CIBC is out with an important call on the financial sector, saying the modern foundation of the lending market is about to be uprooted as FICO scores, the long trusted gauge for lenders in determining risk and price, will prove virtually meaningless in this credit cycle.
Today, as a higher percentage of people own homes and many of them have taken on "too much house" or high LTV (loan to value ratio) loans, things are different. Many previously-considered "prime" customers who took on 80+% LTVs are performing closer to sub-prime loans. While "indirect" exposure to sub-prime losses has already been felt through banks' exposure to mortgage backed securities of all flavors (CDOs, RMBS, etc.), the firm believes the impact of "direct" exposure to subprime loans on the books has yet to be truly appreciated by investors.
High LTV mortgage loans is the greatest risk pool of U.S. consumer loans, and Citigroup (NYSE:C) has the single highest exposure to it. CIBC estimates that C will incur losses on such loans of $4-6.5 billion in 2008, or 31% to 51% of its 3Q07 total loss reserve. Accordingly, they are again lowering their estimates.
Firm's 2008 EPS estimate is now $2.95, down almost 10% from our prior estimate and nearly 30% below consensus. They believe downside for C is under $30 or 2-2.5x $11.70 estimate for tangible book value.
CIBC continues to rate Citigroup 'Sector Underperformer'. Trading at 11x 2008 EPS estimate, shares are expensive, in firm's opinion, given that in the early 1990s, a troubled C traded as low as 7x forward EPS estimates.
Notablecalls: While the market is currently trading up in the pre-market, I suspect this call may cause it to go into red territory today. We have heard a lot about the turmoil in the mortgage-backed securities side, with some claiming that the problems are well insulated. CIBC's call gives another glimpse at the thing and I must say it's not a pretty one.
The loans with high LTV ratios mean borrowers have put little skin in the game and have little equity in their home, and thus will be less motivated to stay current on that loan. A high LTV loan can turn even the most prime/high FICO borrower into a sub prime performing borrower.
This means the problems may run much deeper than currently anticipated.
It also looks like Citigroup (NYSE:C) is in the center of this maelstrom. If CIBC is right, I suspect the stock is headed lower here. Shorting C here in the pre-market (while it's still in the green) may prove to be a money-making idea.
Please note that CIBC is also taking their estimates down on JP Morgan (JPM).