Monday, March 31, 2008

5 stages of coping

Voltron says: In the field of Psychology, the Kübler-Ross model of grief has five stages: Denial, Anger, Bargaining, Depression and Acceptance. I think the market's psychology is currently in the bargaining stage.

Bear market rallies only delay day of reckoning

By Ambrose Evans-Pritchard, International Business Editor

Every slump is punctuated by exuberant bursts of optimism, known to traders as "bear market rallies". Japan had four false dawns during its long slide into the abyss. Each lifted Tokyo's Nikkei index by an average of 53pc. Such bounces can be intoxicating.

Teun Draaisma, Morgan Stanley's stock guru, expects the current rally to boost Europe's MSCI 600 index by 21pc from its trough in late January, with similar moves on the S&P 500. The battered shares do best: builders and banks this time.

There have been nine bear rallies since 1970. The average length is four months. The surge misleads investors into believing that sunlit uplands lie ahead. Then the sucker punch hits.

"The Federal Reserve's actions have averted financial Armageddon, but they cannot avert an earnings recession. We don't expect a new bull market until early 2009," he said.

Morgan Stanley says earnings will fall 16pc this year as debt leverage kicks into reverse.

Investor psychology is "asymmetric". The market discounts trouble in advance. Share prices start falling a year before earnings peak. In a downturn investors keep selling until earnings hit bottom.

"Bear markets are terrible for the human psyche. You get one profit warning after another. People see their hopes dashed so many times that they stop believing," said Mr Draaisma.

"You have got to be very disciplined and not buy shares too early just because they look cheap. Things can go down further than you ever dare believe," he said. He is not predicting a bloodbath along the lines of 1929-1933 (-88pc) or 2001-2003 (-49pc): just a long slog, with failed rallies.

For now, the markets are flashing a tactical buy signal. Mr Draaisma's "capitulation indicator" has crashed to the lowest level since the 1998 LTCM crisis: the share "valuation indicator" is near an all-time low.

UBS is also gearing for a big rebound, convinced that the Fed's move to shoulder $30bn of Bear Stearns liabilities has changed the game.

In its latest report -"Ready for a Rally" - it said financial shares rose 448pc in the 12 months after the Swedish rescue in 1992, 88pc after Japan's Revitalisation Law in 1998; and 82pc after Roosevelt's Emergency Banking Act in 1933.

The pessimists at Société Générale remain sceptical, even though the Fed has gone nuclear. "We expect global equity prices to fall by up to 75pc from their peaks as a deep global economic downturn unfolds over the next few years," said Albert Edwards, their global strategist. He fears a 50pc collapse in earnings, compounded by an "Ice Age derating of equities".

It may echo the Lost Decade in Japan, where stocks fell 80pc. The yields on state bonds kept falling as debt deflation engulfed the banks, thwarting efforts to nurse lenders back to health by the usual device: "steepening yield curve". The authorities were left chasing their own tails. Having lived through this, Japan's chief regulator Yoshimi Watanabe has advised Washington to go for a quick taxpayer rescue, rather than trying "to fix the hole in the bathtub".

Whatever happens, there will always be tactical rallies. Mr Edwards cites four Wall Street bounces above 25pc in the 2001-2003 bust. The buying cue is when investor gloom nears black despair. The put/call ratio on options is now at a bearish extreme of 0.90.

"That would historically suggest that a joyous 25pc spring rally is close at hand," he said. Yet Mr Edwards remains wary as long as analysts cling to their belief that earnings will rise 11pc in 2008. This is not the sort of "washout" level of gloom required to clear the air.

Still, the oldest adage on Wall Street is "never fight the Fed". In short order, Ben Bernanke has slashed interest rates by 300 basis points to 2.25pc, and invoked the emergency clauses of Article 13 (3) of the Federal Reserve Act for the first time since the Great Depression to take on direct credit risk.

The Bush administration has told the housing agencies Fannie Mae and Freddie Mac to absorb $200bn of extra mortgage debt. It has implicitly nationalised them in the process. The network of Federal Home Loan Banks has mopped up $900bn of mortgage securities. Congress has rushed through a $170bn fiscal blitz.

This is not to be sniffed at. It is worth a good spring rally, until the inexorable logic of a 25pc house price crash prevails once again.

Bernard Connolly at Banque AIG, who foresaw this crisis with uncanny accuracy, believes central banks will resort to full-throttle reflation, setting off a fresh boom in shares and gold. But this will occur only after the economic slump has spread to Europe and beyond.

The authorities will wait too long to act, believing their own decoupling myth. Unemployment will ratchet up. Civil unrest may rock Latin Europe.

In the end, the whole industrial world will stoke a fresh credit bubble to put off the day of reckoning, for another cycle.

The capitalist system is now so deformed by debt that it requires ever lower interest rates to keep going. It survives on perma-bubbles. Monetary rigour at this late stage would endanger democracy.

How did we ever let matters reach this pass?

Fed eyes Nordic-style nationalisation of US bank

By Ambrose Evans-Pritchard, International Business Editor

The US Federal Reserve is examining the Nordic bank nationalisations of the 1990s as a possible interim solution to the US financial crisis.

The US Federal Reserve
The Fed has been criticised for its rescue of Bear Stearns, which critics say has degenerated into a taxpayer gift to rich bankers

The Fed has been criticised for its rescue of Bear Stearns, which critics say has degenerated into a taxpayer gift to rich bankers.

A senior official at one of the Scandinavian central banks told The Daily Telegraph that Fed strategists had stepped up contacts to learn how Norway, Sweden and Finland managed their traumatic crisis from 1991 to 1993, which brought the region's economy to its knees.

It is understood that Fed vice-chairman Don Kohn remains very concerned by the depth of the US crisis and is eyeing the Nordic approach for contingency options.

Scandinavia's bank rescue proved successful and is now a model for central bankers, unlike Japan's drawn-out response, where ailing banks were propped up in a half-public limbo for years.

While the responses varied in each Nordic country, there a was major effort to avoid the sort of "moral hazard" that has bedevilled efforts by the Fed and the Bank of England in trying to stabilise their banking systems.

Norway ensured that shareholders of insolvent lenders received nothing and the senior management was entirely purged. Two of the country's top four banks - Christiania Bank and Fokus - were seized by force majeure.

"We were determined not to get caught in the game we've seen with Bear Stearns where shareholders make money out of the rescue," said one Norwegian adviser.

"The law was amended so that we could take 100pc control of any bank where its equity had fallen below zero. Shareholders were left with nothing. It was very controversial," he said.

Stefan Ingves, governor of Sweden's Riksbank, said his country passed an act so it could seize banks where the capital adequacy ratio had fallen below 2pc. Efforts were also made to protect against "blackmail" by shareholders.

Mr Ingves said there were parallels with the US crisis, citing the use of off-balance sheet vehicles to speculate on property. All the Nordic banks were nursed back to health and refloated or merged.

The tough policies contrast with the Fed's bail-out of Bear Stearns, where shareholders forced JP Morgan to increase its Fed-led rescue offer from $2 to $10 a share. Christopher Wood, chief strategist at brokers CLSA, says the Fed's piecemeal approach has led to "appalling moral hazard".

"Shareholders have been able to lobby for a higher share price only because the Fed took over the credit risk on $30bn of the investment bank's dubious paper. The whole affair also amounts to a colossal subsidy for JP Morgan," he said.

Lehman Wants To Short-Circuit Short Sellers

Voltron says: Lehman is starting to blame the short sellers. Cry me a river. Short interest in Bear Stearns was about 14% when it collapsed. Short interest in Lehman is currently about 9%.

The Wall Street Journal

April 1, 2008

Lehman Brothers Holdings Inc. has unveiled its latest attempt to try to shake the shorts.

On Monday, the firm announced it plans to issue $3 billion of preferred shares, a move that will strengthen its balance sheet and that it hopes will dispel speculation that it is facing a capital crunch. The question now: Will it be enough? "I think an issue of this size with the investors we have on board will put the false rumors about our capital position to rest," said Lehman Chief Financial Officer Erin Callan.

[Rising Shorts]

Not everyone is on board. The Wall Street brokerage has become a favorite target of short sellers, traders who make money by betting that a stock's price will fall. The shorts now will likely ask: If Lehman had enough capital, why did it need to do the new issue, which will dilute the stakes of existing shareholders by potentially increasing shares outstanding by about 5%?

Thursday, the stock fell almost 9%. Two weeks ago, in the wake of the forced sale of Bear Stearns Cos. to J.P. Morgan Chase & Co., Lehman's stock took another nasty tumble, falling 19% to a 4½-year low. Some Lehman shareholders blamed the decline on heavy selling by short sellers, who borrow shares and sell them, hoping to buy them back at a lower price and lock in a profit.

Monday, Lehman's stock fell 23 cents to $37.64 in 4 p.m. New York Stock Exchange composite trading. But in after-hours trading, the share price declined $1.12 to $36.52. Lehman maintains that the stock will rebound once investors learn both the terms of the offering and the fact that it has been "substantially" presold. Late last night, Lehman said there was $11 billion in investor demand for its offering.

So far this year, Lehman's stock is down 43%, compared with 16% for the Dow Jones Wilshire U.S. Financial Services Index and 23% and 14%, respectively, for rivals Goldman Sachs Group Inc. and Morgan Stanley. Lehman says that over the past few months it has been trying to lower the amount of debt it takes on relative to its assets, both by selling assets and now by raising capital -- so the new offering isn't necessarily aimed at beating back the short sellers.

Still, as of March 12, there were 46.6 million shares, 9.1% of Lehman's total float, sold short. That is up from 9.4 million shares at the beginning of the year, according to the NYSE. Investors also are loading up on Lehman options, another way to bet on a fall in the firm's stock.

The firm says it has enough cash on hand to weather the current crisis, $31 billion in cash and cash equivalents and another $65 billion in assets it can easily borrow against. Furthermore, thanks to a recent change in the rules, it now has access for the first time to Federal Reserve funds, a move that gives Lehman access to an essentially unlimited pool of money at the same rate as commercial banks.

Lehman is no stranger to the skeptics. The brokerage and its chairman, Richard Fuld Jr., fought off rumors about a cash crunch in 1998 that were triggered by the near-collapse of hedge fund Long Term Capital Management. At that time, the firm hired a private-investigation firm to get to the bottom of the speculation circling the company. Since then, Mr. Fuld has won praise for diversifying Lehman, long known as a bond house, into lucrative areas like stock trading and investment banking.

This time around, the firm has publicly spoken out against the shorts. It has met with the Securities and Exchange Commission, and top management is actively trying to track down the source of rumors as they arise.

The main concern: Lehman's still-sizable exposure to the mortgage market makes it easy for critics to draw comparisons to Bear. A recent Bank of America report notes that mortgages represent 29% of total assets at Lehman, roughly in line with Bear, which had one-third of its assets in mortgages, and much higher than Merrill Lynch & Co. and Goldman Sachs, both at 12%, and 13% at Morgan Stanley. Ms. Callan estimates Lehman's total real-estate exposure is closer to 20% and it is a skilled operator in managing real-estate assets.

"Looking toward the remainder of 2008, Lehman investors will be nervously waiting to see if the firm, with its balance sheet loaded with $87 billion of troubled assets which are under pricing pressure and which can't be easily sold, will be able to navigate the continuing credit storm and the de-leveraging environment that we anticipate," wrote Brad Hintz, an analyst at Sanford C. Bernstein & Co. and a former chief financial officer at Lehman.

Nearly $31 billion of its holdings are commercial-real-estate loans. Even as it cut way back on making home loans, Lehman continued to lend to buyers of office buildings and other assets, and analysts expect it will take a hit on these this year.

A big concern is Lehman's 2007 investment in Archstone-Smith Trust, which it bought with Tishman Speyer Properties in May 2007, just as the real-estate market was beginning to melt. Lehman bought in at $60.75 a share. Archstone is now private, but shares of its publicly traded rivals are down substantially, suggesting Lehman's investment is underwater.

During a conference call to discuss its first-quarter earnings, Lehman said it currently holds $2.3 billion of Archstone's non-investment-grade debt and $2.2 billion of equity, both of which Ms. Callan said are being carried "materially below par." She said Lehman is working to sell assets and improve Archstone's financial profile. Lehman says it has taken write-downs on this investment, but the size of the haircut isn't known because it doesn't release this data on individual investments.

Lehman also has significant exposure to so-called Alt-A mortgages, which let borrowers disclose less information about their income than standard mortgages. These loans have been under increased stress in recent months as delinquencies have risen at rapid rate.

Overall, the bank has about $31.8 billion in residential-mortgage exposure and $13.5 billion is Alt-A. The firm has taken $3 billion in write-downs on the residential portfolio, a substantial portion of which was Alt-A. On this front, Lehman argues this positioned is hedged, meaning that any losses will be offset by gains elsewhere.

The Spotlight's On U.S. Alt-A RMBS Issuers As Performance Deteriorates Rapidly

Voltron says: great data in this article. Take a look at table 1. Lehman is right behind Countrywide and Bear Stearns.

The McGraw-Hill Companies

The underperformance of mortgage loans backing U.S. residential mortgage-backed securities (RMBS) at first seemed limited to the subprime mortgage sector, but has since filtered through to virtually every corner of the non-prime mortgage industry. The Alt-A market is no exception.

"Alternative-A" loans are first-lien residential mortgages that generally conform to traditional "prime" credit guidelines, although the loan-to-value (LTV) ratio, loan documentation, occupancy status, property type, or other factors cause the loan not to qualify under standard underwriting programs.

Those underwriting guidelines began to loosen in late 2005, a trend that gained momentum in 2006 as Alt-A originators and investors became more accepting of so-called "layered risk" (the inclusion of multiple high-risk attributes within a single loan). The proliferation of layered risk, along with stagnant or declining home price appreciation (HPA), are factors that have led to the current deterioration in performance. Now, because underwriting standards have tightened in 2007 and HPA continues to fall, leveraged Alt-A homeowners who run into financial trouble have fewer options to refinance their loans, and many are finding it difficult to avoid foreclosure.

In a continued attempt to add transparency and insight into the U.S. residential mortgage markets, Standard & Poor's Ratings Services will release a series of articles commenting on U.S. RMBS collateral performance. In this article, we break down the relative performance of the top 20 Alt-A issuers and look at the market in general, which has seen a sharp performance deterioration in the 2006 and 2007 vintages. Future articles will provide a detailed analysis of underwriting and risk management practices, collateral trends, and economic factors that are contributing to the market downturn, both in the Alt-A sector as well as within other segments of the U.S. RMBS market.

Delinquencies Are High For 2006 And 2007 Alt-A Vintages

Alt-A severe delinquencies (90 days or more, including loans in real estate owned, or "REO," foreclosure, or bankruptcy) have been increasing in recent months, with the number of delinquencies in the 2006 vintage rising to more than double those of the 2005 vintage and more than four times those of the 2004 and 2003 vintages (see chart 1). Both the speed and magnitude of the 2006 vintage performance deterioration is anomalous, given similar loan seasoning compared with prior vintages. What's more, the negative performance trend doesn't seem to be abating for the 2007 vintage. While it's too soon to draw a conclusion regarding the ultimate 2007-vintage performance, early loan seasoning suggests that the deteriorating trend may lead to the worst-ever loss performance within the Alt-A market (see chart 1).

Chart 1


Still, it's important to note that in spite of the recent spike in delinquencies, the vast majority (about 90%) of Alt-A homeowners are current on their mortgage payments. Moreover, while early-period delinquencies have been higher than expected, actual cumulative losses to date remain relatively low. It will likely take an extended period of high delinquencies (and ultimate losses) to pierce investment-grade credit enhancement levels across the overall market, although individual deal performance will vary. Chart 2 demonstrates this point by comparing cumulative losses to date against average 'B' credit enhancement levels. For the most seasoned 2002 vintage, cumulative losses to date are just over 50% of the original 'B' credit enhancement levels. (Note: investment-grade or 'BBB' credit enhancement levels are much higher at 1.26% for the 2003 vintage, 1.72% for the 2004 vintage, 2.08% for the 2005 vintage, and 2.57% for the 2006 vintage.)

Chart 2


Issuer-Specific Delinquencies Vary Widely

The Alt-A market is not homogeneous, but has a diverse mix of borrower profiles and product types. As a result, our opinion of the level of credit risk in the market can vary greatly from issuer to issuer, leading to a wide range of expected losses. The higher end of the Alt-A market (high FICO scores, few layers of risk) closely parallels the prime jumbo market and, therefore, is likely to experience closer to "prime-like" performance. The lower end of the Alt-A market (low FICO scores, many layers of risk) is very different and is concentrated on loans with many compounding risk factors, so loan delinquencies here should more closely follow "subprime-like" performance.

In the below tables and charts, we highlight 2006 vintage performance for the top 20 Alt-A issuers, which collectively represent almost 95% of the total Alt-A market. Severe delinquencies for the Alt-A 2006 vintage are 4.61% (as of September, the latest data period available in the LoanPerformance database). However, delinquencies for the top 20 issuers vary from 2% to almost 10%, a notably wide range (see table 1 and chart 3). Given the diversity of the Alt-A market, we expect issuer performance to vary based on an issuer's strategic position within the market, the types of product and credit risks it favors, and the sophistication and discipline of its risk management, underwriting, and quality control.

Table 1

Standard & Poor's 2006 Rated Issuance (Top 20)
Rank Issuer Rated issuance (bil. $) Severe delquencies (%) Avg. 'BBB' S&P credit enhancement (%)
1 Countrywide 61.0 3.77 2.38
2 Bear Stearns 46.7 7.13 2.80
3 Lehman Brothers 40.9 4.95 2.55
4 IndyMac 28.9 4.38 2.14
5 RFC 27.1 4.48 2.22
6 RBS Greenwich 24.8 3.68 3.00
7 Goldman Sachs 21.7 5.78 2.50
8 Washington Mutual 19.2 2.94 2.63
9 Deutsche Bank 14.2 6.32 2.34
10 Bank Of America 11.4 2.58 1.72
11 JPMorgan Chase 10.9 4.23 1.86
12 CSFB 9.6 5.42 2.23
13 American Home 9.0 2.70 1.75
14 Morgan Stanley 8.9 6.95 2.93
15 Impac 6.6 8.31 3.63
16 UBS 4.9 2.57 2.75
17 Merrill Lynch 4.6 4.65 2.44
18 Citigroup 4.2 2.27 1.81
19 Nomura 4.0 9.83 2.89
20 First Horizon 3.1 2.56 1.33

Chart 3


Clearly, collateral quality plays a fundamental role in the diverging performance trends. We expect issuers with a concentration of high-quality loan characteristics (such as high FICO scores and low combined LTV (CLTV) ratios) to experience better performance than those with lower-quality characteristics. Table 2 shows FICO score, CLTV, and average 'BBB' credit enhancement for the issuers with the highest and lowest delinquency performance. Although the data does show that collateral mix is correlated with performance, it would take a far deeper analysis to fully tease out variations in collateral quality. There are many other loan attributes (in addition to FICO and CLTV) that contribute to a particular loan's risk profile and that ultimately impact performance.

Table 2

Collateral Characteristics - Best/Worst Performers
Alt-A 2006 vintage Market share Average FICO Average CLTV Severe delquencies (%) Avg. 'BBB' S&P credit enhancement (%)
Alt-A 2006 average 707 93.1 4.61 2.57

Highest delinquencies
Nomura 1.0 694 94.9 9.83 2.89
Impac 1.7 703 95.6 8.31 3.63
Bear Stearns 12.2 707 93.9 7.13 2.80
Morgan Stanley 2.3 705 94.1 6.95 2.25
Deutsche Bank 3.7 699 95.7 6.32 2.34

Lowest delinquencies
Citigroup 1.1 697 92.9 2.27 1.81
First Horizon 0.8 724 93.2 2.56 1.33
UBS Warburg 1.3 705 91.0 2.57 2.75
Bank of America 3.0 714 92.6 2.58 1.72
American Home 0.5 712 92.1 2.70 1.75

Product Risks Impact Performance

Product type introduces another strong bias in performance. Unique product risks inherent in certain loans, such as payment option ARM (POA), hybrid ARM, and fixed-rate loans, will lead to substantially differing performance over time (see charts 4-6). The divergent borrow profiles, payment shock characteristics, amortization schedules, and other loan attributes across products lead to a wide range of expectations for the timing and severity of ultimate losses.

Of the three product types highlighted below, fixed-rate loans have the lowest average delinquency levels of 3.47% (see chart 4). This is expected. The stability afforded by the fixed interest rate eliminates all payment shock associated with adjusting rates. This clearly lowers the risk profile of the product over the entire life of the loan. However, the structural protection is a medium- and long-term risk mitigant and is unlikely to be playing a direct role in the low early-period delinquencies that we are seeing in the 2006 vintage. The high credit quality of the typical fixed-rate borrower is likely having a greater impact on low initial delinquencies to date. Because the monthly payment of a fixed-rate loan is somewhat higher than that of other affordability products (hybrid ARM and POA loans), homeowners with fixed-rate loans tend to be more financially conservative and, consequently, migrate toward the structural benefits of the product.

Hybrid ARM products don't enjoy the same level of interest rate stability or conservative borrower profile, and, consequently, current severe delinquencies are at a much higher level of 6.26% (see chart 5). In general, borrowers will be subject to a "payment shock" once interest rates begin to adjust. (Note: there is a wide range of hybrid ARM products, from those with initial fixed-rate periods of two years to 10 years.) However, even for the shortest hybrid ARM products, payment shock has not yet emerged as a key stress on borrowers within the 2006 vintage; most Alt-A homeowners have many months remaining on their initial fixed-interest-rate period. But the self-selection of borrowers with weaker credit profiles into hybrid ARMs and other affordability products is affecting the current spike in severe delinquencies. Many of these borrowers have a financial need for the low initial monthly payments offered by hybrid ARM loans and may not be able to afford traditional fully indexed (or fully amortizing) rates. A hybrid ARM homeowner is presumably more financially stretched than a fixed-rate homeowner and, not surprisingly, is more likely to be falling behind on his or her mortgage payments, especially in light of falling HPA. The shorter the hybrid ARM period, the more vulnerable borrowers may be to rising monthly payments or falling HPA.

Finally, POA loans have the most product risk and, ultimately, are expected to experience the highest level of losses. Current average delinquency levels of 3.72% (see chart 6) are artificially low as a result of "teaser" payment options, which make it easier for homeowners to make their monthly payments during the first few years. The minimum required payment during the first few years of a POA loan is often only a fraction of the fully amortized amount. The vast majority of POA homeowners (more than 75%) have been opting to make only these minimum payments, resulting in a low performance hurdle for borrowers and generally leading to very few early-period delinquencies. However, we expect POA delinquencies (and losses) to rise sharply as loans reach their negative amortization ceiling, when borrowers are required to make significantly higher monthly payments (often two or more times the original payment). This "payment shock" is much more severe than that for hybrid ARM products and will occur at a time when homeowners have little (or no) equity built up in their homes (as a byproduct of negative amortization). While in the past POA borrowers may have been afforded ample opportunity to refinance, in the current market environment, troubled POA borrowers no longer have abundant liquidity available to them. Many borrowers in the future may find it difficult to avoid foreclosure.

Given these contrasting products risks, we feel it is important to view issuer-specific delinquencies by product type, which will provide a more relative view of performance.

Chart 4


Chart 5


Chart 6


Collateral Characteristics Don't Tell The Whole Story

Still, there are clear over- and underperformers within the market. Although subtle differences in collateral characteristics will go a long way in rationalizing diverging performance, they alone don't tell the whole story. In many cases, competitive advantages that issuers possess in underwriting, quality control, or risk management can serve as a key point of differentiation among the best and worst performers.

Ultimate performance will bear out these advantages over time. Given the importance of the issuer's role within securitizations, Standard & Poor's will adjust credit enhancement levels based on a particular issuer's strength or weakness in underwriting, risk management, quality control, or other due-diligence function. An upcoming commentary will provide a more detailed analysis of the various underwriting practices in the industry, including whether certain issuers remained more disciplined during the recent period of rapid growth, which may have allowed them to avoid significant exposure to the most troubled areas of the Alt-A market.

Sunday, March 30, 2008

Equity Loans as Next Round in Credit Crisis

The New York Times

Little by little, millions of Americans surrendered equity in their homes in recent years. Lulled by good times, they borrowed — sometimes heavily — against the roofs over their heads.

Now the bill is coming due. As the housing market spirals downward, home equity loans, which turn home sweet home into cash sweet cash, are becoming the next flash point in the mortgage crisis.

Americans owe a staggering $1.1 trillion on home equity loans — and banks are increasingly worried they may not get some of that money back.

To get it, many lenders are taking the extraordinary step of preventing some people from selling their homes or refinancing their mortgages unless they pay off all or part of their home equity loans first. In the past, when home prices were not falling, lenders did not resort to these measures.

Such tactics are impeding efforts by policy makers to help struggling homeowners get easier terms on their mortgages and stem the rising tide of foreclosures. But at a time when each day seems to bring more bad news for the financial industry, lenders defend the hard-nosed maneuvers as a way to keep their own losses from deepening.

It is a remarkable turnabout for the many Americans who have come to regard a home as an A.T.M. with three bedrooms and 1.5 baths. When times were good, they borrowed against their homes to pay for all sorts of things, from new cars to college educations to a home theater.

Lenders also encouraged many aspiring homeowners to take out not one but two mortgages simultaneously — ordinary ones plus “piggyback” loans — to avoid putting any cash down.

The result is a nation that only half-owns its homes. While homeownership climbed to record heights in recent years, home equity — the value of the properties minus the mortgages against them — has fallen below 50 percent for the first time, according to the Federal Reserve.

Lenders holding first mortgages get first dibs on borrowers’ cash or on the homes should people fall behind on their payments. Banks that made home equity loans are second in line. This arrangement sometimes pits one lender against another.

When borrowers default on their mortgages, lenders foreclose and sell the homes to recoup their money. But when homes sell for less than the value of their mortgages and home equity loans — a situation known as a short sale — lenders with first liens must be compensated fully before holders of second or third liens get a dime.

In places like California, Nevada, Arizona and Florida, where home prices have fallen significantly, second-lien holders can be left with little or nothing once first mortgages are paid.

In December, 5.7 percent of home equity lines of credit were delinquent or in default, up from 4.5 percent in 2006, according to Moody’s

Lenders and investors who hold home equity loans are not giving up easily, however. Instead, they are opposing short sales. And some banks holding second liens are also opposing refinancings for first mortgages, a little-used power they have under the law, in an effort to force borrowers to pay down their loans.

“Acknowledging a loss is the most difficult thing to do,” said Micheal Thompson, the executive director of the Iowa Mediation Service, which has been working with delinquent borrowers and lenders. “You have to deal with the reality of what you are facing today.”

While he has been able to strike some deals, Mr. Thompson said that many mortgage companies he talks with refuse to compromise. Holders of second mortgages often agree to short sales and other changes only if first-lien holders pay them a small sum, say $10,000, or 10 percent, on a $100,000 debt.

Disagreements arise when the first and second liens are held by different banks or investors. If one lender holds both debts, it is in their interest to find a solution.

When deals cannot be worked out, second-lien holders can pursue the outstanding balance even after foreclosure, sometimes through collection agencies. The soured home equity debts can linger on credit records and make it harder for people to borrow in the future.

Experts say it is in everyone’s interest to settle these loans, but doing so is not always easy. Consider Randy and Dawn McLain of Phoenix. The couple decided to sell their home after falling behind on their first mortgage from Chase and a home equity line of credit from CitiFinancial last year, after Randy McLain retired because of a back injury. The couple owed $370,000 in total.

After three months, the couple found a buyer willing to pay about $300,000 for their home — a figure representing an 18 percent decline in the value of their home since January 2007, when they took out their home equity credit line. (Single-family home prices in Phoenix have fallen about 18 percent since the summer of 2006, according to the Standard & Poor’s Case-Shiller index.)

CitiFinancial, which was owed $95,500, rejected the offer because it would have paid off the first mortgage in full but would have left it with a mere $1,000, after fees and closing costs, on the credit line. The real estate agents who worked on the sale say that deal is still better than the one the lender would get if the home was foreclosed on and sold at an auction in a few months.

“If it goes into foreclosure, which it is very likely to do anyway, you wouldn’t get anything,” said J. D. Dougherty, a real estate agent who represented the buyer on the transaction.

Mark Rodgers, a spokesman for CitiFinancial, declined to comment on the McLains’ situation, citing privacy considerations.

“We strive to find solutions that are acceptable to the various parties involved,” he said but two lenders can “value the property differently.”

Other lenders like National City, the bank based in Cleveland, have blocked homeowners from refinancing first mortgages unless the borrowers pay off the second lien held by the bank first. But such tactics carry significant risk, said Michael Youngblood, a portfolio manager and analyst at Friedman, Billings, Ramsey, the securities firm. “It might also impel the borrower to file for bankruptcy,” and a judge could write down the value of the second mortgage, he said.

A spokeswoman for National City, Kristen Baird Adams, said the policy applied only to home equity loans originated by mortgage brokers.

Underscoring the difficulties likely to arise from home equity loans, a Democratic proposal in Congress to refinance troubled mortgages and provide them with government backing specifically excludes second liens. Lenders holding a second lien would be required to write off their debts before the first loan could be refinanced. That could leave out a significant number of loans, analysts say.

People with weak, or subprime, credit could be hurt the most. More than a third of all subprime loans made in 2006 had associated second-lien debt, up from 17 percent in 2000, according to Credit Suisse. And many people added second loans after taking out first mortgages, so it is impossible to say for certain how many homeowners have multiple liens on their properties.

“This is turning out to be a real impediment to solving this problem,” said Mark Zandi, chief economist at, “at least, solving it quickly.”

Saturday, March 29, 2008

The Debt Shuffle

Voltron says: Lehman used an accounting trick (explained in depth here) to account for $600 million in profits because their credit rating went down. Their NET profit was only $489 million! If their credit rating recovers, they'll have to "give it all back." They only wrote down their $87 billion portfolio by 3%. Some of this is surely home equity loans that will be worthless.

Condé Nast Portfolio

Wall Street cheered Lehman's earnings, but there are questions about its balance sheet.

Bear Stearns collapsed for two reasons. It had a short-term funding crisis where lenders pulled their loans and customers pulled their cash. But it also had a longer-term leverage problem. Last week’s crisis didn’t happen in a vacuum; that leverage eventually led to the collapse in confidence.

After the collapse, Wall Street’s attention naturally turned to the other investment banks, especially Lehman Brothers, perceived as the most vulnerable. So, investors were thrilled when Lehman topped earnings expectations on Tuesday—as the firm took pains to reassure the markets that it has plenty of cash to ride out the turbulence.

Yet aside from a smattering of attention here and there, investors and the media mostly overlooked the balance sheet. In other words, they forgot what happened mere hours earlier with Bear Stearns. Wall Street’s short-term memory is notoriously lousy, but this must set a record. (Could Jimmy Cayne be sharing his stash with his hedge fund buddies?)

What actually happened to Lehman’s balance sheet in the first quarter? Assets rose. Leverage rose. Write-downs were suspiciously minuscule. And the company fiddled with the way it defines a key measure of the firm’s net worth. Let’s look at the cautionary flags:

Lehman’s balance sheet isn’t shrinking, as we’d expect.

Lehman finished the first quarter was total assets of $786 billion, up almost 14 percent from the previous quarter and 40 percent from a year earlier. Other financial institutions are taking down their exposure right now amid the market turmoil to be prudent. Lehman says it wants to. It is not.

Lehman got more leveraged, not less.

The investment banks “gross” leverage hit 31.7 times equity, up from the fourth quarter and way up from last year’s 28.1. According to Brad Hintz, an analyst with Bernstein Research, Lehman’s leverage reached its highest point since 2000. Lehman, like all the investment banks, prefers to look at net leverage, excluding hedges, and that went down. And the firm says that the asset rise was mainly a result of increases in short-term items that have low risk. But we’ve heard a lot of that lately across the financial world. It’s quite simple: The more leverage Lehman has, the less room assets have to fall to wipe out its equity.

Lehman includes debt in its calculation of equity. Say what?

It’s always worrisome when a company changes a key definition of a closely watched measure of financial performance. In a note in its earnings release, Lehman said it has a new definition of “tangible equity,” or the hard assets that it has left over after subtracting its liabilities. This is a measure of net worth, the yardstick by which investment banks are valued. Lehman’s new definition allows for a higher portion of long-term subordinated borrowings (which it calls “equity-like”) in tangible equity. Previously, it had a cap on the percentage of “perpetual preferred stock,” a form of equity-like debt that doesn’t have a maturity date, in its equity. Now, it doesn’t have a cap. Think of it this way: If you borrow money from your parents to make your down payment on your house and they don’t expect to get paid back right away (at least not before you pay your mortgage off) is it equity in your house? No, it’s a loan. And Lehman hasn’t borrowed from mommy and daddy.

Lehman says it is merely conforming to the Securities and Exchange Commission’s definition of tangible equity and had contemplated making the change for a while. And the firm says the change didn’t result in any difference to its net leverage ratio.

Lehman reaped substantial earnings gains because investors thought it is more likely to go bankrupt.

For several quarters, all the investment banks have been taking gains on their liabilities. Say you owe $100 to your friend. But you run into severe problems and your friend starts to figure you can only afford to pay back $95. If you were an investment bank, the magic of fair value accounting dictates that you could get to reduce your liability. What’s more, that $5 gain gets added to earnings. Because investors thought Lehman was more likely to default, its liabilties fell in value and Lehman garnered earnings from this. How much did Lehman win through losing? $600 million in the quarter. How much was its net income? $489 million.

Lehman and all the other investment banks are following the accounting rules on this, but that $600 million is hardly the stuff of quality earnings. Indeed, Bernstein’s Hintz called the bank’s earnings quality “weak.”

Lehman’s write-downs seem tiny.

Lehman finished the quarter with $87.3 billion of real estate assets. These include residential mortgages and commercial real estate paper. The bank only wrote these assets down by 3 percent. And its Level III assets —the hardest to value portion of these instruments—were written down by only the same percentage. The indexes and publicly traded instruments and companies that serve as proxies for these securities generally fell more than that in the quarter. Lehman points out that took larger gross write-downs and then made money through hedges, for a smaller net number.

Lehman remains exposed to lots of dodgy mortgages, including a group labeled: “Prime and Alt-A.” Prime mortgages represent loans to good quality borrowers; Alt-A loans go to borrowers a mere step up from subprime, and represent an area with almost as many problem loans as subprime. The total amount of such mortgages on Lehman’s balance sheet was $14.6 billion in the first quarter and it actually rose from $12.7 billion in the previous quarter. Is this the time to be increasing exposure to questionable mortgages? More ominously, only $1 billion of that figure is prime and the rest is Alt-A, according to Hintz’s estimate.

The picture emerging is that of an investment bank that is dancing as fast as it can. If Lehman can keep piling up more assets, and if these assets come back, Lehman comes out a big winner. But if it didn’t properly mark down those assets during these bad times, the investment bank’s returns —and therefore its profitability—will be much lower in the future.

And that’s the good case. If the assets do not recover, then time is against the firm.

There is a larger, monetary policy issue here. The Federal Reserve has announced that it will lend to investment banks for the first time since the Depression, acting as a lender of last resort. At the very least, regulators should be demanding that the investment banks bring down their leverage and reduce their risk. Are the regulators sending a stern-enough message to Lehman? If so, it’s not getting through.