As I See It, 32 Commercial Banks and Thrifts May See the Feces Hit the Fan Blades

By: Reggie Middleton | Fri, May 23, 2008
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I have identified 32 banks that are $@%%. It's really as simple as that. I have been publishing the research that I used to build my investment thesis. Thus far we have:

  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 - counterparty failure will open up another Pandora's box
  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. 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
  7. Reggie Middleton says don't believe Paulson: S&L crisis 2.0, bank failure redux
  8. More on the banking backdrop, we've never had so many loans!

I am almost prepared to start listing more of my commercial banking shorts, but before I do I want to delve even further into the educational realm so there is no doubt as to why I am as bearish as I am. For those who can't wait to see my ultimate shorts, I will give you the complete list of what I call the "Deep Doo-Doo Banks". These are the banks that are steeped pretty deep in it. Are you ready? Can you handle the pressure? Okay, here we go!

Wells Fargo - Popular Inc - SunTrust - KeyCorp - Synovus Financial Corp - Marshall & Ilsley - Associated Banc - First Charter - M&T Bank Corp - Huntington Bancshares - BB&T Corp - JPM Chase - U.S. Bancorp - Bank of America - Capital One - Nara Bancorp - Sandy Spring Bancorp - PNC - Harleysville National - CVB Financial - Glacier Bancorp - First Horizon - National City Corp - WAMU - Countrywide - Regions Financial Corp - Citigroup - Wachovia Corp - Zions Bancorp - TriCo Bancshares - Fifth Third Bancorp - Sovereign Bancorp

Now, I already release some of my work on one of the banks, chosen due to paper thin capitalization - along with a different view on leverage. Keep in mind, for the purposes of this blog, I'm just a resourceful individual investor - albeit one that is very lucky to date (this post was before Bear Stearns dropped 98%). Therefore, no one, and I really mean no one, should be taking my opinions on this blog as investment advice. It is not intended as such and should not be percieved as such.

Before we focus on which banks I am shorting, let's explore the current banking environment. I aimed my team at banks that have high concentrations in risky products, risky geographic areas and low tangible and regulatory capital. There were a lot to choose from. So, to narrow down the list, I had everybody enter the 12 step program - after reading my tutorials above, of course.

2nd lien products in high LTV states that have rapidly declining housing values proffer the opportunity for 100% losses with no recoveries.

Above is a list of states and the home equity and 2nd lien defaults for said states. For those who don't know, 2nd lien loans (of which include HELOCS, piggy backs, home equity loans, etc.) are 2nd in line when it comes to liquidation rights under foreclosure. If the loan was made with a high LTV (let's say 90% combined LTV, with the first loan made at 85% LTV), in an area that has even a modest (these days, anyway) decline in value of 10% year over year, then you effectively have a 100% loan with not equity. Every dollar after this that the house drops is a permanent loss from the bank's loan. Factor in the costs of deed transfer, mortgage tax, utilities, upkeep, brokers commissions and legal fees (about 7.5%), and the bank now get's nothing, even if it can move at auction. When I say nothing, I mean nothing. Not just an NPA on its books, but absolutely not way to recover any value from the home. I can hear the blog readers now saying, "Well, what are the chances of that happening?". Stay tuned, and we will assuredely find out.

The graph above shows a subsection of my 32 bank Deep Doo-Doo list who sport:

  1. HELOC portfolio exposures with high average LTVs that increase the risk of the whole portfolio
  2. HELOC portfolio exposures with full 100% LTVs or close to it consisting of a very large portion of the total portfolio
  3. HELOC exposures with very high, but not quite 90% LTVs consisting of a large portion of the total portfolio

For those that really wondered whether the scenario that I outline above could really take place - well, wonder no more! We have a whole smorgasbord of banks in that position. The key is, which of these bank have loans in the aforementioned areas detailed in the first graph. I know you know that I know the answer to that question. I'm even going to tell you for free, but before we go there let's cover some additional background material. I want you to pay particularly close attention to who is leading the pack in high LTV concentrations. I was short this bank and WaMu since last year, and have since covered both short positions in the single digits are close to it. As a rule, I rarely ride a stock past $10 on the way down because zero is but so far away and the risk/reward ration is rarely justifiable (the two monolines that I have covered in detail are an exception to this rule). In this case, I covered both too early, particularly Countrywide. The moral to the story here is that many of these banks are not too far behind Countrywide, with the largest difference between CFC and them being CFC's piss poor public relations ability. WaMu is right there too, as well as some big name banks with some big name investors behind them. I will end my bank series with a full scale forensic report of my number one short in the sector and I am sure it will shock many of you who like to buy into brand names.

In order to determine how likely the aforementioned event is, let's create a metric by which Reggie Middleton measures risk. This metric will be units of risky or non-performing assets as a percentage of statutory equity. This, of course, can be refined by removing goodwill, Bullsh1t, and the various accounting pollutants to plain old economic earnings, but less just start with this. When applying Reggie's Risk Metric to the graphs above, we can identify more banks.

Looking at risk from this perspective, we not only see who has no clothes on when the tide goes out, but also how well (un)endowed they are in addition.

Please keep in mind that some loans and banking products are much riskier than others. Due to this, I have culled what I believe to be the riskiest products to short list the banks. We have already addressed 2nd lien loans. There is also construction and development (C&D) loans that are still on the books that are by far, much riskier than the conventional commercial loans - which are risky assets themselves in this environment. An off the cuff, anecdotal assumption would be that 20% of these loans will be in default in many areas, with greater numbers the newer the vintage. For a category such as high rise condos, they are usually 24 month, interest only, 20-30 year amortization. The intent is to have them refinanced into permanent loans upon construction completion, which is difficult for projects such as condos. Construction costs have spiked, supply is up and demand is down. Those banks with high LTV C&D loans (ex. Corus Bank) and any 2nd lien loans over 90 LTV should be high on the short list. One to four family properties are also quite risky, for amateur (and not so amateur, actually) investors bought buildings without a firm (or even loose) understanding of cash flows, cap rates, and rental yields - aided and abetted by the banks which apparently missed out on the cash flow valuation memo as well. Well, those who overshot the predictions of rent rolls, undershot the estimation of expenses, or took out volatile ARM products ended up not only underwater, but with negative cash flow as well. It is much easier to walk away from an investment property than it is to do so from your home. As you can see from the graph below, my assertions seem to be ringing true. The rate of change in delinquencies in these are SKYROCKETING!

I am going to cut this short here, and will continue this series in 24 hours or so. I have quite a bit of information, so the series will be at least 4 or 5 additional parts. I also need to post my homebuilder updates (remember I broke the secret on the industry's secretive JV accounting) and Muni default —>CDS failure connection research as well. So much to do, so little time. I do hope you guys appreciate this, for I don't know where else to find it on the net. As if this disclaimer is necessary: I am short, or in the process of accumulating bearish positions in most if not all of the companies detailed in this article. See you in 24 (or so) on the



Reggie Middleton

Author: Reggie Middleton

Reggie Middleton

Reggie Middleton

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.

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