Friday, November 30, 2007

Random Thought of the Day - Nov 30, 2007

It doesn't matter what the Fed does to interest rates if lenders won't lend, so ride the rally up until the Fed cuts rates, and then get short. If you don't believe me then look at this study done by the Federal Reserve back in 2002.


Study

If it gets too dense then read the conclusion paragraph on Page 11 and 12

Tuesday, November 27, 2007

Thrift Capital Ratios

During the last significant recession in the early 1990's the thrift industry was ground zero for everything that was going wrong with the economy at the time, with hundreds of bank failures, etc. This time the problems seems to stem from the "smart money" bankers who have overextended themselves without regard to risk.

The Sept 2007 aggregate thrift financial report shows capital ratios actually getting stronger in September 2007, as measured on a year over year basis.



The full report is here.

Wednesday, November 21, 2007

Thrift Report

The Office of Thrift Supervision (OTS) just released its third quarter report on the state of the thrift industry. While the market and the media have been focused on the travails of the large cap banks and brokers, the thrift industry is just as important to our financial system as it has $1.57 trillion in assets and originated 30% of all mortgages in the most recent quarter. The full report is available here:

Thrift Industry

Highlights include:

1) Loan loss provisions increased to 0.92 percent of average assets in the third quarter, an increase from 0.22 percent in the third quarter one year ago and from 0.38 percent in the prior quarter.

2) Troubled assets (noncurrent loans and repossessed assets) were 1.19 percent of assets, up from 0.95 percent in the prior quarter and 0.64 percent a year ago.

Loan loss provisions as a percent of average assets are now at the highest level as far back as the report goes (1991).

Although these metrics are high, it can get a lot worse. If you look at page 11 of this report, entitled troubled assets, you can look at the peak back in the early 1990's.

Also, as the report notes, if you exclude the top ten thrifts who are active in originating loans for sale, the industry return on assets would have been much higher.

Monday, November 12, 2007

Highly Recommended

I just found a blog that is probably one of the best I have seen on Homebuilders and the related mess that is going on in that area. It is written by Reggie Middleton and is located here:

Reggie Middleton's Boom, Bust & Bling Blog

He brings a lot of insight into an area that is usually full of hyperbole. I would recommend subscribing to his feed.

Thursday, November 8, 2007

No More Bloody Shoes

Everyone is waiting for the next "shoe to drop" in the financial markets. No one knows when or what it will be but the market spends an inordinate amount of time thinking and speculating about it. Here is another scenario:

Citigroup, Inc. releases a press release at 2:00 AM on Sunday Morning on Thanksgiving Weekend. It is noteworthy for its simplicity and brevity. It reads:

"Citigroup, Inc., announced this morning that it will no longer provide credit support to the multiple Structured Investment Vehicles that have been carried off balance sheet. While Citigroup, Inc. previously supported these vehicles through various means in order to maintain market stability, the bank is under no legal obligation to do so, and has decided to use our capital for other purposes."

The silence is deafening - for a moment - as the market takes a couple of seconds to digest and understand the implications of this. At the close on Monday, the first money market fund "breaks the buck" and trades at less than a dollar a share. Panic sweeps the staid world of the money markets, accelerated when the great mass of individual investors finally realize that a dollar in a money market fund does not equal a dollar of cash.

How Many Shoes Can We Handle?

Everyone is waiting for the next "shoe to drop" in the financial markets. No one knows when or what it will be but the market spends an inordinate amount of time thinking and speculating about it. Here is another scenario:

Citigroup, Inc., under pressure from the financial markets and shareholders decides to reduce its balance sheet risk, just in case. A memo goes out from the office of the new CEO. Long time commercial bankers call their customers. The conversation goes something like this:

Banker: Hey John. How are things going?

Customer: Oh good. How's the bank?

Banker: Pretty good. The reason I am calling is that the loan that is due next month. We're not going to be able to roll it over this time.

Customer: What?

Banker: Yeah, I'm sorry but I wanted to give you some notice so you can make other arrangements.

Customer: But we have always paid on time. I've had that loan with you for years. That bank was called First National City Bank when I first took it out. You can't do that.

Banker: Well I've got to go. I have some other customers to call. Bye John.

John decides then not to open that new store, or build that building, or expand into that new line of business.

The credit crunch spreads to Main Street.

Wednesday, November 7, 2007

The Next Shoe?

Everyone is waiting for the next "shoe to drop" in the financial markets. No one knows when or what it will be but the market spends an inordinate amount of time thinking and speculating about it. Here is one scenario.

Ambac Financial Group, Inc. (ABK) is at a 10 year low. ABK insures billions of dollars worth of Municipal Bonds. Small investors basically treat this guarantee from ABK and other insurers as gold. It lets them sleep warm and comfy at night knowing that their nest egg is secured.

The Stock Market panics further and drives down the price of ABK even more after further disclosures on its exposure to risky securities, and ABK loses its ability to provide a AAA credit rating to the bonds it insures. Municipal Bond funds, some of which must hold only AAA or insured bonds according to its prospectus, start selling ABK backed bonds. There are few buyers for these bonds. The market for these bonds shows sharp declines in price since the Municipal Bond market is a fairly illiquid market. Auditors, not wanting to end up like Arthur Andersen, insist that the muni funds mark the bonds down based on the few forced sales out there.

The bond funds holler and scream but they price the bonds at the end of the month based on the few comparable sales out there and on the underlying credit assuming no insurance.

The retail investor opens the statement and sees its fund or individual bond marked down 5 to 10%. A wave of panic selling ensues as they call their stockbroker and tell them to sell. Prices decline even further. Since there is too much supply and not enough demand, public finance slowly grinds to a halt as States and Municipalities can't roll over existing debt or start new projects.

While this scenario sounds like a little bit of a stretch, who knows? If someone had told you six months ago that the largest bank and the largest brokerage firm in the United States would sack its CEOs, that would have sounded a little crazy also.

Tuesday, November 6, 2007

What the Heck Does This Mean?

Moody's put out a filing the other day and this little nugget stuck in my head:

Based on its review of the latest information available, in the opinion of management, the ultimate liability of the Company for the unresolved matters referred to above is not likely to have a material adverse effect on the Company’s consolidated financial condition, although it is possible that the effect would be material to the Company’s consolidated results of operations for an individual reporting period.

Here is the full text from the filing:


Item 1. Legal Proceedings

From time to time, Moody’s is involved in legal and tax proceedings, claims and litigation that are incidental to the Company’s business, including claims based on ratings assigned by Moody’s. Moody’s is also subject to ongoing tax audits in the normal course of business. Management periodically assesses the Company’s liabilities and contingencies in connection with these matters based upon the latest information available. Moody’s discloses material pending legal proceedings, other than routine litigation incidental to Moody’s business, material proceedings known to be contemplated by governmental authorities, and other pending matters that it may determine to be appropriate.

For matters, except those related to income taxes, where it is both probable that a liability has been incurred and the amount of loss can be reasonably estimated, the Company has recorded reserves in the consolidated financial statements and periodically adjusts these as appropriate. In other instances, because of uncertainties related to the probable outcome and/or the amount or range of loss, management does not record a liability but discloses the contingency if significant. As additional information becomes available, the Company adjusts its assessments and estimates of such liabilities accordingly.

For income tax matters, the Company employs the prescribed methodology of FIN No. 48, adopted as of January 1, 2007. FIN No. 48 requires a company to first determine whether it is more-likely-than-not (defined as a likelihood of more than fifty percent) that a tax position will be sustained based on its technical merits as of the reporting date, assuming that taxing authorities will examine the position and have full knowledge of all relevant information.

A tax position that meets this more-likely-than-not threshold is then measured and recognized at the largest amount of benefit that is greater than fifty percent likely to be realized upon effective settlement with a taxing authority. The discussion of the legal matters under Part I, Item 2. “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Contingencies”, commencing on page 30 of this quarterly report on Form 10-Q, is incorporated into this Item 1 by reference.

Moody’s has received subpoenas and inquiries from states attorneys general and governmental authorities and is cooperating with those inquiries.

Based on its review of the latest information available, in the opinion of management, the ultimate liability of the Company for the unresolved matters referred to above is not likely to have a material adverse effect on the Company’s consolidated financial condition, although it is possible that the effect would be material to the Company’s consolidated results of operations for an individual reporting period. This opinion is subject to the contingencies described in Part I, Item 2. “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Contingencies”.

Citigroup Disclosures

The 10-Q filed by Citigroup yesterday has the following disclosures about the extent of its exposure to the continuing financial mess in the markets:

"On November 4, 2007, the Company announced significant declines since September 30, 2007 in the fair value of the approximately $55 billion in U.S. sub-prime related direct exposures in its Securities and Banking (S&B) business. Citi estimates that, at the present time, the reduction in revenues attributable to these declines ranges from approximately $8 billion to $11 billion (representing a decline of approximately $5 billion to $7 billion in net income on an after-tax basis)."

"Citi also announced that, while significant uncertainty continues to prevail in financial markets, it expects, taking into account maintaining its current dividend level, that its capital ratios will return within the range of targeted levels by the end of the second quarter of 2008. Accordingly, Citi has no plans to reduce its current dividend level."

Breakdown of $55 billion

$11.7 billion of sub-prime related exposures in its lending and structuring business.

*$2.7 billion of CDO warehouse inventory and unsold tranches of ABS CDOs.
*$4.2 billion of actively managed sub-prime loans purchased for resale or securitization at a discount to par primarily in the last six months.
*$4.8 billion of financing transactions with customers secured by sub-prime collateral.

$43 billion of exposures in the most senior tranches (super senior tranches) of collateralized debt obligations which are collateralized by asset-backed securities(ABS CDOs).

*$25 billion in commercial paper principally secured by super senior tranches of high grade ABS CDOs

*$18 billion of super senior tranches of ABS CDOs as follows:

*$10 billion of high grade ABS CDO.
*$8 billion of mezzanine ABS CDOs.
*$0.2 billion of ABS CDO-squared transactions.

The $18 billion in super senior tranches are being valued apparently using the new level 3 asset guidelines. These securities are not trading at all. There is still significant risk in these holdings due to the uncertainty described below.

"These super senior tranches are not subject to valuation based on observable market transactions. Accordingly, fair value of these super senior exposures is based on estimates about, among other things, future housing prices to predict estimated cash flows, which are then discounted to a present value."

Monday, November 5, 2007

Citigroup Capital Ratios

Here are the relevant capital ratios for Citigroup as detailed in the 10-Q filed this morning. These ratios are for Citigroup. The 10-Q has a second set of capital ratios for Citibank, N.A. The numbers for Citigroup are as of 9/30/07:

Core capital (leverage) ratio 4.13%
Tier 1 risk-based capital ratio 7.31%
Total risk-based capital ratio 10.61%

My assumption is that these capital ratios don't take into account the latest write offs that hit the tape this morning. The 10-Q states that "to be well capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 Capital Ratio of at least 6%, a Total Capital Ratio of at least 10%, and a Leverage Ratio of at least 3%, and not be subject to an FRB directive to maintain higher capital levels."

Here are the actual numbers as of 9/30/07 in billions (add six zeros):

Total Tier 1 Capital $ 92,370
Total Tier 2 Capital $ 41,453
Total Capital (Tier 1 and Tier 2) $ 133,823

Ratio Calculations

Tier 1 risk-based capital ratio of 7.31% is calculated by dividing $92,370 by total Risk-Adjusted Assets of $ 1,261,790.

Total risk-based capital ratio of 10.61% is calculated by dividing $ 133,823 by total Risk-Adjusted Assets of $ 1,261,790.

Core capital (leverage) ratio of 4.13% is calculated by dividing $92,370 by adjusted average assets.

Saturday, November 3, 2007

Slow and Steady Wins the Race

Last Thursday was a brutal day for the market, and especially for financial stocks. However, there were a couple of banks that were up on Thursday after reporting earnings for the quarter. Neither of these banks are well known, or covered by analysts, or could care less.

One is a cult bank stock that happens to be located in the fulcrum of foreclosure land - Southern California. The other is located in North Carolina and consists of one branch office. Both are Bulletin Board stocks that trade by "appointment" only.

Farmers & Merchants Bank of Long Beach has been in business for 100 years and operates 22 branches in Southern California. It has been controlled ever since by the Walker Family. It traded 2 shares yesterday at $6,575 per share, up 2.65%. Ninety percent of its loan portfolio is tied to real estate, mostly commercial, but the bank did not report any charge offs during the quarter, nor any losses on its investment portfolio. And in case you are worried about insolvency, you should know that its total capital to risk weighted assets is an astounding 39.22% at the end of 2006. A bank is considered well capitalized if that ratio is in excess of 10%.

The bank web site is here.

Wakeforest Bancshares Inc. is a micro cap Savings and Loan located in Wake Forest, North Carolina. It reported earnings for the quarter that were down year over year from 9/06, and full year earnings were up $0.02 from 9/06. The stock traded up 8.55% to $22 a share. So how did they do it? Very simple - "the Company does not make sub-prime loans," according to the press release. Or to put it a little more colloquially - we don't do stupid things like make bad loans to people just to satisfy Wall Street's insatiable need to grow. We don't care if you laugh at us every year at the annual Bankers convention because who's laughing now. The web site is here.

I don't own either of these stocks. I did look into Wakeforest Bancshares Inc. a few months ago and passed because it wasn't "liquid" enough. It occurred to me that liquidity isn't always a good thing since it allows investors to react emotionally without regard to reason or rationality.