Freddie Mac's loan losses go exponential

About 6 months ago I drew attention to the lax standards for buying mortgages at Freddie-Mac (FRE). Remember Freddie Mac is not a lender but a buyer and securitizer of mortgages. At that time Freddie Mac was instituting some tougher standards on the types of mortgages they buy.

Actually it be more accurate to say they were instituting 'some' standards because they didn't seem to have any prior to that.

6 months later Freddie's lax standards have become more obvious. Yesterday the company reported a 45% drop in 2Q07 profit on the back of a significantly higher provision for loan losses. Below you can see, as a I recently pointed out with Countrywide (CFC) , FRE's loan loss provisions are turning exponential.


Remember this is the same company, with the support of senator Dodd, that has been lobbying congress to raise their portfolio cap so they can buy more mortgages.

The same company that only last quarter returned to regular quarterly financial reporting. The same company that hasn't been current on its results since 2002, following an accounting crisis in which it said earnings were misstated to the tune of about $5 billion for 2000 through 2002. Ahhh what's 5 billion between friends?

Thankfully congress have decided against lifting Freddie Mac's cap however it seems that Bush has decided to do something to stem the tide of foreclosures. Or to put it another way, to keep people in overpriced houses they can't afford. From the WSJ:

Bush Moves to Aid Homeowners

WASHINGTON -- President Bush, looking for ways to respond to the subprime-mortgage crisis, will outline a series of policy changes and recommendations today to help borrowers avoid default, senior administration officials said.

Among the moves will be an administrative change to allow the Federal Housing Administration, which insures mortgages for low- and middle-income borrowers, to guarantee loans for delinquent borrowers. The change is intended to help borrowers who are at least 90 days behind in payments but still living in their homes avoid foreclosure; the guarantees help homeowners by allowing them to refinance at more favorable rates.

Mr. Bush also will ask Congress to suspend, for a limited period, an Internal Revenue Service provision that penalizes borrowers who refinance the terms of their mortgage to reduce the size of the loan or who lose their homes to foreclosure. And he will announce an initiative, to be led jointly by the Treasury and Housing and Urban Development departments, to identify people who are in danger of defaulting over the next two years and work with lenders, insurers and others to develop more favorable loan products for those borrowers.

Click on the heading for the full story. The best part is about 2/3 down the page:

Mr. Bush is instructing Treasury Secretary Henry Paulson to look into the subprime problem, figure out what happened and determine whether any regulatory or policy changes are needed to prevent a recurrence.

That should be interesting since Paulson doesn't even think there is a problem. Remember, housing has bottomed and sub-prime is contained

Lehman downgrades major brokers

Yesterday Lehman Bros. (LEH) joined Merrill Lynch (MER) in downgrading earnings for the major US brokers. From Bloomberg:

Goldman, Wall Street Firms' Estimates Cut by Lehman

Aug. 30 (Bloomberg) -- Goldman Sachs Group Inc., Morgan Stanley, Merrill Lynch & Co. and Bear Stearns Cos. will have trouble boosting profit through next year because of the rout in global credit markets, according to Lehman Brothers Holdings Inc.

``Investors are discounting 1998-style declines in returns on equity this quarter and next,'' Roger Freeman, a Lehman analyst based in New York, said in a note to clients today. ``We admittedly have limited conviction about 2008 ourselves sitting here at the end of August with a wall of worry to climb between now and October.''

Analysts across Wall Street are forecasting less profit growth for the securities industry after fixed-income trading fueled three straight years of record earnings. Loans held in subprime-mortgage bonds are going bad at fastest rate in 10 years, eroding confidence in asset-backed securities and corporate credit and triggering a slide in stock prices.

Freeman cut his estimate for Bear Stearns's third-quarter earnings by more than half to $1.45 a share and predicted that profit will decline in the following three months and next year. He also said Goldman, Morgan Stanley and Merrill, the three largest U.S. securities firms, won't earn as much as he expected previously.

Click on the heading for the full article. This comes just two days after downgrades by Merrill Lynch. As noted previously with the general lack of disclosure it's difficult to know exactly how badly earnings will be affected. As the Lehman analyst says he has 'limited conviction' about the state of next years earnings as it is just too early to tell. Below are the analyst's downgrades, click on the chart for a sharper image:

As you can see Bear Stearns is suffering the biggest downgrades especially in the 3rd and 4th quarter this year, no doubt due to the blowup of two of their hedge funds.

Goldman, Morgan Stanley, Lehman and Bear Stearns all end their fiscal 3rd quarters at the end of August and are expected to report earnings the week of Sept. 17. Thus 3Q07 earnings for these companies will only reflect one month of the credit crunch. Two months, assuming the tight credit markets continue, will be factored into Merril Lynch's 3Q07 which closes at the end of September.

If tough credit conditions persist through to the end of the year 4Q07 earnings will be of more interest as they give a better indication of how well the brokers can weather the storm.

Wall sreet revenues to feel the pinch

You may have noticed I've been harping on about earnings for a while. Except for some recent downgrades from Merril Lynch Wall Street seems slow in grasping the effect on earnings for financial companies.

Could it be due to the lack of transparency in the financial markets and company balance sheets in general that analysts have yet to start downgrading in any significant way? Or maybe they're just sitting tight and waiting to see how long this will play out...they could be waiting a while.

Well whilst the brokers have been relatively quiet the folks at Standard and Poor's have been busy calculating potential losses in investment banking and trading revenue for major securities firms. From Bloomberg:

S&P Says Rout May Hurt Wall Street More Than in 1998

Aug. 29 (Bloomberg) -- Standard & Poor's said business conditions for securities firms are worse than in the second half of 1998 and revenue from investment banking and trading could fall 47 percent in the final six months of this year.

The rating company said it conducted a ``stress test'' designed to measure the ``ability of investment banking businesses to withstand such scenarios.'' The conclusions don't constitute a forecast, S&P said in a statement.

``This is more severe than in 1998,'' when investment- banking and trading revenue fell 31 percent in the second half following Russia's debt default, S&P analyst Nick Hill said in the statement. At the time, revenue from fixed-income, currencies and commodities was negligible or even negative, he said. As in 1998, firms are likely to cut bonuses to stay profitable, said Hill, who is based in London.

Click on the heading for the full article. No doubt this time round will be more severe and prolonged. The Russian default and subsequent meltdown of LTCM was relatively isolated.

Today thanks to a vast array of opaque financial instruments the current crisis is spread to all corners of the world - ironically this so-called diversification of risk was touted as the reason we wouldn't experience the kinds of problems we now currently inhabit.

Anyone hear about a bankrupted hedge fund in Australia today? How about the Carlyle group bailing out a subsidiary? Or the shutdown of a London hedge fund? No? What about State Street's exposure to the shoddy end of the commercial paper market? Or the recent revelations of sub-prime exposure for Bank of China?

These stories emerged in just the last week, all but one in the past couple of days. I don't want to get off track here but I think you get my point that this thing is not isolated or 'contained'.

A few of the major securities firms will report 3Q07 earnings next month and we will also hear some earnings pre-announcements from others. More interesting than the numbers will be the forecasts for future quarters. Or will it all be academic if the Bernanke put is invoked on the 18th?

Probiotec achieves prospectus forecast

Probiotec (PBP) announced FY07 results in line with prospectus forecasts as shown above. Whilst NPAT was 20% higher than forecast that is due to the prospectus assuming a 30% tax rate whilst PBP's actual tax rate because of prior years losses was 17.9%.

On the positive side EBIT, EBITDA and NPAT margins showed significant improvement. Despite taking on an additional 6% debt the company's debt to equity ratio has decreased from 85% at June 2006 to 62.7% as of June 2007. Interest cover also improved substantially from 2.7 times to 4.9 times.

As noted at the half year the company capitalizes some product development costs. Total capitalized costs were $1.4m for the full year. I asked management about these costs and it seems they have an 'infinite life' and unless impaired those costs don't have to be taken through the P&L at all.

I find that quite astounding, I've heard of capitalizing costs but they must be amortised through the P&L as the future cashflows from the asset are realized. Or if the future cashflows don't arise they will be written off against the P&L as a one-off abnormal or what is now called a 'significant' item.

It seems that because the asset is deemed to have an infinite life it doesn't need to be amortized. At least that is what I have been led to believe through my correspondence with the company. I will endeavour to clarify that tomorrow.

the reason I place emphasis on this is that if my initial understanding is correct a company can basically wipe costs from their P&L as if they never happened. Sorry but that's just plain wrong.

The company reiterated their forecast of 30% profit before tax (PBT) growth for FY08. As I noted when this forecast was first made, this does not require the company to grow at all in FY08.

A 30% increase on FY07 PBT comes to $7.9m, if we simply just double 2H07 PBT of $4.0m we get FY08 PBT of $8.0m. Thus the company doesn't need to grow at all to achieve it's forecast.

Considering that the recent acquisition of branded pharmaceuticals is expected to contribute materially to earnings in FY08 it would be disappointing if the company did not earn in excess of $8.0m PBT in FY08. Accordingly I have left my previously forecast NPAT at $6.0m for FY08 implying 20% growth at the NPAT level.

Probably the most disappointing aspect of the results was the complete absence of new information on the Phoscal litigation. Previously PBP announced that their liability in the Phoscal claim was between $2.2 - $5.0m. This is still a big unknown hanging over the stock.

Whilst the business is performing well by most metrics I find it hard to get enthusiastic about this stock with the pending litigation and the costs that aren't really costs. On top of that I feel that management are either untrustworthy, incompetent or both.

I continue to hold the stock as by my valuation of $1.11 based on reasonably conservative forecasts for next year is not expensive. However if Mr market offers me a reasonable exit price in the near future I may just take it.

Another shoe drops

Credit-card defaults on rise in US

US consumers are defaulting on credit-card payments at a significantly higher rate than last year, raising the prospect of problems in the stricken US subprime mortgage market spreading to other types of consumer debt.

Credit-card companies were forced to write off 4.58 per cent of payments as uncollectable in the first half of 2007, almost 30 per cent higher year-on-year. Late payments also rose, and the quarterly payment rate – a measure of cardholders' willingness and ability to repay their debt – fell for the first time in more than four years.

Analysts at Moody's, the rating agency, said the trend could be related to the slowdown in the US property market and a fall in the number of borrowers rolling their mortgage debt into new and cheaper home loans.
Story continues below ↓advertisement

"The combination of higher interest rates and a softer real estate market diminished the attractiveness of mortgage refinancings in which many borrowers reduced their more expensive credit-card debt by drawing on the equity in their home," Moody's said.

But it is not clear that the borrowers defaulting on their credit cards are the same people defaulting on their subprime mortgages, it added. This is in part because underwriting standards in the credit-card sector have been more robust than in the mortgage industry.Also, many highly leveraged subprime borrowers, with little or no equity in their homes, may choose to default on a mortgage before risking being unable to charge everyday necessities to their credit card.

But Moody's said the rate of losses remained well below the 6.29 per cent average seen in 2004, a year before the US enacted a new law that made filing for personal bankruptcy more onerous.

The law led to a surge in individual filings and related credit card losses in 2005 as cash-strapped borrowers filed for bankruptcy before the rules came into effect.

Recent increases in credit card losses can in part be ascribed to a steady rise in personal bankruptcy filings since 2005. According to the Administrative Office of the US Courts, quarterly non-business bankruptcy filings have been rising since the first quarter of 2006.

Scott Hoyt, economist at Moody's Economy.com said: "Consumer credit quality will continue to deteriorate as debt burdens and financial obligations rise, house prices continue to fall, credit standards are tightened, labour markets loosen modestly, and gasoline and other energy prices remain high."

Well what did we expect? The Housing ATM has been shut off so now consumers are turning to credit cards as the last resort. For more on credit cards read Mish's article at MGETA

Case-Shiller Index lowest since Jan 1987

The above chart courtesy of the BIG PICTURE shows home prices are down in all 10 major cities of the Case-Shiller home price index year on year in June. The following comes from the press release:

“The pullback in the U.S. residential real estate market is showing no signs of slowing down,” says Robert J. Shiller, Chief Economist at MacroMarkets LLC. “The year-over-year decline reported in the 2nd quarter of 2007 for the National Home Price Index is the lowest point in its reported history, which dates back to January 1987. On a regional level 17 of the 20 metro areas are showing declines in their annual growth rate from what was reported in May.”

During this cycle, Boston was the first metro area to report negative year-over-year returns, back in April 2006. In June 2007, Boston showed an improvement in its annual rate of decline from the value reported in May, –3.9% versus –4.3% reported in May. Boston has shown improvement since the beginning of the year, where its annual growth rate measured –5.5%. More data however, is needed to determine whether Boston, whose growth rate turned negative before other metro areas, is truly the first metro area to turn around.

Shiller also appeared on Bloomberg yesterday and made an interesting observation. He said that according to surveys of households that people are still quite positive about home price appreciation. Shiller was quick to point out that what noone seems to be considering is that house prices may well decline for the next 5 years. That may sound radical but as Shiller points out that is exactly what happened between 1989 - 1994.

Valuable insights from a Minyan

An excellent article that appeared on Minyanville yesterday covering a variety of topics. Particularly interesting was the insightful analysis of Target's credit card business. Really worth the read if you have the time.

This letter comes from Minyan Peter, writing to Todd in response to his column yesterday, "Petty Morning Quarterback", and is reprinted here with permission for the benefit of the Minyanville community.


Todd,

I am a new Minyan, but in my former life I helped build and ultimately ran a Wall Street asset-backed securities business, was treasurer of a top credit card company and treasurer of one of the largest banks in the Midwest.

In light of the past several weeks in the markets, and in the interest of sharing, here are some observations that I think may be helpful to you and the Minyanville community at large.

First, having been there at the beginning, the genesis of the asset-backed commercial conduits was regulatory capital arbitrage. Through the conduits’ convoluted structures, banks were able to "lend" huge amounts off-balance sheet and collect fees on no-capital-required lines of credit. No one - and I mean no one - ever expected these conduits to move from off-balance sheet back on-balance sheet and I don't think the market yet understands the earnings, capital and liquidity impact of this migration. If you figure you need anywhere from 6-8% capital per dollar of loans, then a move of $1.0 trln from off-balance sheet to on requires $60-80 bln in additional equity capital. I don't know about you, but I don't see this kind of free capital sitting around.

Second, I don't think people appreciate the significance of the change in Fed policy that took place on Friday involving the brokerage affiliates of several money center banks. In the asset-backed commercial paper market, maturing commercial paper is normally either rolled over or replaced by loans from standby liquidity banks when it can't be rolled over. With Friday’s change, it would appear that investors now have the ability to "put" unmatured commercial paper back to the bank affiliated brokers - who in turn will pass it along through the Discount window to the Fed.

In doing this, I believe the Fed has established a very dangerous precedent. If investors can now put unmatured CP to the banks (instead of waiting for the standby liquidity banks to fund at maturity), it may not be long before investors pressure the bank-affiliated brokers to accept MTNs and who knows what else further out the curve.

Third, the last consumer led recession was around 1990. Since then, the SEC has placed enormous pressure on the banks to minimize their loan loss reserves. The SEC hates earnings management and the loan loss provision has historically been a key way for banks to "save for a rainy day." I don't think the market yet appreciates the fact that banks are currently provisioned for the top of the market. (And, in fact, up until recently, most major banks reported net provision reductions over the last several quarters.) As credit continues to deteriorate, the earnings/capital hits will be enormous as provisions need to reflect higher and higher delinquency and loss rates. And, experience suggests, that when the banking regulators finally do begin to act (as they did in New England during the late 1980’s), the pendulum will push banks to over-reserve at what will ultimately be the bottom of the credit cycle.

Finally, no one is talking about it yet, but I think the market will soon begin to realize that the credit card lenders have in essence become the consumer lenders of last resort. As consumers have been shut out of the mortgage and home equity world, the last available credit is plastic. One statistic that I have found very troubling is the degree to which credit card balance growth is running ahead of retail sales growth - a key sign that the consumer is stretched. In normal times, you would expect aggregate credit card balance growth to run about in line with GDP and retail sales growth. This year it is running almost 2.5 times that. Clearly consumers are using their cards for far more than purchases. And my guess is that for many Americans their credit cards have become the latest, but potentially last, source of financing available.

Because of the oversized credit card balance growth, however, I think the market is missing what is really happening within card issuer portfolios – particularly loss and delinquency data. Today, no one seems to be very concerned about the increases in reported losses and delinquencies. However, when you start to normalize these statistics for the enormous balance growth we’ve seen, the increases in both are quite dramatic.

To put this all together, take Target’s (TGT) latest financial results and you can see the numbers for real. First, credit card balance growth was up 14% year-on-year - almost 1.5 times Target sales growth of 9.5%. Second, thanks to this balance growth, reported year-on-year delinquency ratios are up only a little bit (60+ days delinquencies of 3.5% versus 3.4% a year ago), but the dollars of delinquent accounts are up almost 18% - to $242 mln from $205 mln – and, as an aside, “late fees and other revenue” are up more than 36% year-on-year.

Digging even deeper, you come away with more unanswered questions. First, annualized net write-offs for the quarter were up 17% - 5.4% of loans versus 4.6% during the year ago quarter. But behind that, masked by 14% balance growth, there is a 32% increase in the dollars charged off. Further, and to me more troubling, Target dropped its loan loss allowance from 8.3% of loans at the end of July 2006 ($501 mln) to 7.4% at the end of July 2007 ($509 mln). Had Target kept its provision at 8.3% of loans, the incremental cost would have been over $64 mln or almost 40% of the pre-tax quarterly earnings of Target’s credit card business. Alternatively, had Target kept its provision at the same 1.8 times net charge-offs as last year (an 8.3% allowance on 4.6% in net write-offs), the required ending provision would have been over 9.7% of loans - at an incremental cost to the company of almost $144 mln – all but eliminating earnings from the credit card operation for the quarter. Put simply, when measured in dollars (rather than percentages of balances) Target’s nearly flat year-on-year loan loss allowance does not synch with the increase in loan balances, delinquencies, charge-offs, and late fees.

And while I have used Target as an example, I don’t think Target is alone. As we have seen already in other parts of the credit markets, many banks and finance companies are managing their businesses as if today’s increases in credit deterioration are merely a “blip”, rather than the beginning of a broader, potentially more serious, decline. From where I sit, it looks like it is only going to get worse, and “it’s already in the cards.”

-Minyan Peter

Merrill downgrades some of the big names

Just last Friday Merrill Lynch downgraded a raft of mid-cap banks and I pondered whether this would be the beginning of a downgrade deluge. Today Merril announced that they have downgraded some of the bigger name brokers:

Citi, Lehman Brothers, Bear Stearns downgraded at Merrill

LONDON (MarketWatch) -- Merrill Lynch downgraded Citigroup Inc. (C) , Lehman Brothers Holdings (LEH) and Bear Stearns Cos. (BSC) to neutral from buy. The broker said Bear Stearns and Lehman have a greater dependence on the debt markets than other firms and earnings are therefore likely to suffer from a slowdown in securitization and mortgage business. Merrill cut its 2008 earnings forecast for Lehman by 22% to $6.80 a share and for Bear Stearns by 16% to $12.07 a share. Merrill cut its earnings estimate for Citigroup by 5% to $4.91 a share, saying the group's broader business mix meant the earnings shortfall should be less dramatic than at Bear Stearns and Lehman. "But given the risks, we feel the need to be more selective," Merrill said. Merrill added its top picks in the sector are Goldman Sachs (GS) and Morgan Stanley (MS) because of their business mix and geographical diversity.

That's some fairly hefty downgrades for Lehman and Bear. The longer the turmoil in credit markets plays out the more it will hit earnings of the big fixed interest players such as Bear and Lehman.

Merrill's are clearly in front of the curve with respect to the downgrade process however at this stage it's still tough to forecast earnings more than a year out considering what's going on in credit markets at the moment.

So expect more tweaking of numbers from Merrill and expect more brokers to jump on the downgrade bandwagon - particularly after we get a look at 3Q07 earnings.

Existing homes inventory at 16 year high

The National Association of Realtors (NAR) reported existing-home sales slipped 0.2% to a seasonally adjusted annual rate of 5.75 million units in July from an upwardly revised pace of 5.76 million in June, and are 9.0% below the 6.32 million-unit level in July 2006.

The national median existing-home price for all housing types was down 0.6% from July 2006. Economists The results were stronger than the 5.69 million sales pace expected by economists surveyed by MarketWatch, however they are still the lowest since November 2002.

So basically sales and prices were flat and economists were on the mark. As always however remember these numbers are subject to significant error.

The highlight of the report was that inventories of unsold single-family homes increased by 2.2% to 3.85 million in July, representing 9.2 months worth of supply and the highest level in 16 years.

For some interesting graphs on existing home sales see this article at Calculated Risk. The point below was of interest as far as what to expect in the coming months:

Note: For existing homes, the sales data is compiled at the close of escrow. So this report is mostly for homes were the sales agreements were signed in June or even May. This is all pre-turmoil, and even the August existing home report will be mostly pre-turmoil.

So from that we can conclude that the worst is yet to come and it looks like we won't get a clear picture of how bad it will get until at least October when we see the numbers for September.

If you're still craving more information on existing home sales (I know I am) check out this post at the same blog for more pretty graphs and insightful commentary. I found this tidbit quite interesting:

To reach the NAR forecast, revised downward again on Aug 8th to 6.04 million units, sales would have to be significantly above the 2006 levels for the remainder of the year. Given tighter lending standards, we can probably already say that even the August NAR forecast was too optimistic.

Too optimistic? That's being kind, how about not even in the ballpark? By the way if you haven't already checked out Calculated Risk - a good read with some great links.

The real lesson of HD's salvaged sale

The market reacted positively to the news that Home Depot (HD) managed to get the sale of it's supply division done. Rumors have it that the company agreed to an 18% discount to the original asking price of $10.3 billion to walk away with $8.5 billion in cash and retain a 12.5% stake in business.

At the end of the day the market along with Home Depot was happy just to get the deal done. For Home Depot it means they can institute their previously announced capital initiatives, however that may have to be reduced a little given the terms of the new deal.

For the market it means that M&A activity is still alive, however it is far from well. The Home Depot deal sounds like the desperate last gasp of a dying animal....a bull perhaps?

Minyanville's 'five things you need to know' hit on the implications of the revamped HD deal:

Any Love is Good Love for Home Depot

Home Depot (HD) agreed to sell its construction-supply unit for $8.5 billion, cutting the price by $1.8 billion, or 18%, according to Bloomberg.

• The original buyers, Bain Capital LLC, Carlyle Group and Clayton Dubilier & Rice, negotiated a reduced price from the original $10.3 billion price tag Home Depot sought just two months ago, according to Bloomberg.
• So here's a question: How did Home Depot's construction-supply unit lose nearly $2 billion in value in less than two months?
• The answer is, it didn't.
• What HD's construction-supply unit lost was buyers with access to formerly cheap credit.
• Wait a minute, wouldn't that mean the previously agreed-to price was more a function of psychology than "value"?
• Yes, it would.
• Ok then, so what is Home Depot going to use the sales proceeds for? To pay down debt? Re-invest in their business? Expand?
• Nah, they're going to buy stock with it. Seriously.
• "Home Depot planned to use the sale proceeds to help fund a $22.5 billion stock buyback," Bloomberg reported.

The points in bold are the most important. It is symptomatic in an M&A frenzy for buyers to pay over the top. Value goes out the window and psychology takes over. Forget about the quality of the deal, more is better.

The private equity dealers that usually put these deals together aren't interested in making better run more profitable businesses. They are opportunists taking advantage of market conditions to get the highest price possible and therefore reap the largest fees possible.

However the the private equity boys have had their run, they made hay while the sun shone but now it's getting very overcast.

A closer look at Countrywide (CFC)

Last Week I noted the $2 billion injection from Bank of America (BAC) into Countrywide Financial (CFC). In return BAC is to receive preferred stock with an annual coupon of 7.25% and the right to convert their stake into CFC common stock at $18 per share. Well apparently not. According to a story released after market last Friday on the Dow Jones news service:

BOA Can't Convert Countrywide Secs Into Common Stock August 23, 2007: 05:58 PM EST

By Damian Paletta

Of DOW JONES NEWSWIRES

WASHINGTON -(Dow Jones)- Bank of America Corp. (BAC) can't convert its $2 billion investment in Countrywide Financial Corp. (CFC) into common stock, the Office of the Comptroller of the Currency said in its letter approving the investment.

"Our conclusion is subject to the condition that (Bank of America) will not exercise the right granted to holders of the Securities to convert the Securities into common stock of (Countrywide) so long as the Securities are held by (Bank of America) or any subsidiary" of Bank of America, OCC chief counsel Julie Williams wrote Wednesday in a letter obtained by Dow Jones Newswires.

Williams said this condition was enforceable under the law. The letter was addressed to Bank of America general counsel Timothy J. Mayopoulos.

Bank of America "represents it will not at any time exercise its right as holder of the Securities to convert them into (Countrywide) common stock," Williams wrote.

The $2 billion investment was approved quickly, as Bank of America approached the OCC about the investment within a week of receiving regulatory approval.

Williams also said that Bank of America's investment would not "confer voting rights" as long as the "yield is current and the issuer is not attempting to alter the holders' rights under the instrument."

Efforts to reach spokesmen at Countrywide and Bank of America weren't immediately successful.

Bank of America's $2 billion investment in the newly issued preferred securities was interpreted by Wall Street Thursday as a major vote of confidence in the huge mortgage originator, with Countrywide stock opening up more than 10% before eventually closing up just 0.92%, or $0.20 a share.

When Bank of America announced its investment, though, little was known about the conditional approval of the investment.

The OCC said that despite the investment being labeled as a purchase of preferred securities, the agency would treat it as a purchase of debt instruments.

"In numerous other instances, the OCC has looked to the nature of an instrument instead of its label to assess whether it is a debt obligation or equity," Williams wrote. "Consistent with the OCC precedent discussed above, the securities at issue here possess characteristics typically associated with debt instruments, rather than common stock."

Williams also said that Bank of America would only have limited voting rights as a result of the investment.

So much for B of A's bargain. Last week I also expressed some doubt that $18 a share for CFC stock was actually a good deal. However I didn't back that up with any kind of analysis. So below is a cursory glance at CFC's financial condition and a look at what we might expect over the next 6 - 12 months.

Firstly let's take a look at CFC's bottom line. As can be seen from the graph below the company's earnings started to tank in 1Q07. Earnings for the first half of this year have totaled $919 million a 35% fall from the $1.406 billion posted in 1H06.


Consider that Countrywide has now closed down their 'non'-prime mortgage origination business. Also at the end of 2Q07 the company was sitting on $34 billion worth of loans for sale. Since the market for MBS has basically dried up I suspect they'll be sitting on most of those for a while yet.

Next take a look at CFC's provision for loan losses. Firstly on an annual basis. As you can see the provision for loan losses doubled in 2006 to $233m from $115 in 2005.

However that's just where the fun begins. Take a look at loan loss provisions on a quarterly basis. Basically they've gone exponential. Last quarter in fact they provided more for loan losses ($293 million) than for the whole of 2006 ($233m) which if you remember from the first graph was double the amount in 2005.

Now of the $444m in provisions for loan losses in the first 6 months of this financial year there have only been 193m, of charge-offs. However what do you think is going to happen as the number of adjustable rate mortgage resets ratchet up in the coming months?

According to this very informative article 45% of Countrywide’s loans carried adjustable rates in 2006. Even if loan loss provisions flatten from the 2Q07 level CFC is looking at $1 billion in loan loss provisions this year alone.

Countrywide's earnings are coming under attack on multiple fronts. Firstly origination revenues will take a hit as mortgage lending standards tighten and CFC stop making riskier loans. The riskier sub-prime loans by the way are the most profitable so expect margins to shrink.

Then there is the problem of having to sit on loans now that the market for mortgage backed securities has dried up impacting fee and service revenues and as we saw recently when CFC announced a 'tap' of their $11.5 billion credit line, impedes their funding ability.

Then there is the little matter of impaired loans which has been rising exponentially this financial year and don't forget the extra $145m in interest expense Countrywide now has to pay B of A each year. All this adds up to a deteriorating earnings picture for 2H07.

In trying to put a value on CFC I have assumed earnings of approximately $780 million for 2H07. That number is before any write-downs and is in line with the earnings decline in the first half. If anything, a 36% forecast decline for FY2007 earnings could prove to be optimistic.

For the sake of simplicity I have also assumed that the dividend will be kept constant as it has been over the past 2 quarters. Based on a FY07 estimate of $1.7 billion CFC's Return on Equity will decline significantly to around 12%

Discounting earnings at my standard required rate of return of 15% gives $17.66 per CFC share. CFC closed on Friday at $21 so it hardly seems attractive even at the B of A conversion price of $18 which as we know now doesn't exist.

More interesting will be in what shape CFC emerges in the next 6 - 12 months. CEO Mozillo believes that because the consolidation in the mortgage origination marketplace there is significant opportunity for Countrywide to gain market share in the prime mortgage space.

There also seems to be an assumption that sooner or later the market for MBS will return to normal. However what is normal? The total disregard for risk and the criminal ratings given by the ratings agencies over the past few years is not a normal state of affairs. It is an aberration. When the MBS market comes back it will be much subdued and the incentive to pump out billions of dollars of junk will just not be there.

Also given that the general consensus that a recovery in housing is 12 - 18 months away CFC is going to get smaller before it gets bigger. Undoubtedly there are other financials out there that are looking at shrinking operations and shrinking earnings.

The penny has not yet dropped on Wall Street that we have reached or are on the brink of the peak in the earnings cycle and are staring down the barrel of downgrades and reduced earnings.

The financial sector is large enough to drag the overall market into negative earnings territory however it will get some help from most things housing related and is sure to a include a fair share of retailers.

FY07 reporting season update

It was a big week for company financial reports. BHP led the way with an impressive 32% rise in eps for FY07. Currently eps growth is running at a healthy 26.5% for S&P/ASX200 companies. Ex Property trusts the number is almost identical at 26.4%.

This week I have weighted the figures by market capitalization to get a more accurate reflection of total earnings growth. A quick note on Seven Network Limited(SEV).

As you can see below SEV reported a 1905.6% rise in eps. This is a consequence of coming off a very small earnings base in FY06. When weighted by it's market cap the huge growth in eps for SEV accounts for 6.3% of the total earnings growth. Therefore if you strip out SEV, earnings growth is closer to 20.2%.

Whilst more than half of the S&P/ASX 200 have reported there still a large number to report this week including WDC, WOW, SUN, ZFX, HVN, FGL, WOR, GFF, ORG, ABS, AMC and CGF amongst others.

(click on the chart for a sharper image)

Durable Goods orders strong in July

Durable goods orders jumped 5.9% in July on higher demand for airplanes, vehicles, computers, machinery, steel and most other kinds of long-lasting manufactured goods. Orders for durable goods increased 1.9% in June, revised up from 1.3% previously.

Excluding the 10.8% increase in transportation goods, orders rose 3.7%, the fastest gain in two years. Orders for core capital equipment goods rose 2.2% after declines the previous two months.

Durable-goods orders are highly volatile from month to month, especially in the aircraft sector. So far in the 7 months of 2007, orders are up 1.2% compared with the same period a year ago.

Second-quarter growth is likely to be revised higher to about 4% annualized next week from the 3.4% initially reported. The latest report on durable goods gives 3Q07 a stronger start than most economists were expecting.

No doubt the numbers show a strong performance from the factory sector in July and add some support to the case for the Fed to hold tight on rates in Spetembet. However there is a lot of data to come out before the next FOMC meeting.

The question remains what impact, if any, the credit crunch that got underway in August will have on companies' ability and willingness to invest in capital equipment.

US New Home Sales holding up but for how long?

New home sales for July increased to a seasonally adjusted 870,000 up 2.8% on an upwardly revised 846,000 in June. Whilst not exactly startling the number beat everbody in the market's forecast.

Inventories of unsold homes fell about 1% to 533,000, the fourth consecutive decline. At the July sales pace, the inventory represented 7.5 months' supply, down from 7.7 months in June. Inventories are down 7% since last July.

As always it should be noted that the smapling error is so high that the government cannot be sure in most months whether sales rose or fell. It is believed that it takes at least 5 months of data to form any kind of trend. The five-month sales average of 867,000 is now down 19% from last July's 1.07 million pace.

Most economists agree it's far too early to start talking of a turnaround in Housing. In August Builders sentiment plunged to lows not seen since 1991. In addition these numbers are largely old news in that they have not captured the period since the credit crunch really kicked in.

A number of mortgage lenders stopped originating riskier loans in August among them Countrywide Financial Inc. (CFC) the nations biggest mortgage lender. Couple this with tighter lending standards and the fact the market for MBS of all grades has practically dried up the risk for New Home Sales still remains on the downside.

B of A's vote of confidence

By now you would have heard of Bank of America's (BAC) $2 billion investment in Countrywide Financial Corp. (CFC). The spin from the market is that B of A's move is a vote of confidence in CFC.

No doubt B of A have crunched the numbers and believe $18 (the conversion price of CFC stock) represents good value. Does CFC really need this injection or is it just another attempt to put a happy face on a dire situation?

Just one week ago CFC announced that they would suck their entire $11.5 billion credit facility dry just to keep afloat. Now add another $2 billion. How much is enough to make sure they don't go under? B of A's CEO had this to say about their investment:

"We hope this investment will be a step toward a return to a more normal liquidity in the mortgage markets," said Kenneth Lewis, Bank of America's chief executive, in a statement. "In the current turmoil the stock market has been underestimating the value in Countrywide's operations and assets."

Interesting the order in which the 2 reasons for the investment were given. Hope? Is that any basis for an investment decision? A couple of questions I'd like answered before making such an investment decision?

Is the investment predicated on a return to more 'normal' credit market conditions in the near future? What if normal is a lot further in the future than forecast? In what kind of shape will CFC emerge at the end of this credit crunch? What shape will their earnings be in? Will they be worth $18 then?

This could be looked back on as a very shrewd investment decision by B of A, then again it could look a little silly.

Beginning of the downgrade deulge?

From marketwatch.com

Merrill Lynch cuts raft of mid-cap banks to sell

LONDON (MarketWatch) -- Merrill Lynch downgraded a raft of mid-cap regional banks citing a range of factors including lower earnings expectations and the potential for margin erosion at some of the banks if the Federal Reserve cuts interest rates. The broker said banks with balance sheets that are very "asset sensitive" -- meaning their assets reprice more quickly than liabilities -- could face margin pressure. It downgraded City National Corp (CYN), Zions Bancorporation (ZION), Associated Banc-Corp (ASBC), Cullen/Frost Bankers Inc. (CFR), Cathay General Bancorp (CATY), FirstMerit Corp. (FMER), First Midwest Bancorp (FMBI) and Texas Capital Bancshares (TCBI) all to sell from neutral. It also downgraded SVB Financial Group (SIVB) to sell from buy.

Is this a prelude to downgrades for major banks? How about brokers including Merril themselves? September is shaping up as an interesting month as a couple of brokers report 3Q07 earnings and the earnings pre-announcements come out at the end of the month.

There have been no major earnings downgrades for the major financial companies since nobody really knows how bad a hit they are going to take.

On Wednesday the FDIC reported that bank earnings dropped 3.4% in 2Q07. Separately, the Office of Thrift Supervision said thrifts' earnings dropped 8.6% in 2Q07, compared to the year-ago period.

This is largely old news however it should be noted that bank and thrift earnings began to fall even before the credit crunch really got under way. The real question is what will those numbers look like after 3Q07 and 4Q07, I suspect not very healthy.

More on the patriot banks

It seems not only David Callaway failed to buy the bright happy face presented to the investment world by the Fed and 4 major US banks. Michael Shedlock of MGETA, was on the ball and as he quoted in his article so were the boys from Minyanville.com. Click here for the full article. Below are the pertinent points:

Minyanville's Mr. Practical had this to say:

"When a bank borrows from the discount window, that normally means they have no alternative for funds. Borrowing directly from the Fed in this way is more expensive and cuts into margins.

If Citi really needs that liquidity it is very negative. If they do not then what is the reason for doing so?

Perhaps psychologically the Fed is asking them to so that others that do it don't look so bad. Whatever is happening is highly unusual. Do not let market pundits tell you otherwise"

Also:

Minyanville's Todd Harrison had this to say in Bullets Over Broadway: The Street Taps the Discount Window:

While you were sleeping. Citigroup (C) has announced that they've tapped the Fed Discount Window for $500 bananas on behalf of its clients. Again, be wary of a cornered animal (they've got sharp claws) but add it to the list of things that make you go hmmm…

Hey now, so did JP Morgan, BankAmerica, Wachovia … y'all think that they got a phone call from Hank & Ben?

Professor John Succo on today's Buzz: "There is a huge dichotomy in the marketplace. On one hand, the market in general is being bid back up while government officials try to reassure investors as to the soundness of the financial system. Some of the same officials that originally didn't see a problem.

On the other, investors are paying prices in options on bank stocks and other financials that indicate bankruptcy. We can't have both.

This is not a 'wall of worry'. I have never seen option prices this high in big capitalization financial companies. Take what you want from that. Either the stock market in general is going to correct massively, or the buyers of this protection are really making a mistake."

The last word goes to Mish who posed the following interesting questions to Citibank CEO Chuck Prince who you may recall last month said:

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing"

Questions for Chuck Prince

• Have you stopped dancing yet?
• Why are you borrowing money for clients at 5.75% when the Fed Fund's rate hit 4.5% today and in theory you could have got it close to that?
• Exactly how is paying 1.25% too much for money benefiting either you or your clients?

In a sense you can't blame Bernanke for trying. The last thing he wants to do is cut the fed funds rate and lose his aura as an 'inflation fighter.' More to the point it makes him and the entire Fed look incompetent as it shows just how far behind the curve they've been. However helicopter Ben is running out of options. The Bernanke put is looking more and more likely by the day.

An act of patriotism - oh please!

"Patriotism is the last refuge of the scoundrel."

Dr. Samuel Johnson

So it seems out of a sense of patriotism that 4 of the largest banks in the US decided to show up at the discount window and borrow a collective $2 billion. From marketwatch.com

Patriotic borrowing from Wall Street

WASHINGTON (MarketWatch) -- The biggest names on Wall Street accepted the Federal Reserve's plea, borrowing a total of $2 billion from the discount window in a show of support for the Fed.

In the past, borrowing from the Fed's discount window was akin to asking a priest to come and deliver the last rites: Only a dying bank would be desperate enough to tap the Fed for operating cash.

But last Friday, the Fed said it would drop the rate it charges for overnight loans to banks to 5.75%, and said it would extend the normal term from one day to 30 days.

The Fed's extraordinary move was an attempt to provide the U.S. financial system with ready cash to counter a systemwide credit squeeze. In essence, the Fed offered to be a temporary substitute for the short-term commercial paper market, which is the lifeblood of corporate finance.

Even with the lower rates, banks could borrow extra reserves from other banks at a cheaper rate of 5.25%.

So why would Citi, Bank of America, J.P. Morgan, and Wachovia pay a monetary penalty (on top of the possible damage to their reputation) by borrowing from the Fed?

Patriotism is one answer. The banks simply want to show support for the Fed in hopes that the smaller banks will also take advantage of the Fed's lifeline.

But the banks aren't being entirely selfish. It's in their interest for the credit markets to recover fully. Anything they can do to persuade lenders and creditors to talk to each other again is good for business.

Oh please! A patriotic act would be coming clean and letting the market know just how bad things are, but no the charade continues in an attempt to bolster confidence. David Callaway seems closer to the mark:

Four little piggies went to market

Commentary: Money banks aren't fooling anybody

By David Callaway, MarketWatch

Last Update: 4:51 PM ET Aug 22, 2007

SAN FRANCISCO (MarketWatch) -- The decision by four money center banks to tap the Federal Reserve for $2 billion to pry open the lending spigots of the U.S. financial system was seen in some quarters Wednesday as a turning point in the four-week old credit crisis.

It was. But unfortunately the point turned from denial to full-fledged fear. Citibank Inc. (C) kicked off the borrowing binge, tapping the Fed's discount window for $500 million, and was quickly followed by J.P. Morgan Chase (JPM) , Bank of America Corp. (BAC) and Wachovia Corp. (WB) , in for another $500 million each.

That this was coordinated by the Fed was pretty much proven by Citi's canned statement to the press, which stated that "Citi is pleased to inject liquidity into the financial system during times of markets stress and to support creditworthy clients."

That it was needed by the financial markets, and desperate corporate borrowers, can also not be denied. The commercial paper market had essentially been shut for the past several days, so kudos to the banks for stepping up, even if it was also in their own greedy self-interest.

But if anyone thinks this ends the credit crisis, then I've got a two-bedroom condo in Florida I'd like to sell them.

What this represented was the latest in a series of almost-daily attempts by Fed Chairman Ben Bernanke to assure the markets that the Fed and the banking system are healthy and on their side, without having to cut interest rates. Bernanke knows that a cut in the federal funds rate, either at the next month's regularly scheduled Fed meeting or before, would be the final arrow in the central bank's quiver to halt the recessionary monster that is emerging from the collapse of the five-year housing boom.

He will try anything before using it, including a spontaneous pep rally of major banks in the middle of the trading day in mid-August. But even the collective might of these banks can't stop the vicious unwinding of the housing bubble. Foreclosures almost doubled in July from the same month last year, and late mortgage payments are at their highest level since the last real estate crisis in the early 1990s. Those numbers will continue to look bad for several months to come, at least until the end of next year. Lenders continue to exit the U.S. market or go out of business on an almost daily basis. Some manage to tap credit lines to keep things going, but without a quick turnaround, that can't last forever.

The question is why the stock market still seems oblivious to what is happening. Even as more lenders abandoned some of the mortgage markets Wednesday -- including Lehman Brothers (LEH) and several layoffs were announced taking the week's total to more than 5,000 people who won't be buying anything anytime soon, the equity markets pushed ahead. The return of some vague merger-and-acquisition speculation was all the market needed to leap 100 points at the open and stay higher throughout the day, with the Dow average (INDU) closing up 145 points at 13,236.

Here's a news flash. The M&A market as we've known it over the past three years is dead as of this summer. With $300 billion in outstanding deals still hanging in the balance, there is going to be almost no appetite among corporations to do a deal right now. That means shrinking M&A profits at the investment banks to go with trading losses and mortgage business losses, which will lead to investment banking layoffs, smaller bonuses, and the decline in the important financial sector of the markets.

The continued denial in equities is the major danger, because if there is an awakening one day and a collapse, that will really speed us toward recession. So Bernanke and the Fed are thinking on their feet here, even if they are scared to death about how this might play out. The trick is to keep the markets as calm as possible as this thing unwinds, whatever it takes. Because it's going to be a while before it unwinds.

And as every investor knows, the next level down from fear is panic.

Nuff said.

The Fallacy of Forward P/E's

A common argument doing the rounds is that stock markets are not over-valued because the forward P/E ratio, that is a P/E ratio based on 1 year out forecast earnings is historically inexpensive.

One objection I have to this much used measure is that forecast earnings can change very quickly. There have basically been no downgrades to the major US brokers and investment banks however you can rest assured over the next few months there will be some major revisions.

John Hussman of Hussman Funds has an excellent article dispelling amongst other things the claim that forward P/E multiples show that the market is currently historically inexpensive.

The article is quite long and starts off with a look at another fallacy - that the earnings yield of the S&P 500 (based on forward operating earnings) should be equal to the 10-year Treasury bond yield.

Hussman dismisses this as a:

statistical artifact of the period from 1982 to the late 1990's, during which U.S. stocks moved from profound undervaluation (high earnings yields) to extreme overvaluation (depressed earnings yields).

The implication is that there is a one to one relationship between earnings yields and interest rates. Hussman adds that:

Unfortunately, there is nothing even close to a one-to-one relationship between earnings yields and interest rates in long-term historical data. Why doesn't Wall Street know this? Because data on forward operating earnings estimates has only been compiled since the early 1980's. There is no long-term historical data, and for this reason, the “normal” level of forward operating P/E ratios, as well as the long-term validity of the Fed Model, has remained untested.

Then with some maths I don't follow completely he comes up with the following graph that illustrates that the relationship between earnings yields and Treasury yields do not move in unison except for the period from about 1980 to 1998 , which is the entire basis of the model.


Moving on to the issue of P/E ratios based on forward operating earnings. It is generally accepted that the historical average P/E of the market is between 14 - 16 times. However that average relates to trailing earnings not forward earnings. Hussman points out that the average historical P/E based on forward earnings is more like 12 times. The S&P500 is currently at about 16 times. In addition:

that average of 12 includes the heights of the late 1990's bubble. The historical average was just 10.6 prior to that point.

Hussman also touches on another interesting point regarding profit margins:

It gets worse. Currently, profit margins are at the highest level in history, which further reduces the P/E multiple we observe. If investors wish to use that observed P/E ratio as their standard of value without normalizing for profit margins, they should be aware that they are implicitly assuming that profit margins will remain at current levels indefinitely.

That assumption is hard to support. Historically, profit margins have been highly cyclical. But it's important to understand the argument here. I am not arguing that stocks are vulnerable because profit margins are going to come down, so earnings are going to come down, so stocks are going to follow earnings lower. No. There is virtually no correlation between year-over-year movements in earnings and year-over-year movements in stock prices. The argument isn't about the near term direction of earnings.

Rather, the argument is about the long-term valuation of stocks. If an investor is going to use the current level of earnings to determine the reasonable price to pay for a long-term asset, it had better be true that those earnings represent a normal and sustainable level of profit. You wouldn't buy a lemonade stand by extrapolating the profits it earns in August.

Those are some pretty important points in bold which basically boil down to the conclusion that stocks are not cheap or even reasonably priced in historical terms. Hussman sums up the situation succinctly:

Investors appear eager to “scoop up” so-called “bargains” on the belief that stocks are “cheap relative to bonds.” All of this is predicated on the belief that profit margins will remain at record highs, that the Fed Model is correct, and that P/E ratios based on extremely elevated measures of earnings should be evaluated based on norms for much more restrained measures of earnings.

That's not investing. It's speculation. And it's speculation that runs entirely counter to historical evidence. While an improvement in market internals might provide reason to speculate modestly on the basis of market action, there is no investment merit in current market valuations. Again, we do not need stocks to become “fairly valued” or undervalued in order to remove most or all of our hedges, but in the absence of reasonable valuation, we do need constructive market internals (short of extremely overbought or overbullish conditions).

Look at the composition of S&P 500 earnings. Financials currently make up about 25% of the S&P 500 market capitalization, but close to 40% of the earnings. Wages and salaries as a fraction of U.S. corporate profits have rarely been lower. Irresponsible lending and suppressed labor costs have been strong contributors to S&P 500 earnings in recent years thanks to a massive leveraging cycle – financial profits exploded, while wage demands stayed low because it was easy to spend out of home equity withdrawals and strong real-estate gains. But these are not permanent factors, and it is dangerous to value stocks as if recent profit margins will endure in perpetuity.

This brings me back to the beginning of the post where I pointed out that the market is yet to factor in earnings downgrades for the majority of the financial sector.

Also some commentators currently assume that after a few months of turmoil in credit markets, a few rate cuts by the fed will get things back to normal. That is the normality of the last 6 years of easy credit, massive fees and big profit margins for financials.

However along the lines of what Hussman is saying I believe that there is a strong case for a reversion to normalcy more in line with historical norms of the last 60 years. Obviously this would not be a positive environment for stocks given current market conditions.

Is it time for the Bernanke put?

So the fed cut the discount rate flooding the markets with badly needed liquidity. The financial markets applauded the move and rallied accordingly. Confidence has been restored to the credit markets and the stock market can resume it's relentless march to ever new highs. Right?

If only it were that simple. The chart below, courtesy of MGETA is not supportive of investors with confidence.

On Monday the yield on three-month Treasury bills fell to a low of 2.4%, 134 basis points below Friday's close – a sharper fall than during the October 1987 stock market crash. Not shown on the chart is the 1 month treasury which fell a whopping 160 basis points to 1.34%.


Whilst the cut in the discount bought the Fed some time before cutting the federal funds rate, Monday's flight to safety suggests the Fed's actions are not having the desired effect on sentiment in the credit markets.

A lot can happen between now and the next FOMC meeting in September, however the pressure on Bernanke to cut the fed funds rate is building. Is it time for the Bernanke put?

Red ink spreads

First we saw homebuilders drawing red ink writing down over-inflated land prices in 2Q07. Now we see it moving to mortgage brokers - the results of which will show up in 3Q07. That's not to say the baton has been passed the homebuilders will continue to do it tough.

Thornburg loses $930M unwinding portfolios

Thornburg Mortgage Inc. said on Monday that it lost roughly $930 million selling billions of dollars worth of AAA rated mortgage securities, while reducing borrowing and unwinding interest-rate hedges.

The company sold approximately $20.5 billion of primarily AAA rated mortgage-backed securities. That cut its mortgage asset portfolio to roughly $36.4 billion at the end of last week, down from $56.4 billion at June 30.

Thornburg also reduced its reverse repurchase and commercial paper borrowings from $32.9 billion at June 30, 2007 to roughly $12.4 billion on Aug. 17. That should limit its exposure to future margin calls on short-term borrowing, the company noted.

Thornburg also unwound roughly $41.1 billion of interest-rate hedging instruments, it reported.

Thornburg estimated that it will realize a third-quarter capital loss of roughly $930 million from the sale of the mortgage securities. Of this total, $700 million was already reflected as an accumulated comprehensive loss on the company's consolidated balance sheet June 30.

The company said it realized a net gain of approximately $40 million from terminating interest-rate hedging instruments.

Remember this is a company with one of the highest quality mortgage portfolios in the business.

Capital One falls 5% in late trading
Credit card giant closes wholesale mortgage unit, cutting 1900 jobs

SAN FRANCISCO (MarketWatch) -- Shares of Capital One Financial Corp. fell 5% during Monday's late-trading session after the giant credit-card company said it was closing its wholesale mortgage unit, cutting 1,900 jobs.

Capital One shares dropped 5% to $63.38. The company said it will immediately stop originating mortgages through its GreenPoint Mortgage business, which offers loans through brokers.

The company also said it will close GreenPoint's California-based headquarters along with 31 locations across 19 states. That will mean the elimination of roughly 1,900 jobs, most of which will go by the end of 2007, Capital One (COF) said.

Capital One said it estimates the total after-tax charge associated with the closures will be about $860 million, or $2.15 a share. The company said it now expects 2007 earnings of about $5 a share. Without the charges related to the mortgage banking business, the company said it would have maintained its existing earnings outlook. Analysts polled by Thomson Financial are currently looking for per-share earnings of $7.05 for the year.

"Current conditions in the secondary mortgage markets create significant near-term profitability challenges," Capital One said in a statement. "Further, recent and continuing developments in the mortgage markets reduce the long-term outlook for profitability in the business, as the company expects markets for prime, non-conforming mortgage products are likely to remain challenged."

That's a 30% downgrade to full year earnings. Analysts are going to be scrambling to catch up with the amount of downgrades to earnings to come through as the red ink spreads through the financial sector.

The extent to which major financial company earnings will be hit is yet to come out. When they do the supposed 'bargains' will no longer look cheap and the argument that stocks are not overvalued on a relative basis (which is flawed anyway - I'll post more on that later) will lose its appeal.

FY07 reporting season

FY07 reporting season really kicks into gear this week. QBE started the week off strongly reporting a more than 50% rise in eps for FY07. Other big names expected to report this week include BHP, TAH, ZFX, SUN, BXB, AMP, PBL, CSL, TOL, STO, FXJ and IAG just to name a few.

So far 60 ASX/S&P200 companies have reported with average earnings growth at a healthy 19.6%. Excluding property trusts that falls to 12.5% however it is still early days. That average is a simple average not a weighted one. Also it includes some companies that are reporting half year results.

Not all ASX/S&P200 companies will report, so I will include results only for those companies whose reporting period ends in either May, June or July. Thus most banks will be excluded.

Click on the image below for a closer look at results to date:

Fed saves the day or prolongs the pain?

On Friday the Fed announced:

For immediate release

To promote the restoration of orderly conditions in financial markets, the Federal Reserve Board approved temporary changes to its primary credit discount window facility. The Board approved a 50 basis point reduction in the primary credit rate to 5-3/4 percent, to narrow the spread between the primary credit rate and the Federal Open Market Committee's target federal funds rate to 50 basis points. The Board is also announcing a change to the Reserve Banks' usual practices to allow the provision of term financing for as long as 30 days, renewable by the borrower. These changes
will remain in place until the Federal Reserve determines that market liquidity has improved materially. These changes are designed to provide depositories with greater assurance about the cost and availability of funding. The Federal Reserve will continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets. Existing collateral margins will be maintained. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York and San Francisco.

OK that's wonderful but what is the discount window and how is this different from the open market operations the central banks have been performing over the past few weeks? This from the WSJ:

Explaining the Discount Window

The discount window is a channel for banks and thrifts to borrow directly from the Fed rather than in the markets. Until a few years ago, the discount rate was set below the fed funds rate and loans were subject to numerous conditions.

Banks were reluctant to access the window because it was associated with a stigma usually reserved for distressed banks. A few years ago the Fed overhauled the discount window to try and alleviate that stigma; the rate was then set one percentage point above the funds rate and subject to far fewer conditions. In spite of that, discount window borrowing has remained paltry.

Discount lending averaged just $11 million in the week ended Aug. 15. Although that was up from $1 million in the prior week it was puny compared to the billions of dollars the Fed has regularly injected into the financial system through open market operations.

Fed officials hope that reducing the penalty rate associated with the window and lengthening the term of loans to 30 days from one further lifts the stigma and gives it a tool to supplement open market operations for reliquefying markets.

Open market operations, under which the Fed buys and sells securities to adjust the supply of bank reserves and keep the federal funds rate on target, primarily operate through a network of primary dealers, some of whom are large banks. Thus, they have only indirect impact as a supply of funds for the thousands of banks that are not active in the money market. The discount window, however, is available to any bank or thrift, and the terms are easier than for fed funds loans. For example, banks may submit mortgage loans, including subprime loans that aren’t impaired, as collateral, and many probably will.

Discount window programs have, in the past, been added or modified temporarily in response to special circumstances, such as the century date change rollover (1999) and problems in the farm credit system (mid-1980s).–Greg Ip

OK, so what this essentially means is credit has become easier to get, because of less restrictions and the fact that institutions can go directly to the Fed.

Once again no-one is being bailed out here. The Fed is not wiping away billions of impaired MBS, CDO's and CLO's and effectively giving out get out of jail free cards. The Fed is providing short term funding which must be repaid in 30 days.

What if some instituitions don't pay their loans back in the specified time period? Well that would be a very silly move. Consider the Fed's circular 10 section 4.2 which states:

If all or any portion of an Advance Repayment Amount is not paid when due (whether by acceleration or otherwise), interest on the unpaid portion of the Advance Repayment Amount shall be calculated at a rate 500 basis points higher than the applicable rate then in effect until the unpaid Advance Repayment Amount is paid in full.

That's not a misprint, the penalty rate for for not repaying loans is 500 basis points or 5% - very costly indeed.

So isn't the Fed just prolonging the pain rather than saving the day? Well yes and no, rather than trying to save the day they are trying to restore some confidence to the financial system. They realize an unwinding of the excessive debt bubble they helped create and associated leverage has to happen, they just want it to happen in an orderly fashion.

However that may be wishful thinking. The problem is that the damage has been done. The dodgy loans have been made, the brokers have placed toxic debt in all corners of the world with the backing of the ratings agencies and the hedge funds are leveraged up to the eyeballs.

The creation of cheap money has come to an end and there is only one way for it play out. The money supply has to shrink and the unwinding of leverage has to take place.

Mark to market write-downs will occur and financial stocks will bleed red ink in the coming quarters. There will be many more bankruptcies with large players among them as the painful but necessary process unfolds.