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.

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?

Quote of the Day - August 31, 2007

"It's not the government's job to bail out speculators or those who made the decision to buy a home they knew they could never afford,"

-President George W. Bush.

The Panic of 2007

Is it possible that we are on the verge of a full blown financial panic? I remember studying about the periodic financial panics that would hit the United States economy every generation or so. They seemed quaint and remote and not something that could happen in the age of deposit insurance, the Federal Reserve and the heavy hand of government intervention.

There have been so many financial panics in our history that they had to name them after the years they occurred. The panics of 1893, 1907, etc. Most of these panics involved banks, but the concept is the same. They are characterized by lack of confidence in our financial system, with a sudden shock to that system being the accelerant that sparks the conflagration or panic. And then a rush for the door, as everyone tries to get their money out first.

Let's look at what is occurring in our financial system:

1) Credit for purchasing residential real estate is drying up. It's no secret that sub prime and Alt A lending is essentially unavailable, but now it is spreading to prime lending and jumbo mortgages. If you think that jumbo mortgages is an issue only for rich people then you should take a look at the average home price in California, where you need a jumbo mortgage to buy a shack. This credit contraction will accelerate and prolong the housing downturn even further. This, of course, will have repercussions in the economy.

2) A money market fund just "broke the buck" or would have, if it let investors redeem their money. This is the first time that I can remember that this happened since Merrill Lynch, Pierce, Fenner and Smith pioneered these in the early 1980's.(Yes, I purposely used the former name to show how old I am.) Most non-professional investors assume that money market funds are "cash," and they are not.

3) We may be on the precipice of major redemptions in hedge funds, which will trigger another leg down in the equity financial markets. Think of all the money that has flowed into hedge funds the last decade, and then consider what would happen if that river reversed. Now if you think this is about a bunch of spoiled hedge fund managers whining because they have to sell their third vacation home, you are wrong. If I remember my numbers correctly, around 40% of Americans are invested in stocks.

4) We have a hyperactive media where every bit of information is available instantly, and then magnified tabloid style. Don't underestimate the effect that the media can have in creating panics. They are at the center of all of them if you look back at your high school history book.

The last recorded financial panic was in 1910, but of course we have had them since then but they stopped calling them "panics" and started using other terms for them. I hope that this doesn't happen in my lifetime, but I wonder sometime what really can be done to stop these events. After all, by definition, they are "panics," implying uncontrollable events.

A Storm Coming?

Here's what people should be thinking about - the New York Federal Reserve did a study in May 2002 called Credit Effects in the Monetary Mechanism. This study examined the effect of changing loan standards or as they put it "do bank lending standards "matter" for the economy—that is, do standards affect loan growth and, more broadly, GDP?....also explore whether credit standards are independent of the monetary policy process or, alternatively, a channel through which policy affects spending and the real economy." They used the Senior loan officer opinion survey for data in this study.

Fed Study

So what does all this mean? Two things - when banks have tougher lending standards does it effect the economy, and second, does it matter what the Fed does to help? The conclusion:

"First, changes in credit standards have a significant effect on both loans and GDP. Second, credit standards appear to be largely independent of the monetary policy process, showing little sensitivity to changes in the Federal Reserve's key policy instrument, the federal funds rate."

They get a little more specific here:

"An unanticipated 10 percent net tightening of standards in the augmented model causes output to fall 0.5 percent at its trough and loans to contract more than 2 percent."

A 10 percent net tightening is not a significant tightening. Using the 2001 recession as an example, net tightening in commercial real estate loans moved 41.2 percent, while net tightening in commercial and industrial loans moved 54.3 percent.

Here's a chart from the study showing the net moves over time.



So when Helicopter Ben says that there is no evidence that the recent credit market turmoil is affecting the economy, he's right because it has only been three weeks since it started. Let's hope the Fed keeps its eye on this measure.

Another Leg Falls

How many legs do we have propping up the Stock Market? I've lost count. We all know that the Private Equity buyout "leg" is history. The latest one to collapse is the buyback stock craze, which has reduced the supply of stock the last few years. Once again a chart from The Wall Street Journal says it all:



Public companies have been levering up to buy back stock, most of them due to pressure from idiotic hedge fund managers who have apparently never lived through a business cycle. I have this picture in my head of the typical company in a meeting with its bankers to renegotiate its covenants during the next business cycle contraction. The CEO says something like this: "We don't know what happened, our largest shareholder told us this was the ideal capital structure." The bankers just stare back at them, their mouths open, unable to formulate a response to this stupidity.

This is now coming to an end as lenders tighten standards and credit rating agencies actually start doing their jobs. Now many legs does a table need to stay standing?

Pushing on a String?

There is an old expression that used to be heard a lot in connection with Federal Reserve monetary policy. It is the term "pushing on a string." So what does it mean? Well, take a string and thrown it down randomly on a table and then try pushing it. What happens? Nothing.

The market is convinced that the Federal Reserve will come to the rescue like Greenspan did in the old days and change the wording of its statement today, or in a best case scenario actually cut rates. But does it really matter what they do? They say a picture is worth a thousand words so look at this chart from The Wall Street Journal today.



The yield on the ten-year declines 40 basis points yet mortgage rates increase 40 basis points. Now granted, the Federal Reserve doesn't control long-term rates, only short-term rates, but the scenario here could still hold. If banks contract credit, then it doesn't matter what the Fed does. Also, keep in mind that this divergence in loan spreads is happening in the business loan market as well.

Keep your eye on the Federal Reserve Senior Loan Officer Opinion Survey. It is a quarterly survey of, you guessed it, Senior Loan Officers. The next one is due out very soon and can be found here:

Senior Loan Officer Opinion Survey

One of the questions they ask to the lenders is whether they have tightened lending standards. This should give us confirming evidence that the credit contraction is raging away in the market for commercial and industrial loans.