GLG News by Bill Bradway

Implications: The news that Treasury Secretary Paulson and Fed Chairman Bernanke are trying to reassure the broader markets that Fannie Mae (FNM) and Freddie Mac (FRE) will not be allowed to fail has not produced the expected calming effect on the markets. Shares of both firms have plunged into single digits. Who would have thought that FNM and FRE would become disastrous ticker symbols whose survival is now being debated? The full faith and credit of the US government is being tossed out as a lifeline, if necessary. Whom would such a lifeline rescue? What will happen to mortgage products, origination – packaging – servicing business models, and the overall housing market?

Analysis: The headlines are starting to sound like obituaries for Fannie Mae and Freddie Mac. What else can happen in this mortgage – credit shakeout.

1. It is safe to say that Federal regulators, the US Congress, and key market participants, particularly fixed income investors, believe that Fannie Mae and Freddie Mac are too big to fail. But, what constitutes failing? Chances are pretty good that it means eliminating FNM and FRE stockholder equity, but conserving the business and maintaining operations as much as possible.

2. Fixed income investors must believe that owning/holding both FNM and FRE debt and their mortgage backed securities (MBS) will be supported by the US government. If not, there will be a run on FNM and FRE debt and the MBS market will crater, dragging down institutions on a global basis. Mark to market for the MBS instruments will be brutal, pushing perhaps many institutions over the edge into failure.

3. The impact of removing Fannie Mae and Freddie Mac overnight as the biggest funding conduits in the mortgage market would crush mortgage loan origination volumes, causing significant damage to the US housing market. Therefore, expect regulators to do what is necessary to keep FNM and FRE operating as close to normal as possible.

4. The fact that FNM and FRE have a doubtful future should be causing every mortgage market player to go into a business disaster recovery planning mode - strategic alternatives that will work are needed.

5. Lending institutions that operate on thin net interest margins will suffer and fade, one way (sell out) or the other (fail). Profitable portfolio lenders with strong market shares face better odds than most.

Implications: Adverse news continues to sprout headlines describing the expansion of delinquencies into new corners of the US bank and thrift loan portfolios. The Mortgage Bankers Association reported that 1Q2008 mortgage delinquency and foreclosure rates continued to expand abovemuch 4Q2007 levels and are now much higher than 1Q2007. How many forced transactions (e.g., Countrywide - Bank of America) or outright failures are likely? Which institutions are inching closer to the edge of extinction?

Analysis: The popping of the nationwide housing bubble has certainly received a wide following from general and industry media alike. Clearly, excesses have been booked, and baked, by a growing number of lenders who are now reporting significant declines in year over year earnings. Upon closer inspection, there is growing evidence that not just one or two (e.g., subprime mortgages, home equity lines of credit) loan strategies produced the current value destruction. The MBA's 1Q2008 delinquency report disclosed that just four states (California, Florida, Arizona, Nevada) accounted for a high percentage of residential mortgage delinquencies and foreclosures. Specifically, these four states produced:

1. 62% of the foreclosures started on prime ARM loans, and 84% of the increase in prime ARM foreclosures;

2. 49% of the subprime ARM foreclosures started in 1Q2008,  and 93% of the increase in subprime ARM foreclosures;

3. 29% of the prime fixed rate foreclosures, and 60% of the increase in those foreclosures; and

4. 25% of the subprime fixed rate foreclosures, and 53% of the increase in those foreclosures.

Regulators have already tuned their review and examination criteria in anticipation of a significant increase in problem institutions. The number of banks and thrifts on the problem list has risen to 90 (1Q2008) from the 35 year low of 47 (3Q2006 - a good proxy for the bubble popping). This total is still way below the cyclical high of the early 1990s at 1,089 institutions (4Q1991). However, that total really reflected the accumulation of many brain dead institutions that had to wait for the S & L bailout legislation that authorized the Resolution Trust Corporation and over $125 billion in funding.

Institutions that were big pay-option ARM lenders appear at risk, especially if their portfolios are concentrated in these four states. Wachovia, Downey Savings, First Federal of California, IndyMac Bank, and BankUnited are in this group. Other lending strategies that were heavily focused on residential construction are also suffering. Corus, Franklin Bank, and Ocean Bank are in this group.

Weeds may spread to other portfolios if oil remains stuck above $100 a barrel for the remainder of 2008. The impact on the broader economy and especially consumer spending could spread to commercial real estate, commercial & industrial, small business and unsecured consumer loans. Liquidating bad loans and foreclosed property takes time to cure. It always has.

Implications: The housing bust has already made headlines from the subprime fallout, claiming dozens of mortgage banks, producing asset write offs approaching $300 billion on a global basis, and forcing many of the largest financial institutions to raise billions in new capital. Now smaller banks are going over the cliff at the expense of its shareholders and the FDIC. How many other banks are destined to fail? What are the drivers that will determine bank failures?

Analysis: ANB Bancshares was an aggressive $2 billion bank that bet its house on construction lending financed primarily by broker deposits. In 14 short  years, this bank expanded to $1.3 billion by raising big chunks of insured deposits from brokers and concentrated 75% of its loan book in construction loans. When the housing boom turned to bust in 2006, many of its builders began to file for bankruptcy. ANB was not addressing the subprime market, yet it failed. Some basic banking principles were ignored, once again proving that there is too much of a "good thing." In some ways, this bank's failure is reminiscent of many bank failures of 1980s and early 1990s.

1. Other banks are destined to fail, the only unanswered question is how many. As of 12/31/2007, there were 76 FDIC-insured commercial banks and savings institutions on the “Problem List,” with combined assets of $22.2 billion. As of 12/31/2006, the list had 50 institutions with combined assets of $8.3 billion. The last recession (2002) yielded a peak of 136 problem institutions with combined assets of $39 billion. The number of failed institutions also peaked in 2002 at 11.

2. A key indicator of difficulty, and ultimately failure, is the “coverage ratio” of reserves to noncurrent loans fell to 93 cents at the end of 2007. This is the first time since 1993 that the industry’s noncurrent loans have exceeded its reserves. At year end, 33% of institutions had noncurrent loans that exceeded reserves up from less than 25% at 12/31/2006.

3. Some of the drivers that will determine bank failures in this cycle are high concentrations of construction lending, especially at institutions that have relied on broker deposits to finance these loans. While construction loans have attractive fee income and higher yields, the ultimate repayment of these loans is tied to the cyclical housing market. Current demand for new houses continues to fall in just about every market. Further, jumbo and broker CDs command a market rate and are not "core" deposits, so there is no franchise value associated with these deposits. ANB Financial concentrated 75% of its loan portfolio in construction lending and about 80% of its deposit base was Jumbo and broker CDs at 12/31/2006. This bank was just waiting to blow up.

4. How many more institutions will fail. Expect the total for 2008 + 2009 to exceed the totals from 2000 - 2003 (25). There are 141 institutions with construction loan portfolio concentrations exceeding 50% as of 12/31/2007. Thirteen of these institutions exceed $1 billion in assets.

Implications: Washington Mutual (WaMu) cut a deal with TPG and other investors for a $7 billion capital injection by issuing common stock and preferred convertible stock. In addition, 1st quarter write offs of $3.5 billion contributed to an estimated first quarter loss of $1.1 billion. Clearly WaMu needs capital, but is this the best option for existing shareholders? What is the upside for shareholders and the new investors? How long will WaMu's troubles last? Is WaMu destined to be acquired? If so, by whom?

Analysis:

WaMu shareholders must be depressed. After suffering through an 80% decline in stock price in just 15 months, they have now lost the quarterly dividend and have been effectively diluted by 50%. This deal adds some 176 million common shares at $8.75/share and another 628 million shares through a $5.5 billion convertible preferred share offering at the same strike price. This deal is priced at below book value and 33% below the pre-deal trading price, demonstrating an extremely weak position for WaMu.

1. WaMu still has some toxicity in its earning assets, particularly subprime mortgages and home equity loans. The latter portfolio includes about $20 billion of home equity lines underwritten at a combined LTV in excess of 80% - before housing prices started to fall.

2. When will the "new" shareholders look to sell? If WaMu's pre-dilution all time high price was near $46, then expect a post-dilution target price range of $17 - 20.

3. WaMu's ability to remain independent is substantially eliminated. The institutional investors will want an exit at a decent to excellent appreciation. WaMu's footprint on the West Coast, particularly California, and in Texas and Florida will be appealing to the largest banks. The short list of buyers will include JP Morgan Chase, HSBC, and Royal Bank of Scotland.

4. WaMu's key FinTech suppliers (i.e., CSC Hogan, Fidelity's LPS, Total Systems) are faced with an uncertain future. Surviving a mega-acquisition is a long shot.

Implications: A number of large banks are looking at severely depressed stock prices and multiples that have dropped to book value or below. Is now the time for a buyer to step up and buy a struggling bank? If not, when does it make sense for a buyer to cut a deal? Will existing M & A deals still close? What will be the impact on other market players and suppliers?

Analysis: The banking industry recorded a decline, believed to be a first, in the number of commercial & retail bank and thrift entities with more than $10 billion in assets. This large institution class has been driving industry consolidation since the 1980s with successive waves of deals combined with organic growth at smaller regional banks.

1. Excess capacity still exists in the banking and thrift segments, so further consolidation will happen. Geographical markets that provided for most of the organic growth over the past five years are in a state of turmoil. Banks with exposure in these markets may find themselves as bottom fishing targets.

2. The list of big bank buyers is not deep. JP Morgan, Wells Fargo and US Bancorp are the best positioned domestic buyers. Several global players with US franchises are possible buyers if the target's franchise fits the long term expansion plans.

3. The class of target's expands with each quarter's results. Three primary problems link the fortunes of these institutions: mortgage credit related losses; sluggish home markets; and overbuilt market exposure. The list includes Washington Mutual, National City, First Horizon, and IndyMac Bank.

4. Buyers are likely to become more active when they sense the uncertainties and potential problems have reached a tipping point and begin diminishing. Odds favor the buyers waiting for each quarter's results.

5. Current deals in the pipeline, particularly B of A - Countrywide, are being watched closely. That deal has many moving parts and, if a new, smoking gun issue surfaces, could fall apart.

6. FinTech suppliers have to be careful. Yesterday's big outsourcing win could be tomorrow's early termination fee. Replacing recently hard won new sources of revenues is both frustrating and challenging.

Implications: The US housing and mortgage crisis has mushroomed into a new level of adversity. When will this bleeding subside and ultimately come to an end? Is the market near a bottom yet? Are there any upside opportunities? Will the bank, thrift and mortgage industry's pain turn into someone's gain?

Analysis: While political, regulatory, and mortgage industry initiatives all seek answers for this crisis, the only real result has been widespread daily media coverage of the problems, which keep expanding and impacting new players. More questions pop up every week and answers are either elusive or turn out to be illusions. Recognized losses will pass $200 billion in 2008. Mortgage delinquencies and foreclosures continue to go up while home sales continue to fall. The credit crunch is now well established beyond just subprime mortgages.

1. Expect at least three years (2007 - 2009), possible five years (2010, 2011), before the bleeding stops and loan volumes and earnings recover. The mark-to-market process is affecting not just mortgage securities and properties acquired through foreclosure. Examinations will raise questions about sub standard and doubtful real estate loans, which will produce lead to more loan loss reserves.

2. Some home lenders have restricted or eliminated mortgage lending in sharply declining housing markets (referred to as blacklisting), driving prices and values lower. In some cases, lenders have ruled out entire geographic regions or types of homes, such as Las Vegas or Miami condos.

3. Streamlining the deed in lieu of foreclosure processing, removing state law barriers to help lenders move on with the recycling of property would help. So would the FDIC's pending move to pay off mortgage bond holders at failed institutions, removing FUD from a viable liquidity alternative. Establishing a uniform, fair equity sharing (between homeowners and lenders) for restructured loans that forgive part of the loan balance would encourage lenders to accelerate recovery initiatives.

4. Big FDIC insured mortgage lenders are crippled and will struggle to stay independent. Raising new capital will be a survival differentiator. The list includes Washington Mutual, IndyMac Bank, Downey Savings, FirstFed Financial, and BankUnited. Large independents like GMAC's ResCap may not make it. Few, if any, Mortgage REITs will survive and prosper.

5. Watch out for similar credit loss firestorms in indirect auto finance and credit card portfolios. Another entire credit sector that is holding its breath is the commercial real estate market, particularly in the hardest hit residential markets (Nevada, Florida, Arizona, California). Consumers that have been pushed out of homes and/or cars have begun to spend less, leaving retail strip malls and smaller retailers at risk.

6. Firms that are best positioned to weather the storm and end up stronger and in a better position are all very well capitalized and have strong, diverse earnings. Examples include both big institutions (US Bancorp, Wells Fargo, GE Capital/Money) and regional banks (Bank of Hawaii, Commerce Bank of Missouri).

Implications: In November 2007, Wal-Mart de México (WMT) opened its first consumer bank, Banco Wal*Mart, in Toluca – an industrial town near Mexico City. The company plans to launch 80 more branches by the end of 2008. Will this initiative be successful? Will the established Mexican banking community suffer at the hands of Banco Wal*Mart? What will this initiative mean for Fidelity National Information Services (FIS), the bank’s new primary core banking and IT supplier?

Analysis:

Wal-Mart withdrew its application for a US banking charter in 1Q2007. While the retailer will have a different game plan for US banking and payments, the rest of the world is still fair game for its banking aspirations. From a demographic perspective, the emerging markets in Latin America are among the most promising for Wal-Mart's banking ambitions.

1. Wal-Mart starts out with a significant presence as Mexico's biggest retailer with 668 stores. Wal-Mart's goal is to attract the unbanked customers from the lower income market in Mexico. For example, less than 25 percent of Mexican households have savings accounts.

2. So far, so good, as Banco Wal*Mart management estimates that about 40% of the new banking clients who have signed up at dedicated desks in the store since the bank's November 2007 launch have never had a bank account of any kind.
 
3. Banco Wal*Mart is applying its retail knowhow to its bank, which is open for business seven days a week from 8 AM to 10 PM. Telephone banking is available 24x7, 365 days a year. The bank has also launched an information centric website to prepare for online banking services in the future.

4. Fidelity National Information Services (FIS) was selected by Banco Wal*Mart to provide core banking and card processing solutions. This deployment went live when the bank opened for business in November 2007. FIS has to be looking at several levels of upside from this relationship.

Implications: Citibank announced that it will cut back on its branch expansion strategy and may sell some recently opened branches due to high costs and/or poor results.  Any future expansion initiatives are likely to be limited to larger markets. What are the implications for Citibank's future in retail banking? How can Citibank overcome its limitations in retail banking?

Analysis: By mashing its retail bank and Smith Barney brokerage unit together in a pilot program, Citigroup hoped that the units would generate fresh revenues and profits for both Citibank and Smith Barney. Boston was considered the key market to validate this "new frontier" strategy. Mixing bankers and brokers was not a new strategy, but Citigroup had never committed, until 2007, to make the effort a strategic one. After one year, the results are starting to crystallize - there is no miracle in the making.

Now, its poor financial health and decimated earning capacity leave Citigroup with no choice but to dramatically scale back its hopes and plans for expanding Citibank's retail bank network.

1. This condition is the result of two conscious (and arguably poor) decisions by prior CEOs that have hamstrung Citibank with a marginal national retail branch network.

* Citibank did not believe that brick and mortar branching was critical to future growth in retail banking. Instead, an expectation that high tech channel alternatives, such as online banking, telephone banking, and ATMs would sustain expansion at a far lower cost.

* Citibank did not participate actively in the M & A game as did the other big US retail bank franchises (e.g., Bank of America, JP Morgan Chase, Wachovia, Wells Fargo, US Bancorp).

2. A handful of regional banks (e.g., Umpqua Bank, Hudson City Bank, Commerce Bank) have demonstrated an ability to launch new branches and rapidly expand the customer and deposit bases. These initiatives are costly, ranging between $2 - $5 million per location depending on real estate costs, branch size, customized interiors, etc. which are designed to achieve the bank's customer experience objectives. Rapid growth also requires competitive pricing for deposits and loans, which while profitable, usually cuts into normal net interest margins.

3. Citibank's US retail banking destiny will remain as a second tier player on a national level. Its 1000+ offices are concentrated in California (a distant #4) and the Metro NY-NJ-CT market (#4 in NY State). The only other state with over 100 branches is Texas and there Citibank ranks #12. It has limited presence in Illinois, Florida, Nevada, and the Metro DC market. With no market leading retail bank franchise, Citibank is hemmed in by competitors. A meaningful M & A deal is the only way out of this box, and is not likely to be feasible until its financial condition and profitability become competitive again.

4. Another option, albeit an unlikely one, would be to carve out and divest its retail bank branch network (at a profit) and pursue a private banking strategy by adding banking services to its Smith Barney franchise for mass affluent clients and sustaining Citibank's private banking operation.

Implications: Intuit Inc. (INTU) and Electronic Clearing House Inc., (ECHO), have signed another definitive agreement for Intuit to acquire ECHO. Under the terms of this agreement, Intuit will pay $17 per share in cash in exchange for each share of ECHO common stock, including shares tied to options. The total purchase price is approximately $131 million on a fully diluted basis. In December 2006 these firms agreed on a deal valued at $142 million, which was abandoned by both parties in March 2007. Why is Intuit still attracted to ECHO? Where is the upside in this deal?

Analysis: The primary reason for terminating the first deal appeared to be over the deal price, due in part to the revelation that ECHO had agreed to become a federal witness in January 2007 to avoid prosecution and assist in the pursuit of illegal Internet gambling in the US. When the first deal terminated in March 2007, it appeared that Intuit should thank someone for saving it from playing out a bad hand. The deal price was over the top based on the presumed synergies that Intuit was going to have to produce after acquiring ECHO.  The new deal price, down by only 8%, is still over the top, and more than two times the recent ECHO share price (which had just hit a 52 week low).

1. In reality, ECHO is a smaller player in a game that has been driven by much bigger players. How small? Consider that ECHO is 15 times smaller than the #10 merchant acquirer and over 350 times smaller than the #1 merchant acquirer. The core payment transaction services ECHO offers, which are growing modestly, are commodity-like and differentiation is difficult for the small player.

2. ECHO’s gross revenues of $77 million are less than 3% of Intuit’s revenues. ECHO card processing revenues represent about 81% of its total revenues and are expected to be the primary source of the synergies for Intuit. Check related services revenues (e.g., check verification, check guarantee, etc.) are declining as checking volumes continue to fall. Intuit is facing a tall challenge to crank up card processing volume through its QuickBooks small business customer base.

3. Merchant acquiring for firms like ECHO is a one customer-at-a-time challenge, typically with small transaction volumes. Remarketing this service through community banks or other channels faces the same challenge – small volumes at the customer level.

4. ECHO’s management team and its largest shareholder, Discover Equity Partners, have to be pleased with this deal price. Otherwise, waiting for ECHO to generate the revenue growth and improved profitability to produce a market cap over $120 million would take years at best.

Implications: Banking, mortgage, capital markets and other industry participants are comparing the current “subprime” mortgage market meltdown to the U.S. Savings and Loan crises whose roots were caused by archaic deposit and loan regulations and nurtured under the Reagan administration’s hands off regulatory watch in the early 1980s. This latter crises cost the U.S. taxpayer over $125 billion by the time the bailout was authorized in 1991. How long will the current crisis last? Will Countrywide and other high volume subprime lenders survive? Will political initiatives from the Bush administration or Congress make a difference?

Analysis: Scarcely a day goes by without another dose of bad news from a large financial institution. Almost all the big firms have admitted to higher loan loss provisions and/or writing down the value of mortgage backed securities. In spite of the staggering amounts, upwards of $10 billion/institution in some cases, it can get worse. Cause and effect linkages will be a drag on the mortgage and housing markets longer than many expect.

1. Financial instrument innovators expanded the secondary mortgage market product offerings with customized features available through securitized instruments. In search of higher yielding instruments for some investors, the origination market players created new mortgage products, loosened the underwriting standards, and turned up the volume. Some bank holding companies tried the old spread-carry trade game with off balance sheet SIVs. The result: we are in new territory as the market decline unfolds.

2. Mortgage loan volumes peaked between 2003 and 2005. Originations dropped in 2006 as a much larger share of the volume was due to expanding subprime mortgage volume. Origination volumes are still falling as new home sales, existing home resales and refinancing of existing mortgages are all still declining. The result: unprecedented volumes of poorly underwritten mortgages will lead to an extended series of losses.

3 .Past housing and mortgage credit declines/recessions have lasted several years. Political initiatives will not shorten this cycle or eliminate losses. Resolving problem mortgages embedded in the massive volume of securitized mortgage backed securities adds time, cost and uncertainty (who gets the money?) to the recovery process. The result: the universe of problem mortgages will likely exceed 2 million mortgages, either through foreclosure or seriously delinquent mortgages. Each case will have to be resolved one at a time, defying a quick, politically driven, fix. Some local/regional markets will take longer than three years to recover (meaning 2010 or later).

4. The mortgage servicing firms are facing a higher cost structure, lower collectible servicing fees, and lower levels for new mortgage related fees. The result: all three factors contribute to a serious drag on profits. Countrywide Financial (CFC), Washington Mutual (WM), and IndyMac Bank (IMB) are large originators/servicers that are trapped by the market turbulence. Subprime servicing firms and Mortgage REITs may not survive at all.

Implications: Fidelity National Information Services (FIS) announced it is spinning off its Lender Processing Services (LPS) business unit to its shareholders in a tax free exchange. The rationale is to focus on its “core banking and payments” business unit, Transaction Processing Services. In light of its recent large acquisition of eFunds, this divestiture announcement is  noteworthy, in part due to the size of LPS. Is this a wise decision by Fidelity?

Analysis: Fidelity believes its two business units (Transaction Processing Services [TPS], Lender Processing Services [LPS]) are "distinct and unique businesses that serve different customer, operate in different markets, and attract different investors."

A brief review of FIS corporate history illustrates that one needs a scorecard to keep up with the business assets at FIS. The predecessor to FIS, Alltel Information Services (AIS), acquired CPI, the largest (then and now) mortgage servicer, in 1992. CPI operated as a sister company to Systematics, which AIS had acquired in 1990. These units and some other acquisitions were mashed together in the late 1990s.

Fidelity National Financial acquired AIS in 2003, and subsequently staged a series of corporate restructurings, culminating with the merger - acquisition of Certegy to form what has become FIS.

Revenues and operating earnings for both TPS and LPS have continued to expand during 2007. In fact, LPS generates over 50% of FIS operating earnings. So why spin LPS out to shareholders?

1. I believe FIS has concluded that in spite of a previously announced strategic deal involving TPS and LPS at Wachovia Bank, there was not enough upside to keep LPS. Or, perhaps the rapidly changing fortunes in the mortgage industry led FIS to use this spin off to hedge against a weak outlook for LPS that would be a drag on FIS.

2. This decision could be a good one for FIS. However, execution excellence will be the key to its future success.

    a. TPS has demonstrated strong organic growth in 2007, which needs to continue, both in the US and internationally.

    b. Also, the integration of eFunds probably needs to beat the initial expectations for cost savings and revenue synergies to help cover for the lost earning capacity that LPS has contributed.

Implications: Countrywide reported its long awaited 3Q earnings report with an update on its mortgage origination, servicing and thrift deposit business. The loss for 3Q was $1.2 billion, in the middle of the analyst estimates. However, while not as bad as some expected, the magnitude of CFC losing 20% of its equity in one quarter is still staggering and may call into question its ability to survive as an independent company. In spite of the 3Q earnings announcement concerning the portfolio write down and significant increase in loan loss provisions, several questions are still to be answered. How does the magnitude of the 3Q loss fit the numerous problems that Countrywide is facing? Will Countrywide live to generate the level of profits in 2005 or 2006? What are the consequences for the rest of the mortgage banking and thrift industry players?

Analysis: CFC is clearly  a damaged company - gored and bleeding from the excesses of its mortgage lending over the past three years. Several lingering problems will likely cloud its recovery, leaving the prospects for a return to its recent profitability doubtful over the next 12 to 24 months. Just as ominous is the likelihood that other mortgage lenders that competed aggressively for subprime, Alt-A, and pay option mortgages will also struggle with reduced levels of profitability or losses.

1. The subprime mortgage meltdown is continuing and its effect will extend through 2008 and into 2009 as foreclosures and other loan modification programs continue to force write downs and/or higher loan loss provisions.

2. Pay option mortgages pose a potential threat to cause massive write downs. CFC noted that 80% of its pay option borrowers are paying the minimum payment after the teaser rate expires. This practice cause the loan balance to increase (negative amortization) at a compounded rate, based on the reset rate. Often the reset rate is much higher than the teaser rate (e.g., 1.75% vs. 7.75%). On a 400,000 mortgage, this would produce approximately $24,000 per year in interest expense that is being accrued as income by the lender even though it has not received any cash above the 1.75% initial rate. When home prices stop appreciating or fall, the loan to value ratio goes up, often beyond 100% on these loans.

3. Countrywide has reported that 89% of the loans it originated in 2006 would not be originated under its revised loan underwriting standards. By and large this means that the 2006 mortgages do not meet Fannie Mae or Freddie Mac standards. This can also mean the loan to value is over 80% or the borrower does not meet the loan underwriting standards to pay for the mortgage at the reset rate. Neither of these outcomes offers any expectation that a lender like Countrywide has turned the corner on profitability.

4. Other mortgage lenders that were big on pay option mortgages is probably facing the same situation. The key will be the concentration of the pay option mortgage portfolio and the underwriting of the borrower (at the teaser rate vs. reset rate). Lenders with a high concentration of pay option mortgages, particularly thrift institutions like Downey Savings or First Federal, must be holding their breath on the negative amortization issue. If enough of these loans go 90 days delinquent, significant reserves will gouge earnings, in effect removing past accrued, but unpaid interest income to adjust the effective property valuation back to a new, lower appraised value.

5. The best scenario for these lenders is a series of ongoing .25% rate cuts by the Federal Reserve that helps revive the housing market and restores confidence that home prices may be near, or at, the bottom of this correction phase. Of course, there is no guarantee that this will happen, so that leaves a state of uncertainty about how bad things might get for some of these lenders.

Implications: Commerce Bank's Board and Management decided to take TD's cash and stock deal, valued at $8.5 billion, barely 90 days after founder Vernon Hill was ousted as Chairman and CEO. The deal is estimated to be worth about $42/share, less than $1 above CBH's all time high. Was the price right for shareholders at  Commerce and TD Bank Financial Group? Can TD Banknorth profitably leverage the Commerce Bank branch deposit gathering network? Who will be the winners and losers from this deal?

Analysis: One group that should be cheering is Commerce shareholders - they should take the cash and TD stock and then keep on cheering for TD Banknorth to be a success (to help TD's stock appreciate). Reasons for this perspective should add a level of concern, if not tears, for TD shareholders as they may wonder if the price is too high in spite of the strong Canadian dollar.

1. Commerce's business model had no long term future as the bank could not sustain the branch and deposit growth without any real organic interest income earning capacity, or loans and fee income, that matched deposit growth. Investing deposits in investment securities is a thin margin game with interest rate risk that has affected its earnings.

2. With limited loan interest income earning capacity to match its deposit liabilities, Commerce was about to become a poor performer with its high operating costs. Ironically, TD Banknorth is not a strong performing bank. Can two below average earning banks combine to become a superior earning bank in the next two years?

3. TD expects to take out $310 million of annual operating costs by 2009. That represents about 20% of Commerce's operating costs. While TD Banknorth claims experience integrating acquisitions, none have ever approached the size and brand-demanding operating profile of Commerce. 10% would be a more reasonable target since there are no overlapping branches to close and TD will probably need to invest in loan generating capacity in Commerce's markets.

Who else benefits or suffers from this deal?

1. Key suppliers, particularly the major IT vendors for TD Banknorth and Commerce will be affected. In this deal, as with many others of late, Fidelity Information Services should be a big winner as FIS is the outsourcing host for TD Banknorth. Metavante should be the loser as Commerce has been a long time, and the biggest, customer of Metavante's Kirchman Bankway core processing application, running on an IBM zSeries mainframe. Conversion fees and additional processing fees from Commerce's accounts will provide a boost to gross operating margins for FIS.

2. Competitor banks in the Commerce footprint will benefit. Big (Bank of America, JP Morgan Chase), medium (Astoria Financial, Hudson City Bank, NY Community Bank, and NY Private Bank) and smaller bank competitors will get some relief until TD Banknorth closes the deal in the middle of 2008 and its future plans are implemented. In particular, Florida and Washington DC area competitors will be spared the Commerce blitz attack for depositors.

3. Commerce customers and employees will have to wait and see what happens. Odds favor a change away from the legacy Commerce model, which will erode the customer "fan" base. New branch expansion is far more likely to follow TD Banknorth's experience to reign in operating cost growth.

Implications: This announcement has been a long time in the making for both ACI and IBM. ACI's Base 24-eps fills a large solution hole in the IBM partner directory. Is this a big deal or not? Who are likely to be the winners and losers from this partnership? What is the impact of this announcement on banks?

Analysis: The ACI - IBM announcement is squarely aimed at the ACI installed base of Base 24-atm and Base 24-eft, many of which are running on old Tandem Non-Stop hardware and software (now part of HP). Base 24-eps, the newest version of ACI's retail payments solution family, is the benefactor of this partnership. Base 24-eps is a comprehensive solution suite designed to replace its older applications on a modern IT architecture.

While not a show stopping announcement, there is now a clear, long term commitment from IBM to convince bankers to make a switch to this IBM supported payments solution. Why would bankers make a switch at all? What are the benefits behind Base 24-eps? Which vendors are most likely to be hurt by this partnership?

1. The vast majority of ACI's bank customers are still running its older applications on highly reliable but increasingly obsolete hardware, primarily Tandem's Non Stop servers. These applications need fault tolerant, high availability as they support ATMs and massive EFT and POS networks. ACI has been the biggest vendor in this solution space. Bankers are finding it increasingly difficult and costly to maintain the proprietary Tandem environment. Ultimately, banks will need to reinvest by replacing Base 24-atm and Base 24-eft which operate independently of each other.

2. Base 24-eps combines these two older application solutions and several others into a single platform that runs on the newest IT infrastructure from HP, Sun and now IBM.  Banks that adopt  Base 24-eps should realize a lower cost, higher value set of capabilities over time. That is the key question: how long will it take to make it worthwhile. Bankers are looking for a 12 month (or better) payback. Some banks have begun this migration and the first wave of ROIs are expected during 2008.

3. This announcement only addressed Base 24-eps. ACI has other solutions that were not covered at this time, particularly ACI Enterprize Banker, its counterpart solution suite for the wholesale banking business. If ACI and IBM had announced that solution too, more upside would be on the table.

4. Of the major industry specific vendors (e.g., Fiserv, Fidelity, and Metavante), not one is seriously by this announcement. In fact, Metavante is probably the biggest Base 24-atm customer. Watch to see if Metavante adopts Base 24-eps on IBM.

5. IBM hopes to take business away from HP and keep Sun out of this business. Pricing is important along with services capabilities for the conversion requirements. IBM's virtualization capabilities may be a deciding factor for banks that are already heavily invested in the IBM zSeries platform.

Implications: Countrywide projects a 25% decline in mortgage origination volume as the reason behind this dramatic employee layoff. Is Countrywide's new origination forecast in the ballpark? How far will the mortgage market fall? Will other institutions be affected too?

Analysis: Countrywide announced it will layoff 12,000 employees, or 20% of its work force, in the next three months to rebalance its origination capacity in a rapidly shrinking market. This announcement includes two recent layoff announcements of 500 and 900 employees respectively.

What does this significant layoff by the largest mortgage originator mean for the rest of the market? Will total mortgage originations fall more than 25%? Who will be the winners and losers in this shakeout?

1. The significance of the size of this layoff at Countrywide coupled with layoffs at other firms (e.g., Lehman Bros., National City, IndyMac) suggests that the mortgage origination market is still searching for a bottom.

2. Previous origination volume corrections involved an economic recession coupled with much higher interest rates than the current level.

  * However, the recent peak origination volumes were fueled in part by historically low mortgage rates, very aggressive loan underwriting (e.g., 100% LTV,  no doc and stated income from the borrowers), and unseasoned teaser loan products (e.g., pay option ARM, 2/28 and 3/27 ARMs).

  * These three factors contributed significantly to the big bump in mortgage volumes since 2002 as speculative investors, subprime borrowers, flippers, and chronic refinancers added to the conventional home purchase financing.

3. Through 2008, origination volume will consist primarily of new home and purchase financing and a much smaller diet of refinancing. If the  2006 volume of $2.5 trillion is reduced by 25% to $1.87 trillion as Countrywide's announcement suggested, then more industry layoffs are coming. The annualized market origination bottom is probably around $1.5 trillion as both new home sales and purchases volumes and unit prices are still declining.

4. The winners are likely to be the portfolio lenders that rely primarily on conventional fixed rate and ARM products. Also, the mortgage banking affiliates of large bank holding companies (e.g., Wells Fargo, JP Morgan Chase, Citigroup, Bank of America) with strong direct loan origination platforms will gain market share.

5. Obviously, some of the losers have already gone out of business. Others are faced with negative outlooks for the next 12 to 24 months. Mortgage brokers, independent mortgage bankers, mortgage REITs, and a wide range of mortgage servicing providers (e.g., Accredited Home Lenders, Ocwen Financial) must quickly revise their business models and operating plans or else.

6. Other mortgage-related service providers such as title companies, outside appraisers, escrow companies, and credit bureaus will all face declining volume and revenue levels too.

Implications: Countrywide needed to restore investor confidence. Quickly lining up Bank of America as a substantial non-voting investor during the market turmoil came at a steep price. Did Bank of America emulate Warren Buffett on this deal?

Analysis:

Yes, B of A got a great price for its investment in CFC. Getting a strike price on the convertible shares at 70% of book value while you earn a 7.25% dividend on your money with the largest mortgage servicer in the US is one great deal for B of A. What are the longer term factors behind B of A's investment decision. What about the value of this deal for CFC shareholders?

1. B of A has said all along that it likes the mortgage product and the business potential that mortgages add to its overall consumer banking franchise. Believe it, because mortgage customers are more likely to have multiple financial services. And B of A has effectively marketed its no fee mortgage for both first mortgages and home equity lines of credit to expand its market share in 2007. Getting a 16% share of CFC is smart investing.

2. B of A has also consistently maintained that it has concerns about how many firms operated their mortgage businesses. Smart thinking, as the pile of failed companies grows every week. However, B of A knows that CFC will be the last independent mortgage company to need a real bailout to avoid failure. What CFC needed now was a confidence building investment to improve the odds that it will survive as a market leader, not a wounded, aging former market leader. The price and yield on this deal are reminiscent of Warren Buffett.

3. CFC now has $2 billion additional capital to weather the likely increase in non performing loans and loan loss reserves that will matriculate over the next six to 9 months. As long as the US economy avoids an outright recession, CFC should be able to successfully manage through the earnings decline that is brewing.

4. CFC shareholders might not be thrilled to see another 16% share of stock float, but that reality is far better than the possibility of a liquidity crunch that could have crippled CFC's day to day operations. The need for an $11.5 billion credit advance from 40 banks in the last week raised eyebrows. If CFC's stock recovers over the next few years, shareholders will be glad B of A was there and will not begrudge B of A for doubling its investment plus the interest carry on its $2 billion.

5. This deal completes a winning triple play for B of A on the investment and acquisition front: China Construction Bank, LaSalle Bank, and now CFC.

Implications: The latest data on mortgage and credit card delinquencies seems to run counter to conventional wisdom - that borrowers will keep paying the mortgage and default on unsecured debt, especially credit cards. Why would the  subprime meltdown and rapidly rising foreclosures have no effect on credit card delinquencies? Is there a new credit crunch paradigm evolving?

Analysis: The dramatic surge in subprime mortgage volume since 2004 has created a new set of conditions for lenders and the broader economy. Never before have so many borrowers purchased a home with so little real equity and under such aggressive interest rate reset and option payment conditions.

Maybe a lot of overextended consumers with subprime mortgages have modified their bill paying priorities to keep food on the table and gas in the car. Folks with modest incomes that are facing a large increase in their monthly mortgage payment may be keeping the rest of their bills current.

Once a mortgage goes delinquent and there is no real equity left in the property, the consumer faces a choice: do I struggle to stay in the home or do I prepare to eventually give up the home? The rapid escalation of subprime delinquencies and foreclosures suggest that many consumers have acknowledged the latter will happen. Why?

1. If bringing and/or keeping the mortgage current is hopeless, then the cash that would go to pay the mortgage (and property tax too) is available to keep credit card, auto, and other personal debt on schedule and avoid bankruptcy.

2. If income can't keep up with all the minimum payment amounts, many consumers still have the balance transfer option to shift outstanding amounts from one credit card or another loan to another credit card. As long as the account is current, the credit card companies are thrilled to book the balance transfer fee, usually 3% with no cap, and earn interest on the balance transfer from the date of the transfer.

3. When a consumer still has equity in the home, then most of them will struggle to hang on to the home and will use all resources to do so. The media's attention to the subprime issue has put the story on the evening news and front page - meaning political initiatives will focus on bending over backward to help as many consumers as possible.

4. In the long run, working through delinquencies, rather than foreclosing, are a better public and economic outcome for local lenders. The other mortgage lending entities, such as out of state institutions and mortgage securities investors, can count on their costs and losses going up as every mortgage has a story that will be resolved on a case by case basis.

What will it take to cure this condition? Time, because there is no quick fix. This problem developed over several years and it may linger just for just as long. Lenders with the strongest, most creative and collaborative collection teams will stand out.

Readers who understand the Dark Side of this story know a day of reckoning for all lenders hits when unemployment starts rising and a recession hits. Signs of distress are expanding: financial institutions, primarily banks and mortgage lending companies, are now laying off thousands of staff. Home builders and their construction workers have hit the wall. Sales at Home Depot, Lowe's and automakers are lagging. Gas and food prices are at or near historical highs. The economy can adapt to a credit crunch - but it is always a painful process.

Implications: The suggestion that Wal-Mart will boldly go where no bank has gone before raises several questions. How can Wal-Mart undercut competitor pricing in order to expand into banking? Is Wal-Mart willing to lose money from a banking strategy to gain market share? Does the unbanked and underbanked marketplace present a big market opportunity for Wal-Mart?

Analysis: The premise that Wal-Mart will boldly go where no bank has gone before is simplistic. Wal-Mart is not the first retailer to try out the banking business. Sears in the US, Tesco and Sainsbury in the UK,  and Loblaws in Canada are just some of the examples of retailers going into banking.

In the early 1980s, Sears, which at the time was the largest retailer in the US, decided to diversify into financial services. Sears already owned Allstate Insurance. Then it bought Allstate Savings & Loan, based in California; Dean Witter, primarily a retail brokerage; and Coldwell Banker, a real estate brokerage. Ultimately, these businesses never generated enough synergy to make the cross selling strategy a success. The banking unit never achieved a strong market share. Sears finally gave up and either sold or spun off the units as its retail franchise succumbed to Wal-Mart, Target and other more successful brands.

The UK and Canadian retailer strategies involve partnerships with banks. In the US, this is likely to be Wal-Mart's only option for quite some time. It already has partnerships with GE Money, Moneygram, and Sharebuilder. And, it rents out store space to banks like Woodforest National Bank.

With no banking franchise foundation, pursuing a price cutting strategy is a loser as enough low cost operators exist in each banking product category to make it a long shot proposition for Wal-Mart, regardless of who Wal-Mart hires. The meltdown in subprime mortgages over the past 12 months shows that Wal-Mart's unbanked and underbanked target market has high risk and uncertainty, neither of which are attractive to Wal-Mart. Watch for Wal-Mart to hedge its US bet by expanding its in-store MoneyCenters that deliver services provided by its partners.

Where Wal-Mart would most like to gain some economic benefits is to reduce its payment transaction costs, specifically the interchange fee it pays for all card related transactions. Watch for more from Wal-Mart on this front - as it does not need a banking charter to cut its transaction costs. The GE MoneyCard is a first step.

If Wal-Mart decides to operate a bank, then the best market opportunities will be in Latin America. Wal-Mart would like a high percentage of consumers who are underbanked or unbanked. The US does not qualify on this measure as only 8% to 10% of adult households fit this criteria. While 10 - 12 million or so households is a big number, it pales in comparison to the market opportunity in Brazil and Mexico. One long term opportunity for Wal-Mart would be to use a Mexican or Brazilian bank to capture the banking business of family members working in the US.

Implications: Mortgage REITs, a dividend paying equity vehicle that expanded with the mortgage industry in the past 10 years, have been facing a severe liquidity crises. The fallout that began with the subprime crises is spilling over to other types of mortgages, particularly the Alt-A mortgage. A virus-like illness has been spreading across sectors of the mortgage industry and has crippled several residential mortgage REITs. Can this mean the mortgage REIT is no longer viable? This past week a large public REIT, American Home Mortgage filed for bankruptcy and others may not be far from bankruptcy.

Analysis: The business and economic assumptions behind the mortgage REIT work well in a calm, expanding mortgage market. As the market turned volatile with the implosion of the subprime segment, the impact on mortgage REITs has been devastating. Will the final answer be the end of mortgage REITs?

1. Mortgage REITs grew up mastering the use of leverage and other people's money that facilitated the flow of untaxed dividends to shareholders. Most of these REITs try to make money at origination, packaging/bundling mortgages into security instruments, and through long term portfolio lending to produce net interest income.

2. The housing market bubble helped these REITs by creating demand for a variety of non-conforming mortgage products, which produced an opportunity for higher yields. Higher yields were appealing to many investors across the bond rating spectrum, so a something-for-everyone securitization business model led to a rapid expansion in mortgage originations to around $3 trillion/year or more during this decade. Since 2004, subprime and Alt-A loans have accounted for an increasing share of the volume, or an estimated 33% of all residential mortgages in 2006.

3. First the bloom on subprime loans wilted and now Alt-A loans have faded as acceptable collateralized assets for mortgage backed bonds are related securities. This rapid loss of acceptability has produced liquidity crunches at several mortgage REITs in all corners of the business model: originations, warehouse lending, packaging/securitizing, and long term portfolio management.

4. The grim reaper is taking full swings at mortgage REITs. The pinch on capital is severe and as mortgage REITs are discovering, there is not enough capital to cover operating losses, a rise in non-performing assets, and margin calls on open lines of credit. As REIT assets are marked down to lower prices, the capital dries up quickly.

Even in their heyday, mortgage REITs were not that profitable compared to many thrifts and banks. As the subprime and Alt-A loan markets shrink, conventional lenders, including big bank mortgage banking subsidiaries, have more market power and more reliable funding sources that include insured deposits, wholesale borrowing from Federal Home Loan Banks, and secondary market buyers like Fannie Mae and Freddie Mac. While the cream of the mortgage REITs may well survive, many, if not most mortgage REITs will be food for the bottom feeders.

Implications: Fiserv is buying CheckFree in an all-cash deal. At$4.4 billion, the $48/share price is about 30% over CKFR's recent stock price. However, a year ago CKFR had just hit an all-time high of $56/share. Fiserv describes this deal as transformative - what does that mean? And, did CKFR get a good price?

Analysis: Fiserv quelled the doubters that it could, or would, do a big deal. CKFR shareholders get all cash by the end of the year. Matching up Fiserv business units with CKFR's three divisions and generating future organic growth, particularly with large financial institutions, will be the key to this deal's success. Is it possible that this deal is good for both companies?

1. Fiserv is paying a premium for CKFR, about 50% of its current market cap in cash, for revenues that represent about 20% of Fiserv's revenues. Or, from an earnings perspective, CKFR's net profit is about 30% of Fiserv's profit. Either way, Fiserv has paid up for CKFR, so CKFR's shareholders should feel good about getting all cash at $48/share by year end. Fiserv shareholders will have to wait into the future to answer the "good deal" question.

2. For this deal to transform Fiserv, there needs to be big wins in the large bank market segment (assets ? $10 billion). No bank is bigger than Bank of America in the US. Fiserv must maintain a future relationship with B of A that delivers about 20% of CKFR's revenues.  Sustaining this revenue level would be a big win. Losing a large share of this revenue stream by 2010 would seriously hinder organic growth from the CKFR customer base.

3. Two recent CKFR acquisitions, Corillian and Carreker, have positive implications for Fiserv's penetration into the large bank market with potentially valuable capabilities: online banking and item processing consulting services and imaging. This latter capability has just been integrated with CKFR's ACH software solution - which serves the large bank market. Fiserv will need to integrate these two solutions quickly and generate incremental business.

4. Fiserv expects to remove $100 million in cost savings out of CKFR's $735 million annual expenses. This is a reasonable target, but producing these savings without disturbing the CKFR customer base is critical. Sustaining strong customer facing service levels and sustaining product development initiatives will be important indicators of success.

5. Fiserv has never done a deal of this magnitude. True, but in the mid 1990s, Fiserv acquired ITI, the largest core banking vendor. That deal has been an unquestioned success and, at the time, transformed Fiserv into the market leader for core banking solutions that serve mid-size and small banks. Other deals in Fiserv's past, for example Citi Information Resources and Mellon's Bank Outsourcing unit in 1991, were also transformative at the time.

After Fidelity Information Services bought eFunds, Fiserv was questioned about doing a big deal. While Fiserv surely looked at eFunds, waiting for CKFR no doubt made a competing bid from Fidelity far less likely. Integrating CKFR comes with long term challenges, none bigger than the contract renewal with Bank of America in 2010.