Monday, August 18, 2008

The Financial Sector Is Still In Deep Trouble

From IBD:

It's the 5th bank [Wachovia] to agree to repurchase auction-rate securities under pressure from federal and state regulators who said the banks misled investors. It'll buy $8.5 bil worth that investors couldn't sell. Citi, (C) UBS, (UBS) JPMorgan Chase (JPM) and Morgan Stanley (MS) also have agreed to buy back the securities. N.Y. may sue Merrill Lynch over the issue and is probing Fidelity and Charles Schwab. (SCHW)


Here's a list from CNBC of who has settled and for what amounts:

UBS agreed on August 8 to buy back $18.6 billion of debt securities, starting with $8.3 billion from retail and charitable clients beginning on October 31, and as much as $10.3 billion from institutional clients beginning in June 2010. It also agreed to pay a $150 million fine.

CITIGROUP agreed on August 7 to buy back $7.5 billion of its investors' auction rate paper at par to settle charges by the SEC and New York State Attorney General Andrew Cuomo. That would cover an estimated 40,000 retail customers. By November 5, Citigroup plans to have fully reimbursed retail investors. It also plans to try by the end of 2009 to liquidate $12 billion of debt held by more than 2,600 institutional investors. Citigroup will pay a $100 million fine.

MORGAN STANLEY settled with New York State Attorney General Mario Cuomo on August 14 and agreed to buy back $4.5 billion of auction-rate securities from individuals, charities and small- and mid-sized businesses by Dec. 11 and pay a $35 million fine. It will also reimburse customers who sold debt at a loss.

JP MORGAN CHASE settled with New York State Attorney General Mario Cuomo on August 14 and agreed to buy back $3 billion in debt by Nov. 12 and pay a $25 million fine, and reimburse customers who sold debt at a loss.


At a time when everybody in the financial sector is writing down the value of a bunch of these assets, we're seeing some of the largest firms buy-back more trash. This will make the next few quarters of earnings releases that much more interesting.

All of these firms settled these ARS cases very quickly -- as in within a few months of the investigation opening. As a lawyer this signals one point very clearly: somewhere all of the companies have a gaping liability somewhere. And that liability is industry wide. The lawyers looked at this situation and said, "you have no choice but to settle this thing." Bottom line: there was some serious misrepresentation/misdirection going on with all of these firms and they were caught red-handed.

But that's not where the problems end. In fact --- the problems are still really bad:

Let's look at this week's Baron's article on Fannie and Freddie:

Similarly, the balance sheets of both companies have been destroyed. On a fair-value basis, in which the value of assets and liabilities is marked to immediate-liquidation value, Freddie would have had a negative net worth of $5.6 billion as of June 30, while Fannie's equity eroded to $12.5 billion from a fair value of $36 billion at the end of last year. That $12.5 billion isn't much of a cushion for a $2.8 trillion book of owned or guaranteed mortgage assets.

What's more, the fair-value figures reported by the companies may overstate the value of their assets significantly. By some calculations each company is around $50 billion in the hole. But more on that later.

.....

Note, too, that Fannie and Freddie have nonpareil lobbying operations and formidable political strength, owing to their hefty donations and penchant for hiring former political operatives. Besides, the agencies claim they've landed in their current predicament through no fault of their own. As Freddie Mac Chairman and CEO Richard Syron recently put it, the GSEs have been hit by a "100-year storm" in the housing market, accentuated by some higher-risk mortgages that they were forced to buy to meet government affordable-housing targets.

The latter contention is more than disingenuous. A substantial portion of Fannie's and Freddie's credit losses comes from $337 billion and $237 billion, respectively, of Alt-A mortgages that the agencies imprudently bought or guaranteed in recent years to boost their market share. These are mortgages for which little or no attempt was made to verify the borrowers' income or net worth. The principal balances were much higher than those of mortgages typically made to low-income borrowers. In short, Alt-A mortgages were a hallmark of real-estate speculation in the ex-urbs of Las Vegas or Los Angeles, not predatory lending to low-income folks in the inner cities.

.....

The cost of selling new preferred stock, meanwhile, would seem to be prohibitive for Fannie and Freddie. The dividend yields on their preferreds have soared to around 14%, in part because of a recent rating downgrade by Standard & Poor's. Yields that high would blight the future earnings prospects of both concerns.

Should the agencies fail to raise fresh capital, the administration is likely to mount its own recapitalization, with Treasury infusing taxpayer money into the enterprises, according to our source. The infusion would take the form of a preferred stock with such seniority, dividend preference and convertibility rights that Fannie's and Freddie's existing common shares effectively would be wiped out, and their preferred shares left bereft of dividends. Then again, the administration might show minimal kindness to preferred shareholders; local and regional bankers have been lobbying the Bushies not to wipe out the preferred since the bankers own a lot of that paper and rely on the bank preferred-stock market for much of their own equity capital.

An equity injection by the government would be tantamount to a quasi-nationalization, without having to put the agencies' liabilities on the nation's balance sheet, and thus doubling the U.S. debt. Treasury would install new management and directors at both, curb the GSEs' sometimes reckless investment and guarantee operations, and liquidate in an orderly fashion the GSEs' troubled $1.6 billion in on-balance-sheet investments. Then the companies could be resold to the public without their explicit government debt guarantees, or folded into government agencies like Ginnie Mae or the FHA.


Let's look at the above mentioned bullet points with the following fact in mind: Fannie and Freddie touch some 70% of the US mortgage market. In other words, they are vital to the current US housing market -- now more then ever. They are simply too big to fail.

1.) They are essentially worthless entities based on immediate liquidation value. This is not the first article to make this claim. Mish has been all over this story, and I pointed out last week that there were serious questions regarding Fannie and Freddie's balance sheet valuation.

2.) They are making political claims (all this regulation made us do this) when in fact they were like everyone else in the financial sector over the last cycle. Company X engages is risky lending behavior and increases their earnings for a few quarters. Now their competitors have to engage in the same behavior in order to "keep up with the Jonses". The bottom line is Fannie and Freddie bought crap loans in order to protect their market share.

3.) We've seen financial companies raise a ton of capital over the last 6-12 months. How much longer can this continue before creditors/investors start to really want a larger amount of flesh in the deal? Simply put, people who have invested in the financial sector have been taken to the cleaners by the market:

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Notice the following points on the five year chart of the financial sector ETF:

Prices consolidated in 2004 and 2005, essentially moving sideways between $27 and $30 (roughly). Prices rallied from the end of 2005 until the beginning of the third quarter 2007. Also notice the index formed a double top in 2007 with the first top occurring in the first quarter and the second top occurring at the end of the second quarter/beginning of the third quarter. Then came the beginning of the financial market problems when Bear Stearns (remember them?) announced they lost $6 billion in two hedge funds. That's what started the giant cliff-diving move down.

Also note the following

-- The average is trading near the lowest level in 5 years.

-- The average is clearly moving in a lower low/lower high pattern.

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On the daily chart notice the following:

-- The 200 and 50 day SMAs are moving lower--

-- The 10 and 20 day SMAs are moving higher. These SMAs have done this several times over the last year. However, the 50 day SMA has rebuffed these move convincingly.

-- Prices are in a clear lower high/lower low pattern

The daily charts longer-term indicators (50 and 200 day SMA) are down while the shorter-term indicators (10 and 20 day SMA) are up. This tells us the current moves are temporary.

But the fun doesn't end there (click on link for a video snippet):

Merrill Lynch, Wachovia and other financial companies are at risk of failure as the cost of raising capital soars at a time when the banks need to pay settlements over auction rate securities, David Kotok, chairman & chief investment officer from Cumberland Advisors, told CNBC Monday.

The cash companies need to shore up bad investments, "is up to about $50 billion and will probably top $100 billion before it's over," he added.


Refer back to point number three from the above discussion of Freddie and Fannie's problems.

Here's the real bottom line: the problems in the financial sector aren't over by a long-shot.