Hawking 'Financial Peace of Mind' and Other Gross Financial Excess
The stock markets rallied strongly this week, although there has yet to be a sighting of anything even remotely resembling financial market stability. For the week, the Dow, S&P500 and Transports jumped 6%. The Morgan Stanley Cyclical index added 4% and the Morgan Stanley Consumer index increased 3%. The troubled Utility sector declined 2%. The broader market experienced solid gains, with the small cap Russell 2000 and the S&P400 Mid-Cap index gaining 5% and 6%, respectively. The technology sector was on fire, with the NASDAQ100 gaining 7% and the Morgan Stanley High Tech index up 6%. The Semiconductors surged 9%, The Street.com Internet index 12%, and the NASDAQ Telecommunications index 10%. The Biotechs jumped 10%. The financial stocks surged, with the Securities Broker/Dealer index up 13% and the Banks up 11%. With bullion up $3.90, the HUI Gold index dropped 4%. It was another extraordinary week.
With stocks in panic buying mode, the Credit market was in anxious retreat. For the week, two-year treasury yields jumped 23 basis points to 2.05%, the five-year 32 basis points to 3.01, and the ten-year Treasury note up 31 basis points to 4.11%. Benchmark mortgage-back yield jumped 24 basis points, and the implied yield on agency futures surged 29 basis points. While the benchmark 10-year dollar swap spread narrowed 2.5 to 62, the spread on Fannie Mae's 5 3/8% 2011 note widened one to 68. Curiously, the yield on December Eurodollar futures rose only five basis points to 1.75%. But it appeared near havoc in the mortgage-back arena. This afternoon it was reported that a hedge fund group had suffered major losses in mortgage-backed securities (asset value sank 54% in September!) and would liquidate. In addition to wildly unstable interest rate markets, bad news from Sears (Credit deterioration in their loan portfolio) saw bond yields spike to almost 9%. Sears' bond yields began the month below 6%. Ford saw its bond yields touch 10% this week, up about 70 basis points for the week and compared to 7% yields not the far back in July. Despite surging stock prices, the corporate debt crisis is alive and well and knocking loudly at the door of the consumer finance sector. Unfolding global financial crisis helped support the dollar's 1% gain for the week.
Broad money supply dropped $44 billion last week. Demand and checkable deposits declined $35.4 billion, while savings deposits jumped $28.6 billion. Small time deposits declined $2 billion, and retail money fund deposits dipped $2.8 billion. Institutional money fund deposits dropped $12.5 billion. Curiously, institutional money fund assets have declined $38.7 billion during the past three weeks. Repurchase agreements dropped $15.5 billion and Eurodollar deposits declined $2.5 billion. Commercial paper increased $3.7 billion, with non-financial up $3.2 billion. Bank Credit jumped $27.7 billion last week. "Loans and Leases" actually surged $32 billion, although Commercial and Industrial loans were flat. Real Estate loans were up $21.1 billion and Security Credit added $16 billion (recovering from the previous week's $18 billion decline).
While stating the obvious when admitting that I am a finance geek, I find earnings reporting season absolutely the most intellectually fascinating time of each quarter. Financial institution by financial institution, it is our opportunity to see how each player is participating in the Great Credit Bubble - historic financial evolution in almost real time. It is our chance to witness to what degree the financial sector is aggressively feeding the consumer Bubble (as they flee the post-Bubble commercial lending debacle). We can look for footprints as to how JPMorgan Chase will attempt to save itself. We can search for clues as to the strategies the troubled subprime lenders are hoping will give them a new lease on life. We can look for evidence of euphoric lending excess (and tomorrow's problems) from those feasting carelessly from the mortgage finance Bubble trough. We are also afforded the challenge of dissecting the activities of the GSEs, Credit insurers, and Wall Street firms, the key players in an increasingly stressed "structured finance" sector.
But as you are reading through these laborious accounts of third quarter lending activities, try to think in terms of a mosaic of a highly monetary economy at the mercy of a dysfunctional and increasingly impaired Credit system. Also keep in mind that the eye-opening (and troubling) third quarter consumer lending numbers are on top of household borrowings that expanded at annualized rate of 9.0% during the second quarter (after growing 8.6% during 2001, 8.3% during 2000 and 1999, and 8.2% during 1998). I was struck by an economist's recent comments regarding September retail sales. Although they had suffered a meaningful decline from August, with absolutely dismal same-store sales figures, he was able to put a very positive spin by stating that they were up 5% y-o-y and that same-store comparisons were impacted by significant new store openings. Well, this is absolutely the key point to analysis today. We have experienced an interest rates collapse, a historic refi boom, and the loosest money imaginable throughout consumer finance. Yet, continued booming consumer borrowing and spending is barely keeping the maladjusted economy afloat - swimming diligently to just tread water… The desperate swimmer has several times been empowered by hopeful land sighting, but the shore today seems to be moving away. The consumer is waterlogged and exhausted…the consumption-based economy looks weathered and frail… And those forecasters that have extrapolated the terminal stage of mortgage refinancings far out into the future should take note of this week's interest rate move.
On the topic of consumer lending excess, August's trade deficit surged to a record $38.46 billion (vs. expectations of $35.5b). Imports jumped 2% to $120.3 billion, while exports declined 1.3% to 81.9 billion. This compares to last year's $29.45 billion deficit. August brought record trade deficits from both China ($10.9 billion) and Mexico ($3.5 billion). Year-over-year, imports are up 13.4% from Mexico, 15.7% from the Pacific Rim, and 12.9% from Latin America. Year-over-year, exports to Western Europe and Latin America are down 17.2% and 11.6%, respectively. Our trade deficit with China, up 20% y-t-d to $63.3 billion, has quickly outdistanced our deficit with Japan (down 4.3% y-t-d to $44 billion).
Last week's bankruptcy filings of 31,388 were up 18% y-o-y. This afternoon, JD Power and Associates was out with a 15.5 million estimate for October vehicle sales. Keep in mind that September sales, at a 15.9 million unit rate, slowed quite markedly from August's 18.4 million and July's 18.1 million pace. If this forecast proves accurate, this will be the weakest month of sales since the 15.5 million vehicles sold during November 1998. And this with zero-percent financings…
From yesterday's Financial Times (Jenny Wiggins): "Buyers Put CDOs Under Closer Scrutiny - There was a chill in the air earlier this month on Paradise Island. Investors at a financial conference on the island in the Bahamas were told that some buyers of structured debt products known as collateralised debt obligations (CDOs) had been short-changed by scurrilous investment managers. They were warned to watch their investments carefully. 'Investors must really drill down to the trading patterns and scrutinise what managers are doing,' said David Tesher, the head of Standard & Poor's CDO group. 'There must be a focus on transparency.' CDOs were very popular in the heyday of the bull market when they were marketed to investors as a means of diversifying risk. But the diversification in many cases did not work. 'There is no question there has been a lot of disappointment,' says Andrew Dickey, managing director for structured credit products and investments at David L Babson & Co… The object of a CDO is to distribute risk among different investor classes. CDOs can make bank loans or other assets attractive to investors who favour AAA-rated assets and would otherwise find such assets too risky by splitting the risk up into different 'tranches'. The deterioration in the credit markets in the past year has, however, been so severe even the most senior tranches can expect to suffer losses, says Moody's. Insurers are among the companies now reporting losses on CDOs."
October 15 - American Banker (Alissa Schmelkin): "Once-Enticing Funding Now Haunts Some - Throngs of banks that earned a high spread on convertible advances they borrowed from the Federal Home Loan banks and the repo market in the late 1990s thought they had found a clever route to cheaper funding. The deals worked like this: Banks would get the advances from the FHLBs or the repurchase market at rates lower than prevailing rates and lock them in for as long as 10 years… Many used the advances to buy mortgage-backed securities or callable bonds. Borrowers, often at the suggestion of advisers, sold options on both sides of the transaction, which created an artificially high spread. The trouble is that interest rates fell instead of rising. The lenders did not call in the advances, refinancing depressed the market for mortgage-backed securities, and the bonds were called. Banks that thought they were being smart got caught with some pretty expensive funding."
October 17 - American Banker: "Outstanding loan volume in the Federal Home Loan Bank of Chicago's Mortgage Partnership Finance program at the end of the third quarter rose 64% from a year earlier, to $34.5 billion."
Fannie Mae reported its usual strong results. For the quarter, $112 billion of new mortgage-backed securities (MBS) were issued, with $69 billion retired (impact of refi boom). "Outstanding MBS" (not held by Fannie Mae) grew at a 20.4% annualized rate to $990 billion. During the past four quarters, "Outstanding MBS" is up $174 billion, or 21%. Fannie's "Total Book of Business" ("Outstanding MBS plus the increase in Fannie's mortgage holdings) is up $238 billion, or 15.8%, over this period to $1.74 trillion. While the number remains quite low, it is worth noting that "single family properties acquired" in foreclosure increased to 5,060 during the quarter, up 47% from Q3 2001. Over the past year, the allowance for Credit losses is about unchanged. It is also worth noting that September saw record business volume (mortgage purchases) of $78.3 billion and the strongest "Book of Business" growth (16.2%) since March. The "good news" is that the recent surprising jump in interest rates should help reduce Fannie's duration gap; the bad news is it cannot be good for the leveraged players in mortgages, agencies, and elsewhere, not to mention the derivative players on the other side of Fannie's (and others) hedges. Assuming that bloated mortgage-back players were caught fully "invested," we would expect that these players' diminished appetite will be made up by renewed balance sheet growth by Fannie and Freddie. Today from Reuters: "Sources in the mortgage market said [Fannie and Freddie's lending] limit could be raised to as much $325,000 from $300,700." This is a very bad idea, although certainly one that could help sustain the Great mortgage finance Bubble.
JPMorgan is a most conspicuous (historic) example of a desperate lender aggressively extending Credit (in the hot area) in hopes of gambling (taxpayer money) their way out of a deep financial hole. Perhaps it's only coincidental, but it is interesting to note that third quarter Investment Banking revenues were down 31% year-over-year, while "managed credit card outstandings" increased 31% y-o-y. Moreover, total assets were basically flat for the quarter (up $1 billion to $742 billion). Yet, Commercial Loans were down 7% as Managed Consumer Loans grew 7% (28% annualized!). Year-over-year, Commercial Loans dropped 16%, while Managed Consumer Loans jumped 15%. Nonperforming loans jumped 27% for the quarter to $5.542 billion (up 109% y-o-y), with commercial nonperformers up 43%. It is almost as if the volatility in JPMorgan's various businesses is a microcosm of the unstable and distorted U.S. economy.
For the quarter, Investment Banking Fees dropped 31% to $545 million and Trading-Related Revenues sank 68% to $365 million, while Securities Gains jumped better than three-fold to $578 million. From the company's earnings report: "Retail & Middle Market Financial Services had a third consecutive quarter of record revenues and operating earnings. Operating earnings of $807 million were up 16% from the second quarter and up 92% from the third quarter of 2001… Operating revenues of $3.73 billion were up 8% from the second quarter and 31% from the third quarter of 2001 driven by continued high production volumes across all consumer credit businesses and low interest rates. Home Finance revenues were up 108% over the prior year and were driven by strong mortgage originations and gains realized on hedging mortgage-servicing rights. In Cardmember Services, managed credit card outstandings increased 31% from September 30, 2001 to $51.1 billion due to the Providian acquisition in the first quarter of 2002 and organic growth. There were close to 900,000 new accounts originated during the quarter, the eighth consecutive quarter of additions at this level. Total average deposits grew 14% from the third quarter of 2001."
Over at Citigroup, "Global Corporate and Investment Bank" core income was down 7% for the quarter (sequentially), while "Global Consumer" income jumped 13%. "Capital Markets and Banking" income dropped 8%. In the consumer arena, "Cards" (102 million accounts in 47 countries) jumped 21% for the quarter (19% y-o-y) and "Retail Banking" increased 19% (25% y-o-y). North American "Card" income jumped 25%, with receivables growing at a 20% annualized rate to $111.1 billion. North American Retail Banking saw income growth of 25%. Year-over-year, "Global Consumer" revenues were up 11% for the quarter, while "Global Corporate and Investment Bank" revenues increased 2%.
At Bank of America "Global Corporate and Investment Banking" revenue declined 11%, while "Consumer and Commercial Banking" revenue increased 11%. During the quarter, "Average consumer loans grew 8% to $192 billion," as total assets increased about $9 billion (about 1%). Mortgage banking income doubled to a record $218 million," while Global Corporate and Investment Banking saw earnings drop 18% y-o-y to $428 million. With consumer Credit card profits up 31%, the consumer lending business generated 71% of bank profits.
After being stung by its foray into commercial and emerging market lending, FleetBoston is moving with the crowd to emphasize consumer lending. (From the American Banker): "Home equity loans rose 47%, to $19.9 billion, and credit card loans 11.9%, to $5.7 billion."
At Wells Fargo, average loans of $181.8 billion during the third quarter were up 11% y-o-y. "We saw strong consumer loan growth, led by robust sales of home equity and home mortgage products. Our average consumer loans increased 24 percent from the third quarter of 2001 and 27 percent (annualized) from the second quarter 2002. Mortgage loans held for sale jumped 44% to 38.4 billion, although "commercial loan demand remained essentially flat." Mortgage origination volume jumped 78% to $89 billion, with "home equity balances up 43%" y-o-y. "Last year, Wells Fargo set the mortgage industry record for originations at $202 billion. It took only nine months to break that record with 2002 year-to-date originations at $221 billion." Home equity loans grew at a 35% annualized rate during the quarter to $34.1 billion (up 43% y-o-y). "The provision for loan losses decreased by $86 million from 2001 due to the improvement in the credit environment relative to last year." Total assets ended the quarter at $334 billion, up $19.5 billion (25% annualized growth rate).
California mortgage powerhouse Golden West financial expanded total assets at a 20% annualized rate during the quarter to $65.5 billion, with the yield on its loan portfolio (adjustable-rate mortgages comprise a significant part of lending) dropping to 5.50%. Washington Mutual saw "record loan volume of $75.48 billion, an increase of 59 percent year over year…" Clearly fixated on the pretty flowers as dark storm clouds gather on the horizon, Wamu "repurchased 26 million shares of the company's common stock." Total assets were about unchanged for the quarter at $261 billion and loan income actually declined.
Capital One enjoyed strong balance sheet growth, with total assets up about $3.1 billion (36% annualized). Earnings looked decent, management remains slick and upbeat, and everything almost appears fine - unless, that is, one takes a glance at their balance sheet or bond yields, and then ponders how Capital One's life (and financing options) will change with much slower lending growth. We do not like to see "cash" balances dropping 35% to $733 million, while "other assets" jump 71% to $1.8 billion. The liability side of the balance sheet is no more assuring. For the quarter, "senior notes" declined 8.4% (33.5% annualized) to $5.6 billion, and are up only 1.8% y-o-y. "Other" liabilities jumped 12.5% (50% annualized) to $3.3 billion, and are up 61% y-o-y. However, the vast majority of balance sheet ballooning has been financed by "interest-bearing deposits." Deposits were up 5.4% (21.8% annualized) during the quarter to $16.9 billion, and are up 61% y-o-y. We'll see if the FDIC remains comfortable with this "arrangement." We are not. We'll also be watching the market's comfort level. With Capital One bond yields approaching 13%, this lender is going to be challenged in sustaining lending growth through balance sheet expansion. This then becomes a major issue if the market looks askance at the company's asset-backed securities. And with this week's dismal news regarding Sears' Credit card business one more major blow, it is anything but gross speculation to think the marketplace may shy away from Capital One securities. Anyway, it does not require a wild imagination to see how this company could find itself in serious trouble. This could prove a very interesting test for the "expand or die" thesis of aggressive consumer lending.
With bond yields approaching 9%, the market's comfort level with Household International is also being tested. Household expanded managed receivables (excluding a $1.6 billion loan sale) at a 14% annualized rate during the quarter. Year-over-year, managed receivables are up 12% to $107.6 billion. For the quarter, average "Real Estate Secured" loans expanded at an annualized rate of 13.6% (up 21% y-o-y) and "Auto Finance" lending grew at a 26.8% annualized rate (up 29.5% y-o-y). Keeping in mind continued strong lending growth, the deteriorating Credit picture becomes only more troubling. "Two-Months-and-Over Contractual Delinquency" (for "owned" receivables) jumped 40 basis points during the quarter to 5.01%. "Private label" Credit card delinquencies jumped 65 basis points during the quarter to 6.84%, while "Real Estate Secured" jumped 44 basis points to 3.22%. Charge-offs during the quarter of $1.17 billion were up 7.2% sequentially and 35% y-o-y. Going forward, we will see how delinquency and Credit cost ratios hold up under what will likely be much less robust growth. Over the past four quarters, Household International increased "Owned Assets" by 18% to $101 billion, with "Total Managed Assets" up 18% to $124 billion. We expect growth going forward to slow significantly.
Growth is beginning to slow at troubled subprime auto lender AmeriCredit. Managed Receivables expanded at a 27% annualized rate to $15.7 billion (up 39% y-o-y), down from previous quarters' 33%, 40%, 37%, 44%, and 48%. Total assets increased 3.3% to about $4.4 billion. Credit trends remain horrible (12.2% of loans delinquent or in foreclosure, up from 11.4%), although the company continues to issue top-rated securities with the great benefit of Credit insurance from Financial Securities Assurance (FSA). Interestingly, the Financial Times reported this week that FSA has losses in its "insured CDO portfolio as a result of corporate defaults and low recovery rates." Well, just wait until they are finally forced to deal with defaults and recovery rates in AmeriCredit's loan portfolio.
Credit card behemoth MBNA financial saw total managed loans increased $2.8 billion during the quarter (11.2% annualized) to $102.8 billion. The economy may be weak and the competitive environment exceedingly fierce, but they're sticking with their story: "During the first nine months of 2002, the Corporation added 11.7 million new customers. The characteristics of new cardholders are consistent with the superior quality of the Corporation's existing cardholders. The typical new Customer has a $72,000 annual household income, has been employed for 11 years, owns a home, and has a 17-year history of paying bills promptly."
We really scratch our heads these days when pondering such aggressive lending (climax of the Consumer Credit Bubble) and stock buybacks by heavily exposed financial institutions, despite what should be recognized as an extraordinarily risky environment. But (muni bond guarantor turned) Credit insurer Ambac's "whistling past the graveyard" really does take the cake. "Adjusted gross premiums written" during the quarter of $305.6 million were up 69% from last year's third quarter. Sequentially, gross premiums written jumped 10.4% (42% annualized). Compared to the year ago quarter (admittedly weak comparisons), premiums written in Public Finance (muni bonds) were up 59%, Structured Finance 67%, and International 88%. Versus the second quarter, Public finance premiums actually declined 6.4% and Structured Finance dropped 16%, while International (Cayman Islands?) more than doubled to surpass Structured Finance for the quarter. With Structured Finance and International comprising 59% of new premiums written (versus the year ago 45%), this company is clearly no stodgy old municipal bond insurer (like they prefer to portray themselves). Public Finance now accounts for only 30% of "Net Premiums Earned," down from 34% during last year's Q3, 45% from Q3 2000, and 54% from Q3 1999. The ratio of net premiums earned in Structured Finance divided by Public Finance has increased from 61% during Q3 1999, to 84% Q3 2000, to 108% Q3 2001, to 117% Q3 2002. "Net Financial Guarantees in Force" increased $21.6 billion (17.2% annualized) during the quarter to $524.6 billion. This compares to an increase of $18.8 billion (15.5% annualized) during the second quarter, and $8.0 billion (6.7% annualized) during the first quarter. During the past year, Net Financial Guarantees have jumped $70.5 billion (15.5%). Five-year growth has been an incredible $275 billion, or 110%. This is a company with "Capital and surplus" of $2.2 billion and "total claims paying resources" of $7.6 billion. A Machiavellian perspective might sink to pondering a "gentlemen's" agreement between Wall Street and management - "We'll keep buying your stock and ensure all your options don't become worthless, but you better insure every damn bond, CDO, and asset-backed commercial paper product we drop on your desks!"
Bloomberg's Suzy Assaad this week interviewed Phillip Lassiter, chairman and CEO of Ambac Financial. Bloomberg's Assaad: "First of all, for someone who doesn't understand what you do, what does Ambac do?"
Lassiter: "Well, the bottom line [is] that we are insuring the credit worthiness of investment-grade bonds to investors, insuring that principal and interest will be paid when due - that simple."
Bloomberg's Assaad: "It's that simple, but also as simple is that we are in an economic recession, that there have been some concerns about municipalities, about - certainly their revenues have been less, their tax revenues have been decreasing. Is this not a concern for your business?"
Lassiter: "Well, it's a positive concern, from Ambac's point of view. Interestingly enough, my larger concern a few years ago, was that we were seeing so many upgrades in municipal bonds that it was reducing the opportunities to insure, so it's actually through some of the stress that's giving us greater opportunities, both in volume and, secondly, the price that we can get for the assurance that we give has risen as well. So it's a two-fold positive benefit."
Mr. Lassiter went on to say they have been in business since 1971, and that they have "kept 95% of premiums ever written…so I feel very, very confident about our ability to deal with this more recent situation in the municipal market, which is actually quite positive for us." Well, we don't think Mr. Lassiter or the other heads of major financial institutions have experienced anything to compare to the unfolding financial crisis. Credit insurance and derivatives will become a major issue.
Lassiter: "I will say, really, Suzy, what I've been saying for a long, long time, and that is that business is excellent. I mean we're sitting in a very unusual situation. We're having a record issuance in the municipal market and at the same time, our business in the asset-backed structured, as well as the international side, remains vibrant. So our business is good. We're operating at - I won't full say capacity, but almost - and candidly, throughout the summer, we normally would see in July and August, a little bit of let-up. We never saw any let-up this year. So when you think about it, many people are surprised when I say our business is really very, very good. But when you know that you're selling financial peace of mind, and you're in an environment where people are anxious, worried and, in some cases, paranoic, it's good for our business."
Assaad: "So it becomes priceless, at some point in time?"
Lassiter: "That's correct."
I will designate these "Comments for The Time Capsule." I expect folks to have a very difficult time comprehending that this kind of stuff actually happened. Indeed, Ambac and others have sold unfathomable quantities of "futures contracts" on "financial peace of mind." It has been a truly glorious market like few in history - incredibly profitable for the sellers and a gift from the heavens for buyers. But when that fateful day arrives - when sellers are called to deliver - it will prove a mighty difficult "commodity" to procure and simply impossible to fabricate. Oh the problem of making promises you can't keep… And how they do seem so harmless when you first start making them.