GLG News by James Butler, C.F.A, Ph.D.

Implications: Citigroup has continued to show losses in global operations, some relating to subprime issues. However, while many of the financial institutions are showing losses, Citi's losses are different, which is a good thing for the investor.

Analysis: "...I think what keeps some investors awake at night is not just so much the bad news that’s currently priced in to current valuations in some of these stocks, but what may come next... and that seems to be another shoe that has yet to drop."- John Brady MF Global

This other shoe could be the credit card portfolios of the major financial institutions. As such, Citi would be a major player in this arena: however, while many of the investing community is "throwing the baby out with the bathwater" by discounting all the players in the financial communities, Citi's problems (both past and the near future) is vastly different from the likes of National City, 5th 3rd, Comerica, Wachovia and/or Bank of America.

Citi still has some remaining MBS exposure, as well as Home Equity and Auto, but no where near the amounts of Merrill, Bear, or other players who went head-first into the Subprime pool. Their costs of operations is within their control, their underwriting on Commercial projects remained true to their credit model, and have been relatively conservative in their lending when others (e.g. BoA and Wachovia) have gone to the other extreme. Keeping this in mind, Citi may actually be 'on-the-cheap' as stock valuations go, with a tremendous upside as other players are shaken-out from their past woes.

Implications: Considering the current fall-out in Commercial Lending with the big banks (most of which were deservingly so), such as Wachovia, Chase, and Bank of America, the Credit Union field has such great opportunities to grow their market-share if they just decided to move into the 19th Century, instead of living in the past, with forgotten lending practices and even more archaic management.

Analysis: I have recently sojourned myself to meeting with several credit unions in hopes to persuade them into entering into the field of Commercial Lending. While the N.C.U.A. bylaws prevents credit unions from directly lending to businesses, credit unions can grab this market-share through what is called a CUSO, or Credit Union Service Organization. The opportunities that await the CUSO that has the intestinal-fortitude to actually provide competitive lending programs to Commercial client, will yield such great rewards, that they can become pioneers of the traditional stale Credit Union Industry. Here's why:

-    Recent fall-out in Commercial Lending by the big banks has created a void in the lending community-at-large. Many big banks, including B of A, Wachovia, Chase, Charter One, and Wells, have all tightened their underwriting guidelines for both new clients, and existing clients looking to renew expiring/maturing relationships. The 'banking-out' of average clients from a bank's portfolio is an excellent way of grabbing market-share without sacrificing credit-quality. Many of the businesses being pushed out of bank portfolios are quality companies, just looking for a lending-home.
-    A captured-audience: credit unions have to have what is called a Field-of-Membership, meaning that their organization applies specifically to a preferred group. Many of these groups allow spouses to participate in the credit union programs. Credit unions for such organizations like fire departments and police departments are ripe for small business lending opportunities. A common joke here in Chicago is: what do you ask a Chicago Fire Fighter? What does he really do for a living? Many people have either their own business, or work for someone who owns a business. Credit Unions have the inside-track to grab these people, well-over mass-marketing endeavors by banks.
-    Cheaper Costs-of-Funds: for years, banks have been lobbying to have credit unions pay the same in taxes as the banks do. Credit Unions have fought back, and ultimately, staved off any legistlation attempting to do, and therefore, operate like a non-for-profit, passing on to the members better rates of savings, and typically lower lending rates.

Imagine having a rolodex of clients who welcome you into their homes as a friend, instead of a cold-calling banker trying to win a deal. Imagine having better rates, terms, and the perception of better client services. Wouldn't you think you'd have a competitive advantage over your banking-counterparts? Common sense would dictate so -- unfortunately, the words "Common Sense" and "Credit Unions" rarely collide in the same sentence. The opportunity to strike while the iron is hot is beginning to pass the credit unions by, as banks regain their footing after their respective credit fallout, and resume aggressive market penetration and solicitation. Now is the time for CUSO's and business partners that are aligned with specific credit unions to move from the stale underwriting standards that few (if any) would qualify for or want to have, into a credit-saavy but moderately proactive credit platform, and grab the waiting market share.

Unfortunately, it would appear the impenetrable-resistance (or stubbornness) put up by credit union management, along with the lack of foresight and ambition, will ultimately lead those who have attempted to lend to the business community, back to the financial institutions that most recently shunned them.

Implications: The Economist recently described specific events that would lead one to believe that the U.S. Economy is already in the throws of a recession, yet the nay-sayers (including our illustrious President) state that there is still some signs of life negating this apparent event. I feel that like the 90's, and later on, we will be looking back and saying, yes, we were in a recession, and why didn't we recognize the numbers that support this truth.    

Analysis: Definition:
What is a recession? It is when you lose your job.
What is a depression? It is when I lose my job.

In the 1990's, some may or may not remember, the U.S. Economy briefly entered into a recession that lasted anywhere from 8 months to 14 months, depending on which think-tank and which economist you polled. However, as the Wall Street Journal reported last week, nearly 80% of the economist polled feel that we are, and have been for the past 4 months, in a recession. A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough - most recently, the boom in the Housing Market, which unlike what Mr. Bernanke stated last February, has a 'tentacled-affect' upon a vast amount of industries.

Some signs that I feel were readily visible to the public were as follows:

Inverted Yield Curve: a reliable predictor an approaching recession, which we had last summer and fall.

Lower long-term interest rates 

Higher short-term interest rates 

Banks paying more for deposits than they receive for loans (a recipe for economic disaster) - anyone remember Countrywide Bank?
 
And now with the specter of rising unemployment AND inflation, I feel the U.S. Economy perilously balances between stagflation, and recession -- maybe President Bush and the remaining optimistic-economists (oxymoron) will eventually take off the rose-colored glasses, and realize that we are in a recession, with some of the most difficult fiscal choices to be made in recent history.

Implications: The rate-freeze approved and being implemented by the government is not nearly the answer to the problems facing the Mortgage Industry, or the Financial District as a whole. The problem is systemic, and the solution is only one of a bitter pill to swallow.

Analysis: The problem is systemic: I have been saying this for over a year now. The band-aid to freeze the rates for "qualified" borrowers actually applies to only 15% of the Alt-A/Subprime mortgages that were originated from 1.95 to 12.07 (ARMs only): the rest will not qualify for a variety of reasons, either due to program limitations or delinquencies on their current mortgage in the last 12 months.

Besides portfolio performance issues, the investor community will not embrace rate-freeze due to the reduction in expected spread (WAC), and the proposed restructuring of the existing mortgages from ARM to fixed rates, which affects the Weighted Average Life. Institutions traditionally hedge the anticipated income derive from the MBS market with current fundings: a change in either side of the equation will greatly impact the quarterly performance for the financial institutions. Finally, the repackaging of the Mortgage-Backed Securities will require a leap-of-faith from the Investing Community to believe that an Assistant-Store Manager for a video store (true story) is making $85k per year. The halcyon days of loose underwriting for people who should not have been placed in the home they currently hold are gone, and the consequences could be dire if a restructuring package that mitigates the true credit risk (Borrowers) and the replacement risk (Restructured MBS issues) is not developed, and soon.

In conclusion, it is too little, too late to offer this salvo to resolve the issues at hand. The problem is too harsh to face completely: we have gone in too deep for too long. Only an unwinding of the mortgages for those who do not qualify for them, or a complete overhaul of the MBS issues, will bring a decisive answer to the difficult problems that are coming.

Implications: Mr. Ross' acquisition of American Home Mortgage's servicing unit is a bold attempt to continue his legacy of "turnarounds" in the business arena. Like Merrill Lynch's purchase of First Franklin, Ross' move may disprove the adage "when there's blood in the streets, buy real estate", and prove the "Greater Fool Theory" by overpaying for an unproven asset.

Analysis: The Brave "New World" of the Mortgage Industry, so described by Mr. Ross in the Bloomberg article, is evidence that there are those who still have faith that the sins of the past can be rectified, and the sinners forgiven.
However, unlike Aldous Huxley's anti-utopian view of the world, Mr. Ross is looking at this transaction through rose-colored-glasses. Forget the servicing costs of both collection and 'work-out', which will inevitably happen with Alt-A lending, the ugly truth will become apparent, but at the cost of the investors who follow him into this financial abyss: there are loans that just should not have been made. Whether it's the $85,000 a year video clerk, the $70,000 grocery store clerk, or the $100K bank teller (these are actual applicants who have received 100% financing through AHM), these applicants are in-over-their-heads: the rule-of-thumb for mortgage lending is that the profits of 20 loans will be eaten up by the loss of one (not even considering the overly aggressive appraisals that were closed in the Detroit, St. Louis, and Florida regions). With this in mind, Mr. Ross will be hard pressed to find the golden-nugget in the new pile of coal he has purchased. (see International Coal Group).

Implications: It is wonderful that President Bush's plan to help the disenfranchised keep their homes, and in some (albeit, few) cases, this program will work. But like the cut in the commercial lending rates, this is more symbolic than helpful, and the true problems will persist after the assistance package is complete.

Analysis: On August 30th, President Bush called for limited help from Congress to to assist in the 'soft-landing' of the eminent foreclosure crisis that is rearing its ugly-head. The relaxing of some FHA underwriting standards, along with the urging of lenders to forego future profits to save their deteriorating Balance Sheets will no doubt be of some assistance. Unfortunately, the truth of the matter, which no one on Capitol Hill seems to either want to address or is willing to address, is the fact that many of these loans were made to people who either could not document their income, or grossly overstated what they actually earned. As such, neither Fannie, Freddie, or the FHA can or will be able to help: the estimated market for these mortgages range anywhere from $250B to $750B in originations. This figure is staggering, and evidence of the systemic issue that we, as lenders and consumers, created. 

The proposed assistance package would only be useful for those who can document their income: with the restructuring of 2-/3-yr ARMS into fixed rate mortgages, the burden of proof for documentation is needed by the borrower, which will not be forthcoming. The secondary market, which readily feasted on issue-upon-issue of MBS securities market for the Alt-A products are no longer available: the restructuring of the existing securities IS ESSENTIAL to this plan. Without it, all that's left is the goodwill of the White House trying to put a band-aid on a major head-wound.

A workable solution would be the repackaging of the existing securities, with the implicit support of the US Treasury in the form of a surety-wrap bought by the guilty parties who are looking for some form of bailout (e.g. Countrywide, Washington Mutual, Wells-Fargo). While this plan would certain erode the institutions' profit margins by increased investment costs, the long run would definitely be beneficial by the reduced amount of foreclosures and delinquencies.

Implications: For years now, the Mortgage and Commercial Lending arena has been the subject of great debate as to whether sound credit decisions were being made. Now, finally, the proof of careless lending practices are coming to light: the question at hand is how will we deal with the fallout?

Analysis: Consumer loans, credit card/auto and mortgage alike, are now flush with a littany of problems, ranging from poor credit performance, to negative equity situations and high-LTV issues. Tiered credit risk cycles usually show deterioration in performance at the unsecured levels, then the secured levels (auto), to the ultimately secured-levels (home). Unfortunately, we are in a counter-intuitive cycle of credit performance due to the constant refinance of our revolving debt into our homes. As such, we have not truly experience a credit event to test the revolving-credit markets.

Typically, attrition for charge-offs in a credit card portfolio will take approximately 18- to 24-months: if this rule-of-thumb remains true, we will begin to see further deterioration in the credit card portfolios, and significant fallout with the aggregate FICO score-card systems for the average US consumer.

A credit cycles go, first Consumer, then Commercial: if so, there could be another credit-crunch for the Commercial markets in 2008.

Implications: Countrywide's heavy reliance on its underwriting programs and steady appetite for Pay-Option ARM's has created havoc for its portfolio management team. Countrywide's belief that it was smarter than the Mortgage Industry has led to this situation, and we have only begun to see the impact.

Analysis: During the heady-times of low mortgage interest rates and a highly competitive market, Countrywide was the leader in the Mortgage Industry for originations and closings: their secret? Quick underwriting and low interest rates captured by quite possibly the worst invention since voicemail, Pay-Option ARMs.

Traditionally, underwriting was tackled by grizzled mortgage professionals (usually in bad moods at best, surly on-average) who had both an extensive knowledge of underwriting guidelines, and a nose for sniffing out fraud or less-than-honest transactions. However, the powers-that-be at Countrywide moved this decision-making power away from its underwriters, who became more 'validators' than analysts, thereby putting sole reliance upon a credit model that scored the transaction as approved or not, and not whether the deal made sense. In doing so, they removed the logical, if not critical, mind of the underwriter, and replaced it with an obvious-less-than-favorable credit model. The theme of the time was: if it says approved, then approve it....regardless of whether or not you feel that a video store clerk can actually make $75k per year (actual story-I offered to quit that day as a consultant to work for this video chain if that is what their going rate of pay was).

The lack of authority given to strong underwriters (who I know personally), and inordinate amount of trust in autonomy by program given by the management at Countrywide, is just beginning to come to light. When we see the cracks on the surface in the form of delinquencies and chargeoffs, you have to figure that they start much deeper than that, and that can only spell more trouble for the nation's largest independent lender.

Implications: The fallout from the subprime mortgage market has been continually underplayed by the Federal Reserve Chairman. However, as the hangover from the mortgage origination party begins to settle in, the long-term impact is being felt across the financial sectors, and not just exclusively within the Mortgage Industry.

Analysis:  

As many economists have foreseen, the fallout from the deteriorating subprime market is having a greater impact that originally anticipated by the Federal Reserve Chairman. The most recent headline reflecting this potential disaster is closure of several hedge funds who were scrambling to cover their bets placed against (and for the ABX), and now trying to meet the margin calls by their respective investors through liquidation of their collateral. While the ABX is simply an index of the subprime mortgage market as a trading instrument, the historic lows it has reached is a subtle reminder that the worse might be yet to come for the mortgage lenders and investment professionals who have bought and sold these debt products.

An underlying theme of the many stories of lenders who are having difficulties managing the rising delinquencies and foreclosures is a credit issue that has never been experienced in the US economy: the combination of rising rates, declining or stagnant home values with little or no equity available – thereby giving a seller of the home an upside-down-look as to mortgage balance v. equity, and an amount of household credit debt that is near biblical proportions. Finally, add the more stringent bankruptcy laws, which would relieve much of the underperforming consumers of their debt, along with the required minimum payment for bank-issued credit cards doubling from their previous 1.5% of the principal balance to 3%, and you have what could be the makings of a “Perfect Storm”. Fortunately, many of the lenders are now offering a restructuring package of those who have ARM’s to convert their personal mortgage into a fixed-rate product, in order to forestall foreclosure. This reactive approach will help reduce some of the credit problems facing the average consumer: however, with little or no equity available in their homes to pay down the installment and revolving debt, the day of reckoning for repayment of this debt is only delayed, not abated.

Finally, many of the ARM products that were used to qualify lower- to marginal credit clients were the Pay-Option ARMs: for the prudent and/or disciplined consumer, this product affords some flexibility in repayment if their cash-flows are erratic or temporarily placed outside of their households (e.g. costs for taking care of an elderly family member, non-reimbursed moving expenses, etc…). However, in many instances, the product was used by brokers and banks alike to place people in homes that either should not have been given the mortgage, or at least not one of that size: many have had their “American Dream” become a living nightmare, and could eventually lose their homes. The immediate impact on the banks will be a stable of vacant properties, but the long-term affect could have a greater impact: many banks will not provide mortgage financing for people with prior foreclosures within the last 7 to 10 years. As such, the ‘One-and-Done’ group this circumstance applies to, will not be able to get another home loan unless the underwriting standards are relaxed enough to allow this credit transgression, which they might due to the fact that this will be a large enough portion of their target market base, to warrant such a credit risk.

Aside from the obvious impact to the lending institutions involved, the continued deterioration of the mortgage industry is indicative of a greater, more macro-level credit situation and could further lead to a ‘critical mass’ of credit performance and debt leverage scenario that might not be averted.