U.S. Banks Still Need To Come Clean on Subprime

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Includes: BAC, C, JPM, WFC, WMIH, XLF
by: Philip Davis

Is today the day?

I’ve been saying for quite some time that the banks need to step into the confessional box and tell us just how much of the $2 Trillion drop in the value of US housing (so far) they are on the hook for. So far we’ve had a Billion here, a Billion there but the big boys have so far had their heads firmly in the sand and that means it’s time for a kick in the ass.

Since ostriches are herd animals, we can expect one admission to follow the others as banks would always prefer to say "Yeah, I lost money too" AFTER someone else admits it. As usual, we have to look to Europe for leadership and we were on top of this story over the weekend (thank you Richard) as ING announced on Saturday that they would take over accounts at NetBank, WHICH WAS SHUT DOWN BY THE US GOVERNMENT FOLLOWING LOSSES ON "SUBPRIME MORTGAGES AND OTHER LOANS." Gee, wouldn’t you think this should be a more prominent story in the US? Once again the sharpies at the WSJ seemed to miss this one.

Aside from $2.5Bn worth of people being dumb enough to give their real cash to a virtual bank, it turns out that $109M in 1,500 accounts was in excess of the $100,000 FDIC insurance cap and those people will now stand in line with other creditors now that NetBank has filed for bankruptcy. For $15M, ING will take on $1.5Bn of NetBank’s insured deposits and will buy out $724M in assets. While the deposits are a no-brainer, would you trust the assets? ING has to: Arkadi Kuhlmann, ING Direct chief executive, said his bank stepped in partly to ensure continued consumer confidence in lenders - such as his and NetBank - that conduct all their business on the web and do not operate branches. "This is all about confidence in the market," he said. "Since we are the largest direct bank we were very pleased to assist and help out and hopefully take on these customers who will continue to do business on the internet."

Damn, I love Europeans! They actually give you their real motives when they do something!

The next domino to fall in Europe this weekend was UBS, who are writing down $3.4Bn in assets, attributable to hedge fund losses and, of course sub-prime issues. There has already been a management shake-out and it makes sense for the new guys to put a price tag on the mistakes made by the old guys so they can show you how clever they are when the bank recovers. We’ve already heard the bad news from MS (-$1.9Bn), BSC (-$700M) and LEH (-$700M) and today’s US domino is the venerable Citibank, who are pre-announcing (earnings 10/15) a net income dip of 60% from last year due to "dislocations in the mortgage-backed securities and credit markets, and deterioration in the consumer-credit environment."

Included in the third-quarter results will be an estimated $1.4 billion in pretax write-downs on leveraged buyouts it is helping to finance, about $1.3 billion in pretax losses on subprime mortgage-backed securities and some $600 million in pretax losses on fixed-income trading. In addition, consumer-credit costs will be some $2.6 billion higher on a pretax basis largely due to increased loan-loss reserves.

At the same time, MER, the sole investment bank to report on a calendar basis, said credit-market conditions "have continued to remain challenging in the third quarter," requiring the firm to make "requisite fair valuation adjustments." A Goldman Sachs analyst forecasted that Merrill could have an up to $4 billion write-down for the quarter, more than the combined write-downs of the investment banks which already released their third-quarter results.

These are those annoying fundamentals I keep harping on about! While the big boys should survive this little debacle, let’s keep in mind that they are not the ones we are worried about. GS, MER, MS, UBS et al have many sources of revenue and writing down a few billion in bad loans here or there will give them a bad quarter, two at the most. But what about the hundreds of regional banks, the thousands of local banks and mortgage companies, who may be sitting on hundreds of billions of bad loans. The fact that they sold them won’t help as there are clawback provisions for bad debts and that will take ages to work through the system.

We’ll keep an eye on bank earnings, especially bellwether WM (10/18), who recently announced 1,000 job cuts and has plans to cut 8% of it’s 50,000 person work force by mid-November (otherwise they qualify for Christmas bonuses) and are sitting on a $215Bn mortgage portfolio, 9.5% of which is classified as subprime. 25% of the entire portfolio is in the ARM category, with the bulk of the resets coming in the next 12 months. ARMs are potentially more dangerous than sub-prime as sub-prime means the loan was made to "riskier" borrowers while arms are loans that were made to maximize the leverage a person could place on a new home at the top of the market - no bank to date has been forced to address this issue but foreclosers are up triple digits nationwide in a trend that has been accelerating for the past 36 months.

Nationwide there are still $1,300,000,000,000 in sub-prime loans outstanding with $235Bn of that debt in ARMs THAT CAN RESET AS HIGH AS 12%, which could lead to millions of loan foreclosures. Is it time to pay attention to the man behind the curtain or are we ready to continue to live in the Federal utopia that is the government’s interpretation of the US economy?

This is still a good thing (in this totally topsy-turvy market we’re in) as we needed to hear this and, as I said above, what doesn’t kill us will make us stronger. If we can maintain our levels off of this move, there might really be something to this rally but lets keep an eye on the XLF, which Happy and I feel is at a critical juncture.

The XLF is 8.5C so we can expect a spot of trouble right out of the gate as Citibank flew down to $45 pre-market. We have the March $47.50s at $2.50 in our Dow portfolio and we will certainly double down or roll (probably roll) down to the $45s this morning as this is a fantastic entry opportunity that will really improve our position. Other major components of the XLF are BAC (8.4%), AIG (6.5%), JPM (5.8%), WFC (another concern - 4.5%), WB (3.6%) and GS (3.3%). This is, by the way, why the XLF is not a good independent indicator of Dow direction as (including AXP at 2.6%) 24% of the index is Dow components. The XLF comprises 19.89% of the S&P 500 and is an excellent leading indicator for the SPY plays.

Asia didn’t know about any of this and the Nikkei was up 60 points today in light trading as Hong Kong and Shanghai enjoyed a holiday. Trading restarts at the Hang Seng tomorrow but the Shanghai will be closed all week, creating a very interesting money-flow dynamic we’ll have to keep an eye on… Despite the holiday, China launced the China Investment Corp, their $200Bn fund which is chartered to start throwing around some of the $1.4T they have sitting around before it loses all of its value - this is something we have been watching, and will continue to watch with great interest.

Japanese consumer spending was up 1.6% from last year and industrial output improved 3.4% over July while a survey of Japanese manufacturers found them "upbeat." Europe is flat despite the bad news from IKB and UBS. NOK is buying NVT for $8.1Bn (but that’s only in US dollars so no big deal for them!) and GRMN does not like it one bit in pre-market, down about 10% already…

At home we’re going to keep our eyes on the SOX at 500, the XLF at $34.50, the Dow at 13,900, the Nasdaq at 2,700 and the S&P at 1,530. If we can hold these levels on at least 3 of the 5 indexes, it may be time to lift up some of our covers (perhaps a 25% reduce) as this (bank confessions) was one of the major body blows we were expecting and if the markets can shrug this off, I know more than a few bears who will be throwing in the towel and say "I have no idea what’s going on."

Hoping to sneak in some bad news on a big bad news day, EBAY is taking a $900M (not $1Bn!) impairment charge in addition to the $530M they are paying to finalize the $2.6Bn Skype deal. If we’re lucky, this may give us a good entry point on EBAY so we’ll keep an eye on them!

It may be time to stop, drop and roll on our IMCL play in the Happy 100 Portfolio, let’s see how they handle $40.50 as I’d rather DD on the $40s if we can get them for $4.30, then we can consider selling perhaps 1/2 the current $40s to recoup some losses and provide a little downside protection.

Interesting day today - let’s have some fun!