The news has certainly been bleak. Investors are left dazed and confused, trying to determine whether the worst is behind us or yet to come.

Recent selected headlines include . . .

 

 


*Mario Cuomo (NY Attorney General) subpoenaed Fannie Mae (FNM) & Freddie Mac (FRE) seeking info on every mortgage purchased from Washington Mutual (WM). This follows his lawsuit of First American (FAF) last week, accAIVSX used of inflating house values under pressure from WaMu. The risk is that mortgages written based on inflated appraisals could be required to be bought back by the lender. Non-performing loans have more than doubled in the past year.

* In its 3Q report, WaMu said expenses for the year may exceed forecasts, but currently believes the $1.3B set aside for bad loans for each of the next two quarters (4Q07 & 1Q08) is sufficient. When asked about the dividend, the CEO said it was ‘hard to speculate’ about the future market environment.

* Citigroup (C) has drawn around $10B to bail out 7 Structured Investment Vehicles (SIVs) held off-balance sheet that were unable to repay maturing debt. They have put Richard Stuckey in charge of its $43B sub-prime mortgage business (he helped unwind Long Term Capital Management in 1998).

* SIVs continue to face a crisis in liquidity. Moody’s is reviewing for possible downgrade another $33 billion in SIV debt, about 10% of the total, and said "the situation has not yet stabilized." Last month, JPMorgan (JPM), Citi, and BofA (BAC) agreed last month to start an $80 billion fund to help $320 billion of SIVs holdings.

* Morgan Stanley is speculated to be the next firm to write down Collateralized Debt Obligations (CDOs) – the method sub-prime mortgages were packaged and resold to banks and investors. Mike Mayo, an analyst for Deutsche Bank stated, "Anything that touches CDOs is showing more pain than we thought."

* Another research firm, CreditSights, estimated that CDO losses for 4Q07 could be $9.4 billion for Merrill Lynch (MER), $5.1 billion for Goldman Sachs (GS), $3.9 billion for Lehman Brothers (LEH), $3.8 billion for Morgan Stanley (MS), and $3.2 billion for Bear Stearns (BS).

* Sales of CDOs have been increasingly popular in recent years, peaking in 2006 at $503 billion (source: Bloomberg).

* Dozens of mortgage lenders nationwide have declared bankruptcy and gone out of business in the past year; the leading bond rating agencies, Moody’s, Standard and Poor’s, and Fitch are also under investigation

* As of June, the FDIC reported only one insured bank out of 8,615 had failed in 2007, with 61 ‘problem institutions’ holding $23 billion in assets. More may fall, but it is far from the thousands that failed during the 1930s and 1980s (with a $151 billion S&L bailout).

* NetBank went into FDIC receivership on 9/28/07 with $2.5 billion in assets, primarily due to their mortgage operations; $109 million was held in 1,500 customer accounts exceeding the federal deposit insurance limits (source: FDIC).

* The Mortgage Bankers Association forecast for total mortgage originations dropping in 2008 is $1.66 trillion vs. $2.73 trillion written in 2006.

* IndyMac cut their dividend by 50% from the prior year, increased their credit reserve by 47% to $1.4 billion, – they said delinquency trends were up sharply in September over August, "loans to home builders that are ‘nonperforming’ could rise to around 30% by the end of this year from about 10% as of Sept. 30 " (from WSJ article). The CEO singled out ‘piggy back’ loans as being a big issue, with many proving worthless – "we are writing them off" (source: The Wall Street Journal).

* According to a First American study from March 2007, $2.2 trillion in adjustable-rate mortgages (ARMs) were written between 2004 and 2006. They forecast 13%, or 1.1 million homes, will be foreclosed upon over 6-7 years, totaling $326 billion in debt. They estimate $112 billion will be lost to lenders and investors. In 2007, $370 billion in ARMs are scheduled to reset, another $250 billion in 2008 and 2009.

* RBC estimates that for non-performing bank assets to reach historical mean levels, they would still need to double from the current level.

Should we sell? Is the horse already out of the barn? Should we be buying at this level?

First, realize that at times stock valuations and company fundamentals can diverge sharply (a good company is not the same as a good investment). Second, it is important realize that while projected mortgage defaults is a large absolute number, relative to the total amount written each year, it is a very manageable figure. So far.

The question is how long and how deep this crisis continues. The sell-off of financial stocks has mainly been emotionally driven. Investor sentiment is extremely negative (although not as bad as 1991 at the height of the S&L failures). What we are witnessing is a classic loss of confidence, not driven so much by reported financial results and information that has been made public to date, but instead by fear. It does not appear that the companies in question have a solid handle on the situation (as evidenced by continued write-downs, reserves, and earnings warnings), so investors cannot possibly have clarity either. The market HATES uncertainly. WaMu has lost nearly $25 billion in market value year-to-date, around $3.7B on 11/7 alone. Citigroup has lost +$110B and the Wall Street brokerage companies are down sharply as well.

Investors rightly fear a spiraling contagion of further weakening in housing prices, exacerbated liquidity crisis (where even highly solvent borrowers cannot obtain financing), further corporate failures (of even strong banks), government investigations, class action lawsuits, the list goes on. Cycles like this have a way of feeding on themselves based on investor emotion. Clearly, a variety of factors led to this real estate bubble – bank were willing to provide financing to anyone with a pulse, homeowners treated their homes as ATM machines, speculators bought homes in overheated markets to ‘flip,’ a lax regulatory environment spawned predatory lenders, etc.

The economy has proven to be amazingly resilient. At the moment, we are not expecting a recession in 2008. Overall, the data remains encouraging with the exception of the housing sector. Historically, housing recessions are not well linked to consumer recessions. Consumers are likely to slow down, however, employment is a much more important factor and the growth in that area has continued. Corporations are also in very strong financial shape. Recent data shows that foreign trade growth is offsetting housing weakness.

If home prices continue to fall sharply nationwide, the pain could indeed become much worse, especially in certain over-heated markets. At least the two recent Fed rate cuts ease the pain to some degree. The bottom line is that we just do not know precisely where we are in the cycle. The First American study estimates that for each 1% drop in housing prices nationwide, an additional 70,000 mortgages will go into rate-driven foreclosure. Yes, the financial stocks are cheap and yields are extremely attractive, but compared to trough valuations during prior banking crisis (1930s and 1980s), there could be further to fall. For long-term risk tolerant investors, this could be an interesting opportunity. However, it is definitely not for those with a weak stomach or faint of heart. There is very likely further bad news to come over the coming months, possibly longer – loan loss reserves are sure to rise and we will undoubtedly see increased regulatory action. Fourth quarter may be a ‘kitchen sink’ quarter for many companies, so at the moment we are on the sidelines watching the situation very closely and looking for a good buying opportunity.

One final lesson – watch your FDIC-limits! Only $100,000 per person ($200,000 per couple) is insured between all accounts at any individual bank. We heard from two people who lost mo
ney in the NetBank failure. Don’t let that happen to you!!

As always, give us a call if you want specific advice for your situation.

 

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