Are FHA Loans the New Subprime?

I just ran into another tenant in my office building this morning - he is a mortgage broker specializing in sub prime lending. He just moved his office to his house due to the fall off in these types of loans. I asked him how the business was and he mentioned something about the growing popularity of FHA loans, referring to loans either made or guaranteed by the Federal Housing Administration. And then he made a chilling statement with a slight grin on his face:

"You know, FHA is the new sub prime."

He then waltzed out the door, safe in the knowledge that his capital wasn't at risk.

I have to do more research on this type of loan. I know a little bit about it - only 3% down payment required I believe. If anyone knows something about this type of lending, please comment and tell me we are not about to make the same mistakes again.

Citigroup Sub Prime Exposure- An Update

Citigroup detailed its remaining "sub-prime related direct exposures in securities and banking, comprised of CDO super senior exposures and lending and structuring exposures" in its first quarter of 2008 earnings release.

CDO Super Senior Exposures

Gross ABS CDO Super Senior Exposures - $33.2 billion.
Hedged Exposures - $10.5 billion.
Net Exposure - $22.7 billion.

The net exposure is broken down as follows:

Asset backed commercial paper - $16.8 billion.
High Grade - $3.8 billion.
Mezzanine - $2.0 billion.
ABS CDO Squared - $0.1 billion.

Lending and Structuring Exposure

CDO warehousing/unsold tranches of ABS CDOs - $0.2 billion.
Sub-prime loans purchased for sale or securitization - $3.6 billion.
Financing transactions secured by sub-prime - $2.6 billion.

Total Lending and Structuring Exposures - $6.4 billion.

A couple of comments:

1) There is still risk in the $10.5 billion in hedges on the portfolio. Counterparty risk is the main problem here.

2) Is the phrase "High Grade" an oxymoron when the securities are valued at 41 cents on the dollar? I mean WTF? (page 19 of the first quarter of 2008 presentation.)

3) I guess the good news is that Citigroup can only write down $22.7 billion more until they are at zero.

It's Official, Securitization Sucks

It took them long enough to prove what we all knew in our heart, but four members of academia just published a paper on it. This excerpt is from the conclusion:

"The goal of this paper is to empirically investigate whether securitization had an adverse effect on the ex-ante screening activity of banks. We exploit a specific “rule of thumb” in the subprime lending market to generate an instrument for ease of securitization. Comparing characteristics of the loan market above and below the ad-hoc credit threshold, we show that securitization does indeed weaken the screening incentives of financial intermediaries."

"An 80% increase in securitization volume is on average associated with about a 20% increase in defaults. These defaults are being driven by characteristics of the loan or the borrower that are unobservable to both the researchers and the securities market. That we find any effect on default behavior in one portfolio compared to another with virtually identical risk profiles, demographic characteristics, and loan terms suggests that the ease of securitization may have a direct impact on incentives elsewhere in the subprime housing market, as well as in other securitized markets."

Full Paper

Countrywide Earnings

Countrywide Financial (CFC) just reported what will probably be its last quarter as an independent company. I won't rehash all the losses and write offs that were detailed in the press release, but I did notice one thing that scared me a little.

CFC reported a delinquency rate of 5.76% in its servicing portfolio for Conventional 1st liens. This is up from 4.41% and 3.05%, at the quarters ending September 30, 2007, and December 31, 2006, respectively.

The delinquency rate for sub prime was a sky high 33.64%, but that did not come as a surprise to me.

The Case for Financials

I want to make the case for starting to put some money to work in Financial stocks. Please don't jump all over me before you read this. Here is the thesis:

1) The Federal Reserve has finally realized the seriousness of the situation and is committed to bringing rates down to stimulate economic growth. The Fed cut rates 75 basis points this morning, and will cut more.

2) Housing, as we all know, is in a deep depression. The latest report on starts show a drop to levels not seen since 1991. The market sold off on this, but this is actually good news as supply must be taken out of the market in order to restore balance.

3) Housing will also be helped during the Fed easing cycle, as the tidal wave of resets on mortgages hits in 2008. Mortgages will reset at lower rates than expected. This will mean less foreclosures than the market expects.

4) President Bush has announced a tax cut to also help the economy. It seems that both parties will work together to come up with some plan to help, despite the election year coming up. The announced plan was for a $150 billion stimulus package, but by the time it becomes law it will be larger than that.

5) The last quarter of reported GDP growth came in very strong at 4.9% for the third quarter of 2007. We all know that the official definition of a recession is two straight quarters of negative GDP growth, but lets assume that one quarter would be enough. The economy would have to contract almost 5% to reach negative growth. That is an extraordinary amount in an economy of our size.

6) The Financials, as measured by the large cap index, the XLF, is at $25.17, after peaking at close to $38. That is a drop of almost 40%, more than a Bear Market. At $25, the index is now at a level last reached in late 2003. It is hard to get a handle on valuation because book values and earnings are in "flux" to put it mildly, but clearly the stock prices are more grounded in reality than before.

7) The banking industry is recapitalizing fairly rapidly, with capital infusions of almost $100 billion from Sovereign Wealth Funds, and other foreign players. The rest of the world does not have an interest in seeing the United States financial system go under. That would be bad for business. After all, there is a reason why 36 countries store Gold reserves in a vault under the Federal Reserve building in Lower Manhattan.

8) Banks have started started to write off bad loans and bad investments from its balance sheets. Although the market sees this as a negative, it is actually the beginning of the end of crisis. Another point that some investors don't realize is that accounting rules forbid banks to "write up" these investments once they are put into the "other than temporary loss" category. This raises the possibility that once the market recovers, these securities will actually have a value despite being valued at nothing on the bank books. So one day, we will have a situation where bank book values are understated on a trailing basis, the opposite of the situation we have today, where bank and other financial book values are overstated on a trailing basis.

9) Newly tightened lending standards means that fewer bad loans are entering the pipeline. Underwriting departments are finally doing its job. Non performing loans, and loan write offs will eventually peak and then turn down. That is how the credit cycle works.

10)Despite all the investment write offs and reserving for credit losses, bank capital ratios are well above minimum regulatory levels.

11) The psychology is correct as well. Everyone thinks that the sky is falling. Panic is setting in, just the time to buy.

Foreclosure City

A great heat map of foreclosures by county courtesy of Mathhew Yglesias and a blog called Grasping Reality with Both Hands.




It's a little too small and hard to read but I think you get the point.

Robert Toll on the Sub Prime Bailout

A few excerpts from the Toll Brothers fourth quarter conference call held last week courtesy of Seeking Alpha

Robert Toll had some interesting comments on the new plan announced by the Federal Government.

Comments on Sub Prime Loan Plan

"With respect to what do I think about the most recent announcements, to be a wise guy, not much. There is no such thing as a sub-prime loan. There’s a sub-prime borrower; that is a borrower who hasn’t got the credit, the respect for his credit in the marketplace that’s equal to what you would consider to be necessary, which we call now prime. A little misnomer in the use of the words."

"What I understand has been offered to the congress to consider and pass is a break for sub-prime. So if you’ve got -- sub-prime borrowers, so that if you are not credit worthy, we’ll give you five years at your present rate but the next door neighbor, who decided he liked the teaser mortgage and went for four for the first six months and six for the next six months and then according to an index with a differential, he would be pushed to eight and then to 10, he’s stuck because he had prime rating."

"I think what would have made more sense, if I were running the zoo, is I would have said we are going to stop teasers, not just sub-prime but for everyone at a rate and pick a number. If we think a -- we’ve done it in the past. The rates used to be regulated in this country up to the elimination of Regulation Q. I think that was in the ‘70s when disintermediation took place."

"I think it wouldn’t be a great feat for us to say that for the next two years, we are going to cap the rates for teaser mortgages at 8%, or 8.5%, which has been approximately the 40-year average rate that we’ve lived with."

Toll Brothers Conference Call

A few excerpts from the Toll Brothers fourth quarter conference call held yesterday courtesy of Seeking Alpha

Interesting that he said that 1974 was a rougher downturn than the current one.

Comments on Current Conditions

"By many measures, fiscal 2007 was the most challenging of the 40 years that Toll Brothers has been in business. 1974 was perhaps rougher, but the difficult times only lasted one year."

"Since going public in 1986, we’ve just reported our first quarterly loss this fourth quarter after 85 consecutive profitable quarters. The loss was driven by $315 million of non-cash pretax inventory related impairments and related write-downs."

"The creation of projections is difficult at any time. In the current climate, it’s particularly difficult to provide guidance for fiscal 2008, given the numerous uncertainties related to items such as sales paces, sales prices, mortgage markets, cancellations, market direction, and the potential for and size of future impairments. As a result, we will not provide earning guidance at this time."

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.

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.

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."

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.

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.

Things We Are Glad We Said but Wish We Had Listened To

California's Housing Market: How Much ‘Froth’ Is Out There?

A conference held in October 2005 sponsored by the Milken Institute.

"Angelo Mozilo of Countrywide Financial Corporation predicts that the market will slow and even decrease by a couple percentage points “so that incomes can catch up with the price of homes.” His concern reflects the historic low affordability level that prices many potential buyers out of the market unless they resort to creative financing, which is inherently riskier."

"With new-loan originations now being comprised of 60 percent adjustable-rate mortgages and 40 percent fixed-rate mortgages, Mozilo concedes that his company “may be selling products to individuals who can’t manage risk.”

Things We Wish We Never Said

California's Housing Market: How Much ‘Froth’ Is Out There?

A conference held in October 2005 sponsored by the Milken Institute.

"Although the market is cooling off, the demand for housing is real, and we will continue to see modest single-digit gains below 6 percent, he said."

-Emile Haddad, President, Western Region, Lennar Corporation

Bring Me the Head of Stan O'Neal

There was a movie made in the 1970's called "Bring me the Head of Alfredo Garcia." You can read about it here at the IMDB database. The movie starred Warren Oates as a bounty hunter, but maybe when they do the remake, they should be hunting the head of Stan O'Neal. Here are excerpts from his grilling by the analyst community courtesy of Seeking Alpha.

"If I can ask Stan, do you feel comfortable that there is not another shoe to drop and a lot more writedowns on the ABS CDOs?"

"We have tried to capture everything that we can capture at this point, in the market. The expectation for progression of these securities as of the date that we took the markdowns. I cannot tell you what the market trajectory might be from here, but as of the date that we took these markdowns, and even looking at it as we sit here today and observing the general environment, we are comfortable that we have marked these positions conservatively."

"How did you wind up with such a large concentration in the first place? I mean the number of employees is such a small fraction of the overall firm, and it results in results like this? I guess I am asking about risk management, and what went wrong and what happened in the last three weeks to wind up with $3 billion of additional charges?"

"The $3 billion in additional charges is taking a look at the methodology and going through the marking models, again, and coming to a conclusion that is still within the same range that we had before, but it was more appropriate to be at a more conservative end of the range than we had previously indicated. That is where the $3 billion comes from. Why do we have such a large position in the first place? We made a mistake. There were some errors of judgment made in the businesses themselves, and there were some errors of judgment made within the risk management function, and that is the primary reason why those exposures exist."

"On the $8 billion in losses, can you give us a feel for how much of that is realized versus unrealized?"

"I think we already said that we are not breaking that down."

"Can you give us some more comfort with your understanding of your current risk loss exposures? I'm having a little trouble with how you can feel that you understand your risk exposure, when September 28 marks deteriorated an extra 75% on you after the quarter closed?"

"It is because we have had some time to do a lot more work and we have reviewed the methodology, we have reviewed the pricing standards, we have reviewed the inputs and we have come to the conclusion that again, within the same range it is appropriate to mark it much more towards the more conservative end of the range."

Homeownership Rate

One of the symbols of the recent Housing Boom was the increase in the Homeownership rate to above trend levels. Some debated the cause of this increase. A recent study by Matthew Chambers, Carlos Garriga, and Don E. Schlagenhauf entitled "Accounting for Changes in the Homeownership Rate," published as a working paper in September 2007 by the Federal Reserve Bank of Atlanta, concluded that the main reason for this increase was the growth of exotic mortgage products, and not demographic reasons.

A copy of the study is here.

"We find that the long-run importance of the introduction of new mortgage products for the aggregate homeownership rate ranges from 56 percent to 70 percent. Demographic factors account for between 16 percent and 31 percent of the change."


What does all this mean? If this study holds up under peer review, it would argue for a more prolonged housing downturn for two reasons - this demand will not be coming back anytime soon, and houses purchased by this group will swell inventories.

Are We There Yet for Homebuilders - Part II?

Are we there yet? Are we there yet? My kids yell this in the car all the time. So are we there yet for Homebuilders? Is it time to buy? First here is the damage to some of the Homebuilder stocks since the peak, which for most of the stocks occurred in July 2005.



I am going to spend a majority of my time figuring out when to buy Homebuilders, but for now here's a quick list of what you shouldn't do.

Don't listen to anyone on the sell side. Most of them told us for years that it would be different this time. Remember that tripe? Access to capital, immigration, consolidation in the industry, better balance sheets, yada, yada, yada.

Second, don't rush out and buy because you see a "cult" investor on CNBC talking the sector up, or a rumor hits the wire that another cult investor is buying. In July, rumors hit the tape that Buffett was buying shares of Hovanian. Let's hope he didn't because the stock was at $16 then and its now at $11. Do your own work. Don't blindly follow someone else. You'll feel a lot better afterwards. This does not mean you or I will ever be as smart or as rich as Buffett, but there's nothing worse than losing money because you listened to some talking head on CNBC instead of doing your own research.

I used to be an equity analyst at a bank and my boss wanted to buy shares of Arrow Electronics (this was late 1998). I took a look at the stock and felt like the trough had not yet been reached, and I told him that. He looked back at me with a sneer and said "What do you know that Bill Miller doesn't know."

So I said to myself, "Well why don't you go out and hire Bill fucking Miller as your analyst then." Instead I just looked at him dumbfounded and swore that I would never pick stocks the way he did.

Third, do not use price to book yet as a buy signal. Book value is in flux and will continue to go down quarter after quarter. The safest thing to do is take the latest quarters book value and write off 30% and then slap a .75 multiple on it and then buy them there.

Last, think about avoiding individual stocks and buying the ETF or index that tracks Homebuilders. It is likely that a few of these homebuilders may get into enough distress that the equity becomes worthless. There is a SPDR that tracks the industry under the symbol XHB. It's not a perfect substitute since it has Home Depot and Lowe's in it but it may be a safer option to play the industry.

Lennar Earnings Call - No Bottom Yet

I just got off the Lennar call and wanted to share these highlights regarding the housing markets. Management has not yet seen the bottom in the markets they build in.

During the call, Lennar said that they would need to see three things before there is a recovery or stabilization in the market:

1) Inventories of both new and existing homes will have to stabilize first and be absorbed.

2) Mortgage markets will need to settle.

3) Consumer confidence is going to have to be restored.

Lennar said that there was no sign during the quarter that any of these occurred, and that in fact they had deteriorated further during the quarter.

General Market Conditions

“These continue to be very difficult times for the homebuilding industry”

“Current market conditions are primarily defined by the overhang of inventory in those markets which is comprised of completed homes on the ground, spec homes that are back on the market and owned homes that are up for sale. The overriding sentiment in our reviews is that the market has continued to become more and more competitive as inventories are managed and there continues to be a great deal of downward pricing pressure through the use of incentives, price reductions and incentivized brokerage fees."

On Signs of the Bottom

“Overall the supply of homes to sell continues to climb in many of our markets and we are not able to get a good reading how quickly this inventory will be absorbed or whether it will continue to increase as foreclosures increase and add to inventory.”

Mortgage Markets

“Adding to the sluggishness on the demand side is the continuing deterioration of the mortgage market as an additional component of demand has been sidelined.”

“We have not yet seen stability in the mortgage market either.”

On the Arrival of Helicopter Ben

“While the recent cut in interest rates by the federal reserve will began a process of rebuilding confidence it will most certainly not be a panacea for conditions as they exist.”

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.