Don't believe Paulson: S&L 2.0, the Bank Failure Redux

I fancy myself to be a pretty good investor. While I think I'm a pretty bright guy, I know I am not at the level of the rocket scientists known to be hired by the quant funds. While I am fairly creative, I am far from an artist. While I am not a high school drop out, I don't have a PhD. So, what makes me a good investor? I have this uncanny knack of being able to smell BS a mile away!

Now, for those banking CEOs, homebuilder CEOs (ex. Mr. Hovnanian), monoline CEOs and government officials (ex. Mr. Paulson), who claim that the worst is behind us - I can smell you guys!

I am starting to come clean on my commercial bank research and personal investment positions. I do not publish my research until after I have established my positions, but I do release broader market and macro stuff early - figuring it can do little harm.

So, I hear Paulson says the worst is behind us!? I am assuming he is referring to the subprime mess, and the capital market melee that followed. Well, I don't believe the subprime mess is over, but if it is we still have to contend with at least 5 other failing categories of bank products that are imploding due to securitization imprudence - all rivaling or surpassing that of subprime.

Let's go over my research trail on the Current US Credit Crisis. Sections 1 through 5 are background material that is probably known to the professional in this arena, but will make good reading for the lay person. I used it to make sure I made judgments based on observable facts vs. media representation and/or personal bias. I feel the section on counterparty risk should be required reading for everybody, though. The report on PNC basically outlines, in full detail, why I chose that bank out of 329 others, to initiate my short foray into the regionals.

1. Intro: The great housing bull run – creation of asset bubble, Declining lending standards, lax underwriting activities increased the bubble – A comparison with the same during the S&L crisis
2. Securitization – dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble – declining home prices and rising foreclosure
3. Counterparty risk analyses – counterparty failure will open up another Pandora’s box
4. The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue
5. Municipal bond market and the securitization crisis – part I
6. An overview of my personal Regional Bank short prospects Part I: PNC Bank - risky loans skating on razor thin capital

Now, let's take a more mundane look at the banking sector in general. Looking at how much of the banking industry's portfolio is concentrated in real estate, one should be concerned when housing prices drop precipitously (no spell checker, and I'm tired). We are in much more heady territory than in the S&L crisis (started by CRE lending), and the housing price drop is much worse as well.

This graph should speak for itself. To put it in a few short words, "You ain't seen nuthin' yet!"

We are overbuilt, not just in residential but commercial as well. Construction and development loans have always been a high risk/high reward endeavor, well the risk part is coming home to roost. We are at a historical high in the riskiest classes of bank loans, at a time when supply is excessive, the macro environment is downright destructive, and bank capital levels are at all time lows.

It appears as if the banks believe Henry Paulson's BS, excuse me, "assertions" that the worst is behind us, for they appear to be explicitly under-reserving for what I see as a historically high level of RE loan concentrations. This is not even taking into consideration the performance trend of those loans over the last few quarters.

More to the point, look at the last two times real estate has gotten into trouble. Both times really hurt the US, with the earlier one (the S&L crisis) probably costing the US citizen and the banking system the most since the Great Depression. Despite this, the banking industry was much more prepared (in terms of loan loss provisions) to weather the storm then they are now.

If you have read through my Asset Securitization Crisis primer and you are a reasonable man/woman, you should gather that we are in a much worse position now than we were in either of the last two downturns. This means that loan loss provisions are going to spike up sharply, and along with it capital requirements increase dramatically (spell the word D-I-L-U-T-I-O-N slowly, for we will be seeing a lot more of it) while earnings plummet. But then again, if the worse is behind us, it doesn't really matter, does it??

I have screeched many times on my blog that some very smart people who should really know better are definitely overestimating the power of the Fed to get us out of this situation. Those guys over at CNBC say, "but we are getting rate cuts, margins are improving, yada, yada." Yes, we did get rate cuts. Yes, margins are improving. But from what level. As you can see, regional CRE lending institutions had it better during the S&L crisis, and you see what happened to over a thousand of them.

Wikipedia excerpt:

The U.S. Savings and Loan crisis of the 1980s and 1990s was the failure of several savings and loan associations in the United States. More than 1,000 savings and loan institutions (S&Ls) failed in what economist John Kenneth Galbraith called "the largest and costliest venture in public misfeasance, malfeasance and larceny of all time."^[1] The ultimate cost of the crisis is estimated to have totaled around USD$160.1 billion, about $124.6 billion of which was directly paid for by the U.S. government -- that is, the U.S. taxpayer, either directly or through charges on their savings and loan accounts-- ^[2], which contributed to the large budget deficits of the early 1990s. The resulting taxpayer bailout ended up being even larger than it would have been because moral hazard and adverse-selection incentives compounded the system’s losses. ^[3] The concomitant slowdown in the finance industry and the real estate market may have been a contributing cause of the 1990-1991 economic recession. Between 1986 and 1991, the number of new homes constructed per year dropped from 1.8 million to 1 million, the lowest rate since World War II.

For the record, we are on track to easily break that housing starts record. Why would anyone bid up the homebuilders??? Study balance sheets and history, people!!!

As a matter of fact, the current environment shows the weakest net interest margins for the last 30 years! To make matters worse, I believe that sooner or later (probably sooner) the government is going to be forced to stop its core inflation charade as energy, food, housing, and the materials used to produce these commodities, skyrocket through the clouds and into outer space.

Of course inflation is under control as long as you don't have to eat, drink, drive or sleep in warm shelter! If real inflation forces the feds hands into raising rates, even just a little, the banks are toast. That little dip in NIMs at 1985 in the graph was probably the straw that broke the camel's back in the S&L crisis. Yes, Mr. Bernanke --- Conundrum! Or maybe not. Mr. Paulson said the worst is behind us!

Below, you can see where we have a whole lot more loans to default on than we did in the S&L crisis, even after adjusting for inflation (not reflected in the chart).

So, after taking all of this into consideration, you can see why I don't think the worst is behind us. As a matter of fact, many focus on subprime, and more recently HELOCs (for good reason). Here is an interesting article on Calculated Risk regarding the losses on HELOC's being understated because the servicers are too busy to get timely information out. But (I know, never start a sentence with a conjuntion, but this is my blog - English teachers are not allowed here), if one simply takes a gander at what is really going on, you will find there is a broad field to choose from when selecting banks to short.

I think I'll end this here. My next research post will be on muni losses affecting credit default swaps, charge offs in the banking sector, more bank short candidates that I chose to bypass, and a homebuilder update. I will also be hosting a high net worth and institutional investor pow wow on the Hudson River leaving from Chelsea Piers in Manhattan, for anyone of the aforementioned interested in my opinions and outlooks. Stay tuned.

Comments

[nickgogerty]

Reggie you have done some good research putting this altogether. I agree, that things are still quite dangerous. Spreads have come down, but the Fed and BOE are still active and advocating for banks to strengthen their balance sheets. One can't fault Pualson for "talking his book". It is part of the job.

My own concern is CDS netting in the event of a few failures or a midsize counterparty failure. The relative illiquidity and slowish netting facilities means that a few days delay on a "EOD" agreement could send some pretty large shocks through various netting nodes on the CDS network of relationships.

Herstatt type risk cascades rapidly through a tightly coupled system. One could argue that the relative lack of liquidity and thin balance sheets increases the "coupling" in the system.

[fabian]

Reggie, you are cool. Future will tell but I'll keep a close eye on your material this WE. Thanks.

[Marty]

Thanks for one of the most intelligent articles on these subjects I have read. I was as a CPA in the Northeast and my contention is that this crisis is not a subprime mortgage mess at all that it is in fact unnanounced inflation and the corrosion in wages/benefits for the working class that is leading to all these problems we are seeing.

Just in the last few days the Govt announced inflation was 2.4% and gas prices FELL last month!

In a nutshell, inflation has been running rampant. It is the additional costs layered on by inflation that have left people unable to pay their bills, not their mortgage. Between 1978-1986 the Govt indexed social security 75% to keep up with inflation. In the last 8 years that number has been 25%.

So lets find the 2-3% inflation. Here are some real numbers that people are paying in my area.

Heating oil up 350% in 10 years
Gas up 300% in 10 years
Medical insurance, family coverage up 500% in ten years
Taxes in my town up on average 86%
Electricity in much of CT up as much as 74% in the last few years alone!
Food inflation, heck we have things that went up 30% in a month but most food items are at highs except for meats because they are killing the animals as the feed is too expensive, wait til fall.

Thus with technology and outsourcing putting a lid in wages ,there is no pressure to raise wages. Real income is declining much faster than the Govt states. 2 days ago they said it declined 1 % based on 2.4% inflation. If inflation is 10% real income is declining by 9%.

People are making less, not more, have less benefits, and less pensions than in prior years. Good paying jobs have been replaced by jobs with lower pay and less benefits. Please note the recent statistics in BusinessWeek in the differences between men and women in the job crisis and how women have less job losses because they are working in those service jobs which often pay less.

In my client base I do not see any problems with subprime loans. I see a lot of people cutting their spending, trying to keep their businesses running.

The ultimate irony is the same Govt that told you the economy was doing well, the jobs market was strong and inflation tame, is now handing out money telling you to spend it.

This is way worse than people think. Student loans might not fund. Those auction rate securities have 320 billion in peoples funds frozen, some earmarked for college. Inflation/foreclosures... pullback is now entering round two. In NJ they have to raise tolls because people are driving LESS and paying less tolls!!!! Driving is way down yet fuel prices soar.

Only the super rich are making it this time and they will watch their saved dollars depreciate right along with eveyrone else.

Id love to talk to you about what I am seeing and compare notes. My email is [e-mail]

Marty

[CrossProfit]

I enjoy reading your articles as they are well articulated with a touch of humor.

There is however one ingredient that goes into the mix that you have omitted throughout the series of articles. Your assumption that what has transpired until now will remain is contrary to the dynamics of government behavior.

Adjustments and policy changes occur all the time, taking into account many of the topics that you have written about. The way governments work is by breaking down macro problems into small parcels that can be readily grasped and dealt with.

I'm not saying that problems don't exist or that there isn't more pain down the road. What I am saying is by nature, the worse case scenario is usually avoided, albeit, at times construed to be too little too late (see song: www.youtube.com/watch?...) , yet still better than nothing at all. There are probably some nasty storms ahead however the sun eventually shines again.

In a nutshell, your analysis may be 100% correct from a scientific perspective, yet this does not guarantee that the future will play out accordingly.

Saul Sterman
CrossProfit

[biomedlives]

I agree that the worst is still to come. Major problems in credit card and home equity lending are looming.

[PublicLiterature.org]

Reggie, your articles are by far the most informative (data-packed) that I've seen relating to housing / banking. I do have one question. You seem to imply that inflation is going to get out of control in the near future. Does this also apply to home prices? If so, we would have inflated our way out of the crisis; if not, then we really don't have terrible inflation if home prices continue to drop. I would like to know what your thoughts are on home prices, because inflation may be the reason folks are jumping into homebuilders (myself being one of them). Thanks, Reggie.

-Jack

[Why the hate]

Yet another great article. I am not sure my thoughts on the future match yours, but the aforementioned analysis is excellent. I think there will be a massive bailout effort during the next few years. Several emerging countries are wealthy enough to finance it for us, so money may not be the concern. The real concern is what is the potential damage to our democracy and middle class for the long term??

[User 190021]

Good Grief! Where's Ron Paul when you need him!

[DaveW]

Reggie,
Many thanks for sharing your hard work and deep research into this topic, truly do appreciate it.
I am in agreement, but also I wonder what exactly to do with this information when the Fed will be there to provide a (ahem) safety net? It will be fascinating to see how this story ends.

[iThinkBig]

All great comments and I recognize PublicLiterature's point. That being said, thank Reggie for posting this. You are a true American Patriot for taking your time to realize that first, people must understand the true scope of the problem and that requires time and sacrifice. I see your comments often of being so tired and I realize why, so I am grateful to you as is my family!

The next step is taking action and will test all of our collective willpower by those of us whom give a damn. Those of us doing this have massive challenges to educate the ignorant masses and those in power purpotrating the spin.

Corrupt power does not relinquish itself Reggie and those attempting to do what is right to dethrone those whom have it often pay a harsh personal price as they slowly attain victory. Holding those truly accountable is very unlikely this time, but the change is possible, albeit not without much personal sacrifice and pain while collaberating as a group.

Please email me about your event on the Hudson. I would like to attend as I have a very interesting idea of how to connect all the concerned people in this nation and focus them on actionable plans. That is the problem with current blogging sites, there is no real focused call to action once the dots of the problem are connected. My email is [e-mail]...

[Marty]

I would like to comment on this comment " inflation is going to get out of control in the near future. Does this also apply to home prices?"

One would think this would happen. The problem is , the things inflating are the things people have to pay for or the things they own. Without the WAGE inflation there is no ability for prices on homes to go up. In the 70s and 80s there was wage inflation.

I will give you a simple example.

During the "terrible inflation of the Carter years" (As we are told to call it), peoples wages ALSO went up. Social security was indexed 75% over 10 years. At the end of the inflation, everyones income was up 75%-100% or more. Now, the higher incomes could easily pay down the mostly fixed debts and that allowed asset prices to increase. When your costs go up, but your income does not (even further distorted by todays lack of benefits) prices on homes will not go up because people cannot afford them.

This is a real mess, and it will take good leadership. The concentration of wealth is so great this time that even the upper middle class is in trouble.

Marty

[pockyclips2020]

I'm scratching my head. Where are all of these low interest rates?
Never missed a payment on my mortgage that I've had for 24 years.
Excellent FICO score. Yet looking around for a home equity loan to spruce up the place, I'm not impressed.

CD rates have trickled down much lower than the loan rates have.

[carey_jim]

My only brief comment is that I don't think we are supposed to "believe" ANY of the stuff that comes from the government. It is on the level of advertising (which is our form of propaganda) and is basically cheer leading for the economy.

[User 30121]

Reggie, Reggie, Reggie...just a MAGNIFICENT piece of work! Thank you so much! Would you suggest buying metals (gold, silver)? I'd be interested in your take on how to best weather this financial storm?

[drmalaka]

As always, a great thank you for sharing your fantastic work.

I am an non believer in inflation for a reason few are talking about, but John Mauldin pointed it out. The amount of money out there is not increasing, banks are lending less. Decreased leverage has a negative effect on money supply. We are confusing increased prices in certain sectors with overall increases in prices.

As Friedman said, inflation is a monetary phenomenon. Conversely stated, the price of everything can not go up if the amount of money around does not go up. It is impossible. If there is only $100 out there and item X increases from $50 to $60 dollars, and you need item X like the oil slaves we are, then item Y is going to cost $40. Does not matter what you want to charge for Y, in Philly it is worth $40.

Marty is correct here when he points out housing and wage deflation. I'm into that theory. Right on.

No doubt about it, we are paying more for commodities and energy. Since this is at best a zero sum game (given the current economic climate), if the consumer is spending more on something he has to spend less on something else.

I think the hit here is everywhere else. Retail, autos, housing, banks, tech, travel, and maybe most of all services. I believe the first thing consumers cut down on are services like, house cleaning, salon, lawn care, stuff like that. Then on to things like dining out and vacations.

The American consumer is all about appearances, they will give up their Hummers last. Credit card defaults are going to skyrocket soon. The US consumer can not continue to finance their spending habits, not with rising unemployment and flat wages. This could be a real mess.

The market certainly is saying this is not happening, but I just do not see where the positive news is. I am not a bear. I am someone worried for the future prosperity of this country. That goes even further if we get an Obama to increase all our taxes and create new "green" ones with McCain. How does this market treat a capital gains increase? Oh, that would hurt.

There is potentially a lot of bad stuff out there, it might not happen, but to bury your head in the sand and signal the all clear bell is insane.

[101010]

Reggie I'd like to join the chorus of people thanking you for yet another well researched and well presented article-- truly a gem amongst the gravel that are most of the articles seen on seekingalpha.

drmalaka -- Respectfully, I have to disagree with your assessment on inflation. The money supply absolutely *IS* going up, and unfortunately since the Fed stopped publishing the M3 numbers, we can only speculate by how much. Keep in mind that even when a homeowner pays $1M for a $500K home, that money isn't exactly buried in the ground... shares of it are paid to the home seller, home builder, mortgage originators, etc. So that money still very much exists and is circulating.

Moreover, with the Fed accepting the toxic loans as collateral to give out yet more freshly printed money at 2%-- and thus allowing these loans to blow up on their books... namely the books of all taxpayers-- that money is going somewhere, maybe not directly to Joe Schmoe home owner with a HELOC at twice the value of his property, but it is making its way into the economy, and thus driving up the prices of all goods. We're first seeing the impact on non-discretionary items such as food, fuel, etc.-- and isn't no surprise at all that these are exactly the items the Gov't does *NOT* include in their inflation numbers?

As I've mentioned before, it's best to not think of yourself as paid in dollars, but rather in the dollar equivalents. We can't eat dollars, and we can't fuel our cars with dollars. One dollar buys half as much gas as it did 5 years ago. One dollar buys half as much food as it did 5 years ago. That's the hidden pay cut of inflation. Inflation is here and now. If our incomes remained the same, we're all paid half as much as we were 5 years ago.

In short, until I hear that the Fed is actively not replacing old bills (net decline in dollars available) you can bet your last ever depreciating dollar that inflation is here, is real, and will be hidden tax on sensible Americans that bails out these unscrupulous lenders and the fools who overpaid by 100%+ for their homes. Until then, I am and will continue to very actively take every spare $US I have and diversify away from the every collapsing US dollar.

minor fyi-- your "Counterparty risk analyses" hyperlink appears to be broken. (not sure if you can edit your article now to fix.)

[e2800]

Good write up, but we all know that when investing we need to temper macro analysis with actual market performance. Its no good to say, "fundamentally, the market should fall" when it continues to rise. The amount of money available to invest has made many a fundamental analysis moot. (See crude oil)

[ReggieMiddleton]

This is the correct link to the counter party risk article: boombustblog.com/compo.../

I also suggest reviewing the logic behind my PNC short. I will be expanding upon this for a while: boombustblog.com/compo.../

Re: e2800
Many a broke person has assumed that they can just consider fundamental analysis moot. Think back to the dot com bust, the housing bust, credit bust, tulip mania, the list can go on for some time. The markets are not truly efficient, and thus in the short time it is quite possible for market movements and fundamentals to diverge. That is how the more knowledgeable and more resourceful make money. One could never buy an undervalued stock not short an overvalued stock if the market instantaneously reflected the accurate fundamental value of a company's share price. Guys like me would always be broke!

Over time though, history has never shown where the market fails to converge with the fundamentals, and sometimes quite violently.

In addition, ust because one does not fully grasp the fundamentals behind a price does not mean that those fundamentals do not exist.

[johngonole]

Couple comments:
Marty I think your take on inflation is correct. Demand and supply of all those commodities is pretty steady. The only explanation is a change in money supply. House prices are not re-inflating (which is the Fed and govts intent) because the money is being spent elsewhere. This brings me to Public Literatures speculation that maybe inflation will save house prices.

We must remember that inflation of housing is measured not by house prices but by the cost of making those payments. If interest rates rise then falling house prices may still yield the same payments or visa versa. Also even though interest rates are being forced lower by the Fed mortgages are indeed not dropping. This is because the banks are having to take a large portion of the newly printed capital to meet required capital requirements. Plus some ends up in foreign countries paying for ever more costly goods. Due to fractional reserve banking banks are highly leveraged. Small amounts of loan losses lead to large percentage of on hand capital losses.

What I see here is a Fed induced housing bubble created by the reckless expansion of personal and Federal govt debt. This has lead to poor investments and allocation of capital. Bankrupcies and reposssesions are now leading to a contraction of debt instruments or money and thus causing deflation. We must avoid the deflationary death spiral which because our whole economic system is based on debt even our currency. Deflation makes it harder if not impossible to pay back debt. However we are not seeing deflation because of further inflationary expansion of govt debt and newly printed money. That money is staying at the banks to meet capital requirements once its deposited by you and I. So in essence newly printed dollars (backed by Federal govt IOU's) are now replacing lost capital in the banks due to bad loans. These new dollars are backed by govt IOU's or debt. They must print this money quickly in order to keep the banks solvent. The M1 money supply is being increased so banks can maintain their capital requirements. In essence the taxpayers and those who are storing their purchasing value in the form of dollars are shoring up the banks cash flow via inflation or future taxation and interest on the government debt.

The Federal Reserve is trying to keep the total money supply constant. The problem is that they are trying to keep our economy solvent by keeping the total supply of dollars in the country constant. They must do so because remember its the US banks that are in trouble. Also a portion of newly printed money ends up over seas. When this is repatriated it will cause massive inflation. In essence they are printing money to prevent a credit crisis and runs on the bank. The end result is many times more dollars in circulation. Once it is expanded via fractional reserve banking we end up with a huge net gain in money supply. This becomes larger when we account for the fact that the global economy has absorbed much of the dollars via commodity trading. This perhaps explains why commodities prices are rising while others are falling. The expansion of the money supply is always an expansion of one form of debt or another.

All of the above is speculation. I haven't researched any of this. It seems though that all of us would be better off if the Federal Researve and the Govt would stop deficit spending and messing with the money supply. In a natural world we'd all see slow deflation and wouldn 't need social security and medicare. Instead our whole system hinges on an every increase expansion of debt. How long till the people can no longer carry this burden.

I suppose debt will have to be constantly expanded until all those foreign dollars flood the country. At that time the government should pay down its debt to reduce the money supply.

To be honest their are many other factors that effect money supply but I think the net result is an increase in money supply leading to inflation. This would all be undone if the Federal govt ever paid down their debt but we all know that will never happen. In the mean time the bankers including the Federal Reserve take thier cut essentially of the whole economy to provide a service that isn't really required.