Whose definition of subprime?

There is no standard definition of subprime. I used to think of the world in terms of “Household International Subprime” and “Conseco Financial Subprime”. The guys at Household didn’t think you could ever write loans at the Conseco level profitably over a cycle (discussion in year 2000). The HI credit modellers I talked to were well aware of the risks of the business – but thought it was unlikely that there would be severe stress on it outside periods of large unemployment. (They were wrong!)

Nonetheless the year 2000 distinction between Household and Conseco could be given with FICO scores:

· Household Subprime was FICO620 to 680, and

· Conseco subprime was below 620.

I think the guys at HI were more-or-less right. The HI business might be profitable on average over long periods and the Conseco business was hopeless at the outset. [Profitable over long periods does not make it a good business.]

After that conversation the world changed and everyone started doing Conseco subprime. There were plenty of issuers who worked with FICOs of 575 and below. I was short several – not because I thought a blow-up was inevitable –just that that sort of business cannot be profitable over a cycle.

High FICO defaults – or why FICOs were misleading

FICOs have proved not to be a great indicator of default.

There are deals done with a weighted average FICO of 710 which are defaulting very badly – see the FICO in Mish’s bad deal for instance. These deals consisted almost entirely of refinances – often cash-out refinances. A person with very poor credit could show as having good credit if they always repaid their last loan. They can achieve this by sequential cash-out-refinances. (A rolling loan gathers no loss.)

Deals with average FICOs above 700 that are behaving that way usually contain a very large number of cash-out-refis.

Why I mention

One of my games is to look at the definition of subprime that people were using (particularly prior to the recent credit crisis). Lots of companies wanted to deny they did subprime loans – so all they did was define subprime to be a credit notch below where they were. Defining the loan as Alt-A doesn’t make the bad credit go away – but it made you look safe. [See IndyMac for a company that denied doing bad credit by defining good as what they did.]

Anyway here are two definitions that stand out for me. The first is from MGIC – a mortgage insurer. The second from Ambac.

Here is MGIC’s definition (2006 annual report):

A-minus and subprime credit loans are written through the bulk channel. A-minus loans have FICO scores of 575-619, as reported to MGIC at the time a commitment to insure is issued, and subprime loans have FICO scores of less than 575. [MGIC defined prime loans as having a FICO above 620.]

To me this definition was astounding. The whole of Households year 2000 business would be prime by MGIC’s definition.

Ambac drank the poison too. It drank less poison but was less aware that it was doing it. The word FICO never appears in the 2006 annual which is full of soothing words about how they had reduced their underwritings in the subprime area. By the 2007 annual report they included a FICO definition:

FICO scores range from 300 to 850. Though there are no industry standard definitions, generally FICO scores are as follows: prime (FICO score over 710), mid-prime (FICO score between 640 and 710) and sub-prime (FICO score below 640).

The entire MGIC midprime business and some prime business is subprime by Ambac’s definition.

I knew in advance that MGIC’s underwriting standards were worse than Ambac. Much much worse. I was short MGIC and had sold out of Ambac. [I always wanted to be long Ambac as much as anything because I liked the CEO. I just did not like the credit cycle and some deals they were underwriting - so I sold my position well before the top.]

MGIC will pay almost 2 billion in claims this year. They are paying less claims than they anticipated – but not for any good reason – it is just that state legislatures are passing bills to slow down foreclosure and the courts are jammed and there are delays.

Ambac pays about 20 million in claims a month (admittedly rising).

Ambac has many times the claims paying capacity of MGIC and a small fraction of the claims rate.

But MGIC is still writing business and Ambac has almost ceased.

They might both be bust – indeed I express no opinion about the insurance companies. But if MGIC remains solvent and Ambac fails then the world is a very strange place indeed. [I will explore MGIC in more detail in a future post. Suffice to say I have no position long or short and the world might indeed be strange.]

Changing tone on MBIA

I have just sold my small holding of MBIA. I have been convinced - following a careful examination of documents issued for GICs - that this post is incorrect in several important ways. In particular the GICs at MBIA have a larger effect on parent company liquidity than GICs at Ambac.

I still have no opinion whatsoever on the solvency of the insurance company. [I intend to do that work - and if I form an opinion that is worth having then I will again take a position in the stock.] I now however take the view that if the insurance company is bad the parent company is likely bad.

And that the statement by Jay Brown about parent company liquidity in a recent letter to shareholders is actively misleading.

I have retained my holding in Ambac.

I make plenty of mistakes. This sort of mistake I enjoy. I made a profit.

Interest rate risk, credit risk and a comment on bank margins

A theme of this blog is the interest rate risk and credit risk of American banks. As regular readers know I got the interest rate risk versus credit risk wrong of late.

But being wrong in the past won’t stop me trying to be right in the future. Besides it is worth considering what proportion of a bank’s margin comes from accepting interest rate risk, what portion comes from accepting credit risk and what portion comes from just servicing customers.

The current yield for interest rate risk

Currently you can buy an “on-the-run” Fannie Mae guaranteed 30 year fixed rate mortgage with a yield of 615bps. Before the Fannie Mae credit crisis it was still almost 600bps. Bloomberg gives a series of what the on-the-run mortgages yield – the so-called “perfect coupons”. You can find this sequence by typing MTGEFNCL on your Bloomberg – or just find a graph here.

Currently the intended Fed Funds rate is 200bps and (highly) secured borrowings will cost only (say) 50-100 bps more than Fed Funds.

Now if we presume that the Fannie Mae mortgage is guaranteed by the Federal Government (a good assumption after last week) and is hence riskless then you can earn approximately 300-350bps by taking only interest rate risk. All you do is borrow floating to buy “perfect coupons”. And you don’t hedge anything.

300bps levered 10 times and with 30% tax taken out will still give you a 20% post tax return on equity.

Unfortunately you take a shocking amount of interest rate risk to get that 20 percent return on equity. The mortgages will (at least in normal times) refinance if rates fall. They will however extend for an unknown but long period if rates rise. Pretty well all movements in interest rates are negative for someone taking that sort of interest rate risk. Indeed it is very easy to model insolvency for such a company.

It was my contention – wrong it seems – that the main risk taken by US banks was interest rate risk. You can see the gory details of my mistake here.

State of the banks

There are banks that take mostly interest rate risk and banks that take mostly credit risk.

Banks that take mostly interest rate risk tend to have floating funding and have assets that are either GSE securities or very secure mortgages. Extreme examples included Commerce Bancorp (something I was short on interest rate risk and lost), and New York Community Bancorp. [State Street also takes a surprising amount of interest rate risk whereas Bank of New York tends to prefer credit risk.] Banks that take mostly interest rate risk have had great relative performance. In the event of an inflationary spiral those same banks would under perform massively. [The jury is still out on inflation – another theme of this blog.]

Other banks however eschew almost all interest rate risk keeping their asset and liabilities of matched duration – which usually means keeping securities of short duration. If you took mostly credit risk and were reliant on wholesale funding your very existence is threatened at the moment. To some extent the way I am shorting now is to find smaller banks that were consciously rejecting interest rate risk two years ago – but still have fat margins. They had to have done something bad to maintain those fat margins…

Margins and risk

I mention all this for a reason. If you are earning more than 300-350bps of spread in a bank you are taking some funding or credit risk – because it is simply not possible to earn that in interest rate risk unless you own some very exotic instruments.

Contra: I know of one bank which issues callable funding to buy callable assets. This sounds like it is matched – but if rates go up the funding gets called and they lose (having to refinance at higher rates). The assets however stick around. If rates go down the assets get called – and the funding sticks around and they lose. This bank has held up remarkably well through the crisis because they don’t take many credit risks – even if they do take enormous interest rate risks. The bank could still wind up highly problematic but it won’t get that way on credit.

But short of such exotic behaviours if you are earning more than about 300-350bps you are taking credit risks. If you earn 350-400bps of spread and you specifically disavow interest rate risk then you are taking a very large amount of credit risk. Find me regional banks that rejected most interest rate risk two years ago and I will find you regional banks that are potential credit problems.

Hybrid banks

Most banks fall somewhere in the middle. To pick one of many examples, Webster Financial Corp is a bank which is pretty well run. It is headquartered in Waterbury Connecticut and its management are known to several Connecticut hedge fund types.

Webster made the same mistake as me. It thought that interest rate risk had to be avoided. So it reduced interest rate risk – quite sharply. It decided to take some (quite a small amount) of credit risk. You would call this risk diversification. The stock price shows the result.

Webster was early to recognise their mistake. As I said – they are pretty well run– and in the scheme of things they are hardly a bank that is likely to wind up owned by the Feds. But shareholders have hardly had a nice time.

Webster took mostly interest rate risk. This is its five year margin summary – which shows non-performers including real-estate owned reach the princely sum of 1 percent of assets (on their way quite a bit higher).

Note the interest rate spread was always below 350bps but still above 300bps.

That is very high by global standards because in most countries banks do not have huge refinanceable assets – and hence do not carry the sorts of interest rate risks that American banks take. Its a middling spread by American regional bank standards.

My regional bank

Last week I referred to a regional bank which I had been working on with a reader. Small cap – so we won’t mention its name. I wanted to short the subordinated debt – but couldn’t get a borrow so I shorted the common. It took me about 15 minutes to make that decision.

Here are the things that stood out:

1. It had specifically disavowed interest rate risk saying that it had shifted its security holdings towards FHLB securities because they could easily be pledged (as they contain little credit risk) and could be purchased with short durations,
2. It had massively grown its deposit base in deposits greater than 100K by using promotional rates,
3. After this promotional binge it was the bank most dependent on jumbo deposits that I have ever seen. Given the noise of banks failing the populace could get quite jumpy about jumbo deposits and I would not think that funding base is very secure,
4. Despite having expensive funding and not taking interest rate risk it had a margin of 4% (now declining) - which suggests it was doing something else to get the margin,
5. That something was (more or less obviously) accepting credit risk. It had 1.75 times its shareholder equity in home-equity-line-of-credit products, 1.7 times in real estate construction loans and one times its capital in loans secured by vacant property owned by developers. It grew its HELOCs sharply in 2006. In 2006 it also more than doubled its mortgages on unimproved land.

I think there is a fair bet that this regional bank is cactus. I really wanted to short its debt.

But hey – what do I know? The provisions through the income accounts were less than 10 million – and outstanding provisions are about 20. The non-peforming loans are only half Webster Financial – and they think the lending is so good that they expanded loans in every one of these categories during the last quarter.

This of course leads to the real reason I won’t name the bank. I smell a rat. A big, nasty hairy one, but I can’t quite identify what it is. On this blog we don’t want to make it up and want to correct our mistakes – and we will not blurt out quasi-fraud allegations against small regional banks unless of course we have three decent forms of evidence.

The Wells Fargo puzzle

So now I will leave you with a question for which I do not know the answer. How is it possible that Wells Fargo’s margin 450bps? Please – serious answers are gratefully accepted as I do not understand.

This is not unusual in the history of Wells Fargo. There have been several points where their margin was greater than the prime rate.

Wells Fargo’s margin is off-the-scale high by global standards – I once did a global survey and it was the fattest margin major bank in the world.

Prima-facie that is good. High margins allow you to take considerable losses and remain profitable.

But usually have to take some risk to get high margins – and as the calculations above show – it is unlikely to be all interest rate risk. When I did my survey the other super-fat margin financials were subprime credit originators (mostly autos and credit cards).

As I said – I do not fully really understand just why Wells Fargo is quite so profitable. Can someone help?

Please...

Babe – I can’t find a vein

Paul Kelly – an Australian poet troubadour howls about addiction: babe – I can’t find a vein.

I know how he feels.

One reader is working with me on some very small regional banks for shorting. I will not write about them – because they are just too small.

However we have found one where we think the subordinated debt is a fabulous short.

So here is my howl:

Babe - I can’t find a borrow.

The security in question is not on the SEC’s new list of things you can’t naked short – but still the discount broker is not giving me a borrow. They are usually pretty good – but sometimes they can’t maintain the borrow and they call me in.

Does anybody know a broker who will give me a naked short?

I thought not.

I will continue in the way of Paul Kelly

Little cloud little cloud way up in the air
Little cloud little cloud way up in the air
Well I ain't receiving, little cloud's moved on somewhere

Things I got right and wrong

In a previous post I referred to a history of US finance I wrote in the first half of 2007.

Most (but by no means all) of that document reads pretty well.

Time makes most predictions in the stock market look awful.

There are few here that bear repeating.

One paragraph is as follows:

For American banks in general there are few credit risks we can identify. [Oops - I really wrote that...] There are exceptions - regional banks with undiversified Florida apartment construction loans...

There is some redemption in that paragraph. The regional bank I was referring to was Bank United. See this stock price chart...

In the same document I noted Washington Mutual had a massive subprime mortgage exposure but I thought that it was not existentially threatened. Well its deeply subordinated debt is trading at 30c in the dollar - which sounds pretty existential to me.

----

All this is to prove that there is a reason that stock-pickers shouldn't make too many public pronouncements. Humble pie will be the bloggers diet.

----

I have a short idea I am working on. The company just put out a record profit. Humble pie coming up!!!

John

Thing that stuns me - Natixis: French turds and raisins

Alejandro Valverde a pre-race favourite who rides for the Caisse d’Epargne cycling team in le Tour de France blew up on the mountain top finish into Hautacam. He is down more than 4 minutes – and his chance of emerging a winner of the tour is now low.

Group Caisse d’Epargne – the sponsor - is a collection of mutual savings banks in France. The mutuals however own majority control of an investment bank with a big asset management business. That investment bank is Natixis. It used to be called Natexis but it merged with Ixis (which used to be outright owned by mutuals) and changed its name. Ixis is an asset management business. Ixis has since changed its name to Natixis Global Asset Management. They also own a none-too-bad wealth management group in there – La Compagnie 1818.

The blow-up of Caisse D'Epargne's subsidiary cyclist cost 4 minutes. The blow up of their susbsidiary investment bank is somewhat more expensive.

The Natexis investment bank is very bad. It had most of its business in securitisation where they were the suckers at the end of many deals. They are one of the more spectacular blow ups of Europe.

Howeer Ixis has some very good businesses in it. Ixis got that way by using the profits of the mutuals (which could not be distributed) to buy lots of good asset managers (often at high prices). The fund managers it owns include Harris Associates (Oakmark Funds) and Loomis Sayles. Ixis is the largest funds management group that you have never heard of. It manages about 600 billion euro - almost a trillion dollars. Natixis is a large proprotion of the size of UBS.

The asset management businesses must spit off cash. They would generate capital even in this environment. But Natexis has blown it and all. Natixis is doing yet another big capital raise - this one for USD6 billion.

This all leads to what I call the French banking question: why do very well run regional banks with perfectly solid wealth management businesses insist on being bad investment banks? It all reminds me of the Munger view of turds mixed with raisins. They are still turds.

I guess this is also the UBS question. UBS took the best wealth management business on the planet and mixed it with an enormous pile of turds. Natixis is just more problematic and much cheaper...

Now does anyone have any idea how you separate turds and raisins?

Mistakes

We all make mistakes.

I have made two substantial mistakes I know about in doing this blog. (There are probably more I do not know about.)

For one mistake I just annotated the post. The other mistake was so central to the argument I just deleted the post as a demonstrably false argument is not worth any reader's time. [That post was on Fannie Mae and Freddie Mac. If you remember it - just forget it.]

In this business mistakes cost money.

If any of my readers spot something that they know to be wrong - or even think to be wrong I would really appreciate an email. We might agree to disagree - but I will try to approach any position with an open mind.

I am not writing this blog to push positions. I would rather tell you of the warts in positions (such as GE Real Estate at GE). The world is complex and most good positions have a bit of hair on them. Intellectual honesty is - in my view - a key to good investing. I am trying hard to cultivate that trait.

So please readers - keep the emails coming.

Thanks

John Hempton

The peculiarity of Fannie and Freddie’s market cap

This post is deleted. It is wrong.

I much appreciate people indicating mistakes. I am kind of embarrased about that one...

J

The Norwegian bank collapse – a fixed currency model with a current account deficit

In my post about the Japanese bank collapse I showed how insolvent banks could remain liquid and hence operating for decades provided that they had (a) sufficient deposit funding and (b) low enough interest rates. [Please read the Japan post before you read this one.]

Given that the Japan situation required sufficient deposit funding I argued the Japanese deflation model was not a good model for how the US situation would wind up. I promised to talk about the Scandinavian bank collapse in a follow up post.

As I wrote this post I realised that I did not know enough about the Scandinavian collapse generally to write a useful post. But I know plenty about the Norwegian collapse.

This is helped by the Norwegian Central Bank (Norges Bank) who have published a long English language description of the Norwegian banking debacle and its aftermath. You will find it online here – and it is free. This is the single most useful document I have ever read on decoding that sort of banking disaster – and anyone that claims to speak knowledgeably about this sort of banking collapse who has not read it should probably be ignored for spouting theory rather than data. (Ideology abounds amongst the pundits – ignore it.)

The Norwegian case is held up by many pundits (including Krugman and myself) as the best model for how government and central banks should behave in a financial debacle. For reasons that will become clear in this post I am not sure that is always the case.

Anyway Norway had a few preconditions not all of which are necessary but which are often associated with bank failure:

• It had a recently deregulated financial system where new forms of lending and new processes of credit approval were rapidly introduced
• It had a current account deficit
• It had a fixed exchange rate and
• It had a fairly recent adverse terms-of-trade change (namely a big fall in the oil price).

Of these – in my view – and probably in Norges Bank’s view – the most important factors were the fixed exchange rate and current account deficit.

Financial institutions and current account deficits

Financial institutions intermediate current account deficits. Joe Sixpack is hardly borrowed a couple of hundred thousand for his mortgage by going to the global financial market. Instead he goes to a local bank and the local bank raises the money in global markets either by issuing debt in its own name or by securitisation, covered bonds or some other route. This is true everywhere that there are current account deficits. When there are sustained current account deficits banks on average lend more than they take in deposits.

If there is a run on a fixed currency – meaning people want to take money out of that currency – that in effect becomes a run on the wholesale funded banks.

Norway had a current account deficit and naïve wholesale financed banks. They were naïve because recent deregulation meant that they really knew relatively little about wholesale funding risks or the new types of lending they were doing. Worse it had a fixed exchange rate. This was a nasty set of preconditions.

Further, in the early 1990s there were several countries that had fixed exchange rates in anticipation of European monetary union. In some of those countries (especially the current account deficit countries) the exchange rates were too high – and were vulnerable to speculative attack. By far the most famous speculative attack was against the UK pound. George Soros famously made a billion pounds “breaking” the bank of England. To this date the UK has never never even looked like again fixing its currency to the Eurozone.

The Scandinavian countries were likewise subject to speculative attack. The Norwegian attack was the most severe because the current account was getting massively worse. [Norway – an oil rich economy – had a massive spending boom financed by bank lending as the oil price crashed towards $10.] The speculative attack quite literally ran the banks out of money. There was thus an economy wide crash.

It is worth making an aside here. When the banks actually run out of money they can’t lend. Asset prices depend critically on the ability to borrow against them (and that includes the price of current mortgages in the secondary market). When the banks can’t lend asset prices can fall to very low – indeed insanely low levels. At the height of the crisis some 2 bedroom apartments walking distance from the centre of Oslo (one of the richest cities in the world) and with full 180 degree fjord views traded hands for USD15000. You would have easily made 30 times your money buying those properties. Property prices can fall to very low levels without any bank lending. Indeed the ability to borrow to buy assets is often crucial in maintaining their prices…

Now at this point it is worth noting that the banks are illiquid and point-in-time insolvent. When property prices had fallen to such (absurdly) low levels the entire market was upside-down and if you were to liquidate the banks they would be grotesquely insolvent.

All this ended very rapidly. The government guaranteed bank liquidity – and wound up with ownership. The mechanism by which they nationalised the banks is beyond the scope of this post. Most importantly they floated the Kroner – and the currency driven run on the banks ended almost overnight. Certainly the crisis had seriously abated within three months.

When the run ended the banks were again liquid – so they could again lend. Property prices rapidly rose returning to something that looked more normal (if not expensive by global standards) and the banks were solvent. This was a strange crisis because if the underlying assets were priced rationally the banks were solvent always – they were just illiquid.

There is a proof of this assertion. Paul Krugman suggests in the NYT that the Scandinavian bank bail-out cost a lot of money. But the Norwegian government actually made a profit on the bank bail out. The loans wound up not-very bad and the Norwegian government wound up owning most of the banking sector which they again privatised. Norway is as close to the case of illiquid but solvent banks as I am aware of.

What does this mean in the US context?

It is regularly asserted that the Norwegian model is the superior model for dealing with banking crises. The economy bounced back very fast (and isn’t that the goal?). The government didn’t wind up insolvent. Indeed all was indeed well.

But this misses the point. Norway was the case example of illiquid but solvent banks. Bailing out illiquid but solvent banks is the right thing to do (if you can trust the government to identify illiquidity without insolvency). Bailing out insolvent banks tends to reward behaviour that makes you and insolvent. And it is costly. If you think that the Norway experience can be duplicated in any bank bail out – then unfortunately you are sadly mistaken. I doubt the average government can identify the difference between illiquidity and insolvency. Certainly the bulk of the investor population couldn’t (or the banks would not have been illiquid). The Norwegian government got really lucky because the banks it chose to bail turned out just fine.

What does this mean generally?

For investors there is a simple lesson: be careful of fixed exchange rates and current account deficits. I have already pointed to Spain. I have a post coming which points to what I believe is a huge forthcoming financial crisis with nasty geopolitical implications. Oh, and a great investment idea.

But dear readers, you will have to wait for that one…

John

Santander buying Alliance & Leicester

Whoa big news just after I write about Spanish banks.

Santander is buying Alliance and Leicester. That fits with Santander’s other UK operation – Abbey National. So I shouldn’t be surprised.

Santander is a bank with funding problems – as is A&L. The funding issues however are reflected in A&Ls share price. A&L has been for sale for a long time – and Credit Agricole didn’t confirm the rumours by buying them at 12 pounds. 3 pounds (the Santander price) is a long way down.

All this reminds me of a conversation I had a long time ago at a banking conference in London. It was the conference dinner and I was sat next to an indescribably boring US fund manager who simply didn’t have a clue that there were risks in banking and a somewhat more interesting (but equally clueless) senior executive at Alliance & Leicester. I was drowning my sorrows in cheap cheerful French wine.

I remember taking the guy (who worked in the finance department at A&L) through his own balance sheet. Amusingly I seemed to know it better than him. They had relatively few risks in the mortgage business – but they had taken considerable funding risks. The inter-bank funding was growing 25% per annum – and that funding is hot. They were also running out of capital. My clueless executive understood they were running out of capital and suggested that that was OK because when they ran low they would just sell the bank. The clueless fund manager thought that was fine because he could buy A&L waiting for the takeover. And maybe he made money so maybe he wasn’t so clueless – provided he sold on the rumour of the Credit Agricole acquisition…

But neither of them realised that the liability side of their balance sheet contained risks. My notes clearly say that the senior finance executive simply had never thought about the risks on the funding side.

I guess Santander is thinking about them though. They are paying stock.