How Safe Is Your Bank?

Europe slowing...

1st the US, then Asia, (excepting China), now Europe. Confidence among EU consumers and business dropped to a six- month low last month.

Europe's manufacturing and service industries grew this month at the weakest pace since 2005 after a sudden increase in credit costs hurt banks.

Unwind Undone? Yen pulls back, dollar tanks...

Cheaper money is helping out the carry trade. Japan's yen declined against all 16 major currencies as investors jumped back into carry trade bets.

So far, primary benefit has gone to the Euro. The dollar index hit a 15 year low at 78.39 and the Feds trade weighted dollar index hit a 36 year low at 74.78.

A lower dollar, should help Q4 exports and multinational profits on forex exchange rates.

The London Inter Bank Offered Rate (LIBOR) that banks charge each other for overnight loans in dollars dropped 4bps to 4.90%.

High Yield Market returns...

We've Nattered before that a rate cut would spur the value of high yield paper, helping out pension funds & insurance companies which were scooping it up at a substantial discount in the past few weeks.

Three companies sold junk bonds in August and none in the first half of September. Sales of the securities averaged $3.5 billion a week through July.

The day following the Fed cuts, borrowers sold $13.3 billion of bonds, the most since Aug. 8.

The drop in corporate borrowing costs is encouraging investors to buy riskier assets. Is this a good thing? Maybe, maybe not.

The yield premium on high-yield bonds narrowed 37 bps, to 421 basis points this week, the biggest weekly decline since August 2003.

This lowers the yield premium that companies pay to borrow over similar maturity Treasuries by the most in four years.

How Safe is Your Bank? ...

We've Nattered before on the virtues of the old school mortgage origination model, originate to hold, vs the evils of the modern day leveraged "hip hop" model, originate to sold.

Jim Jubak has an excellent missive regarding this subject, entitled
How Safe is Your Bank?

Northern Rock's loan book is 3.1 times its deposit base, for example. And, because loans are growing far faster than deposits, the bank's reliance on the capital markets increases as well.

At the end of 2006, about 73% of the funding for mortgages at Northern Rock came from the capital markets. In the first half of 2007, its dependence had climbed to 85%.

Alliance & Leicester, the No. 9 mortgage lender in the United Kingdom, and Bradford & Bingley, the No. 10 lender, are up near 50%.

That dependence is intrinsically dangerous because it is based on a mismatch between the lender's short-term liabilities, its borrowings in the commercial-paper market and other short-term markets, and its long-term assets, the 30-year mortgages that back the lender's debt.


How did this happen?

In the good old days, the days when Jimmy Stewart ran the Bailey Building & Loan Association in Bedford Falls, S&Ls and banks took in money from depositors and then lent out the cash from these savings accounts as mortgages.

And, quaintly enough, the banks even held on to the mortgages, collecting monthly payments for 30 years before retiring the debts.

Writing new mortgages depended on money flowing in from new deposits, from monthly mortgage payments and from the occasional early payoff of a mortgage.

The model at Northern Rock -- and at Countrywide Financial and its U.S. peers -- is very different.

Yes, some of the money lent out in mortgages may come from deposits, but most of the cash comes from the capital markets, where mortgage lenders of every stripe tap buyers of commercial paper for new cash.

Mortgages don't sit on the books until they mature, and originating companies actually collect very few monthly payments on these debts.

Instead, the mortgages are sold off and then turned into asset-backed securities of various flavors. This system supercharges the returns that financial institutions can make in the mortgage business.

A company that originates a mortgage can sell it off in a matter of weeks, regain its capital (plus a fee for originating the mortgage and, if interest rates and the financial markets break right, a profit on the sale of the mortgage) and then, having freed up its capital, originate another mortgage.

That works just fine as long as the capital markets are willing to lend the mortgage companies the short-term funds that they will turn into long-term mortgages, and as long as the capital markets are willing to buy the securitized mortgages so that the mortgage lender can get the mortgages it has written off its hands and free up its capital again.


The Nattering One muses... When short term money becomes more expensive than long term, thats when the problems start.

Worse yet, when no investor wants to touch the short term asset backed commercial paper, you have a solvency problem.

JJ suggests what to look for:
1. Having a big mortgage book and a small deposit base.
2. Raising the majority of its money from the capital markets.

In the U.S., Countrywide Financial, with $34 billion in time deposits (about $25 billion uninsured) on the books at the end of 2006 and recent monthly mortgage production of $34 billion fits that description.

A bank such as Wells Fargo (WFC, news, msgs), with $270 billion in core deposits on the books at the end of 2006 and $68 billion in monthly mortgage production, doesn't
.

The Nattering One diverges here: Wells Fargo and other lenders are using the short term market.

Their exposure depends on the percentage of short term funds they need to raise vs. their deposit base.

The size and quality of their mortgage book can also be a factor, as no one is buying non FNMA, FHLMC conforming loans.

Defaults & foreclosures present another imminent threat.

More often than not, the originating lender must take the bad paper back and service it, and the value of underlying asset is already less than the original loan.

As the number of REO's grows, (In California, Countrywide 2700, Wells Fargo 3700), the cost of carrying the bad mortgage paper rises, while the value of the underlying asset and paper erodes further.

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