Friday, July 25, 2008

The Dick Bove problem and an investment idea

Dick Bove is an analyst I do not know. He is a regular talking head on Bubblevision. I won’t hold that against him. (If Dick Bove wants a friend – please get in contact.)


These days Mr Bove seems best known for a report released after the Indy Mac failure in which he asked “Who is next?” Next was BankAtlantic (NYSE:BBX).

BankAtlantic has sued him. That is a move which is astoundingly stupid and reflects terribly on BBX management. The record for companies that sue critics is not exactly good.

However this is not the Dick Bove I want to talk about. Dick Bove gave an interview on Fox Business which is well worth a watch. Go on - watch it. In it he decries the bear case for banks. In particular he notes:

  • In 1990 when the troubles were occurring with banks non performing assets (NPAs) were about 5% of the industry when it is now about 3%.
  • He looked at NPAs compared to bank capital – and noted it was about 40% during the last crisis (a danger zone) and he notes it is now at 17%.
  • He thinks that big banks (like Bank of America) consist of more than their construction portfolio and their home equity loan portfolio. He notes that net interest income is going up. They are also a huge money management firm, huge data processing firm etc and these are all doing OK.

He is very annoyed at what the government is doing to smaller thrifts:

  • Government officials have said that they will allow banks to fail – and they have said many banks will go under – but they seem to save the larger banks.
  • It thus makes people move to Bank of America, JP Morgaan, Wells Fargo etc at the cost of smaller banks.

Anyway it is obvious that bank bad loans in American banks are nothing like as high as in the early 1990s. There is plenty of bad credit out there – but it is mostly not in American banks. In my history of the US Financial Market I wrote early last year I indicated that I thought the credit risk was in the securitisation market and mortgage insurers and by-and-large not in the (US) banks – and funnily enough that is what is happening – the huge losses realised by banks notwithstanding. [I underestimated bank credit problems – but that does not change the fact that the problems outside the US banks are much worse than the problems inside American banks. The credit problems at Natixis and UBS dwarf anything in America except maybe Citigroup.]

Moreover when I start trying to bash up banks there are many I can’t make them go bust including banks trading at 0.6 of book and where their subordinated debt is trading very distressed. One example: I think Fifth Third Bank is fairly clearly solvent – and the pricing of the equity and (particularly) the debt indicate that the market at least thinks insolvency is a realistic possibility. [Often the debt is a better buy than the equity – though as Bill Gross will point out in this video anyone who has purchased debt-like bank equity instruments is not very happy with themselves…]

I will assert that trading unrealistically depressed for the subordinated debt is commonplace. Even the (very problematic) Washington Mutual is probably solvent – though its biggest problem – which I think makes the stock unable to be owned – is the death-spiral financing it took with TPG. [TPG have an anti-dilution clause which makes raising any additional equity outrageously expensive.]

The Dick Bove problem

Let me phrase the Dick Bove problem this way: if bank credit is substantially better than the last cycle (even if non-bank credit is appalling) then why do the banks look so toxic?

Dick Bove asserts that they are just not so toxic. He made that call a couple of months ago – and anyone that followed his advice has been smashed. I will give him credit though – he has stuck to his guns.

I have another take.

My answer to Dick Bove

My answer to Dick Bove is as follows: despite all appearances to the contrary this is not a credit driven crisis. It’s a funding driven crisis. It is much worse than last time not because the losses are worse than last time (they are the for the whole system but they are not for the banks). It is worse than last time because the funding situation is diabolical.

What has happened is that American banks and investment banks have sold lots of toxic waste to Europeans and Asians and their credibility – both individually and collectively is impaired. The same banks have to sell their own debt and subordinated equity to the same Europeans and Asians that they ripped off only two year ago. To put it mildly that makes it harder for banks to fund themselves.

It’s the lack of credibility that is the major problem for many financial institutions.

Washington Mutual as an extreme example

Washington Mutual sold dross to the market. Mish follows a particularly bad WaMu deal. This deal is really toxic. WaMu simply didn’t care what it originated if it originated stuff like this. It didn’t care because it sold the risk. WaMu was in the business of ripping off the people funding its mortgage originations.

But what is left in WaMu is not actually that awful. I am not saying WaMu is pristine. That would be stupid. WaMu is a mess – but you need to make some pretty extreme assumptions to model it as insolvent. It has just over 20 billion dollars of tangible capital left (admittedly after a huge raise). It has 240 billion of loans with 8.5 of provisions already against them. It makes about 8 billion a year in pre-provision income and the net interest margin is rising as are low cost deposit volumes.

If you assume that WaMu takes 30 billion in cash losses on the loans (mostly mortgages) over the next two years it should be survivable. The pre-provision profit will cover 16 – the provisions another 8 and the capital ratio starts in the 7s. Tangible capital of 20ish would drop to 16 less any new provisions – and given the capital ratios at the moment would wind up at say 5. It would be difficult for management – but solvency should be OK. At 30 billion in cash losses the stock is probably OK long term provided the losses can be stretched out and WaMu is not forced into a capital raising. If the losses are closer to 10-15 billion the stock would be a big winner.

30 billion in losses is a number way larger than guidance or indicated in the delinquency. However nobody (including myself) believes WaMu because their credibility is stuffed. Remind yourself again about Mish’s bad deal.

The internet is full of stories about WaMu being insolvent – and those stories are credible precisely because WaMu has no credibility.

If WaMu were to take 45 billion of cash losses over four years the subordinated debt (trading just over 30%) should wind up worth par. [The stock of course would be awful.] It is not plausible to me that the cash losses on the portfolio will be that high.

The problem for WaMu is that they need to take their hit over three years. If they took it all at once WaMu would hit the wall very hard. They need to maintain their funding continuously to remain liquid.

Funding is a real problem (actually the problem) for WaMu. WaMu has net loans of 231 billion and a bundle of other assets. The core funding is deposits of 182 billion. There is a bunch of FHLB funding (secured) adding up to most the difference – but there are also “other borrowings” of 30 billion.

How much credibility does WaMu have to support those “other borrowings”? Short answer: not much. And if you look you will see the “other borrowings” are falling quarter by quarter reflecting the real problems that WaMu has maintaining those borrowings. WaMu has no choice but to shrink its way out of the “other borrowings”.

The very fine women who run Gimme Credit (possibly the best and most savvy independent credit analysis firm) have note that unsecured creditors are “pulling funds” from WaMu. They don’t want to use the phrase “run on the bank” – but it is probably a “walk on the bank”.

The difficulty maintaining wholesale funding is not caused by current balance sheet problems. (They are just not that bad.) The problem is caused by WaMu’s lack of credibility. If WaMu hadn’t sold a whole lot of toxic dross marketed as AAA the capital markets might trust them.

Cost of not being believed

The cost of not being believed as a financial institution is high.

Washington Mutual says that it has no need to raise capital – but the cynics argue that the truth is that they can’t raise capital. Certainly when the preferred shares yield 24% and they have an anti-dilution clause on the common –any capital raised would be enormously expensive.

I don’t think they need regulatory capital at the moment (see the calculation above). But the amount of capital you need is not a regulatory function – you need capital if the financial markets won’t lend to you. Capital gives you credibility – and because WaMu has no credibility it needs considerably more capital than its regulatory standard or its unsecured creditors will “walk”. So hang the regulatory standard – WaMu is short capital because it is short credibility.

If WaMu shortage of credibility (capital) turns into a liquidity crisis they will need to sell the whole shebang. Anyone say Wells Fargo, $1 per share?

If you don’t believe me think of Bear Stearns. There is a lot of dross around (most visibly the Vanity Fair article) which argues shorts bought down Bear Stearns.

I argue otherwise: Ambac insured a Bear Stearns home equity line of credit deal where Ambac has already provisioned over 80% of outstandings. Almost every loan made in that deal will default.

Bear told people things about that deal to get it sold and to get Ambac to write the insurance. Those things were lies, pure unadulterated lies.

If you tell lies for too long nobody will believe you any more and you will not be able to roll your own funding. And as a financial institution if you can’t roll your own funding you are going down.

It is entirely possible that Bear Stearns had adequate capital and inadequate funding (though I express no opinion). But the story that shorts told lies that bought down bear doesn’t hold water. Bear told the lies that bought down Bear. The fault resides totally with Bear’s management.

An investment idea

I have no strong opinion on whether you should be long Washington Mutual common or not. I think the problem with being long the common is the death spiral equity (with the non-dilute clause) that WaMu sold TPG is probably enough to decide against the common. Besides if the “walk on the bank continues” WaMu will need to sell itself in distress. The common is very cheap and very dangerous.

But if this is a credibility crisis and not a solvency crisis – and I can’t count it any other way – then the WaMu subordinated debt should be money good. There is a preferred instrument (the K class preferred) which is trading in the 6s against a face value of 25 – implying almost a three quarter chance of insolvency.

If – like me – you think that is overblown – then this is a buy.

You will lose 100% if WaMu if there is an FDIC takeover of WaMu. But if WaMu sells itself at $1 per share to Wells Fargo (or similar) you make a triple or more as the instrument returns to near par. And if WaMu is solvent independently you also make a triple. Meanwhile – as it is a 7.25% yield on face – you get a 26.6% running yield on the current price. That is sweet enough for me.

I purchased quite a few – and despite the 10% fall in their price yesterday I am still showing a profit...

But I can’t say this is a low risk position – and – in the tradition of this blog – I am looking for people to tell me I am wrong. I need plausible arguments as to why WaMu is not only illiquid – but is not worth Wells Fargo rescuing at $1 a share.

I will publish decent arguments explaining why I am wrong if the senders want that. (I am the arbiter of decent here – but if the arguments make me worried about a position I will publish…)

Thanks in advance. This is another position that scares the s--t out of me...


PS. I retain only two positions that scare the c--p out of me. You dear readers know both of them.


Anonymous said...

Can you find me a single catalyst that will prevent bank runs, more lack of confidence, skepcticism etc that doesnt involved killing shareholders?The negative reports are all over the place and I will be surprised if in this Q they dont lose retail depositors, like shocked.
Unless another 1.5 month of the worst is over their liquidity will keep drying up and there is no way housing will change as to affect the mood of the market

Anonymous said...

John - you can achieve similar yield to the preferreds with WaMu's January 2009 bonds. That puts the finish line only 6 months away, and the bonds would be senior to the preferreds in liquidation.

Even 6 months is a long time, in the current context.

Your assessment of WaMu's sustainable capital position appears to be correct. And, Gimme Credit overlooks the fact that the depositors who have withdrawn funds have left WaMu with a relatively low amount of such deposits remaining - so the damage on that front has perhaps largely been done.

However, one leaked letter from Chuck Schumer is apparently enough to start a real bank-run of insured depositors who'd prefer not to wait around for the FDIC to make them whole. Once that happens, it's all over.

John Hempton said...

Murph - you miss the point.

I want the long dated paper trading at a big discount to par. I want the capital appreciation.

I am hardly interested in a short dated 12% yield.

I want a long dated one!!!

Anonymous said...

If they need more capital TPG et. al. are likely to kick in as they benefit from a new lower price according to their agreement. Despite this, debt prices in about 60% chance of default over five years. The big risk is a deposit run and that seems serious to me, but hey - it isn't 60%, so the debt is pricing in too much risk in my view. Like you, I own prefs but I think they are more risky than you suggest - the bank can stop paying pref dividends at will, likewise a new buyer could keep WaMu as a sub, like BofA has done with CFC, and then chose not to declare pref dividends. We may see a moratorium for a few years if they need more capital. That makes sub debt more attractive to me. However, I own series R prefs as they just seem awfully cheap (and cheaper again today..)...Good luck!

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