It is the nature of things, sad but true, that these periodic disruptions will occur. We have to be honest enough to recognize that as hard as we work at this, sometime in the future another surprise will occur... Mistakes were made, there is no question about that."
~ E. Gerald Corrigan, Goldman Sachs Group
First some thoughts on the unfolding subprime mess and Washington's latest "solution."
Consider the spectacle of Treasury Secretary Hank Paulson negotiating an agreement with the banking industry to keep millions of subprime adjustable rate home loans at the introductory rate. The banks will do this voluntarily, you understand. Just ask the Chinese government officials (aka "clients") who periodically meet with Paulson at the University Club in DC what it's like to negotiate with the former CEO of Goldman Sachs (NYSE:GS).
If the banks agree to Paulson's gambit, bank shareholders and loan investors will take a bath, credit available for housing will disappear, and a least one in three subprime borrowers will eventually default anyway. The editorial yesterday in the New York Times supporting the Paulson proposal is dead wrong: Loan modification does not help struggling subprime borrowers, only the politicians of both parties who prey upon them. Loan modification a la Paulson hurts investors, financial institutions and the US economy.
As one reader of The IRA at a major bulge bracket firm commented earlier this week:
The Paulson proposal will paralyze the US housing market for years. Who in their right mind will lend money for home ownership ever again if the contract can become null and void the second the hoi polloi start screaming to their elected officials? Fannie? Freddie? Hell, they're bankrupt as it is and will only lend up to $417k which does nothing for either coast of the United States. Everyone in a protected [GSE guaranteed] mortgage won't ever leave cause they'll never get a better deal. Home prices will not reset to more sane levels. The Paulson proposal is a clusterfuck for generations X, Y and Z. Thank you very much. If this continues, the US is going to be just like Japan in the '90s.If Secretary Paulson really wants to help subprime borrowers, then he should tell them to hand their lenders the house keys and go back to renting. We don't know a single loan officer or risk manager among the readers of The Institutional Risk Analyst who believes that the subprime bubble, specifically the increase in the rate of US home ownership from the mid-60 percent range that prevailed since WWII to the low 70s today, is anything but a complete write off.
Repeat after us: housing is not an investment, it is a necessity. You can make big money speculating on home price appreciation, just don't pretend that it is an investment.
The operative motivation behind Paulson's seeming generosity toward subprime borrowers is political expedience. He first learned this talent from the masters of political dirty tricks in the Nixon White House, this during a stopover in Washington in the early 1970s on his way to becoming Master of the Universe.
Who better than Paulson, the Harvard educated protege of Watergate felons H.R. Halderman and John Erlichman, to strong arm the banking industry into forbearance on subprime loans, mortgages which the Washington politicians seduced the industry into making in the first place! Remember that the whole notion of "affordable housing" is a political concept, a creation of the Congress, albeit one eagerly embraced by Wall Street, the GSEs and the real estate industry.
Like the moribund MLEC proposal, Paulson's latest good idea supposedly is intended to stave off banks' losses on mortgages and other assets that have been securitized. Unfortunately, nothing that Paulson or anyone else in Washington proposes will delay the day of reckoning for holders of structured assets based on subprime debt -- or the institutions which underwrote same.
We note, for example, that William Mills, chief executive officer of Citigroup's (NYSE:C) markets and banking division in Europe, testified this week before a UK inquiry that his bank already suffered losses that "greatly exceeded the profits" from structured finance in the past several years. Interesting that Mills makes that judgment even before the real fun starts in terms of valuation losses from moving the SIVs back on balance sheet and the resulting securities fraud litigation.
Indeed, is it a coincidence that in the Q3 Economic Capital benchmarks just released by IRA all ten of the largest US banks by assets show increased risk-adjusted capital needs? The answer to that question brings us to the main subject of this week's missive, namely the decision by Wells Fargo (NYSE:WFC) to write off 3% of total loans in Q4.
WFC ended the third quarter of this year with an ROA of 1.58% and ROE of over 15%, both figures are annualized and both a full standard deviation above peer. Run rate defaults were 80bp (annualized) through September 30, 2007, but WFC announced last week that it will write off 300bp or 3% of total loans which the bank considers problematic. That will take gross loan and lease defaults for the full year up to about 400bp or 4%, more than 2x the maximum probable loss from lending estimated by the IRA Bank Monitor or just inside the upper range for a "B" bond equivalent rating for the bank's portfolio.
The decision by WFC to immediately write down loans equal to 3x the expected defaults for all of 2007 may seem like bad news, but we view it as a sign of strength. Unlike the the big players in structured finance such as C, JPMorgan Chase (NYSE:JPM) and Merrill Lynch (NYSE:MER), WFC does not have much of a trading or capital markets operation.
The majority of WFC's Economic Capital needs stems from the investment book, followed by trading and then lending activities. The 0.8:1 ratio of Economic Capital to Tier One Risk Based Capital for the bank at the end of Q3 compared with just 0.5:1 for Q2, a more than 50% change in a single quarter. The increase comes from a big jump in WFC's securities portfolio.Unlike many of its larger peers, WFC seems to have the capital and the earnings power to navigate its way through the coming credit risk storm. Will JPM, C, Bank of America (NYSE:BAC) and Wachovia (NYSE:WB) follow WFC's lead and take an aggressive posture in terms of loan write downs in Q4 or leave the pain for 2008? In the case of both WB and BAC, the answer probably is yes.
But C and JPM do not have the capital or the earnings strength to clean house all at once. We commented on C's situation last week ( 'Citigroup: How do You Value Systemic Risk?', November 26, 2007). JPM's ROA and ROE are below peer and, even with 9.5% Tier One RBC, JPM's ability to offset losses from its trading and banking books is even more doubtful, in our view, than the situation facing C. With a ratio of Economic Capital to Tier One RBC of almost 5:1 in Q3, to us JPM remains the member of top ten US banks most vulnerable to a "surprise."