Explaining the brokers Part I

Don’t read this series if you expect clear tradeable answers. I don’t have them (yet?) and really this is just the beginning of another intellectual journey. It may be a dead-end.

For someone that might open a fund I am about to do something profoundly stupid. I am going to have a peek at the broker balance sheets in public without being entirely sure what I will find. This series might go nowhere – or it might wind up being very interesting. I am trying to get readers to help me pick apart the brokers.

I have to say that I got a lot of email on Fannie Mae when I did the series there – almost all expressing religious belief on whether Fannie is OK or not. Not much counted as analysis and less contained methods which are testable..

I hope my readers are better this time – but I am not counting on it.

Before I start my instinct on Wall Street Brokers is hyper-bearish. It is not that I think they have solvency problems (on that I have no opinion). It is just that I think that their stated business and their actual business differ substantially. When companies can’t explain clearly what they are doing then I get bearish – and nobody seems to explain brokers clearly.

With Fannie at least I could explain how the business was meant to work. With Goldman Sachs I don’t even start with that.

Part I is just going to leave everyone with a puzzle. Why are the broker balance sheets so big – and what business inflated their size to such grotesque levels? I think this is the key issue wit the brokers – but for the moment I will just give you some numbers.

The FED flow of funds data gives type of debt outstanding in the US at any time. At the last release (Q1 2008) there was 30.8 trillion of non-financial sector debt outstanding. [You don’t want to count financial sector debt because you are double counting though I have known a few reputable people who have done just that.]

Of this “only” 14.0 trillion was to households and “only” 10.6 trillion was mortgages. The mortgage growth rate had slowed to 3 percent. The fastest growing category was the Federal Government (up at over a 9% annual rate). That hardly bodes well for the US. 5.2 trillion of Federal Government debt outstanding. Private sector debt was 24 trillion. I want you to keep that number in head for the reason I am about to bold

• 24 trillion – total private sector debt – is the maximum about of debt that it possibly makes sense in any way for financial institutions to intermediate. Brokers can’t make money intermediating government debt.

The second set of statistics is about the sheer size of broker balance sheets:

• The Goldman Sachs balance sheet is 1.09 trillion in size at the last quarter (admittedly a slightly different date to the Fed Flow of Funds data).
• Lehman is 0.639 trillion – and that was after some questionable moving of items off balance sheet.
• Merrill Lynch is 1.04 trillion at the closest quarter
• Morgan Stanley is 1.03 trillion.

On top of this there is probably almost a trillion of investment banking assets at Citigroup, over a trillion at JPM (including Bear Stearns) and another trillion at Barclays Global Capital.

Somewhere investment banks got on their balance sheet maybe 7 trillion in assets which is very large compared to the total assets that could theoretically be intermediated in the US.

Goldman Sachs has a balance sheet the same size as a smaller Japanese megabank.

One thing is for sure – you don’t hold all these assets because you are facilitating trades on behalf of your customers. I have seriously been told my investor relations at investment banks that the reason they hold so many assets is to facilitate client transactions.

I might be young and naïve – but I am not sure I was ever that naïve…

The investment banks are full of people considerably smarter than me. But the shareholder letters are not very explanatory. (These companies fail Warren Buffett’s test of clear shareholder letters.)

They don’t do what they say they do. So what are they? We all deal with them so we think we have some idea – but the places that I deal with don’t produce balance sheets that look anything like Wall Street. I have some answers – but I know before I start that they are not complete answers – moreover my answers are hard to test.

Some exploration (but probably few answers) coming in Parts II, III etc…

If people have suggestions I will include those (with some analysis) in later parts. Email me please.

John

Weekend edition: the somewhat cooler Hempton

My cousin got the movie star looks and the saxophone. I got the penchant for reading accounts of banks. I think he got the better deal!

I suppose he got the girls too! And he got the MySpace page with the cool jazz soundtrack.

For my NYC readers - he is back in NY -

22 Sep 2008, 07:30 PM
183 W10th st @7th Ave, New York, New York
Cost : $20 incl. a drink!

Foreigners selling Fannie and Freddie debt

I wrote here about what seemed to be the irrationally wide spread on Fannie and Freddie debt. We are after the Paulson plan. The US Government has promised it stands behind these entities. But the spreads still widen.

Widening spreads will cause the end - because Fannie and Freddie need to borrow humungous piles of money.

Now Naked Capitalism has a nice post on foreigners selling Fannie and Freddie debt. That seems irrational to me - but it is still happening - and that is not good news for the GSEs.

J

Estonians trash their flash cars: can't make the lease payments

The most read post ever on this blog was "Hookers that cost too much, flash German cars and insolvent banks".

In it I predicted a future for the Baltic States where the middle class rioted and Swedbank (the Swedish bank most responsible for funding the bubble) was trashed either by depreciation caused default or just by default.

Anyway I love this story. An insurance company in Estonia is having troubles with customers trashing their flash cars because they can't make the lease payments.

It gets worse and worse and worse from here.



J

PS. I mentioned the geopolitics in the first post on this subject... I said I was "loudly calling the likely collapse of a politically sensitive country". Well now the Estonian press is actively speculating about a Russian takeover. I think it is unlikely - but do not forget the Bronze Soldier.

For those with a real interest I know enough history to be dangerous. My version comes from the perspective of some Jewish relatives who were holocaust survivors. My relatives saw the Baltic States as containing particularly enthusiastic Nazis. (They tend to site Lithuania over the others but I think that was bitter experience. Lithuania had a gruesomely effective holocaust). Whether the Balts were more enthusiastic Nazis than some other Europeans is something I have no real knowledge of. Indeed the initial Russian-Nazi treaties gave Lithuania to the Germans but the Lithuanians refused to participate in the invasion of Poland and passed to Rusian influence until the Nazis reinvaded...

The Russians still look on the march into the Baltic States as a liberation from Nazism. They revere their Bronze Soldier. Many Baltic people see the same Bronze Soldier as a symbol of Russian oppression.

When the Estonians moved the statute there were deadly riots. These wounds are still open.

My Jewish relatives however wound up living in an apartment building in Bondi Australia one floor above some post-war Lithuanian immigrants. They became firm friends . And both could see the other's point of view...

Article in Portfolio magazine on British banking

I haven't written much on UK banking - an article about Barclays, one on Alliance and Leicester and one on Northern Rock.

But I got quoted in this neat and accurate story in Portfolio magazine.

All I noted was that the UK had taken Maggie's philosophy to heart and decided that if financial institutions didn't have much capital the market wouldn't deal with them. The result is that UK institutions got to run with much less capital than their American counterparts and that left them vulnerable.

That is clearly true. But the journo found a better story about why wholesale financing arrangements shouldn't be regulated... that lovely cliche about "consenting adults".

Hey you know what happens to "consenting adults"...

I thought you did...

Things that make you go hmmm...

Fannie Mae conducted one of its regular "benchmark note" auctions today. Here is the relatively non-descript Reuters report.

The spread over Treasuries was 122bps.

In the old days when Fannie debt was explicitly not backed by Treasury it was about 60bps or less.

The US Government has made it clear that it backs Fannie - so this extra-wide spread is surprising...

Unless people no longer trust the US Government.




John

PS. The investment implications are not good. The only plausible buy case for Fannie at the moment is that its not much to pay for a franchise with a US Government guarantee. If nobody trusts the guarantee there is no franchise...

The crudest of models for Fannie Mae cumulative losses – (Fannie Mae Part III)

As explained in the “modelling post” there is very good reason why you cannot sensibly estimate prime mortgage losses. They are getting worse at an increasing rate.

I didn’t want to make it up. So I asked my readers for guidance. Nobody much helped me – but several people pointed to Jamie Dimon’s various statements on the subject. Those statements come down to Dimon’s broad guess that losses will triple.

We know the trends look awful.

But I have a model. Its crude – but in the face of radical uncertainty it is about the best I can do. So I will present it.

Below is a chart of the type that most thrill me as a bank analyst. It’s a cumulative loss chart as presented in Fannie’s last quarterly results.

What this chart shows is the cumulative loss on loans versus the time the loan was originated. It’s a sort-of-generalisation of the securitisation cum-loss charts with which I am so familiar.

This chart contains several trends that are representative of the whole mortgage industry. The 2007 pools are radically worse than the 2006 pools which are in turn radically worse than the 2005 pool. The 2004 pool is OK but turning a little sour at the edge…

I have a pet theory as to why the 2007 pools are so much worse than 2006. Its not that the lending was any more stupid in 2007 or that property prices had gone one step too far. It was that there were many bad loans made in all years after 2002 however the bad loans didn’t default – they were refinanced. They all thus wound up in the later pools and hence the later pools preferentially contained the bad loans. They are thus awful.

Anyway Fannie Mae doesn’t give us this data in tabular form – but here is my simple model.

Data:

• The 2006 pool is currently behaving about 3 times worse than the 2000 pool.
• The 2007 pool is currently behaving about 6 times worse than the 2000 pool
• The rate of deterioration of prime delinquency is increasing
• Fannie Mae took credit risk on 615 billion of mortgages in 2006 and 746 billion of mortgages in 2007. We do not know how many of those mortgages are still outstanding – but total mortgages outstanding are a bit over 3 trillion.
• The baseline 2005 pool wound up with cumulative loss of 1.25% plus a trivial amount in the out-years.

Assumptions

• That the outstanding mortgages from 2006 are 450 billion reflecting some repayment to date. (This is a good educated guess – if Fannie publishes the data somewhere I have no memory of it…)
• That the outstanding mortgages from 2007 are 650 billion reflecting some repayment to date (another educated guess…)
• That the relative performance of the 2006 and 2007 pool vis the 2000 pool remains the same – which means if it starts 3 times worse it ends 3 times worse.

Calculations

• The 450 billion outstanding from 2006 will wind up a further 2 times 1.25% worse than the baseline 2000 year. That is 3 percent of 450 billion – say 15 billion.
• The 650 billion outstanding from the 2007 year will wind up a further 5*1.25 worse than the baseline 2000 year. That is 7.5% of 650 billion – or 49 billion.
• That totals 64 billion.

Some notes on the model

There will be a few losses from 2005 and other years – but they are small.

The numbers could be MUCH worse than this – because as I have noted the rate of deterioration is accelerating – which tends to indicate much worse.

They could also be worse than this if the mortgage insurers who are the frontline protection on the high LTV loans fail. [Mortgage insurance is already built into the base line losses.]

There are also a few things that Fannie is currently doing in loan modifications that look like loss deferral and that could further mean my numbers are conservative.

Against this, losses could be better than these calculations because there could be a pig-through-the-python effect in the conventional mortgage market just as I believe there has been in subprime. [Indeed there is some evidence that the 2007 pool is so bad precisely because a lot of bad loans did one last refinance into Fannie Mae. That is proof that Fannie’s management is incompetent. But it would cause a pig-in-python effect and mean my loss estimate for the 2007 pool is overstated.]

But – in the absence of a better model based on better data (something I think the world cannot provide us at the moment) I suspect that there is about 64 billion in excess losses coming through at Fannie Mae.

That is enough to render Fannie Mae insolvent. Indeed it is nearly enough to render Fannie Mae as “profoundly insolvent”. Not quite – but close.

I am not buying the stock here. If given a guess I would be on the short side – but I can find plenty more to short that I think is easier and more likely to be right than this.

Personal conclusion

My a-priori expectation was that Fannie was going to be better than that. If you had put a gun at my head and asked me would I prefer be long or short I would have said long.

Now I would say short.

I have no position and it is likely to stay that way. But for once I do not think the shorts are grotesquely overstating their case.

To my readers

Thank you for coming on this intellectual ride. Its caused me some grief as I have promised you a model which I could barely deliver. And it scares me to pretend I know more about the future than I do about the past and present.

But I have learnt something – and I hope you have too.

To the several people out there (including friends) who just knew in their gut what the answer would be - all I can say is your gut is more knowing than mine...

John

Losses recognised to date - and where to look for more

I was somebody who believed in 2006 that most the risks were outside the US banking system. I knew very risky loans were being made - but most were being securitised.

A lot of them wound up in the European banking system - witness Natixis and UBS.

I did however underestimate the losses that would wind up in the US banking system - and Tanta is now saying that it was a little more complicated than my 2006 view. (See this Tanta post I mildly disagree with.)

But data is what I tend to crave. Bloomberg publishes a list of total losses recognised in this crisis so far. The number just passed 500 billion - which means I think it is about half-way there...

Here is the list - but I have done something else - I have divided it into US Investment Banks (Lehman, Bear etc), US Banks dominated by investment banks (Citicorp, JPM), and conventional US banks (Fifth Third, Keycorp).




The conclusion - conventional US banks are only about a sixth of the losses. The Europeans have hurt MUCH more. What Tanta derides as conventional wisdom of 2006 was mostly correct.

What is interesting about this list is the absence of one core type of financial which is loaded with long term assets, CDOs, mortgages and other potentially toxic stuff. Where are all the life insurance companies?

I have a few shorts in that pile. There are probably plenty more - but I don't see anyone publicly berating those incomprehensible piles of mediocrity.

If you are looking at conventional banks you might find some credit losses. Indeed I am short a few conventional banks in anticipation. But they are not where I think the really good ideas are.

Thoughts anyone.



J

Post script: my classification of institutions seems fair enough in most cases - though JPM has made a fair few of its losses outside the investment bank. I also classified Barclays as a US investment bank. That seems fair enough to me...

The Bloomberg list does not include other culprits such as the GSEs, mortgage insurers and bond insurers. If anyone has a more complete list please forward it to me...




John

I was considered a scaremonger with my Swedbank post

Along with those other scaremongers at the IMF who essentially repeated the story yesterday...

See this story about the IMF warning Swedbank and SEB off their Baltic investments and the Swedish Central Bank having to down-play the risk.

I guess the IMF is scared that they will have to bail out the Baltics less the Ruskies do it for them...

J

PS - if you are interested in Russian-Baltic relations see this Wikipedia article about the Bronze Soldier in Estonia... or this BBC version...

Insolvent versus profoundly insolvent – Fannie Mae Part II

The origin of this post came about because of a blog post about Freddie Mac being “profoundly insolvent”. Infectious Greed thought it too fine a distinction between “insolvent” and “profoundly insolvent”. As this post shows I think there is such a distinction.

Fannie Mae and Freddie Mac right now have vast books of prime mortgages for which the credit is deteriorating at an increasing rate. I gave some delinquency sequences in this post and asked people to estimate where the losses peaked.

Nobody was prepared to take a guess but several people quoted back JP Morgan. If JP Morgan is right (and I will guess they probably are) delinquency is more than doubling from here and losses are more than tripling. But it is a blind guess as explained in the modelling post. It remains very bad for US domestic financials – and the more prime your business the more your credit losses will deteriorate. That does not bode well at all for the GSEs.

Fannie Mae and Freddie Mac came into this crisis with a bad history because of stuff-ups in interest rate risk management. This was explained in Part I.

Fannie Mae’s shareholder equity includes a massive tax asset – reflecting that their past sucks. [I was asked whether sucks was a technical term the other day...]

There is no question that the situation is difficult. Moreover given the thin equity they start with and the large books of Alt-A business (even if it is higher quality than average Alt A business) it is likely that the companies are insolvent.

There I said it. But that still doesn’t mean it makes sense to short them.

In my Fannie Mae Part 1 post I suggested that pre-tax, pre-provision income of an unimpaired Fannie Mae is about 10.5 billion dollars. Call it 6 billion post tax and some minimal normal provisions. If someone were to waive a wand and give you a well capitalised and well managed Fannie Mae tomorrow you might pay 13 times earnings for it – say 78 billion. [A government guarantee - implicit or otherwise - has a lot of value...]

The problem is that Fannie Mae is not well capitalised (or well managed) now. If you buy it you are almost certainly going to have to chip in equity, perhaps a lot of equity.

Under no circumstances is it profitable to chip in more than 78 billion in equity because at the end you are left with something that is worth 78 billion in total. If the shortfall at Fannie is more than 78 billion then Fannie is “profoundly insolvent”. It is so insolvent it is not worth saving. That doesn’t mean it won’t be saved. More than a few financial institutions have solved their problems by leaking out the bad news over time and doing more capital raising than their end net worth. But if the losses are more than 78 billion the first capital injection is not going to be sensible and Fannie can only survive if the capital market is prepared to throw good money after bad.

However if you “only” have to throw in 10 billion dollars then Fannie is a steal right now. The market cap is only 8.6 billion – and you would only be paying 18.6 billion for something worth 78. You would get a 4.5 bagger out of the stock. That I think is the upper limit for Fannie Mae stockholders now.

I am beginning to find a way of modelling this – subject to the radical uncertainty in the modelling post.

But that is for Part III.

John