Martens On Business

Does Banking Have Something To Learn From Newspapers?

2011-11-20T20:58:00.001-08:00

The November 14, 2011 issue of the New York Times carriedseparate articles dealing with the current state of the banking and newspaperindustries. With a career in the bankingindustry that in recent years included financing a newspaper chain, I read eacharticle with interest. The bankingarticle dealt with how the industry is scrambling to replace the revenue nowlost from the limitation on debit card transactions which comes after an earlierregulatory action that eroded income from overdraft fees. The article actually began on the front pageof the paper and continued inside the business section. It went into detail about the clumsy and muchpublicized debit card fees that have since been rescinded for the mostpart. When you cut through all of thearticle, it described an industry that was basically saying “OMG (to use today’stexting terminology), we need more revenue to cover our cost”.

The first page of the business section carried the start ofan article about John Paton the CEO of Media News Group, a chain of 57 dailynewspapers that is rapidly moving its business away from print to digitalmedia. While this transition may seeminevitable to outsiders, consider what the insiders must deal with in theprocess. Digital media product generatesabout 10% as much income as the comparable print product. The industry calls it trading in dollars fordimes. But, instead of fighting thedeclining trend in print revenue, Paton decided "it was time to start stackingdimes”. Contrast that attitude to thedebit card fee fiasco. Most estimates I’veseen put the cost of a debit card transaction in the range of a few pennies. The new limit reduced the amount charged bybanks from $0.44 to $0.22. While it’strue that profit is being cut by roughly 50%, it still leaves this as one ofthe most profitable products anywhere…. at least that is still legal! So instead of discouraging the use of theproduct by imposing a fee, why not instead react by “stacking dimes”?

The bulk of the content of the two articles was publishedtogether on page 6 of the business section. There, just above the banking headline was a quote from a newspaperinsider about John Paton. Paton, he said“deserves kudos for frankly acknowledging what other publishing CEOs’ won’t,which is that the cost structure will not be supported by the business modelfor much longer”. After reading thatquote, I went back to the banking article and read it with a freshperspective. What the banks were sayingbasically is that their customers are obligated to provide them with the necessaryrevenue to cover their cost structure. No they are not. No more thanconsumers of news are obligated to cover the cost of printing a newspaper inevery city in America.

Banking Industry's Third Wave

2011-11-14T20:24:00.001-08:00

The American banking industry through the 1970’s operatedwithin a patchwork of state and federal regulations that were largely rooted inlegislation from the great depression of the 1930’s. Within that framework banks were limited tooperating within a single state and in some states to a single location. Beginning around 1980 state regulations beganto give way to demands to modernize the industry through deregulation.

The 1980’s became what I would characterize as the firstwave of deregulation, or perhaps more correctly, reduced operating restrictions. During this wave banks found success throughconsolidation both internally and externally, both for the purpose of gainingoperational efficiency. Merged banksconsolidated branches and back office units. Operations and lending functions were centralized with smaller branchstaffs focused on sales. Although itseemed quite challenging at the time, in retrospect it seems more like we werejust “harvesting the low hanging fruit”.

The consolidation of the industry continued into the 1990’swhen it combined with a re-energized economy to produce growing bankprofits. After catching its breath withthe internet bubble induced recession of 2000, the economy took off again, thistime driven by increasing real estate values. During the 1990’s and well into the next decade, banks large and smallcontinued to grow their profits. Inaddition to the benefits from consolidation, profits were driven by growingloan portfolios and fee income. If youlook below the numbers just a bit, you could see that loan growth was largelydriven by real estate across all categories. The real estate bubble that developed in thelast decade was made possible by consumers’ willingness to go deeper and deeperinto debt. For many community andregional banks their loan growth was concentrated in construction lending andcommercial real estate in general. Interms of fee income, if you looked below the top number you could not help butnote that much of the growth was coming from overdraft charges. As I summed it up at the time, banks werefeasting on commercial real estate and overdraft fees. One of my favorite expressions is from afictional economist who said, “Things that can’t go on forever, tend notto”. Indeed they did not. The real estate bubble burst and consumersfinally reached their breaking point on debt and their tolerance of bankfees. Today banks are dealing with theaftermath of a collapsed real estate market and a reduction in fee income fromoverdrafts and debit card transactions.

This brings us to what I would call today’s “third wave” ofthe post-depression era banking industry. Most banks today are well into the process of recovering from the elevatedloan loss provisions that they somewhat grudgingly began in the fourth quarterof 2008. Nearly every bank will be ableto look to their loan loss provision for a lift in earnings in 2012. But, the lift will not be enough to restoreearnings to prerecession levels. Evenwith the benefit of historically low funds cost, tepid loan demand will limit growthin net interest income. Fee income as weall know is now limited by both regulation and consumer backlash. This operating environment, in my view, willcontinue well beyond 2012. In fact, itcould very well get worse. In a futurearticle I plan to write about what may be the future for bank branches.

In this new “revenue challenged” environment the winnersthat will emerge will have two distinguishing characteristics. They will be exceptionally skilled creditgrantors and exceptionally skilled at improving operating efficiency. A banker reading this sentence will likelyrespond by saying, “hey, we are already good in both areas”. No you are not! Not in the manner that will be required goingforward. With the pressure building tofind new loans, a bank will need to be able to land the good credits and leavethe marginal ones to competitors. And,having tough credit approvers who are willing to just say no (maybe toowillingly as if they enjoy it), will not be enough. Anyone can find a reason to say no to acredit, it takes skill to understand when and under what conditions to sayyes. In a sense, this will be somethingof a back to the future process. Thewinning banks will be those that put forth skilled bankers that can discern creditand at the same time convince those good borrowers to do business with theirbank instead of the competition. Interms of gaining operating efficiencies, let’s just say the industry is ripefor disruption. In yet another article Iplan to write about a growing amount of money being invested by some very smartpeople with an eye to being very disruptive.

Blogging Again

2011-11-01T20:05:00.000-07:00

I returned to the banking industry in mid-2008. Since then I've been absorbed in my job as a workout specialists and after a long day of analyzing, writing, and talking, found it difficult to muster the strength to do yet more of the same in the evening. While I am still busy on the job, I have decided to find the time to add some thoughts here from time to time.

Actually, what brought this on was an accidental Google search that brought up my June 2008 post below about what I then observed as the de-leveraging of America. At the risk of indulging in a bit of self-congratulations, I must say it was "spot on". Just above that post is one about Hudson City Bancorp. I now see that their stock price has taken a beating this year, not because of poor lending habits, but the scarcity of earnings in our de-leveraging economy.

And WOW! The CountryWide acquisition turned out to be even worse than I predicted!

On another evening I plan to write about what I see as the banking industry being in the second phase of the post deregulation era.

This Operation Is No CountryWide

2008-07-03T14:56:00.000-07:00

I recently saw Ronald Hermance, CEO of New Jersey based Hudson City Savings Bank being interviewed on CNBC. He was on the show as the rare exception in the otherwise dismal banking sector. He described his $44bb institution as a simple and careful lender that continues to generate record profits. He said they concentrate on mortgage loans and individually underwrite every loan based by the traditional measures of collateral and income. Every loan, he went on, even those they eventually sell are underwritten as if they would be retained forever.

Being something of a skeptic, I wondered if there might be more to the story. So I pulled their financial data and guess what? The only “more” to the story is that they seem to be even more plain vanilla then what was described. Their earning assets are split about 60-40 between mortgage loans and mortgage backed securities. But, all of their mortgage securities contain only loans carrying government agency guarantees. And, while many regional banks have been ‘juicing’ their earnings with construction loan portfolios totaling 200 to 300% of capital, Hudson has a whooping construction portfolio equal to 1% of capital. No typo there…it is 1%. Home equity loans are almost as inconsequential.

So how are they doing? Very well, thank you! Their stock, while off from recent highs, is still double the level from 5 years ago. It sells at 1.8 times book value compared to most banks that now trade at a discount to book value. I can’t help myself from making a comparison to Bank of America which now sells at a 10 year low. In fact, you have to go back to the old NationsBank to get a higher price. Its price is .7 times its book value. Another comparison – Bank of America is 40 times larger than Hudson but has a market capitalization only 10 times larger. Hummm… think Hermance would have acquired CountryWide?

Is America De-leveraging?

2008-06-23T16:31:00.000-07:00

One of my favorite books is The Tipping Point. It is a fascinating look at a range of situations using unconventional economic theory. After re-reading portions of it recently, I have begun to focus on what I think may be two areas where we have “tipped” and things will never be the same. The obvious one is energy and its ramifications are being addressed in the media so I will not repeat them here.

The other less obvious one is what I call the de-leveraging of America. First, the good news is that corporate America, with the huge exception of investment banks, has already completed this process. The vast majority of large corporations have used their cash flows and attractive equity market conditions in recent years in a manner that has left their balance sheets in excellent condition. But, some of those same companies were encouraging their customers to do just the opposite. (What’s in your wallet? Don’t leave home without it. Isn’t it about time for your home to start paying you?) The result is that American consumers are more heavily in debt than at any time in our history. The level of debt has been setting records for years now, drawing continuing comments from economists. Which brings to mind that sage economist’s comment, “Things that cannot go on forever tend not to!” Or, we have finally “tipped” and things will not be the same. Parenthetically, I would add that the ‘baby boomers’ finally reaching retirement age is a big factor in all of this. Which reminds me of one of my favorite books from some years ago, Mega-Trends. But, I digress. The mortgage crisis, I believe, is just a sub-component of this broader trend toward de-leveraging. We are already beginning to hear of home-equity and other consumer loans as the next big problem areas. If we sink deeper into recession as some believe, these portfolios will only come under more and more stress.

I believe every business in America, particularly the banks, needs to assess how this de-leveraging will impact their business. As consumers are able to repay their debts, don’t expect them to return to their profligate ways, even with your most clever advertising. As to real estate, we have also reached the point where home buyers are looking at things very differently. Or, as a person on television today said, ‘until we reach a point where buyers once again view a home purchase as consumption instead of an investment, we will not know the true value of homes’. Sounds like a tipping point within a tipping point. Like any change of this magnitude its effects will not just be negative. Big opportunities will be created for prescient companies to exploit.

Bank of America CountryWide Watch - Update

2008-06-17T13:28:00.000-07:00

The stock market was not kind to banks today on fears of additional write-offs and possible dividends cuts. BofA in particular was noted in this regard as it set a new 5 year low below $30. One year ago the stock traded at over $50 with the decline amounting to about $100bb in shareholder value. Their common stock now yields 8.75% which means the market is betting on a cut in their dividend. The CountryWide acquisition is largely viewed by analysts as ill-conceived and adding more risk to an already risk-laden business. Yet the bank seems determined to go forward.

I like to contrast BofA to U S Bank. U S has chosen a very different path. It has carefully selected its business lines and manages risk with even greater care. Its acquisitions are also carefully strategic in nature. While BofA's stock this past year dropped over $20 to below $30, US Bank has seen its stock slip a mere $3 to $31. Wonder why Warren Buffet owns US Bank and not BofA?

Bank of America CountryWide Watch 2

2008-06-05T15:16:00.000-07:00

The Fed today approved the merger. Now it seems they only need shareholder approval which I believe is later this month. So, it looks as if they are staying the course despite calls for them to get out of the deal. And get out they could. I'm sure the controlling purchase agreement has sufficient language regarding deterioration and legal issues that they could easily kill the deal with no risk of legal retribution. Business deals are often driven by ego & stubbornness, and I think that is what we are seeing here.

BofA will follow one of two options. One, as I have written earlier is just to write down the value of CountryWide's loans just prior to closing. And, I mean REALLY write down to cover their worst case scenario. This will result in booking a relatively large increase to their goodwill account but not doing the deal would mean a write-off of their Preferred stock investment and the various extensions of credit to CountryWide. I wrote about this in more detail in an earlier article. Essentially this is just a clever way to transfer their loss to the goodwill account. The other option for them is to go the bankruptcy route as I also wrote about in an earlier article. It will be fascinating to see how they proceed.

Bank of America CountryWide Watch

2008-05-28T09:48:00.000-07:00

Bank of America today announced its management structure for the combined companies. This is certainly a signal that they do not intend to scuttle the deal despite my humble advice to the contrary. This also in despite of what the market seems to be telling them. BofA's stock is down nearly 20% YTD. In fact, BofA is trading at its 5 year low. By comparison, US Bank which I think is one of the best managed banks in the country, is up 10% YTD. I still can't imagine the bank assuming all of the legal and credit risk now peculating up at CountryWide. The managed bankruptcy I wrote about earlier must be the path they are on. But, that could prove costly as well because it will most certainly trigger additional lawsuits attempting to shift the liabilities to BofA. It will be interesting to watch this unfold.

Bank of America - CountryWide Update

2008-05-19T17:42:00.000-07:00

I am more convinced than ever that Bank of America's prime motivation in taking over CountryWide was and is to avoid the huge write-offs that would be required if they allowed it to continue into bankruptcy. The cost of this maneuver, however, continues to rise. Last Friday a federal judge ruled that CountryWide, its officers and directors must deal with shareholder lawsuits claiming fraud. Also, the FBI is continuing its criminal investigation of CountryWide (and other lenders). In the face of these rising legal costs added to the mounting credit losses, it is becoming apparent that Bank of America's too clever by a half effort to bail itself out of a lousy investment is becoming intolerably expensive. I am looking for a possible announcement this Friday before the long holiday weekend. That seems to be the popular time to release unpopular information.

By the way.... I ran across an analyst's report of last August touting Bank of America's $2bb investment in CountryWide. He said 'this is no fly-by-night lender, it is THE preeminent mortgage lender in the nation'. Wow... wonder how much money this brain surgeon makes.

Bank of America Bails Itself Out of a Problem - update

2008-05-03T15:51:00.000-07:00

When the purchase of Country Wide Financial (CFC) was announced in January I wrote that I viewed it as a clever way for Bank of America (BAC) to bail itself out of a problem loan. Here is why. BofA had invested $2bb in preferred stock last August that is convertible to common at $18 per share. By year end with CountryWide heading for certain bankruptcy, that investment would need to be written off, likely against '07 earnings. Also, BofA had long been CountryWide's principal commercial bank so would have also had credit facilities likely in the range of multiple billions of $$'s. Add-in other possible exposures on swaps, etc and the total charge-off they were looking at was quite likely in the range of $10bb. So, for a mere $4bb in BofA stock (that's not real money, after all!!) they get to soak up the problem with nary a stain left on the floor. Worst case for them is that if the net value of the assets acquired were to fall below their $4bb purchase price, they would incur good will.

When I wrote in January I noted that one significant risk to BofA was the continued deterioration in the quality of CountryWide's assets and operation. Well, it looks like this is happening in spades. At quarter end, just under 10% of CountryWide's loan portfolio was more than 90 days delinquent. That looks to be an astounding $10bb of loans on the verge of foreclosure. And in this case the "trend is not their friend" as some like to say. There is no reason to believe this deteriorating trend will not continue. Operationally, the company is facing multiple investigations including at least one that is criminal. The potential cost from these cannot be quantified. Thus, in a matter of several months what may have seemed like a clever way of dealing with a problem borrower has become very costly. Several shareholders literally begged Ken Lewis to call off the deal at BofA's recent annual meeting.

With the cost of the "acquisition" ever rising it is little wonder that BofA has now let it be known that they may take steps to avoid direct liability for debts and presumably legal issues. (Or, perhaps this was their plan all along.) In their SEC filing on Thursday BofA indicated they would likely not assume all of CountryWide's liabilities. CountryWide has some $97bb in Notes Payable. How can they, you ask, if this is a stock for stock purchase not assume the liabilities? Fortune Magazine's on-line edition today has an article filling in the blanks a bit. It seems the actual entity doing the acquisition is a new subsidiary called Red Oak Merger Corp. The plan, according to Fortune, is for Red Oak to hold the CountryWide entity and then sell certain assets, such as CountryWide's commercial bank, directly to BofA. Red Oak would then hold whatever amount of cash that equaled the fair value of the assets transferred which could then be used to satisfy CountryWide's debt. BofA could also pay for assets transferred by assuming debt but cautions in their SEC filing that they cannot give any assurance that they will assume all debt. They did indicate that some $11bb in revolving bank debt would be assumed. (A big chunk of which is likely owed to guess who ... BofA, that's who) In the end, Red Oak would itself be put into bankruptcy.

What is fascinating about this is that it starts to look very much like what happens when a bank is closed by the regulators and then sold to an acquiring institution. It is also similar to what happens in a bankruptcy liquidation. All of which raises the question, was BofA given the OK by the regulators to pursue this strategy? It will be interesting to follow the drama.

Margin Requirements

2008-05-01T15:29:00.000-07:00

This is a tad off the general subject of business but yet seems appropriate given the current economic turmoil. Margin, as you know, is the percent of cash needing to be posted to purchase a position in securities like common stock, commodities and such. Currently, one must put up 50% cash to purchase and carry common stock on margin. But, should you prefer to purchase crude oil futures you need only put up 8%. If you don't know why this is important you have not filled your gas tank lately. While politicians talk of suspending gas tax for the summer, no one seems to be calling for an increase in margin requirements. Yet, some of the experts I read are saying that speculation on the price of crude oil has played a role in pushing the price ever higher. We also know that energy cost is then "fueling" (bad pun) the rise in the cost of food and other items. Anyone running a business today is grappling with the effects of the increase in energy cost.

While I am not certain which of the federal agencies sets margin requirements (likely the Fed), I do know a phone call from the White House is all that would be required to deal with this.

How Did a Brand Die?

2008-04-21T11:10:00.000-07:00

I returned last week from an extended road trip through Wyoming and Montana. During the trip I looked for subjects to write about and found no shortage. I'll leave the plight of Native Americans to other writers, but the view from the freeway was not encouraging. I also found an interesting idea about entrepreneurship and the annual summer ritual in cattle country involving male calves, but I will leave that one to others as well!

What I did notice on two occasions was the unique gable architecture of buildings that had once been Stuckey's and Nickerson Farms roadside restaurants. As you may remember they were once scattered throughout the US with their brand identification pulling in travelers off the interstates for food, snacks and souvenirs. Now, I can't recall seeing a single one in operation. What happened? How could operations of such size and identity just disappear? Unfortunately, I don't know the specific reason but it obviously involved mismanagement operationally, strategically, financially, or all three. If someone knows either of the stories, please send it to me. And, it's not that the concept was not viable because Cracker Barrel is substantially the same as what Stuckey's and Nickerson Farms once were. Cracker Barrel has tremendous brand loyalty. People in the East and Southeast plan their road trips around Cracker Barrel locations. One distinction may be that Cracker Barrel, while near interstate highways is also in urban locations. But if that were the key distinction, why didn't the other two see that and adjust their strategy?

Help for homeowners???

2008-04-05T10:42:00.000-07:00

From time to time I see an interesting juxtaposition of seemingly unrelated news items. Such was the case this past Thursday in the New York Times. In the news was a report on the approval of a bill to assist homeowners at risk of foreclosure. In the final version of the bill the only item that could even remotely help homeowners was a provision for funding counseling for those about to loose their homes to foreclosure. HUH? That is like the t-shirt on the little boy that had printed "My parents went to Hawaii and all I got was this lousey t-shirt". Home builders, on the other hand, will fare a bit better. They will be able to carry back financial losses on their books & can immediately recoup taxes paid for the last four years. How long do you think it will take for a bunch of other industries to hold up their hands and demand the same treatment? Another provision will provide a tax credit of $7,500 to someone buying a house out of foreclosure.

An unrelated story in the same issue of the Times told about a couple in Detroit waiting to sell their home to relocate to another city for a new job. Despite reducing their price they have been unable to sell in part because they must compete with foreclosed homes on the market. So the foreclosed house down the street they are competing with now has a $7,500 cash bonus attached to it. This will likely help the mortgage company sell their house but how does it help the homeowner? It doesn't, quite simply. In fact, to maintain their competitive position they may need to lower their price by $7,500 or more. But hey, they can get counseling!!

Get Ready to Tweet

2008-03-30T15:58:00.000-07:00

The Internet continues to evolve and generate new words and expressions. Remember when you first heard about Google? Now it has become a verb. Just Google it!!!

Now it's time to get ready to Twitter. (To "tweet", a verb makes you a "Twitter", a noun) My tech savvy son brought this to my attention several weeks ago and I must say I am fascinated. Not that I will be spending a lot of time tweeting, but I keep thinking of how this will move into the mainstream for commercial applications. Ooops, perhaps I should explain what a Twitter is. In brief, it is part blog, part e-mail, and part instant messenger. You can broadcast messages but you are limited 140 characters. I say broadcast because someone must decide to "follow" you through your Twitter name. Most new users start with simple things like "Hi, I'm at the airport on my way to Palm Springs". Presently, it is a cutting edge social networking medium but like blogging, MySpace, & YouTube will likely find commercial applications very soon. I like it for its versility and cost (zero). You can send and receive on any device that connects to the internet. It's ability to communicate to large groups of people almost instantly seems to be its commercial value. You could easily communicate with employees regardless of their location. I could forsee even communicating with customers. In any event, if you are in business and are interested in what lies ahead, I would suggest learning about Twitter. To read more you can click here which will take you to an article on the subject including a link to a very well done YouTube video explaining it all. A clever way to use two new technical mediums.

Homeowner Bailouts?

2008-03-22T16:45:00.000-07:00

It had to happen sooner or later. Legislation has been introduced in the US House and Senate that would provide a method of relief for financially troubled homeowners. What seems to have pushed this forward now is the recent "bailout" of Bear Sterns. Comments being made by politicians are along the line of 'if we can provide $30bb to bailout Wall Street, we can surely provide something for homeowners'. But, like many political analogies it does not stand up to scrutiny.

First, if you owned Bear stock I doubt you feel the government bailed you out. You will get $2 for you stock that was trading at $160 last year and $60 just days before the "bailout". Even the $30bb may not ultimately be a cost to the tax payers as it is in the form of a loan. Second, and most importantly, the real bailout was our financial system. Bear was facing a run and would certainly have had to tell clients they could not get to their funds and would have had to declare bankruptcy. We just could not take the risk that this could have led to runs on other investment banks and even commercial banks. Remember, it was not the stock market crash of October 1929 that caused the Great Depression, it was a series of runs on banks in 1930 and 1931 that was the culprit.

Now let's look at the legislation being proposed for homeowners. The federal government would create a fund to purchase mortgages from lenders at an amount equal to 85% of the homes's current value. The lender would then make a new loan to the borrower on terms reflecting the homes reduced value. That seems reasonable on the surface but lets look at how it may look in reality in your heighborhood. (Kind of like the econonist who retorted, sure that's the way it works in reality, but will it work in theory?) Let's assume two neighbors each purchased homes in an overheated market it the peak value for $400k each. One took out a loan for the full $400k purchase and the other put $200k down. Today, each house is worth $300k and the neighbor with the $400k loan cannot make the payments after the initial teaser rate expired. Under the proposed terms of the legislation, the over extended neighbor gets his loan re-writen at $300k. Having nothing invested in the house he has not suffered a loss. The more conservative neighbor, on the other hand, has suffered a $100k loss. How long to you think it would take for someone in this circumstance to demand that their loss be covered as well. This becomes a clear example what is called a moral hazard, or rewarding the wrong behavior. I just don't see how this sort of bailout can fly.

Controling, Managing, & Leading

2008-03-21T12:02:00.000-07:00

I recently saw a quote by the late management guru Peter Drucker. “So much of what we call management consists in making it difficult for people to work”. I have it printed on my desk and ponder its meaning from time to time. More recently I found myself responding to a colleague that “controlling is not managing”, and then added, “and managing is not leading”. It seems to me that is what Drucker was referring to. I re-read my post from a year ago in which I discussed leadership versus management. I would now add the notion of control as a component of management. I once found myself working for a huge bank as a result of a merger. Several years earlier the bank was in severe financial distress due to some very risky mistakes. In addressing these missteps the bank had created a culture of extreme control, to the extent that it was stifling. Risk was controlled at the expense of innovation or even simple initiative. While the bank’s name continues today, the organization was soon taken over by a bank with a more open and aggressive culture. Surprise! Surprise!If you think back to jobs you enjoyed most, I suspect it is because you worked for a very good manager, maybe even the rare leader. Think of a job you hated, and most likely it was working under a “controller”, or micro-manager. While “controllers” think they are managing, as Drucker says they are just making it difficult for people to do their job.

Is The Fed Re-flating The Economy?

2008-03-13T11:16:00.000-07:00

Commodity markets, particularly gold, seem to be answering yes to that question. For centuries governments have fell to the temptation to use asset inflation to solve economic problems. They did so often knowing they were only trading today's problem for an equal or larger problem in future years.

In recent weeks the Fed's response to the credit market's problem has been to lower interest rates and expand the money supply, even though neither step will have much impact beyond psychological. The fact is lending institutions and investment bankers combined to act with incredible stupidity and all the money in the world at near zero rates will not repair the damage. It will simply take time, and yes institutions and homeowners will have to accept their medicine. When my children were teenagers I called it the law of collective stupidity. Meaning the more teenagers you add to a group the lower becomes their combined IQ's. Based on this my son was never allowed to invite more than 2 friends to join him on our boat, allowing him in turn to enjoy those summers accident / incident free. It looks like Wall Street got together with mortgage bankers while ignoring my law of collective stupidity.

But, as to inflation, the US dollar is at an all time low and commodity prices are almost all at record highs. Almost every business is feeling the effects as food, fuel and everything imported goes higher. Consider steel, much of it is imported. Almost everything, it seems anyway, at Walmart is imported. So, if we are in line for more inflation it will eventually work its way into the price of real estate creating a sort of backdoor bailout. While I hope this is not the case I fear it may be the real Fed agenda.

Introducing alt-A

2008-03-06T11:47:00.000-08:00

Move over subprime it is time to make room for alt-A. You can be excused if you don't know what an alt-A loan is. But, all they seem to be are subprime loans to borrowers with more respectable credit scores. (See my earlier post on credit scoring titled The Mortgage Mess) Like their subprime siblings, the loans lack income or asset verification and with an advance rate of 100% of value. In other words they ARE subprime loans with a prettier face. Lipstick on a pig would be a good description. It turns out this was not an inconsequential part of mortgage lending in recent years. The Mortgage News trade publication reports that a total of $1 trillion (that right, trillion) of such loans were made in the past two years. For more on the subject click here to read the CBS Marketwatch article.

Warren Buffett is doing what????

2008-03-02T14:57:00.000-08:00

There was a recent bit on late night TV that went like this; "You know the world is upside down when 1) the best golfer in the world is black, 2) the tallest player in the NBA is Chinese and 3) the German's finally found a war they don't like". Well, perhaps we can add another line, "when Warren Buffett shuns the US dollar and invests in (gasp) the Brazilian real. But, according to his letter to shareholders issued last Friday that is exactly what he is doing. In fact, the real was his only currency position last year. In fairness, this does speak well for the economic progress made in Brazil. Progress, by the way that was made by going against the very vocal advice coming from both Wall Street and Washington, D.C. In recent years Buffett has made money betting against the dollar by investing in other currencies including the Canadian dollar. That is the real story here, the world's strongest economy in terms of output, at least, can't manage its own finances. Click here for a link to his letter.
I avoid making political comments here but the fact is our fiscal / monetary policies have us requiring upwards of a trillion dollars from overseas each year. Given that, the dollar can do nothing but decline. While a cheap dollar helps exports, it adds to the cost of just about everything we consume.

Is The Other Shoe Dropping?

2008-02-28T11:38:00.000-08:00

Since leaving the banking industry some years ago I have been active selling lending software applications. In the course of that I familiarized myself with the composition of each bank's loan portfolio. In the mid-nineties I began to notice the growth of construction and commercial real estate portfolios. Today it is common for community and even regional banks to have 40% to 60% of their portfolio in these two categories, double what one might have seen 15 years ago. With all of the focus on subprime lending, I have been wondering when it will dawn on folks that the traditional soft spots for bank during economic down cycles has always been in these two real estate categories. Well, yesterday that changed when the New York Times ran an article titled "Small and Midsize U.S. Banks Beginning to Struggle in Credit Crisis". (Click here to go the the article) In the article they express the exposure in terms of such loans in relations to capital with the ratio going from about 150% in 1990 to 285% today. Or, total capital is equal to 35% of such real estate exposure which will not provide much of a cushion if the economic down cycle becomes severe. Adding to this concern is Fed Chairman Bernanke's acknowledgement today that we are headed for an increase in bank failures.

A Subprime Legal Question

2008-02-25T09:52:00.000-08:00

In my January 28 post I attempted to explain how credit scoring came about in the 1980's and eventually morphed its way to subprime lending twenty years later. In brief, the theory is that you grant credit to a broad group of borrowers with common characteristics and at a higher than normal interest rate. The belief was that in total such a portfolio would produce profits sufficient to cover losses and still yield an above normal return on investment.

The critical element here is that the lender did not attempt to underwrite each individual loan in terms of repayment risk. So, the legal question is, "does this failure to assess individual borrower risk change the lender's position in foreclosure?" To my knowledge this has never been tested in court. We have always had so called hard-money lenders that largely ignored the borrower's ability to repay. But, they protected their position by underwriting the loan against the value of the collateral. In the case of subprime we had lenders not just ignoring the borrowers ability to pay but also advancing 100% and often more than the value of the collateral.

So, could a borrower reasonably take the position that they were reassured by the bank's willingness to advance the money that the bank was satisfied with both their ability to handle the loan and the value of the collateral. I'm quite certain the lender NEVER told the borrower, "hey, we have no clue as to whether you will be able to pay this loan, and if you do not the house will not come close to covering the loan, so you will be left with a big deficiency".

Legislating Good Sense?

2008-02-21T13:10:00.000-08:00

There is an old expression that says you cannot legislate morality. To that I have always added that you also cannot legislate good sense. Well, I guess I have been wrong all this time.

Legislation is now pending in the US Senate that would mandate mortgage lenders to consider the ability of the borrower to repay the loan! Similar legislation, I understand, is pending in Oregon and other states. Back in December the Federal Reserve found it necessary to issue a 'rule' that banks had to have proof of the borrowers income when granting a mortgage.

All of this frankly boggles my mind. How did we arrive at a point where it is necessary to mandate banks to use good sense. Or, how did this chief credit officer;

Get replaced by this one?

The Mortgage Mess

2008-01-28T11:47:00.000-08:00

John Stumpf the CEO of Wells Fargo Bank recently said in a speech that “I don’t understand why bankers have to come up with new ways to loose money when the old ways were working just fine”. What a great way to summarize the mess we are now in.

I was witness to the train wreck that was the savings and loan debacle of the 1980’s. It was not difficult then to recognize the problem as it rose to the level of a crisis. And, it has not been difficult more recently to recognize the problem developing in the real estate sector, specifically in mortgage loans. And just like in the 1980’s the government agencies responsible for oversight, namely the Federal Reserve, did nothing but watch.

Mortgage lending for banks has always been about as staid and boring as any business can be. Mortgage loan losses were rarely big enough to even comment on in the bank’s financial reports. So just how did the industry come up with this new way to loose money and in mortgages of all things? To answer that question we have to look at several of the moving parts that came together to create something of a perfect storm.

The first component, oddly enough, I believe to be credit scoring. Without going into the boring minutia, credit scores are today being used in a manner for which they were never intended. Credit scoring came about in the 1980’s as a means of improving the profitability of loan portfolios. The scoring algorithms had to be validated for each lending institution and for each loan type within that institution. Individual applications were given scores for the sole purpose of managing the portfolio’s aggregate profitability. What is important to understand is that the bank for the first time was abandoning the notion of underwriting a specific application. In effect they said we have no idea who will fail to repay us; we just know our scoring model says that in the end we will make more money. This naturally caused no small amount of angst among traditional bankers and also gave rise to all those stories like twice bankrupt, crazy Uncle Fred getting yet another credit card offer. But love it or hate it, it has worked reasonable well for credit cards, auto, and similar such loans. Somehow this whole scoring notion morphed itself into you the individual having ONE credit score as something of a badge of general credit wothyness. I’m not sure how this happened but the fact that the folks behind it were the same ones that said crazy Uncle Fred should get a credit card, should have been a clue!

The second component leading to the mortgage mess is that somehow this notion of credit scoring portfolios instead of underwriting individual loans escaped their confinement to general consumer loans and made their way into mortgage lending. Remember, the purpose of the credit score is to allow the bank to extend credit to riskier borrowers and still grow their profit. Suddenly, sub-prime loans were born. I’m certain that the scoring companies, of which there are only several in the nation, were able to develop statistical models showing how these more risky loans in total will perform in a manner that is profitable. What a great day it must have been when crazy Uncle Fred got a mortgage on that big new house of his! While I am certain I could find more than a few flaws if allowed to examine these models, what is more important is what eventually transpired in the industry. In short, if only one or a handful, of lenders persisted in making these sub-prime loans the portfolios may have performed reasonably close to their models. But, when such lending became widespread it began to alter the very reality within which the models were created. Sub-prime loans created enough additional demand to turn a cyclical upturn in the market to a genuine asset bubble. As in any bubble, during its early stages owners could sell at any time and take a profit which served to obscure those borrowers who were selling because they could not make the payment. The scoring folks could then point with pride to their models as working perfectly. But hey, crazy Uncle Fred was now a move-up buyer hotly pursued by real estate agents and mortgage brokers alike.

The third component added to this witches brew was the investment bankers. (Why is it whenever a financial train wreck occurs you see investment bankers walking away with only scratches but their wallets stuffed with cash?) Investment bankers, who in recent years have become adept at creating exotic trading instruments, just couldn’t resist getting involved with this new sub-prime market. After all, they had been successfully packaging conventionally underwritten mortgages into marketable bonds for years, so why not sub-prime loans as well. In the low rate environment of recent years there was no shortage of demand from investment managers looking to improve yields. No doubt they had the reassurance of the credit scoring agencies that their models show the portfolios will perform just fine. So mortgages became just another trading instrument. It reminds me of the story of the young man learning the ropes at the Chicago Board of Trade. One day he asked his mentor, “just who eats all these pork bellies anyway?” To which his mentor responded, “You don’t understand son, pork bellies ain’t for eat’n’ they’s for 'trad’n”. So too it became for mortgages, they were not for financing homes they were for trad’n. And trade they did. Seemingly just to make things interesting, the same loan was sometimes used to back multiple bonds which were sold to separate buyers. They call these tranches which is French for slices. Hey, nobody would buy a slice, but a tranche, now that is a different thing all together! So, this time when Uncle Fred defaults on his mortgage he can’t sell his house, and he has two, three or more folks that come collecting. One wants the interest, one a portion of the principle, etc, etc. You can see how, on the face of it, it is virtually impossible to restructure this loan into something that makes sense to every party involved.

So how will all of this work itself out? Painfully and slowly I am afraid. Like all asset bubbles, it is ending badly; meaning even innocent people are and will get hurt. Foreclosures are skyrocketing and home values declining. While no one can predict how long this will continue, it does appear that we are still very early in the process. Unfortunately, it seems to be like a bad cold. About all you can do is tough-it-out. The steps taken recently by the federal government are about all that they can do but their effect will be minimal.

Over the holidays, I watched the classic movie “It’s a Wonderful Life”. How quaint! A local bank making loans to local citizens to finance their homes.

Subprime Humor!!

2008-01-26T15:35:00.000-08:00

The link below will take you to a YouTube video that is terrific. Especially if you love British humor. It is an interview with an "investment banker" that explains the process of making subprime loans and turning them into "investment grade securities". Like most good humor there is a great deal of truth in it. (the subprime discussion starts in the third minute) Enjoy!

http://www.youtube.com/watch?v=SJ_qK4g6ntM