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June 10, 2008

The Anatomy of a Sick Bank!
by Reggie Middleton

So, how safe is your Doo-Doo? This installment of Reggie Middleton on the Asset Securitization Crisis (part 17) is more consumer orientated, and attempts to reveal who the riskiest banks are in the Doo-Doo 32 list that I have compiled. This should be telling, for the list itself is comprised of banks that are basically knee deep in Doo-Doo, hence the moniker (for those that didn't get it). Below is where we stand in the Asset Securitization Crisis as of this article (this may even be the makings of a best seller in the fact is stranger than fiction department of Amazon, publishing companies - you know what to do ).

The Asset Securitization Crisis Analysis road-map to date:

1. Intro: The great housing bull run - creation of asset bubble, Declining lending standards, lax underwriting activities increased the bubble - A comparison with the same during the S&L crisis
2. Securitization - dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble - declining home prices and rising foreclosure
3. Counterparty risk analyses - counter-party failure will open up another Pandora's box (must read for anyone who is not a CDS specialist)
4. The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue
5. Municipal bond market and the securitization crisis - part I
6. Municipal bond market and the securitization crisis - part 2 (should be read by whoever is not a muni expert - this newsbyte may be worth reading as well)
7. An overview of my personal Regional Bank short prospects Part I: PNC Bank - risky loans skating on razor thin capital, PNC addendum Posts One and Two
8. Reggie Middleton says don't believe Paulson: S&L crisis 2.0, bank failure redux
9. More on the banking backdrop, we've never had so many loans!
10. As I see it, these 32 banks and thrifts are in deep doo-doo!
11. A little more on HELOCs, 2nd lien loans and rose colored glasses
12. Will Countywide cause the next shoe to drop?
13. Capital, Leverage and Loss in the Banking System
14. Doo-Doo bank drill down, part 1 - Wells Fargo
15. Doo-Doo Bank 32 drill down: Part 2 - Popular
16. Doo-Doo Bank 32 drill down: Part 3 - SunTrust Bank

This installment in the series is a little different. Here's why.

This series was started as a check and balances macro study to either support or debunk my wide ranging shorting of the US, Asian and European banking system (that's right, I believe global banking is F@#$%@, and I am willing to put my money behind my convictions, not to mention publish them across the web) and real asset related companies. The series became quite popular, and a few people have asked me if I thought their particular bank was safe, should they withdraw their funds, etc. I, as a rule, absolutely do not give out advice to the public. Even if I did I don't think anyone should be taking that type of advice from a blog, but I don't give it anyway. I even shy away from giving my opinions on certain matters because I don't want to be responsible for yelling "Fire!" in a crowded theater. Then I came across this article in the WSJ: Memorandum Agreement With Regulators Effectively Puts Banking Unit on Probation, excerpted below -

National City Corp.'s banking unit, which has been buffeted by rising bad loans, has recently entered into a "memorandum of understanding" with federal regulators, effectively putting the bank on probation.

The confidential agreement with the Office of the Comptroller of the Currency was entered into over the past month or so. It illustrates the growing regulatory pressure some financial institutions are under as they struggle to deal with fallout from the credit-market turmoil.

Under such agreements, which are entered into privately and aren't publicly disclosed, banks are given an opportunity to work with federal regulators to address serious financial problems without triggering alarm among depositors.

The terms of the agreement with National City aren't known. However, regulators usually urge banks to maintain adequate capital and improve lending standards...

... National City probably isn't alone in operating under such a memorandum of understanding. Regulators, hoping to fend off a wave of bank failures, have been pushing lenders to raise more capital, curtail their growth, and improve their risk-management and underwriting practices. Banking experts estimate that a handful of midsize banks recently have entered MOUs.

Such MOUs are agreements between regulators and bank management. They are considered serious and are fairly rare, though it is even less common for a bank to face a public enforcement action. If a bank receives a nonpublic enforcement action and then resolves all of the issues in a timely manner, regulators would likely never disclose the sanction publicly.

If a bank fails to comply with an informal enforcement action, regulators can bring more-severe penalties -- often publicly -- to clamp down on a company's management or operations...

I pointed out to my regular blog readers that this bank and most likely quite a few others touched by the OCC (federal oversight agency for banks) are on my Doo-Doo list . I received a few more inquiries, and thought to my self, "If it were my money in the banks, I would want to know if it was in trouble." So, after blogful ruminations, I decided to approach this from more of a consumer perspective than an investment one.

Let me explain the five major tenets of the sickness troubling banks these days.

1. An absolutely horrible macroeconomic environment with the convergence of a downward banking business cycle, a bear market approaching, and recession.
2. Rapidly depreciating assets borne from excesses during the recent real asset and credit bubble.
3. High levels of these rapidly decreasing assets on (and off) the books of many banks
4. High levels of leverage (the highest historically) used to purchase the aforementioned. Leverage which exacerbate both profit and loss (we are in a loss moment, now). The combination of this high leverage and the prices paid for the assets mentioned in point 2 create an INSOLVENCY trap for companies that attempt to reduce risk by delevering (ala Lehman Brothers or Citibank). When in this situation, the only way to reduce risk is to realize significant losses (and some banks are trying to hide them).
5. Thin profit margins that are beyond the ability of the government to help. The banks can't earn their way out of this one.

This all basically leads to insolvency if not corrected timely.

This is an insolvency issue, not a liquidity issue! I have been banging the table on this for almost a year...

As concluded in the bullet list above, the trifecta of diminishing margins, increasing insolvency, and high leverage leads to a sick bank. I would like to delve deeper into each symptom and side effect in order to identify the sickest amongst the Doo Doo.

Insolvency exists for a person or organization when total financial liabilities exceed total financial assets. Financial and real estate institutions that have binged on overvalued risky assets at the top of a bubble, paying for said assets via highly leveraged credit, are now facing the effects of the devaluing of those assets and that devaluation being applied against the excessive debts that have been accumulated to buy those assets when they were bubblicious. Although the Fed appears to by trying to use excessive liquidity through rate reductions to re-inflate risky asset prices (the rate reductions bypass the debt, and only inflate asset prices) in a bid to make these institutions more solvent, the process is backfiring. The assets that weren't binged but are relied upon for daily consumption are inflating, but the speculative real assets that were at the heart of the problem are still devaluing against a mountain of debt. Lots of debt, diminishing collateral. Whoa!

Solvency ratios

There are a variety of ratios and metrics floating around that attempt to measure the risk of failure in banks. The Texas ratio has received a lot of media attention lately, and is simple and straightforward. It is a measure of a bank's credit troubles, developed by Gerard Cassidy and others at RBC Capital Markets. It is calculated by dividing the value of the lender's non-performing loans by the sum of its tangible equity capital and loan loss reserves.

In analyzing Texas banks during the early 1980s recession, Cassidy noted that banks tended to fail when this ratio reached 1:1, or 100%. He noted a similar pattern among New England banks during the recession of the early 1990s.

As you can see, some of the Doo Doo banks have 6/10th's of their feet in the grave already. To be realistic in today's environment of high leverage and structured products, a Texas ratio of 100 is unlikely. A bank that even got close to 1o0 would be out of business before it got there. Case in point is Countrywide, at a 40% ratio, is only still in existence due to a proposed acquisition by another troubled bank. Huntington Bancshares, at 60%, is literally the walking dead and is assuredly on some (if not many) government entity's watchlist.

Looking back over the last two quarters, one can notice significant jumps in this ratio for the entire spectrum of banks on the Doo Doo list. These spikes are quite significant in most cases, and are fairly consistent, in that they are for several quarters and not a one time phenomena.

Leverage Significantly Exacerbates Solvency Problems, and Ladies and Gentlemen We Have Solvency Problems

To quickly recap how this leverage works let's revisit "Banks, Brokers, & Bullsh1+ part 2" wherein I breakdown the layered effects of leverage on Morgan Stanleys books.While commercial banks are generally less levered then investment banks, the effects of leverage and the multiplier effect of cascading losses remain the same. I urge all who are not familiar with it to peruse the afore-referenced link.

In the graph above, notice how the banks in question are bringin leverage down and realizing substantive losses in the process. The standout is Citigroup, who in essence is bringing large swaths of assets on balance sheet that were off. Citi is simply coming clean on past leverage, and not truly increasing it.

Bernanke comes to the rescue that doesn't

Federal Reserve chairman Ben Bernanke has spearheaded the most aggressive rate cutting and monetary policy action in the history of this country. He has reduced the effective federal funds rate by nearly 50% in just 5 calendar quarters, from an already relatively low 5.3% to 2.6%.

History's most aggressive rate cutting does nothing to help sick banks. As a matter of fact, some of the banks got sicker after the rate cuts. For those not familiar with bank numbers and net interest margins, let's look at it from a manufacturers perspective. Banks inventory can be equated to capital. Banks borrow to get inventory, just as manufacturers borrow to get physical inventory. The banks, and the manufacturers must pay interest on these loans. So, let's say the manufacturer has to buy inventory (bank's capital) for $5 each to make widgets. The company then sells widget inventory items at $5.20 each retail. This gives the manufacturer a 4% profit margin (the manufacturer must turn the borrowed money into product, where the banks can actually use the borrowed money as product). Now, the manufacturer runs into trouble because he bought 40 million too many widgets due to his belief the whole world would go on buying more widgets then it needed, and could afford, forever. So, the government comes to bailout out,,, oh, sorry about that, apply monetary policy to the situation and subsidizes the cost of said widgets to the manufacturer by 50%. That's right, the government takes 50% off of the manufacturer's widget costs so the manufacturer will have more profit in order to dig himself out of this hole from which he so aptly and skillfully dug himself into.

But, guess what's happening? Contrary to all of the "know it all" pundits, arm chair investors and ivory tower economist's preachings and teachings (no disrespect intended towards "know it all" pundits, arm chair investors and ivory tower economists) the manufacturer still can't make money and his profit margins are remaining the same, or even going down in some cases. Click any graph to enlarge to a full page, print quality presentation.

The primary reason why the Fed's lowering of the interest rates is not helping the banks is because monetary stimulus via discount windows and low interest rates can solve liquidity issues, which the banks have - but the banks liquidity issues stem from INSOLVENCY, and illiquidity. Thus, all the Fed is doing is taking a pricey, risky (inflation and weakening currency that pisses off our trading partners) and volatile band aid and applying it to deep and gushing wound. Those band aids with the pretty colors do indeed tend to make Mama's baby's little boo-boo feel better, but from a scientific perspective do very little in regards to addressing deep puncture wounds.

Thinning Margins are Impervious to the Medicinal Elixir of Low Interest Rates Proffered by the Fed. Unfortunately Inflation is not!

This is an example of what a healthy response to the Fed's rate cuts should look like. As the funding rates (which are the primary expenses for commercial banks) drop the profit margins in the capital intensive businesses should expand (net interest margins). As you can see, JP Morgan took full advantage of the Fed's bailout-i-licious actions, although as you can see we seem to be hitting a point of diminishing returns. Let's see how the banks on the Doo-Doo 32 list have fared under this rather generous environment created by the Fed Chairman.The Fed Funds rate has dropped 225 basis points over the last 5 quarters, nearly halving bank's funding costs. As the most prescient among you have already surmised, we have a slew of sick banks, and they seem to have actually choked on Dr. Bernanke's thin rate elixir. Oh Uh! Heavens to Mercutroids! Whatever will we do when the Fed can no longer rescue the banking system by dropping rates??? Oh my....

Keep in mind that if the Fed is forced to raise rates for whatever reason, the marginal banks on the Doo-Doo list are toast.

A visual depiction of margin health among Reggie Middleton's Doo-Doo 32 is below. Remember, these banks have a multi-dimensional problem set. Even though some may be doing relatively well via interest margins, they are getting killed in mark-to-market losses, credit risk exposures, etc., and vice versa.

The Visual Doo-Doo

	Bank	Y-o-Y share price	Chg in NIM (1Q08/ 1Q07), FF:-2.25%	Texas ratio	Tangible Equity/ Assets?
Watch your money!	Huntington Bancshares	-63.10%	0.31%	59.5%	7.6%
Watch your money!	WAMU *	-80.40%	0.21%	47.0%	6.9%
Watch your money!	National City Corp	-84.70%	-0.34%	40.4%	6.5%
Watch your money!	Countrywide *	-86.25%	-0.10%	38.8%	4.7%
Highly Suspect!	Popular Inc	-41.50%	0.34%	29.7%	7.4%
Highly Suspect!	Fifth Third Bancorp		0.16%	26.9%	7.7%
Approaching the brink!	SunTrust		0.05%	26.4%	7.2%
Very Sick Bank	First Horizon	-75.20%	-0.16%	26.3%	6.6%
Very Sick Bank	Wachovia Corp	-60.40%	-0.24%	23.9%	6.2%
Very Sick Bank	Synovus Financial Corp	-66.80%	-0.34%	21.2%	9.0%
Very Sick Bank	Marshall & Ilsley	-53.70%	-0.31%	18.3%	8.3%
Very Sick Bank	Regions Financial Corp	-54.20%	-0.42%	18.3%	6.7%
Sick Bank	KeyCorp	-49.50%	-0.22%	17.2%	9.2%
Sick Bank	Wells Fargo	-26.80%	-0.10%	17.0%	7.0%
Sick Bank	First Charter	-37.90%	-0.07%	16.8%	9.4%
Sick Bank	M&T Bank Corp	-24.60%	-0.19%	16.4%	7.0%
	Citigroup		0.16%	16.3%	6.1%
Sick Bank	Associated Banc	-21.30%	-0.06%	15.2%	7.8%
Sick Bank	BB&T Corp	-31.60%	-0.20%	15.1%	7.3%
	Sandy Spring Bancorp		0.12%	15.0%	8.8%
Sick Bank	Sovereign Bancorp	-60.80%	-0.35%	14.4%	6.9%
Sick Bank	Zions Bancorp	-49.50%	-0.21%	14.0%	7.2%
Sick Bank	U.S. Bancorp	1.90%	-0.13%	11.5%	8.1%
	Harleysville National		0.09%	10.9%	8.1%
Sick Bank	Bank of America	-37%	-0.12%	9.4%	5.6%
Sick Bank	TriCo Bancshares	-29.40%	-0.24%	8.6%	10.8%
Sick Bank	Nara Bancorp	-20.80%	-0.41%	8.1%	10.6%
Thinnest Capital in Class	PNC		0.40%	7.4%	6.8%
	JPM Chase		1.29%	6.5%	5.9%
	Glacier Bancorp		0.09%	6.4%	10.9%
Sick Bank	Capital One	-47.14%	-0.12%	5.8%	9.4%
Sick Bank	CVB Financial	-9.10%	-0.13%	0.9%	7.7%
Averages		-46.2%	-0.04%	19.0%	7.7%

Reggie Middleton
Reggie Middleton, LLC
Perpetual Interests, LLCTM
http://boombustblog.com/

Who am I?

Well, I fancy myself the personification of the free thinking maverick, the ultimate non-conformist as it applies to investment and analysis. I am definitively outside the box - not your typical or stereotypical Wall Street investor. I work out of my home, not a Manhattan office. I build my own technology and perform my own research - in lieu of buying it or following the crowd. I create and follow my own macro strategies and am by definition, a contrarian to the nth degree.

Since I use my research as a tool for my own investing to actually put food on my table, I can stand behind it as doing what it is supposed too - educate, illustrate and elucidate. I do not sell advice, I am not a reporter hence do not sell stories, and I do not sell research. I am an entrepreneur who exists just outside of mainstream corporate America and Wall Street. This allows me freedom to do things that many can not. For instance, I pride myself on developing some of the highest quality research available, regardless of price. No conflicts of interest, no corporate politics, no special favors. Just the hard truth as I have found it - and believe me, my team and I do find it! I welcome any and all to peruse my blog, use my custom hacked collaborative social tools, read the articles, download the files, and make a critical comparison of the opinion referencing the situation at hand and the time stamp on the blog post to the reality both at the time of the post and the present. Hopefully, you will be as impressed with the Boom Bust as I am and our constituency.

I pay for significant information and data, and am well aware of the value of quality research. I find most currently available research lacking, in both quality and quantity. The reason why I had to create my own research staff was due to my dissatisfaction with what was currently available - to both individuals and institutions.

So here I am, creating my own research for my own investment activity. What really sets my actions apart is that I offer much of what I produce to the public without charge - free to distribute and redistribute, as long as it is left unaltered and full attribution is given to the author and owner. Why would I do such a thing when others easily charge 5 and 6 digits annually for what some may consider a lesser product? It is akin to open source analysis! My ideas and implementations are actually improved and fine tuned when bounced off of the collective intellect of the many, in lieu of that of the few - no matter how smart those few may believe themselves to be.

Very recently, I have started charging for the forensics portion of my work, which has freed up the resources to develop the site to deliver even more research for free, particularly on the global macro and opinion front. This move has allowed me to serve an more diverse constituency, which now includes the institutional consumer (ie., investment turned consumer banks, hedge funds, pensions, etc,) as well as the newbie individual investor who is just getting started - basically the two polar opposites of the investing spectrum. I am proud to announce major banks as paying clients, and brand new investors who take my book recommendations and opinions on true wealth and success to heart.

So, this is how I use my background and knowledge in new media, distributed computing, risk management, insurance, financial engineering, real estate, corporate valuation and financial analysis to pursue, analyze and capitalize on global macroeconomic opportunities. I have included a more in depth bio at the bottom of the page for those who really, really need to know more about me.

Visit his blog Boom Bust Blog.

Copyright © 2007-2008 Reggie Middleton

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