Citigroup vs. Merrill Lynch: A Neck-and-Neck Race for the Biggest Losses of All Time

While Merrill Lynch’s massive $8.4 billion asset write-down and release of long time CEO Stan O’Neal may have been last week’s big story, Citigroup captured headlines this week by publicly declaring that in addition to the $6.5 billion write-down for the third quarter, it expects to write-off the balance sheet a total of $11 billion before the year’s end. With the deployment of the awful news, Citigroup’s board of directors appropriately dismissed CEO Charles Prince (seen at right). After searching through related blogs, it is apparent that expectations for the future are far grimmer than analysts predicted this past summer. The subprime mortgage crisis, which was once viewed by skeptics as unlikely, is now approximated by some to be just the tip of the iceberg, with the true meltdown expected by mid-2008. If this proves accurate, Citigroup and Merrill will not be the only holders of subprime debt to feel the wrath of a careless and unmonitored system

Article 1: Memo to Citigroup and Merrill: It’s time to kill the financial supermarket

This is a classic case of how hindsight is always 20-20. Merrill Lynch and Citigroup are merely the first of many large, conglomerated or “supermarket” firms that will suffer from the poor lending practices and exaggerated market appreciation in the early part of the millennium. As noted on Bloomberg, the exposure of bad debt from subprime loans soaking up massive amounts of capital on companies’ balance sheets is the manifestation of poor risk-awareness by these massive firms as well as by the mortgage brokerages. That said, however, the “credit-crunch” is not the result caused by the amalgamation of different financial sectors under one corporate name, but rather, it is the result of lax and ill-considered lending practices by mortgage originators. Admittedly, the blame is, in turn, transferred to the major banks such as Merrill and Citigroup for not performing sufficient due-diligence on the mortgages they were buying, packaging, and selling to investors as CDOs and the like. That said, however, I certainly disagree with the assertion that former Citigroup CEO Sandy Weill (seen at right) is to blame for the subprime meltdown two and half decades after he introduced the financial supermarket. While having various financial sectors combined under one roof may “link” a firm’s banking sector with its investing or lending sector, there is little if any documentation to prove that is actually counterintuitive to a firm’s profitability (which is good for both investors and the firm). Finally, I would argue that if anything, there would be a significantly greater amount of positive synergies arising from the linkage of various financial sectors under one roof due to enhanced communication channels and a uniform corporate vision with intertwined interests and goals. Not to mention that if every big bank were to sell off its individual business units there would in all likelihood be far more units for sale than potential buyers.

Article 2: Poll Shows America Does Not Support Federal Intervention in Sub-Prime Mortgages: FreedomWorks poll shows 62 percent believe individuals should take responsibility

First of all, without regards to this poll in particular, it should be known that polls can be manipulated to show a statistic that favors the agenda of whomever is doing the polling.

That said, the poll used in this article is nevertheless pertinent and indicative of at the very least a minority opinion. The sheer problem with this poll, in my opinion, is that the statistic views federal intervention and federal legislation as synonymous. Currently, the American economy is standing on the edge of a very big cliff caused by the roughly $370 billion worth of outstanding bad subprime debt. As stated in the Money Times, the majority of this debt will be resetting over the next year at a monthly rate twice that of this past year (400,000 mortgages/mo rather than 200,000/mo.). This is why the Citigroup’s and the Merrill’s are suffering so perilously, and this is why the Fed cut interest rates for a second month in a row. Too many Americans bought a house in the last couple years and cannot afford their adjustable mortgages once they reset to a higher rate, while at the same time he or she cannot afford to get out of it (that is, pay off the debt portion of their home since their home's equity decreased significantly as home prices fell over the past several months). This is why federal spending must be increased to provide subsidized mortgages to those who are currently being evicted from their homes and to those lenders whose companies stand at the mercy of the subprime market. This oil spill of a problem the economy has on its hands will continue to spill into other sectors; according to MSNBC, auto sales will slow inversely to the number of mortgages that are defaulting. Also, according to Kiplinger, consumer spending will also be aversely effected as households’ discretionary income is sucked up by their increased house payments. I agree that federal legislation dictating regulations on financial firms’ practices is extreme and not appropriate for the situation on hand. In order for the markets to recover, however, the government must aid the consumers AND the lenders as both continue to feel the negative effects of this credit-crunch.

Sale-leasebacks: Europe’s Answer to the Housing Bust

In the dawn of what may become the largest real estate recession of all time, Americans are not the only ones to feel the bursting effects of the housing bubble. In fact, several European financial firms that were heavily invested in the U.S. housing market have been hit as hard, if not harder, than similar domestic companies. But while the situation at home continues to deteriorate, and it is deteriorating, the Europeans have identified a way to reallocate their assets and realize a positive return on real estate investments through the sale-leaseback process.

The sale-leaseback technique basically means that a company who owns the real estate it occupies will sell it to a purchaser who, in turn, immediately leases the property back to the company. This method is mutually beneficial for both parties: it allows the seller to generate a substantial amount of cash that can be used elsewhere, while at the same time, it gives the purchaser the stability of regular lease payments.

Historically, European and American philosophies have contradicted one another on this matter. Generally speaking, European companies felt compelled to own the land their company occupied, something akin to the “family silver.” In the United States, however, just 20% of corporations own the land they occupy, three times less than the amount in Europe. With the explosion of the housing bubble, European banks have seen their cash-pools dry up as they are left holding unwanted mortgage-backed securities. In turn, their ability to lend has been severely restricted and thus the cost of obtaining capital for these European companies has significantly increased, making it more apropos to sell one’s real estate to fund other operations rather than borrow money.

The practice of sale-leaseback is also working for companies who appreciate the financial model and see it as a way to redeploy assets and balance out their portfolios. For instance, Barclay’s-one of the world’s largest banks-has done sale-leaseback deals worth nearly $800 million in the last year and a half. These large transactions have attracted both foreign providers of capital as well as smaller companies in search of a buyer. The European market for sale-leasebacks is growing so quickly that Boston-based STAG Capital Partners recently opened a new office in London purely for their European sub-grade capital asset investments.

Like any investment, the acquisition and re-deployment of real estate yields a return proportionate to the risk of the security, which in this case, is the lessee. The smaller-to-mid-size firms, or ones with sub-investment grade credit worthiness, can generate returns much greater than the cost of capital. On the other hand, however, investments that are simply “financial re-engineering” of a company’s financial structure generate normal returns; around 5% in the U.K. and somewhere closer to 6% most elsewhere in Europe.

In any case, the growth in the sale-leaseback market has at least given real estate investors a reason to go to work in the morning; investor’s phobia of American real estate has caused stagnation in the market. Mortgage securities, especially sub-AAA rated ones, lie unsold and depress the margin of liquidity for banks, brokerages, and hedge funds alike. For those firms that have already collapsed, sale-leaseback’s might not be the solution, but for the industry, this may be the light at the end of the tunnel. Like STAG Capital Partners, American investors should consider some sort of European asset-backed security or debt-obligation, which, through these deals, could potentially revitalize their portfolios and eventually, the investor confidence and the market.

Seattle: A Needle in a Haystack

New York, London, and Los Angeles–all have felt the tremor of the sub-prime housing fiasco over the past few months, as evident by the decline in home values in these major cities. Homeowners have lost substantial amounts of home equity, while at the same time seen their adjustable mortgage rates rise, making their monthly payments greater, sometimes beyond their means. This led to a larger amount of foreclosures and subsequently a greater amount of houses entering the 'for sale' marketplace, creating an excess of inventory amidst wary home buyers. How then, in a time of such excess, can any major city boast appreciation in home values? Just ask home sellers in Seattle (one of only five major cities in the U.S. still seeing home prices grow) and they might say it is because Seattle is a hidden gem, or maybe because of all the rain; either way, there are undeniable economic factors of supply and demand keeping this lucky city afloat in the midst of the sub-prime storm.

For starters, Seattle is a desirable place to live. Located between water and mountains and geographically spread out amidst lakes and hills (downtown Seattle left, Bill Gates' home below), its scenery is naturalistic and unequaled in beauty. Not to mention, it boasts a top seat among America’s fittest cities (1st in 2005 and 8th in 2006) as well as the number one spot on the most educated (52% of Seattleites have college degrees). In other words, Seattle benefits from what is known as the “knowledge economy,” which draws highly educated individuals to live and work in the city.

So how does this translate over to the housing market? Well, in an area geographically dense with water and mountains, livable land is scarce, making homes a relatively valuable commodity (simple economics of scarcity). This creates a greater demand for homes than there is supply, causing housing prices to be greater than average ($439,000–median home price in Seattle as compared to the average U.S. median home price of $213,900). Additionally, the city has a below average public transportation system that, when compared to the likes of San Francisco's BART or London's Tube systems, is plain embarrassing (see image below). The disdain for public transit, though heavily used, keeps the city's housing market up due to the desire to live close to one's work.

Geographic availability, however, is not the only thing working in favor of Seattle's robust real estate market. The positive synergy created by Seattle's intelligent populace earning relatively high incomes is the amount of bad-debt loans is substantially below average. As of September 2007, 5.12% of all loans held in the United States are delinquent, verses 2.6% in the state of Washington during the same period. The outlook is even better for Seattle. According to economist Matthew Gardner, “[Mortgage delinquencies and foreclosures are] not happening to Seattle to any degree whatsoever…we’re not seeing any fallouts.” Furthermore, of the 40,000 prime-loans in Washington, only 167 are at risk. So with significantly less foreclosures, local lenders can afford to issue mortgages with lower yields than elsewhere in the country, enabling borrowers to remain present in the marketplace, and keeping the housing market in afloat.

What about Seattle's future? With the Bill and Melinda Gates Foundation's recent donation of $105 million to the University of Washington's Medical Research Center, which is part of the Cancer Care Alliance, Seattle instantly became the most funded cancer-research city in the country. This, along with the prosperity of Starbucks, Microsoft, and Boeing, lead city-planners to believe that Seattle's population will double by 2011 (currently 2.8 million, expected 5.6 million). If this becomes reality, not only will there be more traffic jams, but residential real estate within the city will become more precious as well-and Seattle will continue to defy the country's real estate crisis.

The Aftermath of September 18th: Interest Rates Down, Housing Market Down, What's Up?

The Federal Reserve, chaired by Ben Bernanke, made a bold move this past Tuesday in its decision to lower interest rates by half of a percent. This was a highly speculated decision that sent stocks through the roof on Tuesday, but the market quickly recovered and, by Thursday, the outlook was dreary. So, begs the question, do the long-term ramifications of a deflating dollar and an increased chance of recession merit the decision to reduce interest rates? To analyze this question, I looked to the world of blogs. My search took two different routes; first, I pursued how the decline in interest rates was received by the real estate and finance industries. I did this at Ben Jones’ blog, known as, “The Housing Bubble Blog.” Second, through the Boston Real Estate Blog, written by John A. Keith, I responded to how the man behind the scenes, Mr. Bernanke, was addressing the credit-crunch.

Article 1: Fed Cutting Interest Rates: Is there an upside?

Who are we kidding? By lowering interest rates last week, the Fed torpedoed hopes that this credit crunch currently strangling the U.S. housing market will somehow go away. This thing created by the “greedy investors and irresponsible borrowers” has stumped even our brightest economists. Our battleship is sunk. The signs are everywhere – Bear Stearns declaring its largest profit decline in over a decade; the cost of obtaining a home loan has gone up; Europe’s largest bank – HSBC – will shut down its sub-prime sector and cut 770 jobs; and worst of all, current Fed Chair Ben Bernanke (on the right) and recumbent Fed Chair, Alan Greenspan (on the left), don’t even agree with a recovery plan. Who on Earth (and I literally mean Earth) thought this was a good decision? Surely not the thousands of employees being laid off by the HSBCs or CITs of the world. Surely not the average American homeowner, whose home’s value has already declined 3% and will likely continue. Surely not the Aussie hedge funds or German banks that were so deeply entrenched in the American sub-prime mortgages that they’re now facing record losses. Even the poor schmuck who thinks he’s got it made by refinancing at a lower rate will see his home’s equity value take a hit far in excess of his meager refinanced gain. I see no rhyme or reason to any of this – it feels like this decision was a clueless stab at an unknown monster.

I do know this, however, the one in three odds Greenspan gave the U.S. economy for entering a recession is starting to look like a mighty small number.

Article 2: Bernanke to Congress: Butt Out

Ben Bernanke, the Federal Reserve’s Chairman, has testified before Congress that U.S. legislation needs to reflect tighter regulations regarding home-mortgage consumer disclosure. While, at the same time, declaring that, “any new regulations to raise mortgage-lending standards should be careful to avoid limiting the availability of loans in ‘legitimate transactions.'" Hold on just one second! Isn’t this the source of the credit-crunch nightmare in the first place? Indeed it is, and this, coming from the same guy who punished the dollar a week ago by reducing interest rates? Give me a break. Mr. Bernanke, I realize that historically it’s been the Fed’s de jure policy to ride the fence, and embrace the myriad of ways one might issue and resell a loan, but times have changed, and the more is no longer the merrier. If the mortgage crisis is as severe as the Fed believes it is (and indeed it appears it is – default loans last year exceeded any historical figure since they emerged in the 1980s), then the Fed needs to stick to the task at hand, and firmly enforce the issuance of loans, specifically sub-prime loans, to credit-worthy buyers.

A Recession: Six One Way and Half a Dozen the Other

Apparently the state of the American economy hangs in the air, waiting to receive its fate from Ben Bernanke and the Federal Reserve (the “Fed”), who will announce this Tuesday whether or not interest rates will be lowered. The decision reflects a series of bearish events that have given credence to the possibility of a recession in the near future. If the Fed chooses to lower interest rates, Americans can expect sluggish markets across the board through 2008. But if interest rates remain unchanged, should American’s believe that somehow they’ve been spared from the “credit-crunch” disaster? No, that would be ignorant. Regardless of the outcome on Tuesday, the economy must reckon with the negligent decisions that were made by the credit-lending institutions, specifically those in the sub-prime mortgage sector, and the ensuing financial turmoil that will inevitably come of it.

To accurately understand the scope of the “credit-crunch,” it’s worthwhile to understand how this whole downward spiral started. Basically, the sub-prime mortgage lenders were ignoring the rules set in place to ensure that an individual’s mortgage accurately reflected his or her credit worthiness to take on the loan, which is shown by the specified interest rate the borrower receives on the loan. Worse, the individuals at fault here received little of the downside; these individuals work under a quantity-over-quality philosophy, simply trying to sell off as many mortgages as they possibly can. In doing so, the mortgage broker transfers the inherent risk of the mortgages to what are known as whole loan buyers. These are the large financial institutions that buy, aggregate, package, tranche, and sell loans as quickly as possible to clueless buyers who believe they are buying BBB or BBB- rated securities (generally in the form of Mortgage Backed Securities). As stated by Kyle Bass, managing partner at Hayman Capital, “this transference of risk is the crux of the Subprime situation,” and what has ultimately reeled in the numerous other markets that are feeling the adverse effects of the loan-crisis.

So who loses out? Well to begin, those who bought the packaged securities composed of mainly ultra-risky junk-loans, but with just enough prime, AAA tranche loans to get the package rated above Moody’s minimum BBB requirements, exposing investors to an unforeseen (and unimaginable) downside to their investment. This is only the tip of the iceberg, however, as numerous markets have felt the backlash from the sub-prime fiasco. For instance, nearly $2 trillion worth of commercial paper “remains locked up” due to investor wariness of a non-asset-backed security, driving yields on the paper way up, forcing banks to either sit on their current allotments of paper or sell at a loss. Either way, banks are seeing their lending power dwindle inversely to the rising yields on these papers, which is bad for them, and worse for us. As banks’ lending power decreases, their required minimums for borrowing rise. So not only are mortgages defaulting at astonishing rates (which aren’t expected to slow down until at least 2009), but daily loan applications are falling in number as well. Connect the dots, and it now seems obvious that the real estate market is headed for bad times.

What might be conveniently dismissed as typical summertime lows in the housing market is merely the beginning of what will be a long-run downward spin in the housing market. This is not merely a notion but a fact, and there are telltale signs everywhere. For example, foreclosures have more than doubled since this time last year. Also, home sales for the month of July have decreased by more than 1.2% from where they were last year. Together, these two facts detail the inevitable; the number of houses available for sale is rapidly increasing while the number of homes being bought is declining. This means that house prices will have to drop in order to find buyers, and they have – median home prices fell for the 12th month in a row this July.

Not only is the backlash of the credit crunch affecting the housing and financial markets, its likely going to hit the retail market as well. Historically, retail trends trail those of the housing market by just a few months. This time, however, the trend is not as prevalent. While this could be due to the relatively healthy economy, it’s more likely due to the large gains homeowners saw in their home’s equity over the past several years. This makes sense given that in 2006 alone, a whopping $382 billion worth of home equity was pulled out of homes across the U.S. In addition, the unemployment rate is the lowest it has been in six years. Therefore, not only are homeowners still riding the additional income generated by their home’s equity, they have little concern about their economic situation and are therefore disinclined to cut-down their retail spending. However, this disparity between economic reality and consumer spending cannot last, and as retail sales growth figures suggest, retail growth may decline until it reflects more accurately the flailing housing market. That is, unless the Fed reduces interest rates.

Well, if lower interest rates will save the home buyers and consumers alike, at least in the short run, why on Earth doesn’t the Fed just lower interest rate?

Because then we’d be in a recession…