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.

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.

Wilbur Ross Speaks and You Damn Well Better Listen

I just listened to a great interview with Wilbur Ross on Bloomberg which was brought to my attention by the people at Vinvesting


Wilbur Ross Bloomberg Interview

The interview is 25 minutes long and goes into good detail on the issues of the day, including the sub prime lending fall out, brokerage earnings, the growth of the hedge fund industry and the inherent weakness of quantitative "black box" investing.

Jackass of the Day - August 31, 2007

"The program could play a very important role in saving from foreclosure American homeowners who have been taken advantage of by unscrupulous subprime lenders and brokers,"

Senate Banking Committee Chairman Christopher Dodd, D-Conn

And how will you tell them apart? Can you distinguish between greed and stupidity?

Wilbur Ross - Words of Wisdom

Can someone please get this guy to run for president?

Wilbur Ross sums it all up

When Numbers Lie

"We will follow developments in the subprime market closely. However, fundamental factors--including solid growth in incomes and relatively low mortgage rates--should ultimately support the demand for housing, and at this point, the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system."

Chairman Ben S. Bernanke
June 5, 2007

American Home Mortgage Undertakes Substantial Reduction of Employee Base and Operations Aug. 2, 2007

American Home Mortgage Investment Corp. (NYSE:AHM) today reported that, in light of the liquidity issues resulting from extraordinary disruptions occurring in the secondary mortgage market, the Company has determined to significantly reduce its operating structure as it seeks the most appropriate course of resolution to preserve the value of its remaining assets.


From AHM 10-K for period ending 12/31/2006:

Mortgage-backed securities owned

$9.3 billion- Total Portfolio
$8.5 billion - AAA Rated
91.6% AAA

Loan Origination Summary

Prime Loans - 91.1% of all loans originated
Alt-A - 8.9%
Non-Prime - 0%


Cumulative 5 year GAAP Net Income

$682.1 million


Return on Equity

12/31/2006 - 22.74%
12/31/2005 - 28.05%


Book Value

$1.27 billion
$25.19 per Share

Schadenfreude

I confess that I am one of those people who sometimes take a perverse pleasure in the misfortune of others.

Schadenfreude

The latest bunch of smart guys to have their asses handed to them are the people at Sowood Capital Management, a hedge fund started a couple of years ago by alumni of the Harvard Endowment. It was reported today that funds they run have lost 50% of its value in a month. This is getting to be a commonplace event lately but the news with Sowood is that they didn't invest in sub prime paper but in regular corporate debt.

How does such a thing happen? Major hedge funds have entire departments dedicated to risk management.

Was it a fatal combination of leverage, lack of liquidity and hubris? Was it a reliance on impenetrable mathematical black boxes that tell you the pricing relationship between different securities but that never seems to work in times of market crisis?

We'll never know. The principals at Sowood will no doubt move on and start another hedge fund with an equally impressive sounding name and raise another billion from people who are supposed to know better.

Conundrum Solved?

Has the great Wall Street conundrum been solved? I wrote 2 days ago about the disconnect between deal fever and the viability of financing those deals, and the decline in the market yesterday may have validated my words. The market was down 447 points at one point in the afternoon and it was a little unsettling to watch such a free fall.

Is it over? Wall Street is notorious for having a selective memory so maybe the buy on the dips investor will drive things back up. But remember 300 points is not what it used to be. The market is down 4.8% from the high reached a week ago but that statistic is deceptive since it is from the intra day high of 14,121.04. The market closed that day at 14,000.41, giving us a correction of 3.9% from that close.

I had some serious flashbacks yesterday to the late 1980's, when Wall Street was riding high. It was the age that gave us "Bonfire of The Vanities" by Tom Wolfe, and the movie "Wall Street" directed by Oliver Stone. Everyone remembers the famous "greed is good" line from that film but the one I remember was spoken by Martin Sheen who played the father of Bud Fox.

"Stop going for the easy buck and start producing something with your life. Create, instead of living off the buying and selling of others."

We thought it was the age of excess but now 20 years later we know it is nothing compared to today.

I remember sitting at my desk when the news came out that Michael Milken had earned $550 million in one year heading up Drexel's junk bond unit. Today that might not even get you a table during the evening rush at the 21 Club. And then one day in October 1989 it came to an inglorious end when the leveraged buyout of United Airlines fell through. It was a watershed event that precipitated a 7% drop in the Dow in one day.

Does Chrysler equal United Airlines? With hindsight it just might be.

The Conundrum

The Conundrum is simple and is this - the market continues to climb based on a "buy on the dips" mentality fed, at least in part, on continued takeover speculation that is embedded in the value of equities. Every time the market declines significantly, it bounces right back as investors jump into names they have been stalking. I think that at every buy side shop there is an investment thesis template that reads "potential buyout candidate" and all the analyst has to do is fill in the name and symbol, and give it to his Portfolio Manager.

However, the financing that supports that takeover activity is starting to undergo a repricing by investors based on a reevaluation of the perceived risk. Many investors have stopped investing at all here or have paused, while other investors are rejecting covenant lite and toggle or pay in kind bonds while demanding higher yields. Higher yields mean less of a return on these deals which will shrink the universe of potential buyout candidates.

There are at least 6 "hung up" bridge loans held by investment banks where Wall Street firms provided interim financing to buyout shops, in anticipation of replacing the bridge loan with permanent financing. Until this pipeline clears or the investment banks feel that conditions in the credit market are returning to normal (I hate to even use the word normal) this type of stop gap financing will be harder to come by.

The latest deal financing to fall through was reported today by The Wall Street Journal - the buyout of Allison Transmission, a unit of General Motors. Investment banks postponed an offering of $3.1 billion in loans.

We have a conundrum here. The stock market cannot continue to be propped up by the private equity buyout frenzy if the financing that supports that frenzy is no longer viable. There are a number of possibilities here:

1) The market is seeing through the current turmoil in the credit markets and expects the financing to return. If true, this would be extraordinary considering the market usually has a one-week time horizon.

2) The market believes that even if risk reprices at a higher level - the internal rate of return (IRR) on private equity deals will still be sufficient enough that the buyouts will continue.

3) There are other things that are pushing the market higher besides the buyout frenzy. This could be a number of things, perhaps even the dreaded "liquidity" excuse that I hate so much as OPEC and the Chinese have so much money they have to put it somewhere.

4) I am completely wrong and have no idea what I am talking about and shouldn't be writing an investment blog much less running a hedge fund. If this is true please send me an e-mail privately and tell me.

5) The investors who are propping the market up don't fully understand the reasons supporting valuation that I described earlier in this post so therefore they cannot stop investing when these reasons end.

6) There is a lag time before the financing problems impact the stock market.

7) Investors believe that private equity shops have so much money that they will spend it no matter what. If they make bad deals it will be years before the limited partners who invest in these funds feel it.

If I had to make a bet, it would be on reasons 2 and 7 (I hope it's not #4). Interest rates are still low historically, some marginal deals may fall through, but many would still work at least on paper based on a spreadsheet with optimistic projections of future cash flow growth and EBITDA exit multiples.

The Death of Liquidity – Part I

Liquidity…it’s Wall Street’s excuse for everything. Why does the stock market keep going up? Liquidity. Why do real estate prices keep going up? Liquidity. Why haven’t we had a significant correction in months? Liquidity. Why do the skirts of CNBC anchorwomen keep getting shorter? Liquidity.

Recent articles in the financial press represent an obituary for this pesky little word that has come to mean so much to so many people.

The Wall Street Journal, reported today that Wall Street investment banks are having trouble placing debt to finance the latest round of private equity buyouts. They even had to extend bridge loans with their own capital since bond investors seem to have finally realized that covenant lite and toggle bonds are dirty words.

Will the end of liquidity knock out one of the legs that are propping up this market? Time will solve that mystery. Could it be that it is not really the death of liquidity, but just investors demanding a higher yield for the risk that they finally realized they are taking?