BAC) and Citigroup (C) can be summed up in one word: WAIT. While I rarely agree with The Wall Street Journal’s opinions, “Mugging Bank of America” provides a compelling summary of the Bank of America situation. Though they might be more to blame for their current predicament than Bank of America, the Citigroup situation is similar.
Bank of America was coerced by the current Administration (with the consent of the new Obama Administration) to complete the Merrill Lynch acquisition to its own detriment. For preventing further erosion of confidence and helping to save the world financial system, Bank of America will receive $20B in cash and partial insurance on $118B in toxic assets. Bank of America will actually have to pay $24B in 8% preferreds plus warrants to the government, including a $4B initiation fee for the insurance. The President Obama – Larry Summers plan for reducing common stock dividends to 1 cent and tight government monitoring of mortgage modifications is getting its start with this deal. Bank of America’s CEO Ken Lewis doesn’t know how or when he can get out from under the government’s thumb; so much for being a good corporate citizen.
Bank of America and Citigroup are both using government funding to work an increasing difficult lending portfolio. Both have potentially steady, if low margin, core businesses. The difference is that Citigroup is in the process of simplifying while Bank of America is becoming far more complex. It appears that Citigroup will pay back the government by selling at least half of its businesses. I was right that Citigroup would split, but wrong up to this point on construction of the split. Bank of America wants to remain whole and pay back the government through profits or eventual capital raises. In either case, the government will be sucking out much of the cash flow through its preferred dividends for the next 3 to 5 years and a great deal of equity through its warrants.
The 1 penny dividend is in place to give assurance that the preferred dividends will continue. Preferred dividends are an important confidence builder, but investors should not pay up for them. The preferred dividends could easily disappear too. Even the trust preferreds have deferral clauses in the underlying debt. But the trust preferreds are better than the standard preferreds, and both are more valuable than the common. Bonds are still too difficult for the retail investor to buy, given their steep markups.
Whether the government eventually eases up on its warrants to rebuild common equity is a political guess. I don’t think the government wants to nationalize the large banks; they simply want to control them and use them as a mechanism to carry out public policy. After the social objectives are met, the banks will be set free and common shareholders will regain control. At that time the equity would be worth something. Five years from now the government will want a strong equity base and take the steps necessary to reverse dilution.
There have not been any signs of a bank run on either Bank of America or Citigroup and the government is backstopping their solvency. The price for this is the removal of any cash flow and price upside for common shareholders, and the potential removal of cash flow for preferred holders. Investors need to calculate the price to pay now for the potential of cash flow resumed in 5 years, if they believe Bank of America and Citigroup will remain public companies at that time. The best opportunity will come if the dividends on the preferreds are temporarily suspended because preferreds will never be subject to dilution. Buying Bank of America or Citigroup preferreds at $1 or less would be irresistible (not investment advice).
Disclosure: Author is long BAC and C.
President Obama: From Hope to Desperation
The New York Times “Democrats in House Unveil $825 Billion Stimulus Bill” is reporting that the House is allocating only $90B out of President Obama’s $825B stimulus bill to infrastructure. Highways, public transportation, water and environmental projects give way to returning political favors for a President who pledged the economic recovery package would be free from earmarks. What’s even worse is that the majority of the bill allocates funding for continuing operating expenses rather than investments.
Let’s look at the non-capital expenses included in the bill: $87B to help states with Medicaid, $79B to help local school districts, $54B to “encourage” production of renewable energy, $43B in unemployment and training benefits and a temporary reduction in Social Security taxes. Additional money is allocated to targeted (read earmarked) educational benefits. The most disturbing aspect of the bill is $39B to subsidize COBRA health insurance benefits and short-term coverage for the unemployed under Medicaid. Why is it that only the unemployed can buy Medicaid coverage?
I don’t see any hope here from a President that promised change. And all that President Obama seems to be preaching is how desperate the economic situation in America is, that the second Great Depression is at our doorstep. There’s no time for real change, all we can do to prevent the next Great Depression is to spend and spend BIG. Larry Summers tells us that it is more risky to under spend than to over spend. Summers never distinguishes good spending from bad spending. What’s changing?
COBRA was devised as a way to placate a worker’s need for health insurance between jobs without instituting an all out open enrollment in the individual private health insurance market. The program makes workers pay their former employers the full cost of insurance plus an administrative fee. The COBRA premiums are far higher than available in the individual market - if the unemployed were guaranteed acceptance. Eliminating medical underwriting in the individual market would be real change. President Obama promised this during the campaign, but disappointingly reverted back to the status quo of patching old programs that aren’t working.
I encourage President Obama to be truly bold and not hide behind how desperate America has become. Push the healthcare agenda that you promised during the campaign NOW. The unemployed and early retirees need access without all the red tape of COBRA. Spend the stimulus on projects that have lasting value. Create a national high speed passenger rail system, greatly strengthen the electrical grid, and allow unlimited expensing of capital purchases for businesses. Put all businesses on a cash basis for income tax purposes. And finally; tax cuts should go to all taxpayers, not just those paying Social Security. To do otherwise risks a revolt of the senior citizens and unemployed.
President Reagan achieved revolutionary change in the income tax system through optimism. Just like President Obama learned from President Lincoln to bring his opponents in-house, he can learn from President Reagan that change can really happen.
Morgan Stanley Smith Barney and the Future of Citigroup
The short story is that Citigroup (C) and Morgan Stanley (MS) are allegedly combining the retail brokerage operations into a standalone entity with enough financial advisors to top the merged Bank of America (BAC) Merrill Lynch herd. Morgan Stanley is reported to be paying Citigroup an extra $2B to $3B for at least 51% controlling interest. Currently Citigroup’s Smith Barney has substantially more financial advisors than Morgan Stanley. Morgan Stanley is said to have the option of buying out Citigroup’s interest in the joint venture within 5 years.
I believe that this is the first step in splitting the current Citigroup into Citigroup Domestic and Citigroup International, with Citigroup Domestic eventually merged into Morgan Stanley. The current shareholders will probably be left with only Citigroup International. This appears to be happening with not only the government blessing’s, but with the government’s prodding. The government has already created a special facility to quarantine substantial portions of Citigroup’s most toxic mortgage securities to facilitate such a merger. And worry exists that Citigroup could become American International Group 2 (AIG). Remember that the Treasury did not really kick up the volume until Morgan Stanley and Goldman Sachs (GS) were targeted for implosion. Morgan Stanley is clearly on the most favored list while Citigroup is just a big problem.
How does each side benefit? Citigroup gets cash and the ability to write up its investment in Smith Barney. Some have reported a non-cash gain of up to $10B. Though, Citigroup will lose a portion of Smith Barney’s steady earnings with its reduced interest. Morgan Stanley will gain economies of scale and a potential upgrade in the average net worth of its retail clients. The Smith Barney clientele is most likely wealthier than the legacy Dean Witter clientele that Morgan Stanley acquired. That said I don’t doubt that Morgan Stanley has plenty of high net worth retail customers.
As a Citigroup stockholder, I favor the joint venture. I don’t believe that dependable profits from the likes of Smith Barney and Merrill Lynch retail operations will continue. History argues that retail customers always return to full service brokers after each financial blowup. After all, didn’t investors need a feeling of security and hand holding following the dot-com blowup? These firms were there to offer high margin can’t lose products for their tattered customers. Demand was so great that these firms were able weed out their lower net worth unprofitable customers.
Now that the trend is toward simpler, more understandable investing will their customers still seek the shelter of full service brokers? I think they will, but the customers will be less likely to purchase the high margin products that led to a large portion of these firms’ profits. Asset based fees have already come under scrutiny, as have pushing difficult to understand products like auction rate securities on retail customers. The firms will still be able to market some simpler new corporate and municipal debt, and maybe even a few IPOs to retail customers. But the demand for the highest margin structured products targeted at retail customers should be waning.
Full service retail firms have been most profitable when they can give their customers the illusion of risk free investing. Products, such as indexed link securities, promised to at least return your total investment when held to maturity. Originally these products were conceived as a combination of treasuries, futures contracts and a hefty profit margin for the house. Next came retail structured products that customers actually could lose money at maturity, but the brokers must have convinced their clients it was unlikely. Then the last cycle culminated with high fee retirement date targeted mutual funds that shifted investments from stocks to more conservative bonds as customers aged. Trouble was everything lost value. Even opening the door to the prestigious would of alternative investments like hedge funds and private equity has lost the allure for retail customers.
In a simpler world, profits at the imagined Morgan Stanley Smith Barney could be steady but at a lower level. Full service brokering will become a utility, just like the rest of banking. And with my imagined Citigroup Domestic, Morgan Stanley will become a real bank.
Disclosure: Author is long BAC and C.
Bank of America facing Mortgage Servicing Losses
Bloomberg’s “Handling Home Payments Loses Profit Luster as Bad Loans Pile Up” reports that Countrywide lost $2.2B on loan servicing in the first half of 2008, following a $441M loss for all of 2007. Bank of America doubled its loan-workout staff to 5,600 as the business is becoming substantially more labor intensive. Ordinarily, the business produces steady profits with little risk. But when the mortgage delinquency rate crosses over 2%, the tables are turned. By September 30, delinquency rates reached 6.99%.
Servicers usually charge between 2.5% and 3.5% of the mortgage balance for administrating billing and collection. Servicers must continue timely payments to investors (advances), even when borrowers are late or delinquent. Advances continue until the servicers determine the loans are not salvageable. This negative cash flow along with added labor costs to negotiate mortgage modifications has turned servicing temporarily from an asset to liability. After GMAC’s Residential Capital advanced more the $2B to investors on behalf of delinquent borrowers, no one is interested in buying the unit.
Bank of America (BAC), Wells Fargo (WFC) and JP Morgan Chase (JPM) service almost half of the $11.5T mortgage market. Citigroup (C) follows with 7%. Analysts have questioned the wisdom of Wilbur Ross paying $1.8B for American Home Mortgage and Option One Mortgage’s servicing units when their loans are performing so poorly. Ross counters that most of the money went toward advances which he plans on recovering.
Ross has a history of building empires from bankrupt companies and my bet is he will be right again. Obviously, the increased labor cost will not add any value to the servicing units. But, at least the major banks can easily finance the advances if they are only temporary as Ross indicates. And the computer systems and operations that Bank of America and Ross recently acquired would be difficult and expense to replicate.
It looks like the trend of mortgage servicing moving to stronger hands will continue. The servicers will need increasing access to credit in a market where any type of real estate credit is almost nonexistent. Five years from now Bank of America could have a cash cow rising from Countrywide’s ashes. Do you think Ken Lewis knew all along how large Countrywide’s losses would be before the goose will start laying her golden eggs?
As the megabanks morph into low margin utilities, highly efficient mortgage servicing on a grand scale will become just as important as credit card processing. And in good times mortgage services is much less capital intensive.
Disclosures: Author is long BAC, C and WFC.
Fed Pushes Housing into Stronger Hands
Just like the FDIC, the Federal Reserve and Treasury pushed weaker banks into the hands of stronger banks. Now they are no trying to move houses from weaker (read defaulted) borrowers to the strongest borrowers. Treasury Secretary Paulson has placed undue obstacles and complications in every program to mitigate foreclosures at the same time the Fed is aggressively trying to push down rates for the strongest borrowers. Even FHA (Ginnie Mae) requires at least a small down payment and substantial fees.
Bloomberg “U.S. Banks Offer Mortgage Rates Below 5% as Fed Buys Securities” reports that with excellent credit and 20% down, JP Morgan Chase (JPM) is originating 30-year fixed rate mortgages for 4.75%, Wells Fargo (WFC) for 4.875%, and Bank of America (BAC) for 5%. Bloomberg attributes these low mortgage rates to the Federal Reserve’s program to purchase $100B in Fannie Mae (FNM), Freddie Mac (FRE) and Ginnie Mae debt, along with $500B in direct purchases of their highest rated 30-year fixed rate MBS.
In a second article, Bloomberg “No Recovery for Real Estate as Speculators Dominate Sales” reports that speculators are creating most of the demand for foreclosed properties:
“You don’t have it in strong hands, you have flippers,” said Shiller, who helped create the S&P/Case Shiller real estate price indexes. “These speculators are preventing the market from crashing now, and when they get out it could fall again.”
“We’re creating a shadow inventory of homes that will be right back on the market as soon as the economy and the housing market begin to improve,” said Stiglitz, a Columbia University professor of economics. “We could see a double-dip in the housing recession if that happens.”
The government is telling us that it is of paramount importance to get properties in the hands of stable homeowners. Regardless of the economics of foreclosure prevention, it is better to weed out the weak and promote the strong. Only by moving properties to strong owners will the inventory be reduced and a floor in housing prices established. This sounds just like the argument against weak banks that prolonged the previous Japanese route to recovery.
The Ft. Lauderdale Sun-Sentinel “Builders want housing aid in rescue package” reports that desperate home builders don’t care whose hands their homes wind up in as long as they are sold. They want subsidies to push mortgage rate below 3% and a tax credit of up to $22,000 for home purchases. The builders are not specific on which buyers they want to qualify. Remember Paulson said that the cost of bringing mortgage rates to 4% would be astronomical.
This leads me to conclude that the most economical plan to stabilize housing is to take from the poor and give to the rich, in a reverse Robin Hood. In other words, take from the imprudent and give to the prudent. As the Bernie Madoff episode taught us, even the wealthy can become quite imprudent.
Disclosures: Author is long BAC, FNM, FRE and WFC.
Paulson’s Endgame for Fannie and Freddie
My Fannie Mae (FNM) and Freddie Mac (FRE) preferreds were listening today to: “Remarks by Treasury Secretary Henry M. Paulson, Jr. on The Role of the GSEs in Supporting the Housing Recovery before the Economic Club of Washington”. I cannot say for sure that some doubled from their sub-dollar base due to Paulson, but much of the Paulson team and financial rescue infrastructure will remain with the new President Obama Administration.
My guess is that Geithner will follow Paulson’s lead when he inherits the Treasury Secretary post, despite Summers and Bernanke’s lack of discipline on fiscal and monetary expansion. Let the floodgates open. But, remember Paulson is always looking for ROI, even though at times his plans appear to be schizophrenic. While Obama, Summers and Bernanke appear to be soul brothers in “better to over stimulate then not enough”, they appear confused in how to structure long-term benefits. This leaves an opening for Paulson via Geithner to direct the evolution of Fannie and Freddie out of conservatorship.
Paulson gave us additional insight into why he structured the GSE rescues as conservatorships. He purposely did not ask Congress for an explicit government guarantee of Fannie and Freddie debt and MBS because he did not want to lose the discipline of private sector credit evaluation. At the same time he did not believe the private sector had the capacity to guarantee the totality of the mortgage market, citing the difficulties encountered by the monolines (ABK and MBI). All this was of course academic when no one was willing to buy GSE securities without some type of government guarantee. But, Paulson was actually planning the exit strategy from the start.
Paulson sees support for the mortgage market as a public-private partnership with the amount of public support to keep mortgage rates low to be determined by the Obama Administration. His vision is that the GSEs will not incur the interest rate risk of holding a portfolio of mortgages. They would be limited to warehousing mortgages in preparation for securitizations. The GSEs primary function would be to insure credit risk. Limiting credit risk is key to keeping mortgage interest rates low.
Paulson appears to favor one of two models. The first would only partially guarantee MBS credit risk, forcing the private sector to still evaluate credit risk. The second would turn the GSEs into heavily regulated utilities with 100% government guarantee against credit risk. Though Paulson liberally uses the word replace, he never states the preferred shares will not be carried into the new enterprises.
While Paulson clearly wants to wind down the GSEs’ profits and risks in maintaining large mortgage portfolios, he states that the government is profiting immensely from the spread between GSE backed MBS and treasuries. Unstated is the risk the government is incurring by borrowing short and lending long. Given enough leverage, the government could drive mortgage rates down to 4% and make a huge profit. This is Paulson dreaming because he then states that the amount of Treasury borrowing to accomplish this would be astronomical. I don’t know if Bernanke read the second part. But even if Bernanke did, he would not be afraid of large numbers.
I believe Fannie and Freddie will eventually become low profit utilities, guaranteeing less than 100% of the mortgage credit risk. Under either of Paulson’s recommended structures, the GSEs would pay the government for reinsurance. As utilities, the GSEs’ preferreds become more secure and therefore more valuable. Thank you, Secretary Paulson.
Final note: Paulson declared the GSEs failure would set off a systemically overwhelming disaster in the derivatives market. Since when is it the government’s job to prevent moral hazard from CDS counterparty risk? Likewise, government would not let American International Group’s (AIG) counterparties suffer.
Disclosure: Author is long ABK, AIG, FNM, FRE and MBI.
Little House on PIMCO’s Prairie
The Wall Street Journal “Would You Pay $103,000 for This Arizona Fixer-Upper?” reports on how a 576 square foot house not fit for human occupancy wound up as a foreclosure on a triple-A rated PIMCO MBS. PIMCO’s never short for words Bill Gross and Mohamed El-Erian refused to comment for the Journal article. These are the people that advertise themselves as the “experts” endlessly on CNBC, and are always available for television comment and consultation on every potential move by the Federal Reserve and Treasury. PIMCO is held in such high esteem that they were chosen as one of the four managers for the Fed’s $500B Fannie Mae (FNM), Freddie Mac (FRE), Ginnie Mae MBS purchase program.
The story starts with the $3500 purchase of a suburban Phoenix home four decades ago by a woman who has been on various forms of public assistance for the last 13 years. The former homeowner admits that her weakness for hard liquor and gullibility for multiple cash-out refinancings lead to her downfall. In the end the house was in such disrepair that she gave up and moved to an apartment.
The last refinance in early 2007 netted the homeowner only $11K cash-out on a $103K mortgage. The 30-year adjustable rate mortgage started at 9.25% and capped at 15.25% for a woman with children who was “earning” $3000 per month in public assistance. The appraiser earned $350 for valuing the property at $132K. He plugged all the right numbers into to the formulas, even though he personally did not believe the house was worth that much. He claimed that he technically played by the rules, if not the spirit of the appraisal process.
This playing by the numbers amounted to putting “square foot logic in a round hole”. The Journal’s hut is certainly the type of outlier that trips up the mathematical formulas of the ratings agencies.
The final mortgage was originated by Integrity Funding LLC (a mortgage broker no longer in business) which collected $6153 in origination, documentation and other fees. Integrity earned an additional $3090 when the firm sold the mortgage to Wells Fargo (WFC). Wells Fargo subsequently sold the mortgage to HSBC (HBC) which packaged it along with 4050 other subprimes into a security. Standard & Poor’s (MHP) and Moody’s (MCO) rated this collection triple-A. Our notable expert PIMCO was one of the greedy that bellied on up to this trough. And that’s the short story of how this love shack became PIMCO’s little house on the prairie.
Don’t forget how Sherri Winston, an educated Ft. Lauderdale Sun-Sentinel columnist, got seduced by cash-out refinancing. The Journal leads us to feel bad for its disadvantaged homeowner, but as I detailed in "The Anatomy of a Subprime Mortgage" almost anyone can be seduced by cash-out refinancing.
Disclosure: Author is long FNM, FRE, MCO and WFC.
Blame HGTV for the Housing Bubble?
Jim Sollisch, creative director at Marcus Thomas LLC, wrote what I presume is a satirical editorial in The Wall Street Journal: “Blame Television for the Bubble” Sollisch humorously leads us through HGTV shows where couples are obviously spending beyond their means, and have overly optimistic assumptions of the value of luxurious upgrades and renovations. He finds irony in a “House Hunters” episode where a couple in their 20’s is shopping for homes priced from $425K to $675K, and wanders how much money they could possibly be earning.
My first reaction is blaming HGTV for the housing bubble is like blaming Robin Leach’s “Lifestyles of the Rich and Famous” for running up our credit card balances. I too am addicted to HGTV and the house flip shows on A&E and TLC. But I watched them to see how much more ridiculous each flip became. The prices paid and the expected selling prices for overly improved flips increased with each episode. Faux stainless steel appliances and a little granite were installed to pretty up 1,000 square foot 2 bedroom, 1 bath houses. Then the California flippers expected to get close to $1M. The culmination came with the expectation of making money flipping a $400K dump in a rundown Los Angeles neighborhood.
As usual, TV follows trends rather than creates them. You can’t blame “Dallas” and “Dynasty”for creating the culture of greed in the 1980’s. And TV did have some semblance of balance when you consider TLC Kirsten Kemp's Oprah Winfrey-like home spun advice. Kemp often warned “Flip that House” and “Property Ladder” participants to watch their budgets and not overspend for the neighborhood. While the shows’ intro voiceover told us the risks were high, they got the juices flowing by telling us there’s money to be made. Being risk adverse (at least in real estate), I could never justify the risk-benefit in any of the episodes I saw. I always thought the participants paid too much, over improved, and were extremely lucky to get the properties sold.
Kemp’s advice was not always taken, much to the flipper’s regret. As the housing bubble waned, so did profits. More and more homes were sold at a loss or did not sell at all. I thought it served them right. Now Kemp warns in a tough market you have to be especially careful. Her advice for the value of improvements and how to salvage as much value from what features your home has already is a benefit to all homeowners.
Are Home Prices Still too High?
The Wall Street Journal “Home Prices Declined at Record Pace in October” reports that the Standard & Poor’s/Case-Shiller home price index fell 2.2% month over month and 18% year over year for October. Some of the metropolitan areas fell more than 30% year over year. Prices peaked in mid 2006, but are still 58% above early 2000.
The value of homes to a large extent depends on where consumers are anchored. Those that bought during the bubble endear the Federal Reserve’s view that we are in a deflationary spiral. Those that were priced out or too cautious during the bubble still see inflated prices. Funny, how the Fed only sees the danger of asset price deflation, and never recognizes the inflation in asset prices. Anchoring plays a large role in a person’s view of economic value.
It’s old news that the Fed and Treasury are trying to prop up housing prices by every free market means possible. Most of their methods are truly bizarre. After socializing Fannie Mae (FNM) and Freddie Mac (FRE), the Fed wants to purchase up to $500B of their MBS in the free market. At the same time the Treasury won’t explicitly guarantee the GSE debt. Wouldn’t it be cheaper and more effective for the Fed to buy directly from the GSEs? All this to create a shortage of guaranteed high quality agency MBS theoretically pushing conforming mortgage rates to the mid 4% range. The Fed apparently believes that low mortgage rates are the answer to everything. History warns us that the Fed never believes that consumers consider the long-term value in asset purchasing decisions.
All of the Treasury’s previous attempts at free market mortgage modification have failed. I believe this is because mortgage investors are viewing the long-term economic value of housing based on more than temporary measures by the Fed. “Lite” modifications have failed because mortgage investors, banks and servicers have not matched payments with borrowers’ ability to pay. And investors only want to take true write downs if they can completely exit the transactions through foreclosures or short sales.
The purposeful failure of free market mortgage modifications will lead to the feared “cram-downs” by bankruptcy judges if enabling legislation is passed during the next Administration. Judges will determine the comparative economics of the NPV (net present value) of foreclose versus modifications. This fear should rightfully strengthen the mortgage underwriting process.
Let’s look at a few general methods of measuring the economic value of residential real estate. The first is affordability. The mortgage payments and operating expenses should not exceed the 30% to 40% range of the buyer’s gross income. Operating expenses include real estate taxes, insurance, utilities and any condo or HOA dues. The range should also consider other debt and credit score. The old rule of thumb was the purchasers should not consider homes costing more than three times their annual income. This means a couple earning $60,000 should not pay more than $180,000 for a home. With operating costs greatly inflated, the Fed’s interest rate lever is much less a factor on affordability.
The second general valuation factor is rental return on the property. The Fed considers owners’ equivalent rent rather asset value in calculating housing inflation. But, the Fed did not consider negative rental returns an indication of a housing bubble. The last general valuation factor is appraisals. I consider appraisals to be the least dependable indication of economic residential housing values. In many instances, prior sales are more of an indication of emotional values rather than economic values. The rent verses buy calculation provides a much stronger support level.
The Fed and Treasury believe that they can create equilibrium of supply and demand by freeing up mortgage credit and lowering rates. If they can tempt enough buyers to enter the market based on artificially low rates, they believe a floor in housing prices will be maintained. I say they’re wrong. Housing prices will have to fall to their economic value based on expected longer term interest rates and inflated operating expenses. The free market was tempted by artificially low interest and got burned not too long ago.
What good is it to buy a house because you can afford the mortgage payments, only to find out that you will have to sell it at a loss later?
Disclosure: Author is long FNM and FRE.
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