Earnings and Headlines 7/21/2010

• Morgan Stanley had a great quarter! Seriously! I know, I can't believe it either (see yesterday's highly inaccurate prediction below.) The investment bank roared back into the big leagues with a second quarter profit of $1.96 billion, up from $149 million a year earlier. $514 million of that was related to the sale of its retail asset-management arm, but earnings on a continuing basis were still better than expected. Results in its new and improved asset management unit were boosted by the purchase of Smith Barney from Citi. CFO Ruth Porat stated that although the banking industry will undergo a period of intense scrutiny, the firm was not a target of a major investigation. So things are looking up including the stock price, which is up 8%. Now go sell your real estate arm while you have the chance.
• BlackRock also had strong results, posting a near doubling in quarterly profit to $432 million. The surge in profits was attributed to the purchase of BGI last year. Seems like the thing to do to boost profits is go out and buy a money manager.
• Wells Fargo posted a profit of $2.88 billion, higher than last year's $2.58 billion but on slightly lower revenues. Results were better than expected and the stock is up 5%.
• The WSJ's quarterly housing report is out and shows a deteriorating housing market. It's nothing you didn't already know; pending sales down sharply after expiration of tax credit, new housing construction down, inventories up across the board. etc etc. But it has a nice city by city chart that makes you say things like "Wow, I'm glad I don't live in Detroit."
• MBA purchase applications are actually up slightly, which may have something to do with mortgage interest rates being at their lowest levels in the history of the universe.

Headlines 12/8/2009

• Both Fitch and Moody's out stating the obvious today, with massive downgrades of both Greece and Dubai. The Dubai downgrade is patently ridiculous. If there is anyone left out there that doesn't know that Dubai World defaulted on its debt and the Dubai government refused to step in to bail it out, Moody's is here to educate and protect those investors about to make a foolish decision. Maybe word hasn't reached those sitting in debtor's prison in Dubai? Who knows? Oh, and also, in a completely shocking development, Nakheel, Dubai World's real estate development subsidiary that owns all those half-built buildings on man-made palm shaped islands, lost a boatload of money, $3.65 billion in the first half of 2009 to be exact. As for the Greek downgrade? Rumors abound about the country's troubled finances. But don't worry. The Dubai crisis, much like the subprime crisis, is contained.
• US consumer credit shrank for the ninth month in a row, by 1.7% in October. A couple of interesting highlights from the WSJ article: In 2005, over six billion credit-card offers were sent out to consumers. This year just 1.4 billion have been sent out. Also, Visa reported earlier this year that people for the first time were using their debit cards more than credit cards. The trend lower is likely to continue for some time in order to reverse the absolute explosion in consumer credit over the past few decades. What's shrinking along with consumer credit? The probability of a strong V-shaped recovery. Good chart at Calculated Risk.
• Citigroup and Wells Fargo are getting in on the "We wanna pay back the TARP" action, according to the WSJ. The banks are wrestling with the US government over how much capital they need to raise to exit from the program so they too can "compete" with all the other large banks that have managed to negotiate an exit. The problem is that issuing more stock is expensive. Of course, with the strong market rally looking like its finally petering out, they'd better pick up the pace before it gets even more expensive. I'm all for paying back the TARP. Get on with it. Just as long as everyone agrees that there is no next time if you were wrong about your balance sheet being strong.
• As if you needed yet more evidence that the government employees in charge of protecting our TARP dollars are a bunch of spineless twinkies, the Pay Czar actually caved in to AIG's general counsel's demands for no pay cuts for her and her cronies. It seems that the five employees who threatened to quit so they could collect a fat severance package will get to keep their over-$500,000 salaries. That's right, because without the right general counsel, there's no way that AIG will ever crawl out of that $100 billion hole.

Wells Fargo Attempts Loan Mods With Option ARMs

I will give Wells Fargo bonus points for trying to make the best out of a rather dicey loan portfolio. Known as a conservative lender through most of the insane lending of the housing boom, Wells Fargo inherited a the toxic portfolio of option ARMs when it chose to purchase Wachovia in a fire sale last year. The bank is being proactive by introducing loan mods to deal with the pesky problem underlying most option ARMs: borrowers used them to purchase homes they couldn't actually afford and once the minimum payment resets higher, the borrowers will default. Wells Fargo is attempting to solve the problem by converting option ARMs into interest only loans that will defer balances for as long as six to 10 years. The bank is essentially extending the minimum payment period on the option ARM because it knows that the borrower would otherwise default if the payment were allowed to adjust to the fully amortizing amount. Also known as "kicking the can down the road" this strategy clings to the hope that either housing prices will stage a miraculous recovery in the next few years, or that the borrower's financial situation will improve dramatically so that he can meet higher mortgage payments in the future. In reality it is just delaying the inevitable and allowing Wells to take smaller writedowns in the present against the souring portfolio. Wells Fargo claims that it is keeping borrowers in their homes, which, I suppose is slightly better than having to deal with yet another foreclosure. However, the fundamental problem of borrowers being upside down on their mortgages and having a rather large financial incentive to walk away remains.

WFC, MS Earnings

Morgan Stanley's earnings were subpar, according to the ticker. Second-quarter income plunged 87% to $149 million from $1.14 billion, while revenue declined 11% to $5.41 billion. Although the results beat the average analyst's estimates, the stock is still trading lower before the open. The weakness in earnings came from a large loss related to the company's credit spreads tightening in the quarter, as well as the cost of paying back the $10 billion in TARP funds it owes Uncle Sam. Fixed income and investment banking revenue jumped 44% and 19% respectively, while institutional-securities swung to a loss on a revenue decline of 24%. In any event, compared to Goldman's blowout quarter, it's hard to be impressed.

Wells Fargo's second-quarter earnings soared 81% to $3.17 billion or 57 cents a share, up from $1.75 billion or 53 cents a share in the prior year. Revenue nearly doubled to $22.5 billion from $11.46 billion, with Wachovia making up 39% of the total. Still, the market is not impressed with the earnings report as the company's stock is trading lower before the open. Credit-loss provisions were $5.09 billion, up 69% from a year ago and 11% from the prior quarter. Meanwhile net charge-offs rose to 2.1% of average loans from 1.54% in the prior quarter, while nonperforming assets grew to 2.2% from 1.5%. With the continued deterioration of the economy, particularly in California, investors are perhaps concerned that the credit loss provisions aren't adequate to cover future losses on Wachovia's legacy option arm and commercial real estate portfolio.

Option ARM Defaults Now Worse Than Subprime

Buried on page two of the Money and Investing section of the WSJ is a very interesting article that highlights one of the few reasons why I believe a true recovery in the US economy is far off. Option ARM (or "pick-a-pay") default rates are now surpassing those of subprime. As a quick review, option ARMs were mortgages issued to borrowers with solid credit ratings that allowed them to choose from a variety of payment options. The minimum payment option was a partial interest-rate payment, where the unpaid interest portion was merely added to the loan's balance. A few years into the life of the loan, the loan would recast and require that the borrower begin to pay principal causing the monthly payment to balloon. The loans were most popular in high-priced real estate areas such as California and Florida, where they were used to aid in the purchase of houses that consumers couldn't afford with a traditional fully amortizing mortgage. As of April, 36.9% of option ARMs were at least 60 days past due, while 19% were in foreclosure, according to First American CoreLogic. This compares to 33.9% of subprime loan delinquencies and 14.5% of foreclosures. Many of my posts last year focused on the looming option ARM debacle, as it seemed very clear to me that these loans were being used as a mechanism for homeowners to "get in" on the great housing market ponzi scheme with the intention of just refinancing or selling before their payments recast and they were required to actually pay down the principal on the mortgage. The largest option arm lenders, Wachovia and Washington Mutual were predictably torpedoed by option ARMs but their toxic portfolios live on inside of their acquirers, Wells Fargo and JP Morgan. Certainly both banks took large writedowns on the option arm portfolios when they required the now-defunct lenders at distressed prices, but only time will tell how these mortgages end up performing. According to the WSJ article, Wells Fargo holds $115 billion, which it had marked at $93.2 billion, giving the bank room to absorb future losses. According to a securities filing in May, borrowers making the minimum payments accounted for 51% of its outstanding Pick-A-Pay balances as of March 31. JP Morgan holds $40.2 billion in option ARMS that it acquired from Wa Mu and another $46.5 billion sitting in complex off-balance sheet entities. Furthermore, our friends at the FDIC are picking up the tab on potential future losses on a $5 billion portfolio from BankUnited, the Florida-based bank that the FDIC seized and sold to private investors with a loss guarantee.

What is disconcerting about the option ARM debacle is that I don't believe we are near the peak in loan defaults. Most subprime lenders went bust in early 2007, and only now are we working our way through the worst period of subprime lending, which data shows was the mid-to late 2006 period of subprime lending. I wrote a post recently about the extraordinarily high default rates coming out of this period of lending from now-defunct subprime lenders. But option ARM and alt-A lending continued through 2007 and 2008, until it became clear that the credit crisis was not just contained to subprime. So, many of these loans have yet to recast and cause problems for borrowers. We have that to look forward to, which is nice.

Unemployment Hits 8.1%

The jobs report was as dreadful as expected by those who can still stand to look at economic headlines.  The economy lost 651,000 jobs and the unemployment rate leapt to 8.1%.  Revisions for the prior two months showed losses of an additional 161,000 positions bringing the total number of jobs lost since the recessions began in December 2007 to 4.4 million.  The jobs report is sobering and yet really makes you want to have a drink all at the same time.

Following the lead of other financial institutions looking to retrench, Wells Fargo slashed its dividend in order to save $5 billion annually.  Clearly there is no longer a stigma related to reducing the dividend as investors have begun to prefer the idea of their banking institution actually remaining a going concern over a quarterly dividend check.  JP Morgan and GE made the same announcement recently and I view these actions as prudent, but necessary, if an institution is going to survive the brutal downturn.

Finally, in the "investment bank that needs to finally go away" category, Merrill Lynch is once again in the headlines.  The bank informed regulators that it had discovered discrepancies in certain trading positions.  Conveniently, the losses, which occurred last year, weren't discovered until after Bank of America purchased the investment bank and allowed it to pay out accelerated bonuses.  The details are sketchy so far, but apparently a London currency trader who had recorded a trading profit of $120 million for the fourth quarter, may instead have lost a "large amount."  The Bloomberg story doesn't specify whether we are talking Nick Leeson-large or Jerome Kerviel-large.  At least we have some insight into how Merrill managed to punt $15 billion in the fourth quarter.     

Weekend Bailout/Merger/Banking Alert

Germany's Hypo Real will receive a new 50 billion euro "rescue package" after a bailout package negotiated last weekend failed to materialize.  The German government and the Bundesbank have claimed that Germany's second-biggest property lender is too big to fail.  Meanwhile, BNP Paribas will buy 75% of Fortis Bank Belgium from the government for 8.25 billion euros in stock and purchase the Belgian insurance operations.  BNP Paribas will also acquire 66 percent of Fortis's bank in Luxembourg.  

In the US, Citigroup and Wells Fargo spent the weekend in court battling over Wachovia, the US bank that was ordered to merge last weekend with a bank, any bank, just merge before the opening bell on Monday.  The FDIC threatened to seize Wachovia if a merger was not forthcoming.  If you missed the action, here's a quick summary:  Citi bid $2 billion for parts of Wachovia on Monday.  Wells Fargo offered to pay nearly 7x Citi's bid on Friday for the entire bank.  This really pissed off Vikram Pandit so much that he filed suit against Wells Fargo.  He even called the Wall Street Journal and told them to replace the stock photo of him grinning like a loon with one where he looks angry, because he's not fooling around.  It appeared as if Citi won a victory in court on Saturday when it persuaded a New York state trial-court judge to extend the exclusivity agreement between Wachovia and Citigroup until Friday.  However, Sunday a state appeals-court judge overturned the extension of the exclusivity agreement.  Meanwhile, the Fed has jumped into the fray and asked the battling banks to make nice and work out a deal.  According to the Wall Street Journal, Citi and Wells are being asked to carve up Wachovia along geographic lines.  I would bet that a carving up of the bank will not pan out despite the Fed's best efforts and Wells will more than likely wind up owning Wachovia.

As an aside, I must note how amazed I am at how quickly the court system in America works when something "very important" is on the docket.  I spent six weeks serving as a juror on a very brutal murder trial this summer.  The murder happened in 2002 and it took six years to come to trial.  The prosecution had ample evidence for a conviction and the jury found the defendant guilty.  During the six weeks of my service, the court never met on a Friday, much less the weekend.  So I have to ask, how did Wells Fargo and Citigroup get to argue their case over the weekend in two different court rooms?    

A weekend's worth of more bailout negotiations by banks and governments around the globe have only served to intensify fears over the soundness of the banking sector.  Markets that have opened are already falling again this Monday, while S&P futures point to a lower open in the US after a brutal week for equities last week.  The good news in all of this?  The short-sale ban expires on Wednesday, so investors can line up their orders for Thursday morning.  Longs have three more days to sell their stocks which makes me wonder if the market will go down more at the beginning of the week as longs try to front-run the shorts.  Furthermore, with hedge funds having their worst September ever, is there anyone left who can still afford to short?  

Citi Cries Foul, Citing Exlusivity Agreement With Wachovia

The Wall Street Journal is reporting that Citi is claiming that Wachovia is in breach of the Exclusivity Agreement it signed with Citi earlier in the week. Citi states that "Wells Fargo's conduct constitutes tortious interference with the Exclusivity Agreement." Apparently, it's about to get ugly as Citi is using nasty legal terms like "tortious interference." The FDIC has put out a statement that it stands behind the Citigroup deal. Might we see a bidding war over Wachovia, who many had given up for dead at the beginning of the week? I find it hard to believe that the FDIC wouldn't welcome this opportunity to get out of the loss guarantee it granted to Citi and allow a much stronger institution to take over all of Wachovia. Not only is the Wells Fargo deal better for the FDIC, it is better for shareholders of Wachovia, for debtholders of Wachovia and for confidence in the market. Naturally, Citi is pissed because it thought it was getting a sweet deal and had catapulted itself into favored status with the government. But if it wants Wachovia, it better be prepared to pay more.

Wells Fargo Snags Wachovia From Citi's Clutches

In a surprise move, Wells Fargo bested Citigroup's bid and snatched Wachovia as its prize. Wells Fargo agreed to pay $15.1 billion in stock for Wachovia, or roughly $7 a share, a significant improvement over Citi's $1 a share bid. Better yet, the Wells Fargo bid does not include any government guarantees. While Citi's bid included a promise from the FDIC to take a maximum of $270 billion in losses after Citi took the first $42 billion, Wells Fargo has indicated it has the stomach to swallow any potential future losses from Wachovia's ailing mortgage portfolio. This is proof that the market has the ability to find value in the banking sector without any need for a government bailout. Some might say that Wells Fargo waited to pounce on Wachovia until it was relatively assured of a bailout package passing in Congress. But then, it should've waited until the unpredictable House actually passed the legislation. Furthermore, Wells plans to issue $20 billion in additional equity to help finance the deal. With the stock near 52-week highs, issuing stock while the SEC short-sale ban in still in effect is brilliant and entirely predicatable. Any bank that doesn't take advantage of this window of opportunity to raise equity while the shorts are banished from trading should be immediately shorted when the ban expires.

WFC Earnings Vs. CPI, What Matters Most?

Wells Fargo released earnings that beat analysts estimates giving a much-needed boost of confidence to financials.  The company also increased its dividend by 10%.  Although Wells Fargo earned $1.75 billion, a 23% decrease from the prior year, revenues were up 10.3%.  You can read more specific details of their earnings here.  Wells Fargo's stock is up on the news, as are the stocks of other large money center banks in the hopes that things maybe won't be so bad when they report earnings in the next couple of days.  In this environment, a plus sign in front the net income column is greeted with huge cheers.  Can BAC with its Countrywide acquisition, JPM with its Bear acquisition, and Citigroup with its asset-puking do the same?  I'm skeptical, as usual.

Meanwhile, in economic news, the CPI report was none too friendly.  The headline number was up a whopping 1.1% and the core was up .3%.  The CPI release knocked Dow futures back down to earth after they had leapt on the WFC news.  The market is flat, while investors duke it out over what is more important: surging headline inflation?  Or the fact that maybe a bank or two might be left standing after the worst is over?  If the worst really was over, it would be easier to tell.