It remains to be seen whether these steps and others like them in other countries will be sufficient to restore confidence in the financial system and increase lending.

In the meantime, lower lending activity will continue to hurt the margins though the low interest rate environment should be beneficial to the banks with a liability sensitive balance sheet.

It still remains a bit too early to begin building a position in bank stocks. We have yet to see any positive momentum from the initiatives so far as shareholders appear to be getting more dilution rather than less. We anticipate further consolidation in the banking space, as the weaker players fail and the stronger players seek to build up their positions, and may be assisted by the regulators in doing so.

Therefore, we suggest investors wait for signs of stabilization in the credit and stock markets. At that point, we suggest interested investors build small positions using dollar cost averaging.

U.S. Winners and Losers

As many of the bigger lending institutions continue work through their issues once again it should be the smaller regional players with local connections and the ability to view opportunities within their own markets that will first benefit from economic growth. In addition, we would expect to see a reemergence of the consolidation theme that ran at a frenetic pace during the 1990s over the next couple of years, albeit as a potentially slower pace.

We like the banks which have:

1. Solid capital levels (more so the Tangible Common Equity level)
2. Less exposure to housing (and or did not diluted their reasonable credit standards) and other related risky assets than their peers
3. Derive a significant portion of their revenues from non-interest income (not loan-based)

Among, the bigger banks, we expect Goldman Sachs Group (GS), JPMorgan Chase (JPM) and Morgan Stanley (MS) to emerge as winners.

Out of the banks that we cover, we like WestAmerica Bancorp (WABC), Commerce Bancshares (CBSH), Hudson City Bancorp (HCBK), BOK Financial Corporation (BOKF), and Texas Capital Bancshares (TCBI).

At this time, we advise the investors totally avoid the bigger zombie banks, which are perfect candidates for capital infusion by the government after the stress tests, like Bank of America (BAC), Citigroup (C), U.S. Bancorp (USB) and PNC Financial Services Group (PNC).

Non-U.S. Winners and Losers

As to non-US banks, we believe that banks in stable emerging economies, such as Chile, Brazil or India, may be more attractive investments, similar to what we expect for certain regional banks in the US. To be sure, banks in emerging economies will face asset quality issues; however, they are not confronted with other significant problems that many of the larger banks in Europe and the United Kingdom are, such as toxic securities, dilution from being forced to raise additional capital, and dividend cuts/omissions.

Moreover, they generally tend to be well capitalized, aren't as heavily exposed to the property markets, and have significant and generally growing sources of noninterest income.

One caveat, investment in non-US ADR bank stocks entails foreign currency risk. Currently, the USdollar is appreciating against many foreign currencies, which tends to depress US$ share performance. On the other hand, when this turns and the US$ starts falling against other foreign currencies, this will accelerate gains in US dollar.

Investors may wish to look at HDFC Bank Limited (HDB), one of the largest banks in India; Banco Itau Holding Financeira S.A. (ITU) in Brazil, the largest bank in Brazil following the February 2009 merger of Uniao de Bancos Brasileiros S.A. and Banco Itau Holding Financeira S.A. (or Itau); or Banco Santander-Chile (SAN), the largest private bank in Chile.

Topics For Consideration

U.S. Banks To See More Asset Deterioration

For the last few quarters, banks have mainly suffered due to the losses in the mortgages and CRE (residential construction loans). We are hopeful about the Obama's "Homeowner" plan, but do not expect the housing markets to turn around any time soon and anticipate continued losses in the housing and related portfolios. Further, deterioration in other commercial real estate loans has started of late and the downturn in this class is also likely to be very challenging.

With the deterioration in the overall economic environment and rising job losses, we anticipate the losses will increase in all the other asset classes as well, especially in the consumer related loans. (It was recently reported that U.S. credit card delinquencies rose to a record high in January. They will likely rise further).

We also expect the deterioration in asset quality to continue at least through the end of 2009. Further, the banks will also continue to take mark-downs in the investment portfolios, further hurting the bottom-line.

We continue to remain a bit concerned with the lack of lending the banks. Not loans that may be placed through the Government Sponsored Enterprises, but rather those that are made by banks. A number of mortgage consolidator websites show what could appear to be non-realistic points and fee structures. While rate including fees and points are at historic low, what some may deem, "The cost of doing business," many others could deem "vulture pricing" or an attempt not do lend. Until this current practice is rectified, the positives from the stimulus program may not gain all the traction possible.

Foreign Banks Face A Daunting Outlook

Many countries have already adopted recapitalization plans.

For example, the British government already purchased large stakes in Lloyds Banking Group PLC (LYG) and Royal Bank of Scotland Group (RBS). Britain also completely nationalized other banks, such as Northern Rock.

When these efforts failed to stabilize the credit markets, an Asset Protection Scheme (APS) was adopted. Under this plan, the government insures the bank against losses on its most toxic assets (e.g., mortgage-backed securities and property loans) for more in return for a small fee and an obligation by the bank to increase lending to consumers and businesses. The bank absorbs the first 10% of the losses, with the British government assuming responsibility for the remaining 90%.

Though Britain and many other countries are trying to restore confidence, it is uncertain as to whether the current measures will be enough.

Consumer job losses and sluggish business conditions are increasing worldwide, which will tend to dampen demand for credit, even assuming banks are capable of lending more. Moreover, these factors will also hurt asset quality and increase losses on the existing "good" loan portfolios, even apart from considerations of toxic assets. Combined with top line pressure due to weakening economic conditions, non-U.S. banks face a daunting outlook.

Bank Nationalization

There is a lot of confusion about what would classify as "Nationalization" as evidenced by the very divergent opinions on the issue.

Some experts view any government ownership as a form of nationalization. Others feel that government ownership above 51% would be termed so. Technically, if the government owns 80% or more of a company's shares, then accounting rules require the company to be put on the government's balance sheet. (This is why the U.S. government decided to take control of 79.9% of the shares in Fannie and Freddie).

Both Treasury Secretary Geithner and Fed Chairman Ben Bernanke have spoken against nationalization, but the fact is that the U.S. government already has a substantial stake in the financial system of the country. With the latest round of bailouts, U.S. taxpayers will own about 78% equity in AIG and 36% in Citigroup. Instead of these piecemeal efforts at the banks, we think it would make perfect sense for the government to take control of such banks for a short period of time, and then split them and sell them to private parties or even relist them through initial public offerings.

Further, we suspect that the government will end acquiring substantial stake in all banks required to raise additional capital after stress tests are applied. This will be a necessity as these "losers" will find extreme difficulty with accessing private capital. As of now, stress tests are mandatory only for the large banks but may be expanded later to cover other banks as well.

In any case, whether it is nationalization or substantial ownership by a government, the investors of such banks will suffer badly or be wiped out. (This is what happened with Northern Rock shareholders.) Nationalization has been around for many years. In the U.S, nationalization was used effectively by the FDIC to take over 16 banks this year so far. Any government assistance accepted is a nationalization of the entity. While the Resolution Trust Corporation (RTC) did work to digest the volumes of assets seized in the last real estate bubble, it took multiple years to resolve, with benefit really only exhibited after the first 3 years and final resolution about 15 years later.

We think that it is important for all parties to remain as fiscally responsible as possible.

In the U.S., the current housing plan calls for mortgages to be reworked if the borrower misses a few payments or can demonstrate really need to intervention to remain in the home. This approach only rewards borrowers that have not been responsible. We believe that aid should be made available but not just given without any reasonable strings attached (accountability remains paramount).

If financial institutions were required to rework loans with reasonable terms and conditions(e.g. changing Alt-A and Option ARMs into more traditional loans), the results would be less foreclosures over the next several years from the pool of 10 million potential loans coming due.

Paul Krugman ably lays out the case for why it's conceivable that Fannie and Freddie could have made a contribution:

Here's the background: Fannie Mae-- the Federal National Mortgage Association-- was created in the 1930s to facilitate homeownership by buying mortgages from banks, freeing up cash that could be used to make new loans. Fannie and Freddie Mac, which does pretty much the same thing, now finance most of the home loans being made in America.

The case against Fannie and Freddie begins with their peculiar status: although they're private companies with stockholders and profits, they're "government-sponsored enterprises" established by federal law, which means that they receive special privileges.

The most important of these privileges is implicit: it's the belief of investors that if Fannie and Freddie are threatened with failure, the federal government will come to their rescue.

This implicit guarantee means that profits are privatized but losses are socialized. If Fannie and Freddie do well, their stockholders reap the benefits, but if things go badly, Washington picks up the tab. Heads they win, tails we lose.

Such one-way bets can encourage the taking of bad risks, because the downside is someone else's problem.

Fannie and Freddie had purchased $4.9 trillion of the mortgages outstanding as of the end of 2007, 70% of which the GSEs had packaged and sold to investors with a guarantee of payment, and the remainder of which Fannie and Freddie kept for their own portfolios. The fraction of outstanding home mortgage debt that was either held or guaranteed by the GSEs (known as their "total book of business") rose from 6% in 1971 to 51% in 2003. Book of business relative to annual GDP went from 1.6% to 33%.

Sum of retained mortgage portfolio and mortgage backed securities outstanding for Fannie and Freddie (from OFHEO 2008 Report to Congress) divided by (1) total 1- to 4-family home mortgage debt outstanding (from Census for 1971-2003 and FRB for 2004-2007) and (2) annual nominal GDP.

The fact that the volume of mortgages held outright or guaranteed by Fannie or Freddie grew so much faster than either total mortgages or GDP over this period would seem to establish a prima facie case that the enterprises contributed to the phenomenal growth of mortgage debt over this period. Krugman nevertheless concludes that the GSEs aren't responsible for our current mess:

But here's the thing: Fannie and Freddie had nothing to do with the explosion of high-risk lending a few years ago, an explosion that dwarfed the S.& L. fiasco. In fact, Fannie and Freddie, after growing rapidly in the 1990s, largely faded from the scene during the height of the housing bubble.

Partly that's because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn't do any subprime lending, because they can't: the definition of a subprime loan is precisely a loan that doesn't meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income.

These developments appear clearly in the graph above after 2003, which is marked with a vertical line. And certainly much of the dramatic appreciation in house prices came in the two years after the GSEs began to contract.

S&P/Case-Shiller Composite 10 home price index (data source).

Even more striking is the explosion of home mortgages held in the form of privately-issued asset-backed securities that did not go through either Fannie or Freddie. By 2006, these represented 20% of all outstanding home mortgages.

Dollar value of home mortgages held by private asset-backed securities (from Census for 1971-2003 and FRB for 2004-2007) divided by (1) total 1- to 4-family home mortgage debt outstanding and (2) annual nominal GDP.

On the other hand, Tanta contributes this:

Fannie and Freddie .... didn't like losing their market share, and they pushed the envelope on credit quality as far as they could inside the constraints of their charter: they got into "near prime" programs (Fannie's "Expanded Approval," Freddie's "A Minus") that, at the bottom tier, were hard to distinguish from regular old "subprime" except-- again-- that they were overwhelmingly fixed-rate "non-toxic" loan structures. They got into "documentation relief" in a big way through their automated underwriting systems, offering "low doc" loans that had a few key differences from the really wretched "stated" and "NINA" crap of the last several years, but occasionally the line between the two was rather thin. Again, though, whatever they bought in the low-doc world was overwhelmingly fixed rate (or at least longer-term hybrid amortizing ARMs), lower-LTV, and, of course, back in the day, of "conforming" loan balance, which kept the worst of the outright fraudulent loans out of the pile. Lots of people lied about their income (with or without collusion by their lender) in order to borrow $500,000 to buy an overpriced house in a bubble market. They weren't borrowing $500,000 from the GSEs.

Michael Carliner (hat tip: Economist's View) adds:

Fannie and Freddie are ... subject to regulation by HUD under mandates to serve low- and moderate income households and neighborhoods. As originators and investors with more energy than brains expanded their (subprime) lending to those borrowers and neighborhoods, it was difficult for Fannie and Freddie to increase their shares. They didn't want to buy or guarantee subprime loans, correctly perceiving them to be insanely risky. Instead they purchased securities created by subprime lenders, taking only the supposedly-safe tranches. Those portfolio purchases were counted toward their obligations to lend to lower-income home buyers, but are now part of the write-downs.

For my part, I have two questions for those who take the position that the GSEs played no significant role in causing our current mortgage problems. First, what economic justification is there for the dramatic increase in the share of loans guaranteed or held by the GSEs between 1980 and 2003 that is seen in the first graph presented above? What sense did it make to increase the ratio of such loans to GDP by a factor of 12 over this period?

Second, what forces caused the explosion of private participation in a much more reckless replication of the GSE game? A year ago, I suggested one possible answer-- private institutions reasoned that, because the GSEs had developed such a huge stake in real estate prices, and because they were surely too big to fail, the Federal Reserve would be forced to adopt a sufficiently inflationary policy so as to keep the GSEs solvent, which would ensure that the historical assumptions about real estate prices and default rates on which the models used to price these instruments were based would not prove to be too far off.

Is that the answer to the second question? I'm not sure. But if anybody has a better answer, I'd still like to hear it.

In the mean time, I very much agree with Krugman that the most egregious problems were not caused by anything Fannie or Freddie themselves did. But I disagree that their actions played no role in causing the underlying problem we face today.

Technorati Tags: macroeconomics, economics, housing, Fannie Mae, Freddie Mac GSE, credit crunch, mortgage crisis

First, a little background:

Both Freddie and Fannie were initially created by the U.S. Congress with the goal of expanding the residential mortgage market. They are for this reason referred to as "government-sponsored enterprises", or GSEs, even though both eventually were converted into private companies for which there is today no explicit government guarantee of their debt....

After a homeowner has borrowed money to buy a home, the original lender likely resold that loan to Fannie or Freddie. The GSE in turn collected some of those mortgages in a pool which was sold in the form of mortgage-backed securities (MBS) to private investors, for which the GSEs collect a fee in exchange for guaranteeing payment on the MBS. Other mortgages purchased by the GSE are held directly by the GSE for its own investment portfolio. The GSEs obtained the funds for these investments primarily with money borrowed directly from private investors, which instruments are referred to as "agency debt".

The table below provides a simplified balance sheet for Freddie Mac. Most of the nearly $800 billion in assets held by Freddie as of the end of 2007 consisted of mortgage loans or securities based on mortgages. The company acquired the resources to buy these assets primarily by borrowing, with outstanding debt as of the end of 2007 of $738.6 billion. The key item on the liabilities side of the balance sheet is stockholders' equity, which represents the capital raised by Freddie through direct sales of stock and cumulative retained earnings. This equity provides a cushion against possible losses on any of its assets, in that the first $26.7 billion in losses would come out of the company's original capital, with creditors losing nothing. That cushion, however, would only cover losses that were less than 26.7/794.4 = 3.4% of the assets.

Fannie's 2007 stockholders' equity came to 5.0% of assets.

These balance sheets leave out the mortgage-backed securities that the enterprises created and sold directly to outside investors, for which the enterprises have issued off-balance-sheet guarantees for payment. The OFHEO 2008 Annual Report to Congress states that Freddie had sold $1,381.9 billion in MBS and Fannie $2,118.9 billion. If you add together the mortgages retained outright by Fannie and Freddie (either as whole loans or MBS) plus the MBS that they have sold to others and offer a guarantee for payment, the OFHEO calculates a total "book of business" for the two enterprises of $4,934.4 billion as of the end of 2007, slightly less than the total publicly held debt of the U.S. government. Fannie and Freddie's combined stockholders' equity amounts to 1.4% of their total book of business.

Fannie and Freddie borrowed the funds with which this empire was leveraged at terms nearly as favorable as those for the Treasury itself. Unquestionably a key reason that investors have received agency debt so warmly over the years, and treated the guarantees as credible, was the assumption that Fannie or Freddie were too big for the federal government to allow to fail. This creates an unambiguous concern of moral hazard. When investors assume that the government will cover their losses, the result is a higher volume of funds flowing into the GSEs than is socially desirable. The upside goes to the lender, the downside is supposedly picked up by the government, and the result is the enterprise is expanded to a greater level of risk than makes economic sense.

Source: Lockhart (2008).

The GSEs' book of business represented 25% of outstanding residential mortgage debt in 1990 but comes to 41.4% today. It is hard to avoid the conclusion that these moral hazard distortions were one factor that contributed to the rapid expansion of mortgage debt over the last decade and attendant excessive price appreciation and risk taking. Granted, the real excesses, such as the subprime loans that everybody was initially discussing, came from MBS created by private institutions rather than the GSEs. But the stock market seems to be declaring pretty loud and clear this week that risks associated with enterprise assets are significant.

Source: Yahoo Finance.

Source: Yahoo Finance.

So where do we go from here? If we indeed reach a point where one or both of the GSEs can no longer honor its commitments, the Treasury's contingency plan might follow the Bear Stearns philosophy of leaving shareholders nothing but protecting creditors and counterparties fully. But if the U.S. Treasury ends up assuming a significant burden, this would at a minimum raise the logistical question of how taxes are going to be raised to cover the costs. One strategy that holds some appeal would be to let the burden of the tax fall entirely on the creditors and counterparties themselves-- in other words, no government bailout at all-- as argued by Nouriel Roubini:

notice that the hit that bondholders will take will be limited in the absence of their bailout. With a debt/liabilities of about $5 trillion and expected insolvency-- as of now and in the worst scenario of $200 to $300 billion-- the necessary haircut is relatively modest: either a reduction in the face value of the claims of the order of 5% (if the mid-point hole is $250 billion) or-- for unchanged face value-- a very modest reduction in the interest rate on their debt after it has been forcibly restructured.

So what's wrong with that idea? The overriding concern in dealing with the current mess is that the process of rapid and radical deleveraging would so impede the flow of new credit that the housing price declines, foreclosures, and bankruptcies significantly overshoot the values that we'd expect in a properly functioning credit market. In addition, I would worry about possible serious repercussions of a flight of foreign capital if there is a sudden perception that agency debt entails heavy risks.

The principle of "make those who caused the problem pay" has a lot of visceral appeal. But the principle of "don't impose severe and gratuitous extra costs on those who had no role in causing the problem"-- in other words, don't make the housing depression much more severe just to teach somebody a lesson-- has to be the basis for our policy decisions.

My recommendation would therefore be for a managed bailout in which the stockholders, creditors and taxpayers jointly share the bill.

And now we can haggle about the price.

Technorati Tags: macroeconomics, economics, housing, Fannie Mae, Freddie Mac GSE, credit crunch