Superior Bank

By: Doug Noland | Fri, Aug 3, 2001
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Personal Income
Wages and Disbursements
Total Unemployed Workers
Total Unenployed Workers
Employment (Non-Farm Payroll)

Global equity markets generally performed well this week. For the week, the Dow and S&P500 added about 1%, with the Utilities bouncing back for a 4% gain. The Transports were unchanged. The broader market was relatively quiet, with the small cap Russell 2000 and the S&P400 Mid-Cap indices gaining marginally. Technology stocks enjoyed a strong rally, with the NASDAQ100 up 3% and the Morgan Stanley High Tech index adding 2%. The Semiconductors jumped 7%, while The Street.com Internet index gained 4% and the NASDAQ Telecommunications index added 1%. The Biotechs underperformed, dropping about 3%. The financial stocks generally performed well, with the S&P Bank index gaining 1% and the AMEX Securities Broker/Dealer index increasing 2%. While bullion gained fractionally, the HUI Gold index dropped 3% this week.

With conflicting economic data leaving analysts in the lurch, it was an unsettled week in the credit market. For the week, 2-year Treasury yields added 3 basis points to 3.89%. Five-year yields jumped 6 basis points to 4.66%, while the key 10-year Treasury yield increased 7 basis points to 5.16%. The long-bond saw its yield increase 4 basis points to 5.59%. Mortgage-back and agency yields generally increased 7 basis points. The benchmark 10-year dollar swap spread was largely unchanged, as spreads generally remain quite narrow considering

The dollar declined to a 2 ½-month low against the euro this week. Even the battered Asian currencies are showing signs of life, with the Singapore dollar at 4-month and Korean won at 2-month highs against the dollar. The Indonesian rupiah jumped to its highest level against the dollar since February. The Swedish krona gained almost 2%, with strong gains for the Australian and New Zealand dollars.

With reserves dropping below $17 billion (down from $21 billion at the end of June), Argentina is running out of options. The government is attempting to expedite IMF payments that were scheduled for September, and the international community is certainly trying to avoid devaluation and default. Still, surging interest costs and sinking tax revenues are creating a rapidly deteriorating fiscal situation. At the same time, Argentine banks lost an estimated 8% ($6.7 billion) of their deposits last month, in a run ahead of an expected currency devaluation. The currency peg appears an intractable problem for the Argentine economy.

With $10 billion of issuance, July was the strongest month for CMBS (commercial mortgage-back security) sales this year. Issuance was led by a $1 billion deal from GE, $1.4 billion from Lehman, and $1.6 billion from Salomon Smith Barney. From Bloomberg, "Of the $212 billion in commercial mortgages held by insurance companies, $35 billion were made on properties in California… 'Life insurance companies definitely believe they have found a haven for mortgages in the Golden State,'" wrote Jack Nowakowski, author of a study by the American Council of Life Insurers. Elsewhere, GMAC is preparing to sell $563 million of mortgage-backed securities after providing $726 million of financing for Silverstein Properties $3.2 billion purchase of the long-term lease on NYC's World Trade Center Building. The real estate finance "Superstructure" hard at work. Bloomberg ran a story today, "U.S. Real Estate Market Faces 'Sharp Contraction.'"

After record asset-backed security (ABS) issuance during July, JPMorgan is increasing its estimates for total ABS issuance this year to $265 billion. This would be a 17% increase from last year's record sales. Credit card issuance is running 56% above last year, with total year-to-date ABS sales ($166 billion) up 35%. Unless issuance slows markedly, JPMorgan's estimate should be a piece of cake. Bloomberg maintains a running total of U.S. domestic bond sales. Last week (July 23 to 27), $33.29 billion worth of bonds were sold, including $14.8 billion from the agencies, $16 billion corporate, and $2 billion "corporate high yield." With many companies taking full advantage of this favorable environment to refinance, it is difficult to analyze this year's total $1.04 trillion U.S. year-to-date domestic issuance. But it sure seems like a big number.

Personal income and spending data were reported Monday, with both again coming in stronger than expected. Personal income increased 0.3%. Notably, service sector income rose 0.6%, while manufacturing income declined 0.3%. Year over year, wages and salaries have jumped 5.9%, led by an 8.2% increase in the service sector. Personal spending rose 0.4%, and has increased 5.5% from last year. Spending on services has jumped 6.4%, and now accounts for $4.154 trillion (59%) of total personal spending ($7.069 trillion). During the past year, spending on services has increased $251 billion, compared to an increase of $75 billion for non-durables and a $40 billion increase in durable goods expenditures. The Commerce Department also released interesting revisions to previous data, with a significant increase in personal income raising the year-2000 savings rate to 1.0% from negative 0.1%. Year-2000 personal income was revised up to an eye-opening 7% (from 6.3%), with most of the revision coming, not surprisingly, from the service sector. In nominal dollars, personal income increased $541.9 billion during 2000, compared to $351.3 billion (4.7%) during 1999. Total "wages and disbursements" increased 8% during 2000, up from 6.7% during 1999. And in what I view as confirmation of the strong inflationary bias that has developed throughout the service sector, sector income was revised significantly higher to an increase of 10.5%. Incredibly, service sector income surged an astounding 20% during the two-year period 1999/2000. With further recognition that productivity gains have ended abruptly (with the tech bubble), I would not too quickly dismiss the inflationary ramifications of these trends.

The easy financing environment continues to fuel a booming (albeit somewhat slowing) construction sector. June construction spending was reported at $861.6 billion, up 7.3% year over year. Private spending was 3.8% above very strong numbers from last year, led by an 8.2% increase in spending on home improvements, and a 6.3% jump in multifamily construction. Non-residential spending was about 1% below last year, with office construction down 2.6%, and hotel/motels down 12%. Public sector construction remains very strong, with June spending up 21% from last year. Year over year, spending on public housing was up 29%, education 19%, roads 26%, and military spending up 9%.

One the back of declining orders and rising inventories, Wednesday's report from the National Association of Purchasing Management (NAPM) was weaker than expected. : From NAPM's Robert Ore (quoted by Marketnews International): "Obviously, the manufacturing sector has stalled - this particular downswing is different from '91 and '81, in terms of the slowness of the recovery and the depth of the problem. It's much deeper than any one imagined." Well, it appears things could turn worse, as tempered activity from the previously robust automobile and housing sectors appears in the cards. With the NAPM index having now been below 50 (indicative of economic contraction) for 12 months there is considerable expectation that recovery is long overdue.

Indeed, it has been awhile since the U.S. economy experienced a deep economic downturn. It may be worth noting today that during the severe recession of the mid-1970s, unemployment surged from 5% to 9% between July 1974 and May 1975. The number of unemployed actually ballooned 3.7 million in 12 months to 8.4 million by May of 1975. During the previous 10 years, the number of unemployed had not significantly surpassed 5 million (6%), and had been below 3 million (4%) for much of the late 1960s. Back when manufacturing was a very significant part of the economy, industrial production sank almost 13% in nine months. And during the year ended June 1991 (the height of the last recession), the number of unemployed jumped 2.1 million to 8.4 million (5.2% to 6.9%). During the past twelve months, the number of unemployed has increased 747,000, as the unemployment rate has risen from 4.0 to 4.5%. Total non-farm payrolls have increased 24 million from the lows of 1992.

It was another interesting month for the auto sector, and it is certainly worth noting that July was the first month this year that sales came in weaker than expected. We would not be surprised by weak sales going forward, with the recent mortgage- refinancing boom having likely pushed sales forward. July's seasonally adjusted annual sales rate of 16.3 million units compares to the year-to-date sales pace of about 17 million. US nameplates continue their dismal performance, with Ford sales down 12.8% year over year. Ford car sales were down 17%, while truck sales sunk 10%. Expedition sales declined 16%, and Excursion sales were down 39%. GM sales sunk 9%, with car sales down 19%. Nothing like watching the value of an old stalwart brand evaporate, as Oldsmobile sales dropped 21%. Chrysler group sales declined 3% (car sales down 11.4%), as "Big Three" market share declined to 61.2% (vs. last year's 63.6%).

Asian market share rose to 31.6%, with Toyota enjoying its best July ever. With sales up almost 6% over last year, Toyota has over the past year seen its market share rise from 9.4% to 10.6%. Year-to-date, total sales are up 6.3%, with light truck sales surging 29%. Lexus car sales were up almost 16% from last year. Acura had its best July ever, while overall Honda sales were down 6%. It was a record July for Subaru, although Mazda sales were slightly below year ago levels. The Korean manufactures continue to do exceptionally well, with record Julys for both Hyundai and Kia. Hyundai sales were up 32%, while Kia sales surged 58% from last year (y-t-d up 39%). It was a record July for BMW, with sale up 26%. Year-to-data, BMW sales have jumped 22%, with "sports activity vehicle" sales up 69%. Mercedes-Benz also enjoyed a record July and is on track for a record year. It was a record July for Audi, with sales up 22%. Porsche (up 4%) and Volvo (up 32%) both enjoyed their best July's in 15 years. Volkswagen had its best July since 1973.

Last week federal regulators seized Chicago-area Superior Bank FSB, a privately owned (equally by the wealthy Pritzker family and New York real estate mogul Alvin Dworman) thrift with $2.3 billion of total assets. A top government regulator blamed the failure on (from the Chicago Tribune) " 'poor lending practices, improper record keeping and accounting, ineffective board supervision of managements' as well as operating a high-risk business - making mortgage and auto loans to people with poor credit - without a good understanding of the risks and ability to control those risks." Today's Chicago Tribune stated that "people familiar with the bank's balance sheet say the total bailout cost easily could amount to $1 billion" (two-thirds of deposits), which would make it one of the most expensive bank failures since the early 1990s. According to The Washington Post, the head of the Federal Office of Thrift Supervision "said the problem became as bad as it did because regulators relied on the accuracy of statements by the independent auditors, Ernst & Young. By last spring regulators realized the bank's books had been maintained in a 'sloppy' and 'improper' manner and forced Ernst & Young to restate the bank's earnings." The Chicago Tribune reported that "Ernst & Young" had miscalculated the value of the assets," with assets "worth substantially less, perhaps a half-billion dollars less, than anticipated."

To those of us that believe lending aggressively to high-risk borrowers is neither socially responsible nor a viable business (and should certainly not be funded by government insured deposits!), this seems but another senseless episode of financial recklessness - with plenty of blame to spread around. Unfortunately, the risks to the FDIC/taxpayer were ignored from the earlier subprime-related collapses of First National Bank of Keystone and BestBank, as well as a bevy of non-bank lender insolvencies. With the economy sinking into recession after years of unprecedented high-risk consumer lending, it is a case of when and not if the U.S. financial system gets hit with a deluge of consumer loan losses.

It is easy, and certainly justifiable, to criticize the regulators who have been aware of the high-risk nature of this institution for years. Who could have missed the commercials offering easy terms for auto and home equity loans to bad credits that for some time inundated the airways? From the company's marketing efforts: "At Superior Bank, you won't have to worry about past or even current credit problems, or let numerous debts prevent you from getting the loan you need." The FDIC actually raised specific concerns back in early 1999, while some believe regulatory efforts may have been relaxed for political reasons. The New York Times (NYT) quoted banking consultant (and eminent GSE critic!) Bert Ely, "there's incredible regulatory negligence here. The more I look into this the more I find; there was mismanagement going way back, and there were lots of accounting problems." Interestingly, the NYT reported on another institution where state and federal regulators (filing a "cease and desist" order back in 1991) "cracked down on an overleveraged bank that was making risky loans to real estate developers and engaging in what they called 'hazardous lending and lax collection policies.'" The institution, River Bank America, was controlled by a partnership that included Mr. Dworman and the Pritzkers. From the NYT: "'It (River Bank of America) became a bank that did a huge amount of real estate speculation,' one regulator close to the situation said. 'It really looked like an institution that had become a venture capitalist.' This person saw parallels with the problems at Superior… 'It looks like in both cases, you are looking for a quick buck, the gold from water,' the regulator said. 'It's almost like gambling."

Yes, it is absolutely gambling, in an obvious case of "heads we win, tails the FDIC and U.S. taxpayers lose." And while the regulators should be held accountable for not closing this institution sooner, I actually sympathize with their predicament. They were placed in a difficult situation, with the players involved obviously very powerful and politically connected. And importantly, we have been in an environment with Wall Street aggressively hyping subprime lending as not only viable but an extremely profitable business. It would have appeared a delicate task to move early and close down Superior's subprime lending and securitization business when such operations were becoming the hottest tickets on Wall Street.

In fact, Superior Bank has for some time been the epitome of aggressive Wall Street "structured finance," transforming high-risk loans into top-rated securities. According to Bloomberg, the Office of Thrift Supervision stated it was the " 'high risk business strategy' of generating subprime mortgages and auto loans for resale in the secondary market [that] hurt the thrift…Its capital dropped after incorrect accounting decisions and aggressive assumptions for valuing residual assets were uncovered." Over the past decade, Superior developed into a significant lender and securitizer, originating more than $2 billion of new loans last year and in 1999, with somewhat less in 1998 (with Superior privately held, financial information is sparse). As has become commonplace in the subprime industry, the bank would lend aggressively to risky credits, and then work with Wall Street firms such as Merrill Lynch and JP Morgan to pool the loan into trusts, structure asset-backed securities, get favorable ratings, and then sell them into the marketplace. There were certainly huge fees to be made by all involved.

On a macro basis, the ability to structure such deals has greatly fostered the availability of credit to risky borrowers, and the proliferation of such strategies in no small way explains the protracted and "resilient" U.S. consumption boom. But this Bubble will burst. Further, these types of securitizations clearly mask the true profitability of the underlying lending business, attracting additional lending and lenders, and allowing an unsound Credit boom to continue much longer than it would otherwise. If Superior would not have had open access to sell securities into the marketplace, it likely would not have lent in such large volumes (balance sheet growth constraints), and it would surely have been much more selective in choosing it borrowers. Moreover, it also would not have had the luxury of employing "gain on sale accounting." This accounting gimmickry basically allows companies to make favorable assumptions about the future returns from a pool of loans, and then book the entire "profit" upfront. Accounting for loans on one's balance sheet, on the other hand, necessitates accruing profits or losses over the life of the loan. This is a much different (and less appealing) proposition, especially for high-risk loans.

Looking at Superior's financial statements, it is worth noting that total assets more than doubled from $954 million at the end of 1994 to a high of almost $2.2 billion at the end of 1999. Over this period, total "loans and leases" jumped almost 60% to $793 million. Securities positions surged 250%. Meanwhile, "other assets" ballooned from $104 million at the end of 1994 to $973 million at the end of 2000. Surely, a large amount of these "other assets" are "residual" interests in securitizations that were sold into the marketplace. The regulators and the FDIC will now see if they have any value.

During 1994, Superior reported net income of $11 million, augmented by $7 million of gains on securities sales. The bank made cash dividend distributions of $8 million. The next year, securities sales gains of $31 million helped create net income of $28 million, and a dividend of $11 million. During 1996, securities gains jumped to $65 million, net income to $79 million, and cash dividends increased to $35 million. 1997 saw gains on securities sales of $91 million, net income of $74 million, and dividends of $37 million. Financial tumult in 1998 was apparently great for business, as securities gains of $137 million stoked net income to $110 million, which allowed dividends of $56 million. After the 1998 Fed and GSE-orchestrated system "bailout," Superior's gains on securities sales surged to $185 million during 1999, with net income of $105 million and dividends of $34 million.

What's not to love about this "money machine"? Well, it appears that with losses from previous reckless lending escalating, and closer scrutiny by the regulators, the bank quickly hit the wall in 2000. As I have written previously, the key to aggressive consumer lending is to always grow fast enough to make previous losses appear insignificant. It is, of course, a losing proposition, and all the sudden Superior lost their latitude for aggressive growth. For year-2000, securities gains of $43 million were nonetheless insufficient to offset other losses and expenses, as a $5 million net loss was reported. And while the bank did not pay a dividend, it is curious to note that "salaries and employee benefits" jumped 88% to almost $52 million, despite a small reduction in its total workforce. With regulators apparently hot on the trail, the company reported a loss of $19 million on securities sales during this year's first quarter. With total non-interest expenses surging to $52 million (compared to $16 million during 1st quarter 2000), the company reported a total loss of $70 million for the quarter.

Today, regulators believe assets are overstated by at least $500 million. This would easily wipe out all previous reported earnings (of which about half were paid out as dividends!), and unambiguously supports our view of the illusionary nature of reported subprime lending "profits." One could certainly enquire as to how such great "earnings momentum" (1998/99's $100 million plus annual "net income") could have turned so abruptly into massive losses. Well, clearly, the company was taking huge gains on the sales of securities based on erroneous assumptions, while losses were also likely coming in much larger than expected. Both situations lead to an overstatement of earnings and assets, which eventually must be written down by recognizing huge losses. Superior, like other risky lenders, retains "residual" interests in the loan pools. These "interests" only have value if there are excess returns in the pool above what is necessary to pay holders of the asset-backed securities and related fees. And if the lender is on the hook for larger than expected pool losses, then such a situation can quickly become (as stated by an attorney for the Pritzkers) "a black hole of uncertain numbers and unknown losses - which appears to be the case."

Since these residuals don't trade in the marketplace, valuing them is left subjectively to management (and their CPAs). If one presumes low rates of credit losses, discounting models will place significant value on these residuals. However, unexpectedly large losses impact expected cash flows throughout the entire life of the trusts, thus immediately decimating the value of discounted residual interests (not unlike the experience now impacting CDO "equity" tranches). Certainly, when an aggressive lender finds itself with escalating losses, there is great incentive to "fudge" on residual values while lending only more recklessly in a desperate attempt to grow out of previous lending problems. In fact, these structures greatly facilitate "fudging" and the masking of loan deterioration, while at the same time providing a too easy mechanism to lend recklessly and plug holes by booking big gains on security sales. It is a mechanism built for trouble. This is, in particular, a major systemic risk in the current extraordinary environment, with the confluence of deteriorating consumer finances and the Fed-induced ultra-easy financial environment. As I said, I sympathize with the regulators.

One might also ponder, with Superior's assets having so deteriorated in value, how could it be that there is apparently no worry in the marketplace with regard to the related asset-backed securities? Looking at one of the ABS trusts created and sold during last year's third-quarter, we see that $350 million of securities were backed by mortgage loans with an average coupon of 11.7% (obviously not your most pristine borrowers). These pools had a large percentage of loans that were risky (high loan-to-value) home equity, second and balloon mortgages, with significant concentration in New York and Florida. But with the alchemy of contemporary finance, complex structures and credit insurance from MBIA and GE's Financial Guarantee Insurance Corporation (FGIC), these loans were converted into "Triple-A"-rated securities - ratings that they maintain to this day. It is worth noting that MBIA currently has outstanding financial insurance in force of an astounding $717 billion, with FGIC ending 1999 with $131 billion. In the event of a systemic crisis, it should go without saying that this type of insurance would be of little value.

There is just absolutely no doubt in my mind that Superior's problems are but the tip of the proverbial iceberg in relation to the festering problems in "structured finance." Sure, there were certainly issues of sloppy bookkeeping and such, but the bottom line is that Superior was dealing in bad lending, and bad loans turn into large losses. They certainly have lots of company. It is only a matter of how long the risky lending and losses are allowed to accumulate. I would hope this failure serves as a wakeup call to the other aggressive lenders, the regulators, the Fed, investors and Wall Street. Perhaps one of these days the insurers will back away from providing coverage for risky credits. In the meantime, we would expect the accounting community to be less accommodating.

The big systemic dilemma is that poor lending practices have become endemic to the system over this cycle, leaving a legacy of massive future loan losses that we would expect to increasingly surface. Being a classic Bubble, any tempering of Credit growth will prove quite problematic. Remember, since 1998 (past 13 quarters), total outstanding asset backed securities have surged 76% to almost $1.9 trillion, while mortgage-backs have increased almost 40% to $2.5 trillion. Wall Street certainly had no problem with Superior's loans, packaging and selling them just like they have and continue to do for scores of other risky lenders. What's more, risky subprime lending has never been more popular than it is today, whether it is mortgage, auto financing, or credit card loans. I will even conjecture a bit and state that if it weren't for the fact that Superior came under the scrutiny of bank regulators, management would have likely (as seemingly everyone else in the industry has done) significantly increased their lending, booked even greater gains on securities sales, posted continued "earnings momentum," and would today be playing the game more aggressively and with seemingly greater success than ever. Certainly, this is the game being played today by Wall Street and the subprime industry.

On this score, it is disconcerting that aggressive subprime lender Providian has funded its lending ($21 billion total assets, up from $4.4 billion at year end 1997) with $15 billion of deposits. Ironically, there are few businesses that have benefited more directly from Fed rate cuts than the subprime lenders. Providian offers "money market deposit accounts" with above-market rates, as well as 5-year CDs yielding almost 6%. Many other "non-banks" lend aggressively outside of the jurisdiction of bank regulation.

While I expect liquidity conditions to deteriorate with the winding down of the mortgage-refinancing boom, the bottom line is that the credit market remains today over-liquefied. I view this as largely the consequence of the continued explosion of non-bank credit creation, particularly by the GSEs and the record issuance of asset-backed securities (as well as the continued significant influence from positioning from the leveraged speculating community). As discussed previously, the contemporary U.S. credit system has an incredible capacity to create its own liquidity, as long as the financial sector maintains its aggressive borrowing and lending, and as long as the dollar doesn't falter. This Bubble, however, could not be more unsound and, as such, unsustainable. In fact, the unfolding financial fiasco remains ripe for a weakening dollar. And perhaps it will take a sinking dollar to set in motion the inevitable contraction of lending to the vulnerable U.S. consumer sector.

Seeing virtually all data and developments pointing to inevitable dollar vulnerability, I will conclude with some recent quotes from the Bank of International Settlements: "Consolidated international bank lending increased by about $560 billion to $8.239 trillion at the end of the first quarter of 2001. German banks were again the most vigorous lenders, with Dutch and French banks also very active. The increase was largely accounted for by interbank business in Europe, but there was a notable surge in lending to the private non-bank sector in the United States...Funds made available through the interbank market supported an increase in lending to the non-bank borrowers in the United States. All of the adjusted $110 billion of external borrowing from banks was undertaken by the US non-bank private sector, half of it short-term. Following an already strong increase in the fourth quarter of 2000, loans to non-banks in the United States in the first quarter surged to 75% of the total increase of the previous year. About 25% of this new lending was guaranteed by entities outside the United States. US borrowers turned to German and Swiss banks for most their funding, with Japanese and other European banks largely accounting for the remainder.

Claims on offshore centers rose by an adjusted $30 billion - mostly on private non-banks and amounting to almost 50% of the total increase in 2000. Outward risk transfers (ie risk mitigants which shift risk exposures to other countries) rose even more strongly, resulting in a $16 billion decline in banks' net risk exposure. The bulk of credit went to non-banks on the Cayman Islands. US and European banks each accounted for about half of the latter increase. While there were some reports of transactions with special purpose vehicles, the expansion vis-à-vis offshore centers may also be due to increased hedge fund activity. Hedge funds can achieve their desired leveraged ratio by engaging in repo transactions with international banks. Such repo transactions would be consistent with the reported large outward risk transfers from offshore centers."

Going forward, it will be fascinating to follow both domestic credit creation, and the international sources and mechanisms for "recycling" the enormous U.S. current account deficits back to the U.S. financial sector. I certainly expect the task of sustaining the Great U.S. Credit Bubble to become more arduous by the month.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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