Philip Gvinter

Asset Reflation Does Not Signal Recovery for U.S.'s Collapsed Economy

I agree with all of the point made above but would like to add one important aspect of the current events which seems to have been overlooked.

One of the cornerstones of American capitalism was the separation of banking from commerce. This principle is of utmost importance in any free market economy which has a central bank and a banking cartel. This separation was broken with the Citi Corp - Travelers merger and has been further eroded with the conversion of Goldman and Morgan into bank holding companies and the mergers of BofA and Merrill. The banking cartel is now being run by investment bankers, who are really commercial entities tied loosely to the financial system. This perversion of our capitalist system and the new status of the investment bankers who by their nature are gamblers and advisors rather than bankers, as systemically important and above the rules applied to all other capitalist entities has caused an acceleration of the distortion caused by Fed interference. A Fed owned by the bankers is a necessary evil, a Fed owned by Wall St. is a quick path to utter systemic failure.

What Were Subprime Loans Modeled On?

The biggest difference between CRA and Subprime which has not been mentioned are the underwriting standards. CRA was a subsidy placed on top of FNM/FRE loans which made them cheaper in designated areas. Subprime are loans made to non credit worthy borrowers with lax underwriting standards. The fact that both types of loans were made to similar demographics obfuscates the true intent and nature of the programs.

CRA = welfare. It was meant to subsidize those considered disadvantaged in the process of becoming home owners.

Subprime lending = high risk lending.

Subprime lending when done as a niche of the overall mortgage market was still punitive in structure for the borrowers. In the 1990s subprime loans were typically used as "credit repair" loans. They were granted to borrowers who met lower than agency but still somewhat reasonable underwriting guidelines which required the documentation of income. The loans were structured to reset in rate after 2 or 3 years at which time the timely payments made on the loan should have allowed borrowers to refinance into an agency or other prime loan. These loans were indeed very profitable because they carried high interest rates and low life expectancies with a significant amount of fee income. They were done by portfolio lenders who had a major stake in their performance.

This changed dramatically with the passage of the Financial Services Modernization Act of 1999 also know as Gram Leach Blyley which allowed the cross selling of financial products. GLB which replaced the depression era Glass-Steagle Act allowed commercial banks, insurance companies, mortgage banks and investment banks to sell the full range of financial services products. This allowed the investment bankers on Wall St. to look for opportunities in markets previously closed to them. Among those markets was the subprime mortgage market. As interest rates fell and house prices rose the default rates on subprime loans declined. This allowed for these risky loans to be packaged up and sliced up into traunches the majority of which could be rated investment grade. This created tremendous demand for the underlying loans as the packaging and re-selling of these loans was highly profitable. In order to meet this demand the traditional underwriting standards in the subprime business began to be relaxed. Higher loan to value ratios, higher debt to income ratios and worst of all the use of stated rather than documented income were the tools used to entice borrowers who would not have qualified.

This created a new set of buyers who placed tremendous demand on the housing market at a pace which could not be matched by the supply of homes further boosting house prices. Everyone seemed to be a winner as more people owned homes, the value of homes went up and everyone was making tremendous amounts of money. The elephant siting in the corner that no one wanted to acknowledge was the fact that the affordability of homes as well as the underwriting standards were reaching historic lows. No one in either political party or in the influential home building and financial services industries wanted the party to stop. It is always extremely difficult to be the wet blanket who turns off the music and ruins everyone's fun.

The need for action was fairly clear in 2003 and 2004 when house prices had reached an unsustainably low level of affordability as measured by median home price to median income ratios and underwriting standards had clearly been compromised and included products like 100% financing with seller paid closing costs and no verification of income assets or employment (no doc loans.) But everyone had too much invested in the housing market bonanza to do anything about it. By 2005-2006 there were not enough borrowers willing to take on huge mortgage payments to keep prices moving up. By 2007 the poor underwriting standards lead to massive foreclosures and the price action reversed. By 2008 the leverage which the financial system had been allowed to use in funding these loans nearly brought it to its knees as default rates quickly surpassed what had been predicted using rose colored models.

Today we are still in the middle of the process as there are still several waves of mortgage defaults coming from traditional factors like job loss to the payment resets on interest only and neg am loans scheduled to take place between 2010 and 2012.

Are Bank Stocks Buyable?

A large part of my bearish sentiment stems from the systemic deterioration of underwriting standards in the mortgage and commercial loan markets. Standards were relaxed on all programs including prime and AAA commercial credit. I believe that the true scope of the consequences of radically relaxing loan standards right before the economy heads into an average to severe recession will have. In my opinion default predictions for prime, prime jumbo, auto and credit card loans as well as small business loans, construction loans, and floating rate debt held by large corporations are still too low. From first hand experience I can tell you that a significant portion (greater than 20%) of mortgages underwritten and purchased by the GSEs would not have passed muster under any other period and is far from prime quality. While I agree that the more conservative banks stand to profit handsomely with the elimination of overly aggressive competitors and the availability of prime assets which would otherwise never be for sale at discounted prices. At the same time I feel that the credit contraction is only starting in earnest. The issue holding back a more expedient end to the necessary contraction is the low quality and illiquid nature of the assets which need to be liquidated off of bank and other financial companies' balance sheets. Because there are no willing buyers for the fixed income exotica created over the last four years it is incredibly difficult for institutions to fully clean out their balance sheets. Until we see some stable pricing and a slight increase in the number of large distressed debt deals in order to be able to ascertain the eventual trading prices of these massive piles of securities which will ultimately reveal the state of many banks real balance sheet health. Another key factor is the fact that there is no real way to at this point accurately predict where the unemployment rate and the housing drop will end. Until such data becomes a reasonable topic of discussion I feel that it is entirely premature to look for investment opportunities in the banking sector as the outcome of these macro events make such an investment perilously close to a roll of the dice.

Are Bank Stocks Buyable?

I am very bearish on bank stocks but do agree that these are good screening criteria. There are still four major factors which are likely to mean more trouble for banks.

The first is the negative equity in car leases. All truck and many car and luxury car leases written in the last three to four years have residual values significantly above the current market value of the vehicles, in many cases the difference exceeds $10,000 per vehicle (take a look at the prices of used luxury cars and mid size and full size trucks right now and compare them to what they were a year ago for vehicles of similar age and mileage, the difference is shocking) which is a tremendous hit to the institution which must take back and sell the vehicle.

The second issue is the upcoming recast of billions of dollars worth of Pay Option ARMs. These exotic mortgages allow borrowers to pay less than the interest due while growing the balance to a cap of 110%, 115% or in some cases an insane 125% of the original balance. When this cap is reached the payments more than double. Most of these loans were done with no documentation of income and are therefore as toxic as the subprime loans. This will add more foreclosure inventory to the already weak housing market and will severely punish those banks which hold these loans on their balance sheets. The biggest holder of these loans is WB with over $120B in their portfolio.

The third issue standing in the way in the way of a banking recovery is the performance of credit card debt. Because consumers used their home equity lines to pay down their credit card debt during the housing boom/bubble they have found themselves with one last avenue of available credit. Defaults in the credit card portfolios of COF and AXP have accelerated and in my opinion will continue to do so as cash strapped consumers use the credit cards to continue to fund purchases which they cannot afford. At this point these purchases are no longer limited to lifestyle desires such as eating out or new luxury goods but now include the increasingly expensive price tag of groceries and gasoline.

The fourth and final issue is the rising rate of unemployment. Increased unemployment means increased levels of default across all classes of consumer loans, and at some point begins to seep into commercial lending as a slowdown of consumer spending hurts small businesses. The continued rise in unemployment numbers and the acceleration of this trend does not bode well for the banking industry.

As I said before while I fully agree with the authors methodology I still believe that looking into bank stocks is premature at this point and will continue to be premature until a bottom is found in the housing market and a top has been reached in the accelerating unemployment statistics.