Traderbill's Financial Markets Weblog

…no, TB isn’t referring to the aforementioned conference call, but to the value of capitalism. On Friday afternoon, TB talked with a friend and former client who runs a very successful credit union (a winner of Credit Union of the Year Award by NCUA). Besides being long overdue, TB wanted to discuss his views on the credit crisis…and it still is a crisis, make no mistake about that.

He shares the same sentiments as TB on this (TB a former banker for the first nine years of his career): credit is a valuable commodity and we have let the controls and quality evaporate to such a state that old man Bailey in It’s a Wonderful Life, rather than looking like Scrooge, now looks like a genius. Whatever happened to banks safeguards on lending?…80% mortgage, no more than one third of your income to make the mortgage payment, full documentation and no stated income.

Look at the logic in this: In any geographical area it is doubtful (was?) that a bank would lose on it’s overall mortgage portfolio, unless they were foolish and concentrated in one small area. If you wanted more debt you had to take out a second…after obtaining the first. So the only way to do that was through an unsecured bridge loan…later converted to a second….that was where the risk was.

Now, what is the difference between a CEO and a hedge fund manager. Both are highly compensated, true but generally for large successful funds the managers have their own capital at risk as opposed to CEO’s who receive high salaries, huge bonuses and stock options plus a golden handshake when they screw up. When the hedge fund manager screws up, he gets hurt badly too…much more so than private equity and especially Blackstone (BX) which was able to get off the worst IPO of 2007 -39% since IPO on 6/20/07 (Vonage (VG) was the worst of 2006), while hedge fund manager Fortress (FIG) is down 20% since the 2/7/07 IPO a year ago.Don’t even ask how these stocks look from the opening day highs! Blackstone’s worst enemy is CEO Steve Schwarzman who can’t seem to stop sounding like a spoiled rich kid…testifying before Congress on how without 15% tax rate private equity would dry up!

The reason for the above is an article TB reported on last week on how hedge funds, not financial institutions are the savior…it credited John Paulson as a hero for shorting the subprime sector and making several billion in the process  …much better than dying to become a hero! Then Paulson & Co. hired Alan Greenspan as a financial advisor…hello? he never did a thing about subprime so perhaps like Deutsche and PIMCO, he is merely being hired as a contrarian indicator?…always a good thing to have.

But the more TB reflected on the article, the more he agreed…two major Wall Street firms, Goldman Sachs (although they got the subprime trade right…as far as we know), and Bear Stearns owned the only major hedge fund casualties since the problems came to light…isn’t that interesting? Furthermore, examining the performance of Funds of Hedge Funds, the good ones did quite well so long as they didn’t lever themselves up and then invest in other levered up hedge funds…hedge funds squared and even then the only casualties were the ones with CDO derivatives creating CDO squared portfolios.

To clarify a point…how could an intelligent manager do something as stupid as buy ABX/CDO’s? The same way the rating agencies did and in many cases it was not clearly disclosed that there was a derivative component to the ABX/CDS. When they were created there was a fever so the orignators put in quality loans for the AAA rating, and some subprime yet based on default rates the rating agencies gave them a AAA on the entire package which also include A rated debt. Sooo…being greedy, and not being able to get the collateral together in time they temporarily used derivatives planning to substitute real loans as soon as they could. What the rating agencies didn’t know is that all of these were based on the same megapool of mortgages so diversification went out the window (also the default rates on mortgages were low due to the boom of the past five years and even before there was little or no subprime origination. Flawed data gives flawed results. So the problem came when the new owners of the debt got margin calls on the derivative portion and since the prices were dropping so rapidly as we migrated from mark to model to mark to (alleged) market, the calls were staggering…that is what wiped out that little town in Norway who had a margin call of millions of dollars (the broker filed bankruptcy and even though regulators saw fraud, the broker was owned by a consortium of banks who pleaded innocent). Now multiply stories like this and then add the monoline insurers to the equation.

They had insured municipal bonds profitably for way too long but wanted to expand so they too headed for the lucrative  CDO/CDS market. Weaker and highly leveraged investors relied on this insurance and worse yet contracts were written based upon having that AAA rating (also heard that with hedge funds if their Net Asset Value fell by 50% the counterparty had the option to cancel the contract), so now the pressure was on the insurers who never anticipated losses of this magnitude…if at all. So then what happens?…the counterparties get the shaft and the margin calls explode. Naturally, the banks are worried as are bondholders fearing a downgrade and many of these are required to have a AAA rating, so it morphed over to munis…not on default risk, but liquidity due to forced sales.

Then eight white knights (black hearted banks?) arrive on the scene to bail out the insurers. That isn’t that hard or expensive as they can put up treasury bills as collateral and earn the interest, but with rates on loans falling faster than deposits…what do you think is going to happen to already shrinking profit margins? Now couple this with rising delinquencies and foreclosures as well as re-fi’s and you have several quarters at least of declining earnings for investment banks and large commercial banks. Have you gotten soliciations for business cash accounts from the major yet? TB has …3.5% or so for deposits!

Now you should see why even the mortgage portion of the fiscal stimulus will be a bust…the banks don’t want to make loans…re-fi’s will be big by those with jumbo loans converting to the new conventionals, if they can qualify…while the lower income people will suffer. Also, most subprimes are ‘contract rate’ loans so that the drop in rates does not help them unless they can re-fi…and pay a big prepayment penalty. Of course the home is now probably worth much less than the mortgage and remember the number of spec buyers with multiple residences…good luck to them. But it is worse than that as it will be a drain on real estate prices for years to come.

If you think buying MBIA, AMBAC etc. stock is a good idea the recent rallies are more likely short covering…the bank actions merely lessen the liklihood of bankruptcy while doing nothing for the shareholders. It is also for this reason that TB can’t see the rally in C and other financial stocks as mere shortcovering…of course he could be wrong, right?

A tale of two financial company banks: Look at these statistic on Citigroup (C) as of 12/31/07: Common Equity to Total Capital: 9.03%; Total Debt to Common Equity: 1007.8%; Debt to Assets: 52.45%….47.5% a year ago. Thru interpolation TB gets the following: Debt to TOTAL EQUITY: 91%; Capital to Assets 5.2%…a year ago  it was 6.4% while Equity Capital was 15.3% of Total Capital…moreover Long Term Debt went from 13.3% of Total assets to 19.6% in one year (actually in 3 mos). This is an extreme case but typical of investment and commercial banks. Contrast to Bank of America (BAC), who has had problems too but Common Equity to Total Capital only declined to 41% from 45.5% and Long Term Debt to 19.6% of Total Assets from 13.3% a year ago.   

Now Look at a major commercial bank: Wells Fargo (WFC), a commercial bank who also suffered as being the largest subprime mortgage originator/servicer: Shareholder Equity to Total Assets 8.2% vs. 9.5% and Common Equity to Total Capital was steady at 29.4%. Unlike Citi who cut their dividend by 40%, Wells and BofA who held it steady,after increasing it in Q3 2007.

Now a major bank that holds no subprime yet was tarnished by the others in the industry, US Bancorp (SB)…TB recently bought this stock. Common Equity to Assets is 8.4% vs 9.7%. Shareholder Equity to Total Equity steady at 27% and Long Term Debt to Total Assets only increased slightly to 18.3%.  

Which institution is best suited for a prolunged downturn? TB would rank them UBS, WFC, BAC, C. Beware of small regional banks that are safe but selling at high multiples to earnings. That is a bet on a buyout…which could come as large banks see huge increases in non-performing assets (especially real estate) and attempt to buy small profitable ones. One TB bought after hearing of it from Keefe, Bruyette and Woods was Provident Bankshares (PBKS) which increased their dividend and even after rallying has an indicated yield of 6.15% while the est. P/E is 13.7X and Common Equity to Total Assets is 10%.

None of the above are recommendations merely reference points to check out for the financial sector.

What about brokers? Merrill (MER) has just a 2.4% dividend and an estimated P/E of 11.7x after losing 7.8B last year. Bear Stearns (BSC) has an even lower 1.4% dividend and estimated P/E of 10.5% after earning 11% of the prior year (but yearend was 11/07). Goldman (GS) is trading at 9.4% times estimate earnings and sports a dividend of 0.67). With a total return over the past year of -2% it is the best of the trading firm brokers…but how come they paid out record bonuses, but stiffed the bottom 10%, and then announced large layoffs…are the shareholders getting the shaft? Contrast to Schwab (SCHW) with a 20.9% return over the past year (30% in 2007), but an estimated P/E of 19x!…see how investors are drawn towards last years winners? IF TB owned a broker it would be SCHW…certainly not E*Trade that was touted on CNBC because insiders were buying the stock and they wouldn’t unless things were looking up. No? Well, unlike Merrill back in 1997 who only gave senior management bonuses in stock and if they were willing to match and hold for at least 2 years…that is insider buying of the good kind. E*Trade directors as a group bought just $1.6 million of stock…in a world of billions…gimme a break!

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