Integrity Bank in Alpharetta, Georgia Goes Down. Any more to come?

FDIC website. A $1.1 billion asset bank. I'd guess a $200 million to $250 million loss to the FDIC insurance fund. Good to see some geographic diversity to the failures. Not just California and Florida. Last week Kansas, this week Georgia. Diversity rules.

Correction:
Somehow I missed in my first scan of the press release that the FDIC expects losses to range from $250 million to $350 million which is 23%-32% of assets. This indicates that loss ratios are getting worse, not better. Particularly when considered in the context of the IndyMac trend referred to in my prior post.

FDIC Announces IndyMac Losses Approaching $9 billion; Predicts Depositor Insurance Will Need to be Socialized

Seriously? $9 billion of losses on IndyMac? When they took IndyMac down, they announced losses would be between $4 and $8 billion. After a few weeks, they announced it would be over $5 billion. Now, just two months later, we are at $9 billion?

How on Earth does anyone trust the balance sheet of any bank???!!!???!!! This is coming from the FDIC. Sheila Bair has been nothing if not straightforward. They don't have the same incentive to lie and deceive that bank management teams have. So, even in their effort to be realistic, they've mis-estimated the magnitude of the problem at one medium sized bank by a mile.

Makes me wonder if perhaps one lesson they have learned is to euthanize broken banks sooner...

It is not as if we are talking about Bank of America where a couple billion is just basis points on its balance sheet. We are talking about a $32 billion asset institution and in two months, the value of its assets has ranged by $4+ billion. If you are levered 12:1 (as a well capitalized bank) and your assets are fluctuating in value by over 10% in two months, your business is broken.

IndyMac is not alone. It does not own uniquely bad assets. While it may be far out on the bad spectrum, it is certainly not alone in its positioning.

What's even scarier is the thought of how much capital it would require to get IndyMac back to "well capitalized". We start with the $9 billion of insured losses (assuming the FDIC doesn't bump this further yet!), add $1 billion of uninsured losses. No we are at a zero equity position. In order to be well capitalized and have some margin for continued deterioration, it probably would require another $2.5 - $3.0. So, just to get the bank back to minimum operating standards, IndyMac would have needed a $12.5 billion injection. Well, that doesn't work from a return standpoint, so nobody in their right mind would be willing to plug that sort of hole (particularly given its lack of any meaningful franchise value).

Now, imagine our good friend Snashington Futual (or SnaFu). SnaFu is 10x the size of IndyMac but claims to have "recapitalized" by raising $7.5 billion. Ha! I laugh at that $7.5 billion. Per the FDIC's own work, that $7.5 billion is nothing in the context of this situation. It is a rounding error.

Also ignored by the mainstream press is that the FDIC is basically stating they expect to blow through their entire deposit insurance fund and may need to rely on the good graces of the American Taxpayer (not that there are many of us left, it seems...and wait until Obama becomes President) via the Treasury to insure further losses. Well, the deposit insurance fund is still about $45 billion strong. Given that losses are averaging more than 20% of assets, the implication of more than $45 billion in losses still to come means that the FDIC is expecting depository institutions with at least $225 billion in aggregate assets to fail in the coming year!!!

How is this not news?! That is failure on a massive, massive scale!

Strap your boots on, the carnival is just getting underway.

Fannie and Freddie Preferreds Could Cause Bank Failures

Honestly, this is all so awesome in some horrible way.

I understand that dealing in schadenfreude is a dangerous game, but really, was this so hard to see coming?

This excellent Washington Post article from today's paper talks about the fact that the preponderance of the $36 billion of Fannie and Freddie preferreds issued in the past year are in either foreign hands or are owned by US banks!

Yes, you read that right. US banks, in the midst of the worst housing crisis since the 1930s, bought billions of preferreds from FNM and FRE despite knowing that both GSEs were suffering enough problems that they needed to recapitalize! Further, the problems Fannie and Freddie are suffering from that caused the need to issue preferreds are housing related...do banks really need to take more US housing market risk? Why add super-levered and super-correlated housing risk to your already troubled balance sheet?

Despite the fact that these preferreds were A rated pieces of paper, the real calculus is this: Fannie and Freddie are massively levered (depending on how you calculate leverage, somewhere between 40:1 and 100:1). That leverage is basically collateralized by mortgages with initial LTVs of somewhere between 20% and 10% as well as a good chunk of third party issued ABS that the GSEs bought for investment purposes (oops!). Freddie and Fannie both had very slim equity cushions supporting the preferreds at the time of issuance and that equity is basically entirely comprised of mortgage/housing related risk.

So, for purposes of this analysis, we can imagine that if FNM and FRE equity (the publicly traded stock) is in the "first loss" position on housing defaults, the preferred is right behind it (second loss), with the US government in the larger "third and final loss" position via its increasingly explicit guarantee of GSE guarantees. Thus, the preferred is much more risky than a diversified pool of mortgages with 20% equity that a bank might typically own, though the preferred holders are compensated by some modest extra yield. Unlike the preferreds, a diversified pool of mortgages represents the entire capital structure of a home behind the owner and any mortgage insurance. So to the extent a bank ties up $500 million of capital in said diversified pool of mortgages, the odds of losing much of it are fairly low. A 5% loss on the pool equates to a $25 million loss to the mortgage holders.

However, by being in the second loss behind the equity in FNM and FRE via the preferreds but in front of $5 or $6 trillion of other folks, the risk of losing a lot on that investment are much, much, much higher. Your $36 billion preferred is less than a 1% sliver in that $5 trillion stack! That relative "thickness" (or, in this case, thinness), is key when compared to the absolute thickness of retaining 100% of a diversified pool of mortgages. The ability to lose your money happens so fast in the preferred that it is basically binary: you either come out whole or lose all your money. That is not the business that traditional banks normally operate within. Given that a bank's own capital structure is already levered 12:1, binary outcomes on large investments are anathema to solvency.

In fact, to the extent that the diversified pool of mortgages is representative of the mortgages FNM and FRE touch, you can imagine that just a small but fast single digit loss on the pool of mortgages may equate to a total wipeout of the equity and the preferreds of the GSEs.

That negative leverage seems to scream to me: Danger, Will, Danger!

It stuns me that folks were still "reaching for yield" from two entities positioned near the eye of the storm while the hurricane was already apparent, gaining strength, and heading for landfall. It is as if a homeowner in New Orleans, on the eve of Katrina, offered All State a little extra premium in order to insure his or her home against a hurricane. Under no circumstance short of enormous premium would All State take that risk and even then, I doubt they'd do it.

But regional banks?

No wonder these banks are all in trouble - they are run by folks that do not understand risk. They literally believe that buying a FNM or FRE A-rated preferred (while the GSEs were already in trouble, so the risk was not exactly a secret) has a similar risk profile to making actual mortgages.

Sadly for the US banking system, on Friday Moody's downgraded all $36 billion of preferreds from A1 to Baa3 (which is kind of like "BBB-" or the lowest investment grade rating). That is a very bad event from a mark to market and a capital requirement standpoint for any banks that own these securities (e.g., Regions, M&T, Astoria).

Those also happen to be banks that don't exactly have capital to spare, due to their own lending struggles.

Strap your boots on.

So Far, Only One Bank is Reported as Dead...

Columbian Bank and Trust in Topeka, Kansas of all places was finally put to sleep tonight by the FDIC.

Columbian Bank is a small $752 million asset bank funded overwhelmingly by deposits ($622 million). Bank collapses in recent months have led to losses to the FDIC of 15%-28% of assets. The greater the portion of the balance sheet that is funded by deposits, the greater the losses to the FDIC tends to be. In any case, we can expect the FDIC insurance fund to eat another $113 - $210 million of losses. Every few dollars that the FDIC absorbs via its insurance fund is a few dollars closer to tax payers socializng future losses.

We also continued to build the backlog, as Bank of the Bluegrass in Kentucky received a Cease and Desist order from the FDIC. Hilariously, they apparently had outsourced their "loan review" and are now going to bring it internal. Seriously?

The over/under remains 1.5 bank failures per week. The unders have been taking it for a few weeks, but the backlog is growing rapidly and I expect we are at the edge of a deluge of failures. Strap your boots on.

It's 4:20 Dude!

For many people, 4:20 on a Friday means it's time to kiss work goodbye and roll a fattie. For me, it means time to start hitting the refresh button on my GoogleNews stream and look for bank failures. Will the overs finally put one on the board against the unders? It's been nearly a month and both housing and credit spreads have done nothing but deteriorate since then. Time to get excited (in a bizarre way)...

Fannie and Freddie or Phonie and Fraudie?

As equity values for Fan and Fred plunge and the stock prices become optically embarrassing (e.g., Freddie is now a $3.16 stock with a $2.0B market cap), it is worth asking "so what?"

So what if they are nationalized? What's the downside?

Some equity holders get wiped out. Who cares? Freddie has a $2 billion market cap; a year or so ago, it was about $40 billion. So the damage is already done on that front. The remainder is just a rounding error.

What else happens? Well, the preferreds will get wiped out and the sub-notes may as well. But that's fine. Corporate bankruptcies happen regularly and the owners of those securities accept that risk. The senior notes will be made whole by you and me via our government's now explicit enough guarantee. So our foreign creditors will be fine (in fact, they'll be better off than they are today while credit spreads remain wide for the GSEs).

What about fear? Won't the "collapse" of the GSEs engender an enormous amount of fear which could lead to widespread financial collapse? Well, no. The reality is that the vast majority of our citizenry has no idea who Fannie and Freddie are, much less what they do. Nobody has deposits and Fannie and Freddie. The GSEs don't have any retail branches. Nobody has a mortgage directly originated by Fannie and Freddie. The reality is that most people are never going to directly "touch" Fannie or Freddie. So, their disappearance will not cause an obvious change to life for most folks.

Won't the cost of financing a house rise? Barring the federal government continuing to aggressively operate the GSEs, yes, borrowing costs will rise. This will happen and it will obviously put pressure on house prices. A conforming 30 year for a decent credit with 20% down is going for about 6.3%. A jumbo prime (eg, a $1 million loan) with 30% (not a typo) down is going for 8.5%-9.0% these days. So, yes, financing costs and standards will likely rise. However, all this will do is eliminate a silly and unnecessary subsidy.

There will be a one-time nationwide home price adjustment, but I want to be crystal clear, Fannie and Freddie DO NOT MAKE HOME OWNERSHIP MORE AFFORDABLE (same goes for the tax deductibility of mortgage interest). While they artificially push the rate on a given mortgage down, all that does is artificially push the price of a given house up until the all in financing cost is basically neutral. While that one time reversion will be a painful experience for existing owners, it is not the government's place to provide a house price subsidy that clearly a) is adding to systemic risk and b) makes each new home buyer more and more trusting of those falsely inflated prices.

My strong suspicion is that the gov't will do everything in its power to prevent this change despite it being a logical step on the road to recovery.

The Unders Take It! Small Florida Bank Collapses

Well, The Brothers Linebacker had set the bank failure weekly over/under at 1.5 institutions (inclusive of banks and thrifts, exclusive of credit unions, which is probably worth another 0.5 or 1.0 per week). The week of August 15th had a bank failures happen in a non-traditional manner: Federal Trust (ticker FDT ) of Florida was a de facto failure. However, rather than actually collapsing, it was re-capped and taken over at tiny share prices. Amazingly, no banks actually were off'ed by the FDIC. I keep re-reading my blog on Vineyard National and I continue to be baffled as to what will actualy catalyze the FDIC to takeover a bank.

Oddly enough, FDT is the stock of a business I used to own shares in at one time. I purchased FDT shares beginning on March 10, 2003 (basically the stock market bottom, as it turned out) for $5.00/share then bought a bunch more a month later at around the same price. Beginning June 20, 2005 and continuing through July 5, 2005 I sold my stake at $11.20/share, which I felt represented a full price given my increasing skepticism of the Florida miracle and worry that the state was overbanked. The company would ultimately trade in the $12+ range for a period of time before collapsing under the weight of a hideous asset base.

Now it's being acquired at distressed prices by a SPAC, which is funny for reasons I may detail in another post someday.
-TTB

More Bad News for Small Banks - Vineyard National Bancorp Says it has Going Concern Issues

Well, the hits keep coming. Vineyard National Bancorp announced in its 10-Q that it is facing going concern issues.

No shit.

On May 5th, they were informed by the Office of the Comptroller of the Corrency (OCC) they they've been deemed to be in "troubled condition".

On May 20th, the Board of Governors of the Federal Reserve System told them the same thing.

On July 22nd, Vineyard "consented" (as if they had a choice) to a Consent Order from the OCC which basically tells Vineyard exactly what they have to do to not be taken over. They are also deemed to no longer be "well capitalized".

And check out this statement from the aforementioned 6/30/08 10-Q. The understated confidence is a thing of beauty:

On a consolidated basis, the minimum ratios that the Company must meet are total risk-based capital of 8.0%, Tier 1 capital of 4.0% and a leverage ratio of 4.0%. At June 30, 2008, the Company’s total risk-based capital, Tier 1 capital and leverage ratios were 2.5%, 1.3%, and 1.2%, respectively.

Wow.

I'm sure it has deteriorated since then, which is saying something.

Stunningly, despositors have not taken well to this set of news. Here is how depositors have reacted (and other liquidity problems) as stated directly from the 10-Q. Honestly, I cannot believe the FDIC allowed the brokered deposit game to continue as long as it did. My comments are in [brackets] and are italicized:

Negative publicity relating to our financial results and the financial results of other financial institutions, together with the seizure of IndyMac Bank by federal regulators in July 2008, has caused a significant amount of customer deposit withdrawals, thus affecting our liquidity and our ability to meet our obligations as they have come due [kind of lame to put any blame on IndyMac when Vineyard so clearly was mismanaged and decaying at an accelerating rate well prior to the IndyMac issue - see the timing of the news flow from above]. During the second quarter of 2008, we obtained $266.3 million in brokered deposits to offset the $226.9 million in run-off of savings, NOW, and money market deposit accounts. [Please understand that this acceptance of brokered deposits (or any deposits for that matter) as a run on the bank is happening is 100% the result of FDIC insurance and thus is going to cost you and me - The American Taxpayer - dearly] As a result of the issuance of the Consent Order by the OCC on July 22, 2008, however, we can no longer accept, renew or rollover brokered deposits unless and until such time as we receive a waiver from the FDIC. The Bank has requested a waiver from the FDIC, but there can be no assurance that such a waiver will be granted [Lord willing, it won't be granted, my taxes are high enough already], granted on the terms requested, or granted in time for the Bank to effectively utilize brokered deposits as a source of required liquidity. If the Bank does not receive such a waiver, we will be unable to employ the use of readily available brokered deposits as a source of liquidity [bold emphasis added due to the incredibility of the fact that a bank this weak still has "readily available" access to deposits].

As of June 30, 2008, we were in default on our secured line of credit with a correspondent bank, as described in Note #10 [doh]. While we were able to negotiate a waiver of the events of default existing as of June 30, 2008, we have subsequently defaulted on the line of the credit as a result of the issuance of the Consent Order by the OCC on July 22, 2008 [double doh]. As a result, while the maturity date has been extended to August 29, 2008, the correspondent bank is entitled to declare the outstanding principal balance and all accrued but unpaid interest on the line of credit immediately due and payable and otherwise exercise its rights as a secured party against the collateral to collect, enforce or satisfy the obligations under the line of credit [triple doh]. Such rights may include foreclosing on the collateral and, subject to regulatory agency approval, acquiring 100% ownership of the Bank or selling the Bank to a third party. As a result of the regulatory restrictions discussed above, prior FRB approval will be required for VNB to make any payments on this line of credit.

Although effective April 21, 2008, the FHLB reduced the Bank’s borrowing capacity from 40% to 30% of the Bank’s total assets, the Bank’s borrowing availability was limited to the amount of eligible collateral that can be pledged to secure that borrowing facility. At June 30, 2008, based on its eligible pledged loan and investment collateral, that availability was $289.4 million of which $155.0 million was outstanding; therefore, the Bank had a remaining borrowing availability of $134.4 million. [emphasis added in bold to highlight how long ago regulators started cracking down on Vineyard]

On July 24, 2008, the Bank borrowed $126.0 million from the FHLB, consisting of four $31.5 million advances with terms ranging from 9 months to 1 year. As a result of these term borrowings, the Bank had a remaining borrowing availability of $2.2 million available against its loan and investment collateral pledged at the FHLB. The proceeds from the FHLB advances were invested in federal funds sold for liquidity needs. At July 24, 2008 the Bank had an aggregate of $178.0 million invested in federal funds sold.[emphasis added in bold: $2.2 million? I know one bank I'll be reading about some Friday in the not too distant future at about 5pm, for sure]

As of June 30, 2008, the Bank had no unsecured correspondent banking facilities with borrowing availability. However, on August 1, 2008, the Bank entered into an intercreditor agreement with the FHLB and Federal Reserve Bank of San Francisco (“FRB San Francisco”) whereby certain eligible loans pledged to the FRB San Francisco, and agreed to by the FHLB, may be utilized to support any advances from the FRB Discount Window. We have pledged loans with an aggregate principal balance of over $400 million which can be used by the FRB Discount Window in determining an available amount to us; however, the FRB Discount Window is not obligated to lend on any collateral deposited.

On July 31, 2008, the FRB notified VNB that VNB must serve as a source of financial strength to the Bank and as such, requested that management perform an analysis of the cash needs for VNB through October 31, 2008. The FRB has further requested that any amounts not required for VNB’s operations be contributed to the Bank to support its operational needs. Management is performing such an analysis at this time.

Going Concern

The conditions and events discussed above cast significant doubt on our ability to continue as a going concern. We have determined that significant additional sources of liquidity and capital will be required for us to continue operations through 2008 and beyond. We have engaged a financial advisor to explore strategic alternatives, including potential significant capital raises, to address our current and expected liquidity and capital deficiencies. However, there can be no assurance that we will be able to arrange for sufficient liquidity or to raise additional capital in time to satisfy regulatory requirements and meet our obligations as they come due. In addition, our regulators are continually monitoring our liquidity and capital adequacy. Based on their assessment of our ability to continue to operate in a safe and sound manner, our regulators may take other and further action, including assumption of control of the Bank, to protect the interests of depositors insured by the FDIC. Finally, there can be no assurance that our correspondent bank will not declare us in default or that the exploration of strategic alternatives will result in an infusion of sufficient additional capital.[bold emphasis added and, on a personal note, good luck!]

As is generally my practice, let's take a look at the losses the FDIC (ie, you and me) are going to have to eat: Vineyard is a $2.3 billion bank (by assets). If we apply the 15-28% loss rate to assets that recent failures resulted in, we are looking at a $345-644 million loss to the FDIC. Amazingly, this almost seems small with the rubble of IndyMac's $5+ billion loss still smoldering and the potential for several $10+ billion asset banks to go under (and really the potential for some $100+ billion banks to be aced).

I suppose that's the silver lining here: at least it isn't an unusually large bank.

Downey Financial - The Next IndyMac?

Well, in my post from July where I predicted the demise of WaMu I also identified three other depository insitutions that I viewed as at risk. Those were Downey Financial, BankUnited Financial, and Sterling Financial. As of now, those are seeming like a good hit-list.

Subsequent to that post, BankUnited chose to sue Dick X. Bove and his employer for its inclusion on a list he published post-IndyMac about who is next. If that doesn't that just scream "confident" to the BankUnited depositor base, I don't know what will (perhaps a government takeover?). So much for "sticks and stones may break my bones, but words will never hurt me."

Downey, however, has taken it a step further by actually suffering a variety of real damages. Since my post, Moody's has cut Downey's primary operating subsidiary's financial strength rating to D rating, it reported a substantial quarterly loss and, last night, Downey announced in its 10-Q that it has been suffering net withdrawals from its deposit base and that the OTS is beginning to limit its activities. Wow.

This language is fascinating to read (from Note 10 - Subsequent Events in Downey's June 30, 2008 10-Q filing). My comments are inserted in [brackets] and italicized:

In addition to its deposits, Downey’s principal source of liquidity is its ability to utilize borrowings, as needed. The Bank’s primary source of borrowings is the FHLB. At June 30, 2008, the Bank’s FHLB borrowings totaled $1.5 billion, representing 12.1% of total assets. As of August 8, 2008, the Bank’s FHLB borrowings totaled $2.8 billion [holy crap. After grwoing just $400 million in the prior twelve months, Downey has tapped an additional $1.3 billion of FHLB borrowings in the last six weeks?]. Approximately half of the Bank’s increase in FHLB borrowings subsequent to June 30, 2008 is being held in cash equivalents and short-term investment securities to meet our liquidity needs [that means the other half went to fund deposit withdrawals]. The Bank currently is approved by the FHLB to borrow up to a maximum of $3.0 billion to the extent it provides qualifying collateral, providing the Bank with an additional $0.2 billion of borrowing capacity from the FHLB as of August 8 [set the bankruptcy clock to T minus six weeks]. The amount the FHLB is willing to advance differs based on the quality and character of qualifying collateral offered by the Bank, and the advance rates for qualifying collateral may be adjusted upwards or downwards by the FHLB from time to time. The Bank also is approved to borrow funds on an overnight basis from the Federal Reserve Bank of San Francisco subject to the amount of qualifying collateral it pledges. The Bank views the Federal Reserve Bank as a back-up source of liquidity. As of August 8, 2008, the Bank had no outstanding borrowings from the Federal Reserve Bank of San Francisco and the Bank’s available qualifying collateral would have permitted it to borrow up to an additional $1.5 billion. Neither the FHLB nor the Federal Reserve Bank of San Francisco is obligated to lend to us under these loan facilities. To the extent deposit renewals and deposit growth are not sufficient to fund maturing and withdrawable deposits, repay maturing borrowings, fund existing and future loans and investment securities and otherwise fund working capital needs and capital expenditures, the Bank may utilize additional borrowing capacity from its FHLB and Federal Reserve Bank borrowing arrangements.

After the end of the second quarter, the Bank experienced elevated levels of deposit withdrawals [no sh!t]. More recently, in response to steps taken by management to address the situation, the Bank has experienced net deposit inflows. If the Bank’s deposit levels continue to stabilize with withdrawals at historical levels, Downey believes its current sources of funds, including deposits; advances from the FHLB and other borrowings; proceeds from the sale of loans and real estate; payments of loans and payments for and sales of loan servicing; and income from other investments would enable Downey to meet its obligations while maintaining liquidity at appropriate levels. However, if elevated levels of net deposit outflows resume, the Bank’s usual sources of liquidity could become depleted, and the Bank would be required to raise additional capital or enter into new financing arrangements to satisfy its liquidity needs. In the current economic environment, there are no assurances that we would be able to raise additional capital or enter into additional financing arrangements.[Prediction: if the press picks up on this language, it is game over. Thusly, it is game over.]

Management believes that the Holding Company, on a stand-alone basis, currently has adequate liquid assets to meet its current obligations, which are primarily interest payments on $199 million of senior notes. Limitations imposed by the Office of Thrift Supervision (“OTS”) discussed below currently prohibit the Bank from providing a dividend to the Holding Company without prior OTS approval, and the Holding Company from paying dividends (other than the quarterly dividend payable in August 2008), and incurring and renewing debt, without prior non-objection of the OTS. At June 30, 2008, the Holding Company’s liquid assets, including amounts deposited with the Bank, totaled $53 million, down from $102 million at the end of 2007 due primarily to a $50 million capital contribution to the Bank.

Downey’s stockholders’ equity totaled $0.9 billion at June 30, 2008, down from $1.3 billion at December 31, 2007 and $1.5 billion at June 30, 2007. The Board reduced the quarterly per share dividend payment from $0.12 to $0.01 for the dividend payable in August 2008 [I love this whole concept that banks, etc. are employing of cutting dividends to one or five cents. Lord forbid that you cut to zero - then you cannot tell people "we've paid dividends every quarter for 105 years" etc.], after which no future dividends will be paid without prior non-objection of the OTS.

In light of the current operating environment and Downey’s recent quarterly losses, the Holding Company and the Bank have been working closely with the Bank’s federal banking regulators. In that regard, the OTS, the Bank’s principal regulator, has also imposed the following limitations on the Holding Company and the Bank: the Bank may not pay dividends to the Holding Company without prior OTS approval, and the Holding Company may not pay dividends without prior non-objection of the OTS; the Bank may not increase its assets during any quarter in excess of an amount equal to net interest credited on deposit liabilities without prior OTS approval; the Holding Company may not issue or renew debt without the prior non-objection of the OTS; the Holding Company and the Bank must provide prior notice to the OTS regarding any additions or changes to directors or senior executive officers (or changes in the responsibilities of senior executive officers); the Holding Company and the Bank may not pay certain kinds of severance and other forms of compensation without regulatory approval; the Bank may not enter into, renew, extend or revise any contract related to compensation or benefits with any director or senior executive officer without prior regulatory approval; the Bank must provide prior notice to the OTS (and not receive any objection) before engaging in transactions with any affiliate or subsidiary. In addition, Downey is subject to higher regulatory assessments and FDIC deposit insurance premiums than those prevailing in prior periods. [emphasis added]

In response to the challenges facing Downey in the current operating environment, Downey has formed a special Board committee to explore a range of strategic alternatives, including the raising of additional capital to levels deemed by the Board to be appropriate under the circumstances. [the end is nigh]

It is worth noting that Downey is a $12.6 billion asset base bank. If it were to be taken into FDIC receivership and the loss metrics of recent failures applied (15-28% of assets are losses that the FDIC absorbs), then the FDIC will take another $1.9B to $3.5B of losses. Also, if this list is to be trusted, IndyMac is #3 and would bump all of the others down one spot. Downey, if it were to go, would bump Homefed and all the banks below it down another notch putting Downey at #9. Not a trivial matter.

Bank Failures get the Headlines, but Credit Unions are Failing too

Occasional commentor on The Investment Linebacker's message boards, Wendell Brock, has begun blogging on his Denovo Strategy site about the difficulties that credit unions are facing. We may think banks and S&Ls are struggling, given the collapse of eight so far this year, but Brock is reporting that TWENTY ONE credit unions have already collapsed.

There's a bull market in hiring FDIC regulators, I am sure.

So, I wrote all of the above yesterday with the intent of posting it this a.m. Obviously Wendell has been all over this issue for a while now. However, I wake up this a.m. and what do I see on the front page of the WSJ? Immediately above the fold on A1 the headline, "Mortgage-Market Trouble Reaches Big Credit Unions".

While The Journal's article amazingly does not address Wendell's specific fact about the collapse of 21 small credit unions, it does highlight the reality that a number of very large credit unions have suffered enormous unrealized losses. It also gets further into the ridiculousness of GAAP accounting and the subjectivity of both Fair Value accounting and the Available for Sale vs Hold to Maturity concept. These credit unions are clearly intentionally obfuscating the facts in order to improve their GAAP accounting performance despite the fact that it may or may not reflect economic reality.

As an aside, having a front page article in The Wall Street Journal on the potential insolvency of your depository institution is probably not great for business. I'd hate to be on the front lines of client confidence assurance at U.S. Central Federal Credit this morning (or any of the other four highlighted institutions).

The Unders Take It (again)

Well, the week of August 8th has passed (yes, I now measure weeks on a Friday methodology) and we had no bank failures. As noted in prior posts, I can't help but have some amount of excitement each Friday after the close of business as we await the announcement from the FDIC as to which banks they have deep sixed. This week was a zero. "Good news, it seems the 'subprime crisis' has been contained. Nothing to see here, nothing to see here. Keep on moving."

The Brothers Linebacker have set the weekly over/under line at 1.5, thus giving another point to the unders. Somewhere in the distance, Hank Paulson does a quiet fist pump.

Is It Friday Evening Yet?

I'm sorry, but to be honest, for some reason I can hardly contain my interest/curiosity as to what banks are going to be put to sleep this weekend.

We have the over/under set at 1.5 per week for the foreseeable future. I'm going with the under yet again this week, but it's just a gut feel.

The reality is that ABS prices have continued to deteriorate and the consumer has done nothing but get weaker and weaker. That said, I think the FDIC wants to make this meltdown happen as slowly as possible initially such that depositors do not gain a fear-based momentum. This is incredibly complex and given the fragility of the typical depository institution's business model, I think fear is the rational behavior.

Anyway, schadenfreude reigns as I await my weekly bank failure news.

Strap your boots on.

Strap Your Boots On, It's Coming: The Alt-A and Prime Mortgage Collapse

One of my recent favorite blogs (linked on the left hand side) is Mr. Mortgage's Guide to the TRUTH! His recent post on the state of the Alt-A and Pay Option ARM Market is directly in line with my recent post on The Pending Mortgage Default Wave - Alt-A and Prime. Take a moment to read those two posts if you haven't yet.

If you look at bank balance sheets, you will find enormous Option ARM portfolios that have not yet taken significant markdowns. I normally pick on WaMu but will give them a break for the time being. Instead, let's look at Wachovia. This is a bit more fun given that it is the fourth largest depository institution in the United States ($477 billion of net loans and $436 billion of deposits).

If you take a look at Wachovia's Q2 2008 earnings presentation you'll see, on page 12, that of Wachovia's entire $488 billion gross (pre-reserve) loan book, Wachovia provided for $5.6 billion of additional reserves in Q2 of which $4.2 billion related to its $122 billion pick-a-pay book (Option ARMs). [stated another way, WB only reserved an additional $1.4 billion on the other $366 billion loan book]. Of Wachovia's total $11 billion credit loss provisions (2.25% of total loans), $5.2 billion related to the pick-a-pays (which means only 1.6% of the remaining loan book is reserved against, but, again, a story for a different day).

So, $5.2 billion of reserves on a $122 billion pick-a-pay loan book sounds like a lot. But is it?

If you take a typical Option ARM securitization from 2006 or 2007 and aggregate all the tranches such that you recreate the whole loan portfolio, those securitizations are generally trading in sum for about $0.40 to $0.60 on the $1.00. Wachovia's whole loan Option ARM portfolio is marked at $0.96 on the $1.00. A tad generous, perhaps?

Now, I accept that Wachovia's Golden West subsidiary, which originated most of these loans, is a superior underwriter in many ways. But the loans are still overwhelmingly California and Florida (about 85%), they are still high LTV, and they are still building size through negative amortization. In addition to these soft factors, we can see on page 14 the acceleration of pick-a-pay delinquencies (NPAs) and charge-offs. NPAs as a percentage of outstanding pick-a-pay loan balance at 6/30/07 were 1.03%. On 3/31/08, they were 3.82%. As of 6/30/08, they were 5.78%. That is literally exponential growth of NPAs. And resets from the nastiest vintages have yet to start while negative amortization continues apace. Even Wachovia's own estimates, which can be seen on page 16, show that the average current LTV on the entire pick-a-pay book will reach 99% at the house price trough. At that moment, severities will be highest and default rates will be brutal.

So, will Wachovia's Option ARM book be worth fifty cents on the dollar? No, it probably won't be that bad. But will it be seventy five cents on the dollar? Well, perhaps. Today, they have that book at ninety six cents.

A 25% write-off on that portfolio means another $25 billion of losses on just the pick-a-pay book. I'm willing to suppose that at that time, the rest of Wachovia's loan book will also be performing below expectations. Now, Wachovia is generating $4 billion of pre-tax operating income every quarter (excluding writedowns and above normal reserving), so the longer Wachovia can string out taking its hits, the better its odds are of earning its way through the problem. And with a $39 billion market cap (as of today's close at $18.40) it is trading at less than 3x pre-tax operating earnings. So, I'm not saying it's a short, I'm just saying that there is a ton of pain left to come and if Wachovia is forced to take that pain in a condensed period of time, as one of the least well capitalized major banks (based on Tier 1 Capital Ratio), equity holders could have a zero (or, more likely, massive dilution). While Wachovia could sell AG Edwards to raise capital, given the suboptimal environment to sell into today, Wachovia would be stealing from its future to survive which would also impair long-term value if Wachovia gets to the other side.

This problem hits WaMu as well, but worse given that a greater percentage of WaMu's asset base is in residential mortgages.

We all need to be very hopeful on two fronts:
1) these losses either do not come or come over a very long time such that depository institutions can earn their way out of this mess; and
2) that investors continue to have an appetite for investing new capital in existing depository institutions such that if losses come fast, the capital shortfalls can be plugged.

Prediction with regards to #2: we begin to see a wave of denovo banks. Why put your money into a blackbox of assets when you can start a new bank without legacy liabilities and use all these fun federal lending conduits (FHLB, Fed TSLF, etc.) to buy highly rated yet wide-spread securities and build your leverage base? I also suspect you'd be able to attract brokered deposits given the lower risk profile of a fresh bank. Buy 7% yielding assets, fund at LIBOR, lever 10x through the bank structure and have a 35%+ ROE. I can think of worse things to do with my money!

Speaking of socialism....

Have to love this. I'm so glad that my money is going to below-market loans to companies that I would guess, in aggregate, have not made money over their 100 year history. Just think about that...and we are talking about lending them $25 Billion of taxpayer money? This is crazy. From Bloomberg today:

Dingell Pushes Access to $25 Billion in Plant Aid for GM, Ford
2008-08-05 15:25:18.980 (New York)

By Jeff Green
Aug. 5 (Bloomberg) -- A Michigan lawmaker is asking the U.S.
to speed rules that would free up $25 billion in government loans to convert General Motors Corp., Ford Motor Co. and Chrysler LLC factories to build alternative-fuel vehicles.

The funding is part of last year's energy bill, and the rules were supposed to be written within a year of its December passage, Representative John Dingell wrote yesterday in a letter to U.S. Department of Energy Secretary Samuel Bodman.

``It is essential for the department to undertake this effort with urgency,'' wrote Dingell, a Democrat and chairman of the House Energy and Commerce Committee. ``Providing the domestic automobile industry with targeted and timely assistance will help stimulate the entire economy.''

The push follows Ford's and GM's posting of a combined $24.2 billion in losses for the second quarter. GM, Ford and Chrysler are closing factories that produce pickups and sport-utility vehicles being shunned by U.S. consumers as gasoline hovers near
$4 per gallon. They are also speeding development of models such as gasoline-electric hybrids, fuel-cell vehicles and electric cars that use less or no fossil fuel.

``The Congress and candidates are asking how they can support an industry critical to the economy,'' GM spokesman Greg Martin said. ``We're pointing to an existing mechanism that can help,'' he said, referring to the Energy Independence and Security Act of 2007. Ford spokesman Mark Truby and Chrysler spokeswoman Shawn Morgan didn't have an immediate comment.

Dingell said that vehicle sales account for about 4 percent of U.S. gross domestic product. He said he is committed to securing ``substantial appropriations to fund the award and loan programs before Congress adjourns for the year.''

The rules call for loans for as long as 25-years with an interest rate set at the cost of funds to the Department of Treasury for obligations of comparable maturity, according to the text of the legislation. The loans can cover as much as 30 percent of the cost for assembly plants, component production and some engineering of qualifying vehicles and components.

For related news:
Autos and government: TNI AUT GOV BN

Ellsworth Toohey, I mean, Hugo Chavez could not be more from an Ayn Rand novel

Chavez's rise and sustained power shows you the manipulatability of people and the oppression that results from desperation. Desperation causes all sorts of irrational behaviors and if combined with certain psychological/influence techniques can lead to lollapalooza effects.

In that sense, Hugo Chavez is a brilliant practitioner of manipulation and control. Here is his latest bit of evil genius. These 26 Decrees are so Randian, it is remarkable. It's fascinating that one of the most frequent criticisms of Rand's works is how improbable the behaviors of the antagonists are, but here we are watching it happen in real time.

From our perspective here in the US, we look at what is happening in Venezuela and say, "wow, that's crazy. That would never happen here." I hope that sentiment is correct. But I always note that Germans are not so different from traditional Americans. Wiemar Germany operated with a constitution and some semblance of a democracy. The damning cost of "reparations" and the ensuing hyper-inflation met head on with the encroachment of communists and socialists and within 15 years, one of the most glorious countries in the world with a historically proud, strong people succumbed to mental and emotional collapse setting the stage for the rise of Hitler. It certainly does not seem beyond the realm of possibility that it could happen here.

I always think about Munger's boiling frog metaphor (if you put a frog in boiling hot water, it will jump out instantly, but if you put a frog in room-temperature watch and then slowly heat it, it will boil and die). While I'm not sure that's actually true about a frog, the point is obviously incremental changes are hard to track and negative incremental changes can lead to stealthily horrible outcomes (e.g., being boiled). We see things like the suspension of habeus corpus for terrorist suspects, torture being justified in certain situations, preemptive wars, mass federal wire tapping, the socialization of credit risk, the specter of tax increases, and the mass push for government driven social/entitlement programs and I cannot help but wonder what the temperature of the water is.

Having property in New Zealand as an insurance policy against what I refer to as Hotel Rwanda outcomes continues to seem like a good idea.

Great Charlie Munger Video at Caltech

Below is a link to Berkshire Vice Chairman Charlie Munger talking about some of his favorite topics including (un)common sense, worldly wisdom, Jacobian inversion, employing a "mental model" framework for solving problems, understanding a few big ideas in a variety of disciplines, investing, why the Chinese have genetic advantages vs. the average American, and "other".

Always funny. Always insightful. Always worth your time.

As an aside, kind of strange to see Whitney Tilson and David Winters ask questions given this was an event for Caltech students.

Enjoy!

Video of Munger at Caltech

If you have not read poor Charlie's Almanack , I highly recommend it. You are missing a great opportunity to expand the way you think about complex issues and investment risks/return scenarios.

The Pending Mortgage Default Wave - Alt-A and Prime

Honestly, this article ought to strike fear. For most, it probably won't, it will just be another housing crisis article. But it should serve as a wake-up call. This article is one of the first major pieces I've seen from the mainstream media on the increasingly ugly performance of the non-subprime portions of the residential mortgage market.

Vikas Bijaj of the NY Times who often covers financial markets and macro economic happenings writes about the sneaky increase in the rate of mortgage delinquencies among Alt-A and prime borrowers. While a year ago many politicians and now-former bank CEOs wanted to characterize the current "crisis" as "contained" and as unique to the sub-prime cohort, we are seeing it is not. Forget for a moment that this credit contagion is almost certain to contaminate other consumer lending collateral types (credit cards, cars, etc.), commercial mortgages, and corporate lending. No, forget that. Focus on the fact that given the crisis's roots are in housing, it is goinng to become an sbsolute vomitorium in the rest of the residential mortgage sphere.

The reality is that:
1) the incentive of avoiding a bad credit score is declining as having a foreclosure (or five) on your credit score will hardly be the anomolistic scarlet letter it once was;
2) declining home prices eats into the homeowner's equity first (to the extent the homeowner ever had any), reducing his or/and her incentive to stay in that specific house and thus pay their mortgage;
3) Alt-A and Prime securitizations are supported by a much thinner layer of equity and other credit enhancement meaning that losses will penetrate to the higher rated tranches faster;
4) resets are coming. As Option-Arm and Interest Only resets hit in the coming 12-36 months, the incentive to default will increase;
5) consumers are being pinched in other ways too. Fuel prices, food prices, job losses, wage cutbacks (including through reduced hours worked), etc., ad nauseum. Fuel alone is scary. If you fill up a 20 gallon tank once a week, that's gone from $35 to $80 per fill-up. That $45/week tax is another $1000 per year hit to the consumer;
6) Alt-A alone is as big as subprime. Prime dwarfs them both combined. If prime goes really toxic, it will make people forget about subprime as a standalone problem. Suprime will come to represent not the core of the issue or the cause of the problem, it will come to represent the (now dead) canary in the coalmine;
7) to the extent prime continues to deteriorate in quick fashion, the equity of Fan and Fred is toast (the speed of the deterioration is really important since Fan and Fred are tonning it on new business and could earn their way through this if the cash losses are spread out over enough time. If not, the GSEs are going to be forced to either do an enormous capital raise or be nationalized; thus I suspect they will do everything in their power to postpone actual cash losses (as opposed to MTM, which is less important))
8) to the extent prime continues to deteriorate, many banks that are perceived as weak will obviously fail and some other banks that folks believe couldn't possibly get hurt may face potentially mortal wounds.

Regarding #8, let's use WaMu's asset base as an example. Since they have yet to release a detailed balance sheet for the June 2008 Q, we'll use the March 31, 2008 version:

Of its $320 billion of asssets, WaMu had a $201 billion loan book: $57 billion short-term option ARMs, $16 billion in other ARMs, $41 billion in medium-term ARMs, $12 billion in fixed rate home loans, and $9 billion in credit card loans. I should conclude by mentioning their $63 billion HELOC book.

Let's just think about that for a second. WaMu's target borrower was Alt-A. Let that sink in for a second.

Seriously, these are scary times.

The Week of August 1st - The Unders take it! FDIC Nationalizations Continue Apace

My younger brother (LB) has set the over/under on FDIC weekly depository institution nationalizations at 1.5. He sent me an email about this on Thursday of this week. I think he's spot on. Last weekend we had two (over). We picked up one more this week (under).

While trying to avoid schadenfreude, I have to admit that I start checking my Blackberry every Friday evening at around 6:30pm EST to see which banks the FDIC chose to euthanize that week. I keep expecting SnaFu to show up on the list, but it's probably still six or eight weeks out. As fear builds, housing prices fall, and credit values decline, SnaFu loses. I can't help but feel it is only a matter of time. Part of me hopes I'm wrong... (see my July 15th and July 27th posts for more on the pending death of WaMu/"SnaFu" - for the record, I'm personally short WaMu, but primarily as a macro hedge).

This week's "victim" (I'm not sure that's the right word, since really the bank is the culprit) is Florida based First Priority Bank. It's a fairly small bank with only $260 million in assets and is almost entirely deposit funded. The FDIC is expecting a $72 million loss on the nationalization. At 28% of assets, that is a relatively enormous hit. Let's hope for all our sakes that if, oh, I don't know, some hypothetical $320 billion depository institution was nationalized it doesn't suffer a similar loss ratio since a $90 billion hit would be astoundingly high. Seriously, how is nobody talking about this? This is a potentially enormous issue with a reasonable probability and there seems to be this radio silence on the topic.

First Priority is the first bank in Florida to go down since March 2004, which is kind of surprising to me given how overbanked Florida is, how crazy its housing situation was, and the generally low level of good corporate governance in Florida. Florida's situation just screams "pending wave of banking failures". I suspect that this will not be the last depository institution to go down this year in America's Right Foot (frankly, I suspect it won't be the last one in August!). By the way, how horrible did the bankers of the 2004 banking failure have to be? Was there a better place and time in history to run a bank?

Anyway, strap your boots on. I'm worried the snowball is still near the top of the mountain just beginning to gain strength.