De-Leveraging America
Location: New York
Author:
IRA Staff
Date: Wednesday, August 22, 2007
"The US economy remains
strong."
Henry Paulson
Secretary of the Treasury
When the Fed announced a 50bp cut in the
discount rate last week and also made a point of announcing an extension of
the maturity of discount window loans to 30 days, our first reaction was to
ask: Great, but what about next week? The troubles affecting the US markets
are about solvency, not mere liquidity.
By the way, who told our former colleagues at the Fed that using the
discount window is a badge of honor? Contrary to what you hear from the Fed,
an institution openly using the discount window is unlikely to make
investors feel more confident about the bank in question. Reports that
Deutsche Bank (NYSE:DB) availed itself of the Fed's generosity is reason for
anxiety, not comfort, since it implies that the bank cannot fund itself in
the private markets.
The last time the Fed faced a real credit crisis was the early 1990s, when
the very solvency of some of the largest US banks was rightly in doubt. It
has been that long since the US banking market worked through a true credit
collapse. Today the numbers are bigger, the assets are increasingly opaque
and illiquid, and the degree of leverage employed many times higher.
In the anxious days of zombie S&Ls and moral hazard, we used to wait eagerly
on Friday mornings for the USPS mail to deliver the Fed's form H.4.1,
“Factors Affecting Reserve Balance of Depository Institutions and Condition
Statement of Federal Reserve Banks,” which among other things shows activity
at the Fed's discount window.
Nothing of special note as of last Thursday, but this week's report will
make a good read. Indeed, we predict that the venerable Fed document is
going to become down right popular in the weeks ahead as analysts and even
members of the banking public try to figure out whether their bank is
financing assets at the Fed's discount window. A couple of research notes:
* First, the lead unit of JPMorgan Chase (NYSE:JPM) is now domiciled on
Polaris Parkway in Cleveland, OH, so if you see a sudden surge in window
activity in Chicago, don't assume it's a local bank gone bust.
* Likewise the lead unit of Citigroup (NYSE:C) is now domiciled on Paradise
Road in Las Vegas, NV, so any surge in window activity at the San Francisco
Fed should not necessarily be attributed to a local institution.
* The largest thrift unit of Lehman Brothers (NYSE:LEH) is located in
Wilmington, DE, making the Philadelphia, PA, federal reserve bank the
logical lender in the event. BTW, the ROE of the $20 billion asset Lehman
Brothers Bank, FSB has almost converged with the peer group's high single
digit ROE, this after peaking at 50 percent in Q1 2003. Call it a leading
indicator.
As of last week, the Fed was offering 85 percent financing on "AAA" rated
collateralized debt obligations or CDOs, paper which changes hands at half
that rate over-the-counter, when it trades. This explicit bailout for the
Street stands in stark contrast to the Darwinian struggle now underway in
the real estate sector, where private loan originators are defaulting in
droves. But the Fed may not escape loss itself as it bails out the major
prime brokers.
Q: When was the last time that a federal reserve bank took a loss on a
discount window loan?
Just consider what happens if an eligible depository institution repos "AA"
rated CDO collateral to a reserve bank for 30 days, paper which has no
market bid. Then imagine that the collateral is downgraded by a ratings
agency. If the bank is unable to adjust the collateral value of the window
borrowing, then the reserve bank might be forced to push the borrower into a
prompt corrective action, sell the collateral into the market and take a
hefty loss. A credit loss to a federal reserve bank is a public subsidy
since it comes right out of the system's income and thus decreases the
annual payment to the US Treasury.
The Fed's discount rate announcement came after Countrywide Financial (NYSE:CFC)
disclosed that it is collapsing its non-conforming loan business and
stuffing what remains into its federally insured bank unit. This kind of a
nuclear winter survival strategy may be appropriate in the present
environment -- especially with the Fed offering 30-day money at 5.75
percent on toxic waste.
The collapse of CFC's non-conforming mortgage production business signals
the end of an asset class and an era in US real estate. As the dwindling
ranks of mortgage brokers retreat away from loans (and customers) which are
either too large or two risky to qualify for purchase by the GSEs, the
entire stratosphere of residential real estate is suddenly standing on sand,
wet sand with lots of warm salt water pulling it away with the retreating
economic tide.
We look for the same price compression in the above $1 million residential
real estate market as already is evident in the OTC market for CDOs and
similar derivative instruments. A 25 percent haircut from the 2005-2006 peak
seems like a conservative estimate. With the secondary market for
non-conforming mortgage paper virtually disappearing, the only place prices
on "jumbo" collateral seemingly can go is down.
Home price appreciation over the past decade was a function of ever
expanding financing, thus no financing must imply a significant housing
price correction from recent levels. We hear anecdotal reports of developers
in Steamboat, CO, writing below market financing on condos and taking
write-downs on the principal approaching 20 percent just in order to move
inventory.
In view of the events in the credit markets over the past two weeks, just
imagine how the economic reality of an imploding real estate market will be
reflected in collateral prices a few months from now. Remember, home prices
in areas like the Northeast and CA could drop 25 percent or more and
long-term owners would still have positive appreciation. But if you bought
in the past three years, you're probably under water right now.
Get used to having wet feet. And next week we look at the next shoe to drop
off the centipede, namely unsecured consumer credit.
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