Ponzi Finance Revisited

The issue that both Washington Mutual and Countrywide have large portions of their retained loan portfolios in Option ARM loans is starting to get some circulation on the internet although I have not yet seen it discussed much in the mainstream media. The reason that it has been getting so much discussion on internet message boards and the blogging community is the expectation that the interest on these options ARMs is funny money. For example, for WAMU's Q1 2007, they accrued $361 million or $0.40 EPS of interest to the option ARM loan increasing the principal balances by that amount and reporting those accruals as current income. No "cash" was actually received. Many of us see this as ponzi finance because cash earnings were closer to $0.46 EPS and the company is paying out a dividend of $0.55 eps per quarter (again in the case of WAMU as an example).

So to appease the longs and play devil's advocate a bit lets look at how this analysis could be overly bearish / negative. There is no actual problem with accruing that interest currently and adding it to the loan principal amounts IF those amounts are actually collectible. In other words - if I am the bank and can originate an Option ARM for $100,000 principal amount at market interest rates and I can also sell it for $100,000 at the same time I am totally in compliance in my reporting. Furthermore if over a 3 year period I accrue $15,000 in negative amortization interest so that the loan principal amount is $115,000, SO LONG as I can resell that loan again for $115,000 in a liquid market three years later, there is little to no difference from actually receiving that cash at the time I am instead reporting and receiving the accruals.

Again focusing on WAMU as I have more experience looking at the balance sheet and their financial statements - about 55% of the retained loan portfolio is either in 1) option ARMS or 2) home equity lines of credit. This means coincidentally that 55% of WAMU's ASSET SIDE OF THE BALANCE SHEET is in these loans - we are talking billions of dollars here - in the case of the Option ARMs - around $50 billion. Now on the flip side of this WAMU's book value is around $26 billion (asset - liabilities). This equates to around $25 per share for the company. Value investors love to point out the book value which acts as a floor for the stock price as well as the high dividend yield (north of 5%) as providing another floor.

Through this piece I want to call attention to another method to analyze the asset side of their balance sheet and then from that information - their book value and SOLVENCY. So long as the "current market value" for the Option ARMs and Home equity lines of credit stays around that $100 billion market and is resellable in a liquid market for the same amount it is reported at on the balance sheet - the company is not going to have any problems and I am blowing smoke. This is because as soon as WAMU needs cash they can just sell off $10 billion of their Option ARMs and reinvest the proceeds in an even more liquid market (e.g. treasury bills, etc.) . However, if as I suspect the Option ARMs are not really "worth" what they are being reported as - WAMU has a problem as it is essentially operating a failing ponzi scheme. It is paying out more cash than it is bringing in and the value of the assets side of its balance sheet is quickly deteriorating. Furthermore, any attempts to begin liquidation would result in current hits to earnings as it becomes mainstream knowledge that WAMU is taking losses on the Option ARM sales - information that is already "suggested" by the quarterly $100 million losses in the mortgage business that continue to mount.

How can we test this theory? Here is where I need help. All we need to do is finding the pricing for Option ARM Mortgage back securities issued by WAMU and Countrywide in the market that approximate the same characteristics (re: origination date, and credit score / rating agency tranche) as the two have actually retained. If we find out that the equivalent MBS have declined in value by 10% then we would want to make a corresponding adjustment to our updated WAMU financials. If instead the the value of the equivalent MBS has increased in value or is level then I am full of it for now and perhaps it is a buy on all the negative news and in fact a "value play."

I hope this introduced a few ideas that people had not previously considered.

Best regards,

BG

Printing Money

We have seen a significant bounce in the market over the past few days including a major rally in homebuilders, lenders, and other real estate related sectors. The bulls on wall street are calling for another bull market led by the financials - just as the financials have led for the past 3-4 years. I don't know if this really makes sense anymore. Financials sold off hard prior to earnings on the anticipation of poor earnings reports which would be negatively impacted by slowing lending activity and higher allocations to loan loss reserves. We are through many bank earnings reports and those expectations have come to pass. Apparently however, the earnings although bad were not as bad AS EXPECTED - therefore we are seeing a nice rally in several banks - re: WM, CFC, C, WFC, etc. as well as the largest brokers.

I guess that you need to be a bull if you see this quarter as a dip on the way to better overall 2007 results as compared to 2006 or 2005. However if you think as I do that Q1 2007 indicates the beginning of a trend of declining earnings, a deteriorating real estate market, and more bad loans that might continue throughout the rest of 2007 and 2008, then this rally should be sold into, with any proceeds going into cash or metals, or if you really want to speculate then into some portion of the portfolio in put options on the major lenders and other real estate related sectors.

It is definitely tough though to get a bead on what exactly is happening with all of the government intervention. Fannie Mae and Freddie Mac have just announced that they are going to step into the market and start buying up any subprime mortgage originations that are having trouble selling in order to keep interest rates in that area of the market from rising too much. The ultimate goal of this type of manipulation is to prevent 1) a credit crunch from happening, and 2) by stopping #1 - hopefully prop up real estate prices. I cannot comment on the rest of the country but at least in San Diego, California - condo prices are down in the neighborhood of 20-30% from the peak and single family is approaching 10% down from the peak - this is in terms of actual listings. The scary thing is that there are not that many sales at these depressed prices due to 1) lack of demand and 2) unwillingness of lenders to approve short sales or foreclosure sales at those type of discounts to the loan principal amounts.

I do not believe that any government intervention short of a hyper inflation (through massive printing of dollars) can stop the decline in nominal prices of real estate throuhgout the country, and even the hyperinflation would not be able to stop a decline in the real prices of the real estate. So why does the government even bother? I do not know.

A couple notes on the WAMU Q1 -2007 earnings. Negative amortization accrued interest reported as earnings rose to $361 million or $0.40 a share so that actual cash earnings fell to $0.46 EPS for the quarter. WAMU raised the dividend to $0.55 quarterly. This is also known as ponzi finance - AKA WAMU is paying out more cash money that it is bringing in. Cash on the balance sheet also fell from $7 billion to $4 billion as WAMU bought back $2.7 billion in stock during the first quarter. Because we know the nature of the operating business pretty well right now (aka - it is in free fall) - the way for WAMU to raise additonal cash at this point which it will need is either through additional borrowing OR asset sales. They have already sold off the mutual fund business for $600 million - lets watch to see what comes next.

Best regards,

Ben

Anticipated Result Materializes 6 months late

We are starting to see a major sell-off in the mortgage lenders including WAMU. Uncertainty has got to be a huge driver here. The banks have not been proactive about informing investors about their situation. New Century (major sub prime lender) went under in matter of a few weeks and Fremont General as well as Accredited Home Lenders had their market values go down by 90% in a few weeks and will probably join the ranks of the bankrupt companies soon.

How does this development integrate with some of the other major cross currents which we are seeing in the economy right now re: rising gas prices, rising inflation, slower economic growth, the housing bubble bursting, geopolitical tensions. I think our only hope in making sense of this market is isolating our focus to #1 - the status of the US capital markets. I personally expect the bursting of the housing bubble to drive the rest of teh analysis. Trillions of dollars of "wealth" are going to evaporate right before people's eyes as home prices decline over the coming few years. With this goes away the wealth effect which should cause a decrease in consumer spending. Finally the larger than ever personal debt levels should also dampen consumer spending.

As a result of these anticipated declines in consumer spending we can expect a developing recession over the course of the year. This still does not explain why energy markets, precious metals, and other inflationary type asset classes are ramping. Are we looking at staglation?

I think that any inflationary concerns at this stage of the game are misplaced. As the US economy crashes we should re-enter the deflationary scare type of environment which we experienced back in 2001-2002 during the dot com implosion. I expect these deflationary forces to be EVEN STRONGER this time around.

The reason that the metals and too a lesser extent other commodities including energy may ramp even higher as the year goes on is due to the anticipated government intervention in the US markets. We have to expect an intervention on two levels: 1) cuts in the Fed funds rate, and 2) multiple attempted bailouts of the housing and loan industry although this may occur over several years.

Money supply growth has been around 10% for the past couple years and does not yet show any major signs of slowing down. The implosion of the housing market should slow the money supply growth and reintroduce some of these deflationary concerns into the market. It is during the coming government bailout of the economy that we truly risk venturing into a Weimar Republic type event with inflation ramping and the US dollar essentially becoming worthless. This is highly unlikely. I do not even consider it probable. It is a possibility however, and we will have to see just how good the bureaucrats are able to engineer an orderly decline in both the dollar and the equity markets.

Best regards,

Ben