Meredith Whitney, the so-called most powerful woman on Wall Street, moved the markets today with a bullish short term call on the banks. She was particularly bullish on Goldman Sachs. Her earnings estimate for Goldman Sachs, which reports tomorrow, is $4.65 compared to consensus estimates of $3.48. She predicts they will earn $20 for 2009 and more than $22 for 2010.
Goldman Sachs had their highest earnings in 2007 at $24.73. 2006 was at $19.71. In a year where Goldman Sachs is deleveraging, if they can pull off these types of earnings, it will be remarkable.
Naked Capitalism has two videos of Meredith Whitney making these calls.
Zero Hedge has a presentation from T2 Partners on where we are at in the housing crisis. It is packed full of great charts.
Here are a few of my favorites:
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So far, the unemployment rate has been higher than the "more adverse" scenario used in the stress test. Calculated Risk has an updated chart using just two month's of data: 
The "more adverse" scenario seems to be a plausible forecast for the economy. In fact, the Unemployment rate looks like it will reach 10.3% this year which is the "more adverse" scenario for the average unemployment rate for 2010. Per the Federal Reserve, "the likelihood that the average unemployment rate in 2010 could be at least as high as in the alternative more adverse scenario is roughly 10 percent." If the "more adverse" scenario is the new baseline forecast, then I wonder how the banks would fare in a worse case scenario.
Seeking Alpha has a great spreadsheet that let's you plug in different unemployment rate forecasts and loss rate assumptions. In the Stress Test, the economists had forecast that the average unemployment rate for 2010 would be 8.8% with a 10% chance of being 1.5% higher at 10.3%. In spreadsheet to the right, I am using an unemployment rate of 11.8% as the more adverse scenario (if you change the baseline forecast to 10.3%, then it seemed logical that there would be a 10% chance that the unemployment rate would reach 11.8%).
There is a big disparity between the healthy banks and the banks that would be stressed under a more adverse scenario than the Fed used.
Sphere: Related ContentEarnings season is upon us once again. According to Marketwatch: "Analysts surveyed by FactSet Research on average expect earnings at S&P 500 companies to be down 35.9% from the year-earlier quarter. Those surveyed by Thomson Financial expect earnings to be down 36.6% from the year earlier."
In the fourth quarter of 2008, earnings were negative as a whole for the first time for the S&P 500. On a bottom up basis, analysts are projecting that continuing earnings for Q1 2009 will come in at $13.00 a share up from -$0.11 in Q4 2008. They are projecting as reported earnings to rebound to $8.75 up sharply from the stunning loss of -$23.16 for Q4.
Analysts missed the impact the recession would have on stocks. Just 6 months ago, they forecast that Q4 continuing earnings for 2008 would be close to the all time record reached in Q3 lf 2007. They forecast that Q1 2009 would break the record.
A year ago, they also forecast a quick recovery from the drop in continuing earnings in Q4 2007.
Analysts are pricing in that the bottom is in for the recession.
Here is an update on Robert Shiller's S&P 500 graph. Going back to 1881, the average P/E ratio using the trailing 10 years of real earnings has been 16.34. As of today, the current P/E ratio is 14.82. Using the historical average, stocks are slightly undervalued. However, the stock market has traded at much lower levels in the past. In 1982 it reached 6.82 times 10 years earnings. In the Great Depression it reached 5.56 and it reached 4.78 in 1920.
Michael Lewis, one of my favorite authors, has a great article on the collapse of the bubble in Iceland. 
The whole article is well worth the read, but here are a few of my favorite quotes:
From 2003 to 2007, while the U.S. stock market was doubling, the Icelandic stock market multiplied by nine times. Reykjavík real-estate prices tripled. By 2006 the average Icelandic family was three times as wealthy as it had been in 2003, and virtually all of this new wealth was one way or another tied to the new investment-banking industry.
Global financial ambition turned out to have a downside. When their three brand-new global-size banks collapsed, last October, Iceland’s 300,000 citizens found that they bore some kind of responsibility for $100 billion of banking losses—which works out to roughly $330,000 for every Icelandic man, woman, and child. On top of that they had tens of billions of dollars in personal losses from their own bizarre private foreign-currency speculations, and even more from the 85 percent collapse in the Icelandic stock market. The exact dollar amount of Iceland’s financial hole was essentially unknowable, as it depended on the value of the generally stable Icelandic krona, which had also crashed and was removed from the market by the Icelandic government. But it was a lot.
It must have seemed like a no-brainer: buy these ever more valuable houses and cars with money you are, in effect, paid to borrow. But, in October, after the krona collapsed, the yen and Swiss francs they must repay are many times more expensive. Now many Icelanders—especially young Icelanders—own $500,000 houses with $1.5 million mortgages, and $35,000 Range Rovers with $100,000 in loans against them. To the Range Rover problem there are two immediate solutions. One is to put it on a boat, ship it to Europe, and try to sell it for a currency that still has value. The other is set it on fire and collect the insurance: Boom!
The world is now pocked with cities that feel as if they are perched on top of bombs. The bombs have yet to explode, but the fuses have been lit, and there’s nothing anyone can do to extinguish them. Walk around Manhattan and you see empty stores, empty streets, and, even when it’s raining, empty taxis: people have fled before the bomb explodes. When I was there Reykjavík had the same feel of incipient doom, but the fuse burned strangely. The government mandates three months’ severance pay, and so the many laid-off bankers were paid until early February, when the government promptly fell.
Sphere: Related ContentBack in April 2006, however, an emeritus professor of economics at the University of Chicago named Bob Aliber took an interest in Iceland. Aliber found himself at the London Business School, listening to a talk on Iceland, about which he knew nothing. He recognized instantly the signs. Digging into the data, he found in Iceland the outlines of what was so clearly a historic act of financial madness that it belonged in a textbook. “The Perfect Bubble,” Aliber calls Iceland’s financial rise, and he has the textbook in the works: an updated version of Charles Kindleberger’s 1978 classic, Manias, Panics, and Crashes, a new edition of which he’s currently editing. In it, Iceland, he decided back in 2006, would now have its own little box, along with the South Sea Bubble and the Tulip Craze—even though Iceland had yet to crash. For him the actual crash was a mere formality.
Throughout the housing bubble, Robert Shiller's book, “Irrational Exuberance”, has served as my compass. In particular, his graph of U.S. home prices adjusted for inflation going back to 1890 was etched in my mind.
In his book, he talked about a home price index that was constructed in Amsterdam with over 300 years of data from 1628 to 1973. He writes “Real home prices did roughly double, but took nearly 350 years to do so…the annual real price increase was only 0.2%.” He released a graph , combining the Amsterdam data with data from Norway and the U.S., in a paper he published later.
Every month I update the S&P Case-Shiller Home Price Index and include what the CME Futures market is pricing in for prices in the near future. Here is a link to my most recent post on the Indexes.
Robert Shiller also had graphs of the S&P 500 going back to 1871. His website at http://www.irrationalexuberance.com/ has spreadsheets that get updated every so often. Here are two of his graphs that I updated with data through today's close.
Going back to 1881, the average P/E ratio using the trailing 10 years of real earnings has been 16.34. As of today, the current P/E ratio is 16.98. Whether or not the stock market is fairly valued right now is in great debate (as shown by the huge gyrations of the stock market in recent weeks). It really depends on what you think will happen to earnings and how severe the slowdown will become. Here is a graph showing the earnings for the S&P 500 going back 20 years.
The analysts have been caught off guard by the severity of the credit crunch. Back in April, analysts thought that 2008 Q2 earnings would be higher than the peak in 2007 Q3. Here is a graph from my April 2008 post. 2008 Q1 and Q2 earnings were substantially lower than forecasted. For the last year, analysts have constantly been surprised by earnings and have consistently overestimated earnings for the last 12 months. Last week's plunge was in part due to the fact the market was realizing that there will be a slowdown in earnings due to the credit crunch. The million dollar question is how much and how long the slowdown will be.
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In January I posted that Option ARMs would be the next storm in the mortgage crisis. At that time, I felt that the dangers of Option ARMs were being ignored. Six months later, the situation is quite different. The Non-Performing Assets (NPAs) have nearly doubled from 2007 Q4 to 2008 Q2. Moreover, the deterioration seems to be accelerating.
Here is an update of the top 10 of Option ARM lenders of 2007. 5 of out of 10 no longer in the business: Countrywide (bailed out by BofA), American Home Mortgage, IndyMac, Capital One (shut down mortgage division), and Luminent Mortgage. Most of the others are struggling for their existence.
On Tuesday Wachovia announced $6.1 billion in writedowns. However, two analysts called the bottom on the stock and the stock rallied by nearly 30%. I think it is too early to call the bottom for many reasons:
The deterioration of the Option ARM portfolio is accelerating. Non-Performing Option ARMs grew to 5.8% in Q2 (pg. 15). In addition 3.9% of the Option ARMs are more than 30 days past due and 1.3% are more than 60 days past due.
Wachovia has a portfolio of $122.026 billion in Option ARMs (pg. 16). The average LTV at origination was 71%. It has deteriorated to 85%. With falling housing prices, Wachovia projects the LTV to reach 99% at the bottom. 58% of Wachovia's Option ARM portfolio is in California ($71.211 billion). The average LTV was 70% at origination and is now 90%. Wachovia projects the California LTV to deteriorate to 104%. Any second mortgages or further negative amortization will further increase the problem.
Wachovia's commercial division is also experiencing a surge in Non-Performing Assets. Their Real Estate Financial Services division has seen an increase in NPAs from 0.46% in Q2 2007 to 3.95% in Q1 2008 to 5.1% in Q2 2008 (pg. 47). This division has $48.355 billion in assets.
In June of 2007, Wachovia was touting their 10 year recast and 125% balance limit. As chronicled in this post, other lender's Option ARMs are starting to recast. The loan Wachovia used as an example until 2011. However when it does recast, the ramifications will be a lot worse. The balance will have grown from $250,000 to $325,000. The payment will jump from an initial payment of $804 to around $2500.
Wachovia's Option ARM borrowers are already struggling as reflected in their rising delinquencies. Their credit scores are also deteriorating. The average Option ARM borrower's FICO at origination was 675 compared to the current average FICO of 661 (pg. 34). For Wachovia's traditional mortgages, the FICO improved slightly from 731 at origination to 732 currently. If borrowers are struggling during the low payment period, how are they going to react when their payments triple and Wachovia projects that many will be underwater?
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Interest rates on Conforming 30 year fixed-rate mortgages rose to 6.71% on Tuesday, up from 6.44% last Friday according to HSH Associates. For 35 year from 1967 to 2002, 6.5% was the lowest the rates had been. Rates reached 18.8% during the 1982 recession. Rates jumped because of concern about the financial health of Fannie Mae and Freddie Mac.
The government is actively firming up plans to make the implicit government backing of Fannie Mae and Freddie Mac explicit. The federal government has already proposed a rescue plan and Congress has reached agreement on the plan on Tuesday per a report on Bloomberg:
Under a modified version of proposals made by the Bush administration, the Treasury Department would gain authority to inject capital into the two largest U.S. mortgage finance companies, through loans and equity investments.
The Treasury would be barred from providing aid that would cause a breach in the federal debt ceiling under the agreement, a constraint aimed at limiting any taxpayer losses. The debt limit would be raised to $10.6 trillion from the current $9.815 trillion.
The legislation would also raise the limit on the size of the mortgages the companies may purchase. The new cap would be $625,000, or the median home price plus 15 percent, whichever is lower, Frank said.
A Congressional Budget Office estimate released today put the cost of Paulson's plan at $25 billion, a figure below the total that some lawmakers had expressed concern about.
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Freddie Mac and Fannie Mae saw their shares get cut almost in half last week. Freddie Mac's stock tumbled from a close of $14.50 on July 3rd to trading as low as $3.89 last Friday before recovering to $7.75. Fannie Mae went from $18.78 on July 3rd to as low as $6.68 last Friday before closing at $10.10. The freefall was kickstarted on Monday when Lehman Brothers analysts wrote a note to clients:
The new FAS 140 rule that seeks to stop companies keeping assets in off-balance sheet entities may force Fannie Mae and Freddie Mac to bring mortgages back onto their books, requiring them to put up capital, Lehman analysts led by Bruce Harting wrote in a note to clients today. Fannie Mae would need to add $46 billion of capital and Freddie Mac would need about $29 billion, the Lehman analysts wrote. The companies will probably get an exemption from the rule because it would be ``very difficult'' for them to raise that amount of capital, the analysts said.
Fannie Mae and Freddie Mac shares rebounded on Tuesday possibly in part because the market realized that the analyst also said that the companies would probably get an exemption from the rule. James Lockhart, the director of the Office of Federal Housing Enterprise Oversight, also said on Tuesday that "Fannie and Freddie are adequately capitalized at this point."
On Wednesday Fannie Mae paid a record yield of 74 basis points over the U.S. Treasuries. This was triple what they paid in June 2006. Credit-default swaps tied to their AAA rated debt were trading at levels implying their debt should be rated A2 instead. Also on Wednesday, William Poole, former St. Louis Federal Reserve President said that:
Freddie Mac is technically insolvent under fair value accounting, which measures a company's net worth if it had to liquidate all its assets to repay liabilities. Fannie Mae may become insolvent this quarter, Poole said, increasing pressure on the government to instigate a rescue. Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair value accounting rules. The fair value of Fannie Mae's assets tumbled 66 percent to $12.2 billion and may be negative next quarter, Poole said.
On Sunday, the U.S. Treasury announced a plan making the implicit guarantee explicit. Here is Treasury Secretary Henry Paulson's statement:
Fannie Mae and Freddie Mac play a central role in our housing finance system and must continue to do so in their current form as shareholder-owned companies. Their support for the housing market is particularly important as we work through the current housing correction. GSE debt is held by financial institutions around the world. Its continued strength is important to maintaining confidence and stability in our financial system and our financial markets. Therefore we must take steps to address the current situation as we move to a stronger regulatory structure. In recent days, I have consulted with the Federal Reserve, OFHEO, the SEC, Congressional leaders of both parties and with the two companies to develop a three-part plan for immediate action. The President has asked me to work with Congress to act on this plan immediately. First, as a liquidity backstop, the plan includes a temporary increase in the line of credit the GSEs have with Treasury. Treasury would determine the terms and conditions for accessing the line of credit and the amount to be drawn. Second, to ensure the GSEs have access to sufficient capital to continue to serve their mission, the plan includes temporary authority for Treasury to purchase equity in either of the two GSEs if needed. Use of either the line of credit or the equity investment would carry terms and conditions necessary to protect the taxpayer. Third, to protect the financial system from systemic risk going forward, the plan strengthens the GSE regulatory reform legislation currently moving through Congress by giving the Federal Reserve a consultative role in the new GSE regulator's process for setting capital requirements and other prudential standards. I look forward to working closely with the Congressional leaders to enact this legislation as soon as possible, as one complete package.
Fannie and Freddie were brought to their knees by declining home values. The decline in home prices may be half way done. If that is the case, it is hard to value how large this assistance to the GSEs will become. However, with the GSEs holding or guaranteeing $5 trillion in mortgages, the number could be staggering.
Sphere: Related ContentThe Joint Center for Housing Studies of Harvard University released their annual report on housing: "The State of the Nation's Housing 2008." The 44 page report gives a detailed look at the forces currently causing the housing crisis. There is a wealth of information and graphs in the report. Here are a few excerpts:
Assuming the vacancy rate prevailing in 1999–2001 was close to equilibrium, the oversupply of vacant for-sale units at the end of last year was around 800,000 units, or 1.0 percent of the owner stock.
In addition, the number of vacant homes held off the market other than for seasonal or occasional use surged from 5.7 million units in 2005 to 6.2 million in 2007.
Despite production cuts rivaling those in the 1978–1982 downturn, the number of vacant for-sale homes on the market did not shrink in the first quarter of 2008. The weak economy, tight credit, and concerns over whether house prices had bottomed out continued to suppress demand and delay the absorption of excess units. Until this oversupply is reduced, housing markets will not mend.
At last measure in 2006, 39 million households were at least moderately cost burdened (paying more than 30 percent of income on housing) and nearly 18 million were severely cost burdened (paying more than 50 percent). From 2001 to 2006, the number of severely burdened households alone surged by almost four million. Because of the unprecedented run-up in house prices and lack of real income growth, over half of this increase was among homeowners.
Housing permits fell 24 percent nationwide in 2007, with single family permits down 29 percent and multifamily permits down 9 percent for the year. This brings the total decline from the 2005 peak to 35 percent, including a 42 percent reduction in single-family permits. The downturn has been widespread, with permits declining in 94 of the 100 largest metropolitan areas over the two-year period. Smaller metropolitan areas have also been affected by the construction pullback, with 214 of 263 posting reductions in permits.
To wipe out past appreciation, home prices have to retreat the most in once-hot markets and the least in cold markets. For example, the 6.7 percent drop in the median house price in Indianapolis from the third-quarter 2005 peak to the fourth quarter of 2007 was enough to cancel out appreciation all the way back to 2000. In Sacramento, by contrast, the larger 21.8 percent drop in the median house price from its peak in the fourth quarter of 2005 to the end of 2007 only erased gains made since 2003.
The report chronicles how housing starts plunge before and at the start of a recession and recover either right before the end of the recession or shortly after. Currently our downturn is being led by housing. It will be interesting to see if the housing crisis extends the length of the downturn, or if the economy recovers first.
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Business Week calls Option ARMs The Next Real Estate Crisis. The article opens with this analogy:
The American homeowner must feel like one of those characters in an old cartoon who has just been hit by a falling piano. After dusting himself off and touching the large bump on his head, he probably doesn't expect another piano to be dangling overhead. But he'd be wrong.
The piano is the impending crisis caused by Option ARMs resetting to higher payments. These previous posts of mine took a look at Option ARMs: original post and an update.
The Business Week article gives us an update on some key statistics:
According to Credit Suisse (CS), monthly option recasts are expected to accelerate starting in April, 2009, from $5 billion to a peak of about $10 billion in January, 2010. Some of these loans have already started to recast. About 13% of option ARMs that were issued in 2006 were delinquent by 60 days by the time they were 18 months old, Credit Suisse said.
About a million borrowers have option ARMs, but only a fraction have already fallen due. [NOTE: should read "only a fraction have already recast."]
Among the states expected to be worst-hit is already battered California. Today, outstanding option ARM loans in the U.S. total about $500 billion, about 60% of which were sold to California homeowners, according to Credit Suisse.
Previously I had posted Credit Suisse's chart on resetting ARMs. This chart did not account for the payments recasting when the balance had grown larger than the recast amount of 110%, 115% or 125%.
The Business Week article now has Credit Suisse's updated chart accounting for recasts. According to the chart, the amount of Option ARMs recasting will rise from the current pace of about $2 billion a month to about $4 billion a month by the end of this year to about $10 billion a month by the end of next year. This is roughly $120 billion resetting in 2008 and 2009 with another $80 billion in 2010.
I posted this chart from IndyMac in my original Option ARM post. To update the status of the top 6: Washington Mutual stripped their CEO of the chairman title, Countrywide is being bailed out by Bank of America, American Home Mortgage went bankrupt, Wachovia fired their CEO, IndyMac is struggling to survive, and Capital One shut down their mortgage division. The others on the list are feeling the pain as well.
The mortgages that are resetting now have huge payment shocks. In an example I used in this post, a borrower with a first payment due in January 2005 had a beginning payment of $574.06 a month. The loan in that example reset in February 2008 to a payment of $1,468.43. That is a huge difference. Especially if the borrower could only afford the teaser payments. Many borrowers that took out these type of loans expected real estate prices to rise faster than their negative amortization. Instead, their loans are hitting 110% or 115% of their original balance causing resets and real estate prices instead of going up faster, have declined.
Wall Street is starting to address the potential problems involving Option ARMs. The recent surge in delinquencies is helping draw attention to this sector of loans.
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The Federal Reserve's April meeting minutes were released today. They believe that the threat of the credit crisis has dissipated.
Although participants anticipated that further improvement in market conditions would occur only slowly and that some backsliding was possible, the generally better state of financial markets had caused participants to mark down the odds that economic activity could be severely disrupted by a further substantial deterioration in the financial environment.
The TED spread has lessened in recent weeks to under 1%, the lowest it has been since July 2007.
Due to the improvement in the Financial markets and the threats of inflation, the Fed signaled that they are probably done with the rate cuts. The possibility of the rate cuts combined with the gloomy economic projections spooked the markets today.
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Indymac reported their first quarter losses today. They posted a loss of $184 million or $2.27 a share. Last quarter they announced that they expected to post a profit of $13 million for 2008. Today they reversed course announcing that they expect to lose money every quarter this year. They also released information on their non-performing assets.
In January, I had a detailed post on the intricacies of option ARMs. The delinquencies are continuing to surge. Countrywide's non-performing Option ARMs (non-performing loans are more than 90 days delinquent) jumped from 5.70% to 9.40% in just 3 months. In the beginning of the third quarter of 2007, Downey Savings launched a borrower retention program "to provide borrowers who are current with their loan payments a cost effective means to change from an adjustable rate loans subject to negative amortization to a less costly financing alternative. At March 31, 2008, approximately 91% of such borrowers had made all loan payments due." Any loans that were modified in that fashion are included in the Downey Savings' non-performing assets even they they may be current. Using this method, Downey Savings' non performing assets is at 11.90%. However that is more of an accounting measure than an accurate guage of delinquencies. Excluding those borrowers who are current but have received modifications, Downey Savings' non-performing assets jumped from 4.78% to 7.41%. 65% of Downey Savings loan portfolio is comprised of Option ARMs. This is down from December 31, 2007 when 74% of their portfolio was comprised of Option ARMs. Washington Mutual's non-performing assets went from 2.17% at the end of 2007 to 2.87% in the first quarter of 2008. 45% of Washington Mutual's portfolio is comprised of Option ARMs. Indymac's non-performing assets now total 6.51% up from 4.61% in the previous quarter. Option ARMs are now 29% of their portfolio held for investment, up from 22% last quarter. Wachovia's non-performing assets increase to 1.70% from 1.14%. As of the end of last year 46% of their residential mortgage portfolio was comprised of Option ARMs. Bank of America and Wells Fargo's non-performing assets increased more modestly rising to 0.84% and 1.16% respectively. Bank of America and Wells Fargo did not offer Option ARMs.
Since I posted the article on Option ARMs, there is some good news and bad news. The good news is the rates have come down quickly. A fully indexed rate on the Option ARM example I used is 5.125%. This is down from the peak of 8.375% where it was for seven months in the beginning of 2007. However, the 12 month MTA index is a 12 month average so it takes time to move up or down. The example loan with a first payment due in January 2005 in the previous post, had a beginning payment of $574.06 on a balance of $178,480. If the loan had a 110% recast and the borrower had made the minimum payments then the loan would have reset in February 2008 with new payments of $1,468.43. If the loan that had a 115% recast and assuming that rates stay the same as they are this month, then the loan won't recast until the end of five years (01/10). The payments at that time would be $1,196.80 (with a fully indexed rate of 5.125%).
The bad news is that the declining home prices have deteriorated faster. Using the Case Shiller CME futures to project future home prices, in January I posted that a borrower would owe 110% of what the house was worth at the end of 2009. Using the current futures prices they will owe 120%. The borrower in that example, will have been on a roller coaster ride. Their interest rate went from 5.375% to 8.375% and is now heading back down possibly to 5.125% or lower. Their house values went from $223,100 in January 2005 to $261,108 in June of 2006. In June of 2006 their CLTV was 79.2%. Their equity position went from their 10% down payment of $22,310 to an equity position of $54,359. Today, the example house would be worth $213,081 and if they made the minimum payments the whole time, they would now owe $221,226. They would have to bring in cash just to sell the property even without considering real estate commissions. The delinquency rates are spiking up on these option ARMs and the bad news is the majority of borrowers with these loans have not had their payments recast into fully amortized payments. At that point we will be moving into uncharted waters.
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Ambac Financial, the second biggest bond insurer behind MBIA, reported first-quarter net losses of $1.7 billion or $11.69 a share. Analysts had expected a loss of $1.51 a share. Ambac insures bonds worth more than half a trillion dollars and yet has a market cap of only $351.65 million after today’s close.
Some of their losses are coming from suspect deals. Per the Wall Street Journal:
Ambac has hired legal and forensic experts to examine 17 of its financial guarantee transactions covering residential mortgage-backed securities as performance deteriorates.
During its first quarter earnings conference call Wednesday, David Wallis, Ambac's chief risk officer, said the company is examining transactions that have performed much worse than expected.
Wallis suggested that one prime candidate for legal scrutiny is a deal with Bear Stearns Co. it closed in April 2007. Another is a transaction with First Franklin.
Ambac originally projected that losses on the underlying collateral of the Bear Stearn's transaction would be between 10% and 12%, but now expects losses at 81.8% of underlying collateral, a transaction that has seen an unexpectedly "rapid escalation of losses," and represents an outsized percentage of the insurer's expected credit impairment, Mr. Wallis said.
Some of the factors the company will examine include loan-level document review and a review of legal documents "focusing on representations and warranties," Wallis said. "Hypotheses are being built which involve fraudulent activity in various guises."
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The speed at which Bear Stearns blew up is frightening. Even more frightening is the fact that they are not alone. Rumors and bad headlines abound.
According to the Financial Times, "Lehman Brothers said on Monday it would sell at least $3bn of convertible preferred shares to US institutional investors to help bolster its balance sheet and dispel persistent rumours that it could face liquidity problems similar to those that sank Bear tearns."
Portfolio.com analyzed Lehman's earnings last quarter in this article.
Lehman reaped substantial earnings gains because investors thought it is more likely to go bankrupt. For several quarters, all the investment banks have been taking gains on their liabilities. Say you owe $100 to your friend. But you run into severe problems and your friend starts to figure you can only afford to pay back $95. If you were an investment bank, the magic of fair value accounting dictates that you could get to reduce your liability. What’s more, that $5 gain gets added to earnings. Because investors thought Lehman was more likely to default, its liabilties fell in value and Lehman garnered earnings from this. How much did Lehman win through losing? $600 million in the quarter. How much was its net income? $489 million. Lehman and all the other investment banks are following the accounting rules on this, but that $600 million is hardly the stuff of quality earnings. Indeed, Bernstein’s Hintz called the bank’s earnings quality “weak.”
Without naming names quite yet, what would you think of a company that accomplished the following in 2007?
- Wrote down book value from $39 billion to $32 billion or from $41.35 to $29.34 per share.
- Increased shares outstanding from 868 million to 939 million.
- Increased Treasury Stock from 351 million to 418 million.
- Increased long-term borrowings from $147 billion to $201 billion.
- Increased preferred stock issuance from $3.1 to $4.4 billion.
- Increased Total debt to common equity to 2816.81%.
and here is another company...
- Wrote down book value from $35 billion to $31 billion or from $32.67 per share to $28.56 per share.
- Increased long term borrowings from $127 billion to $160 billion.
- Increased total debt to common equity to 2496.53%.
- Maintains an $88 billion position in Level 3 assets, or 283% percent of shareholder equity.
It is little wonder that the TED Spread is still at historical highs. Banks are afraid to lend their money out to other banks. The spread between Moody's Baa rated bonds and the Treasuries is also at its recent high.
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