Black Horseman, White Nuckles

Manhattan is big. Manhattan is expensive…I was not fully
prepared for either one.

When your monetarily challenged junior editor stolled into
a pizza joint near your own Eric Fry’s Wall Street office
last week, he expected t

1) Pick up a couple slices of pizza and a panini;
2) Drop $10 on the counter;
3) Wait for change;
4) Walk out of the place.

"That’ll be $18.75 the pizza guy grumbled."

"Come again," I replied.

"$18.75"

"Um…Do you take checks?" We joked.

He did not smile.

So, we reached slowly – and painfully – into our thin
wallets to withdraw 19 hard-earned dollar bills…The pizza
was good, but not $18.75-good.

This was but one of many eye-opening experiences of our
visit to Manhattan last week. Eric was kind (and patient)
enough to share his office with his Baltimore based,
antipodean comrade. For good measure, I dragged along our
Whiskey and Gunpowder publisher, Greg Grillot.

After a rather rude – and very early – awakening last
Monday, we boarded the rickety ol’ Amtrak and set out for
the home of the Yankee’s, Wall Street, Donald Trump and, at
least, one particularly pungent cab driver…more about
this character in a future installment.

Shortly after our arrival, we gawked past the stock
exchange and walked along Broad Street with Eric. "There is
no way to ever be cool enough to NOT be floored by this
city every time we end up here, " I remarked.

"You will never get over it," came the knowing reply. "You
see how cool I am," Eric grinned, "and even after seven
years here I’m still floored by the place."

Being from the Gold Coast, also know as ‘Australia’s
playground’, we are well aware of how annoying gawking
tourists – or ‘touros’ as they are know back home – can be
to those attempting to go about their daily business.
Taking this into consideration we resist the urge to snap
our disposable camera in too obnoxious a fashion…Instead,
we decide to do what us Aussies do best…go
walkabout!…And most of the time, we had no idea about
where we should be walking. But that was part of the fun.

I’ll reveal more moments from my backstreet travelogue in
future editions of the Rude Awakening…An art show from
DUMBO (that’s Down Under Manhattan Bridge Overpass), the
madness of the Wall Street lunch hour and Diane, our
homeless friend from 5th and Madison.

Until then, Chris Mayer has something far more useful than
my ramblings to say.

Cheers,
Joel Bowman

BLACK HORSEMEN, WHITE KNUCKLES
By Chris Mayer

Financial bubbles are like great parties. They’re fun…too
much fun. No one wants to leave too early, so almost
everyone stays much later than prudence would permit.

Hangovers are no fun, but they are quickly
forgotten…which is why we will eagerly attend the next
party. Financial bubbles, though they resemble parties, can
impart far more dire consequences than a mere hangover.
Indeed, sometimes the consequences seem almost Apocalyptic
in magnitude, as Adam Smith, author of The Money Game,
explains:

"We are all at a wonderful party, and by the rules of the
game we know that at some point in time the Black Horsemen
will burst through the great terrace doors to cut down the
revelers; those who leave early may be saved, but the music
and wines are so seductive that we don’t want to leave, but
we do ask ‘What time is it? What time is it?’ Only none of
the clocks have any hands."

Yes, that’s it exactly…financial bubbles are an
Apocalyptic cocktail party. Over in the housing market, the
cocktails have been flowing for a good, long while. Not
surprisingly, therefore, most housing bubble participants
have become a bit light-headed, especially the mortgage
lenders.

Intoxicated by their good fortune, the mortgage lenders
have become increasingly reckless. They have been mixing up
potent cocktails like "interest-only" mortgage and "no doc"
mortgage (where the income of the borrower is not
verified). Some lenders have also concocted 40-year
mortgages. Fannie Mae, the barfly of our metaphor, loves
them all. This government-sponsored mortgage lender
recently announced that it would accept 40-year mortgages
as "conforming loans" – meaning she will buy them.

All of these innovative new "lending programs" enable
homebuyers to borrow more and more money against less and
less equity.

As with most bubbles, the spectacle grows increasingly
ridiculous as it ages. We also now have 40-year mortgages.
Fannie Mae recently announced that it will be stepping up
it’s purchasing of these loans. This all but assures we’ll
see more of them – if the bubble can hold it together a
little longer.

But the Black Horsemen will arrive at some point. As the
credit cycle turns "EZ credit" to not-so-EZ credit, the
housing bubble might deflate very rapidly. Some banks have
been partying harder than others. So these doomed revelers
are likely to feel the Horsemen’s cold steel across their
vulnerable necks sooner than others.

In a new report published last Thursday, Standard & Poor’s
"stress tested" various banks against the possibility of a
housing bust. While the authors of the report conclude that
most banks would not suffer losses that would result in
ratings downgrades, several high-profile lenders would
suffer such losses. We are most interested in these feeble
members of the herd, as they would seem to offer good bets
(as short sales) on the end of the housing bubble.

First, let’s look at those banks who have the highest
exposure to mortgage lending. The following table is a
truncated version of S&P’s list, showing only those banks,
thrifts and specialty finance lenders with residential
loans representing at least half of their total loan
portfoli

Near the top of any list is Countrywide, the nation’s
largest mortgage lender. About 94% of Countrywide’s loan
portfolio, for example, consists of residential mortgage
loans.

Grant’s Interest Rate Observer has identified numerous
worrisome trends within Countrywide’s loan portfolio. For
example, Countrywide’s leverage has skyrocketed since 2000
– which dramatically increases the company’s susceptibility
to a rapid and steep earnings drop when things slowdown.
Additionally, Countrywide has been increasing its market
share, even as lending standards have been deteriorating.
In other words, the big bank has been increasing its market
share by INCREASING its lending to high-risk borrowers.

"Operating in bubble markets," James Grant observes, "many
people lose their bearings. They become disoriented,
financially or morally. As most investors shrugged at the
preposterous high-tech valuations of early 2000 (they had
become used to them), so they are prepared to explain away
the risk-fraught mortgage-lending practices of 2005."

The mortgage bubble looks every bit the equivalent of the
insanity achieved in the late 1990s tech-bubble. And
Countrywide is one of the best pure bets that the bubble
will find its pin. I’ve got puts on Countrywide in my
trading service, CrisisPoint Trader.

But there is another way to look at this. Here we get to
S&P’s stress test.

S&P assumes a 20% decline in housing prices over a two-year
period. The report also makes reasonable assumptions about
default rates by using historical episodes of housing
market busts.

For example, housing prices declined 30% in the 1980s in
Texas – and nearly 16% of Houston’s housing market entered
foreclosure between 1982-87. Such pockets of disaster are
bound to happen somewhere again. Financial history tends to
repeat, at least loosely.

But S&P’s stress test assumes an average default rate of
less than 2% for nearly all loan types. The report compared
the prospective losses to first quarter net income, as a
basis to "gauge a financial institution’s capacity from an
earnings perspective to withstand a spike in both
residential mortgage credit losses and higher nonaccrual
loans, without negatively affecting its capital position."

Based on its assumptions, the S&P report found most banks
did all right in terms of the losses they might take from
such spikes.

However, the test seriously indicts the strength of several
lenders. The table below presents the lenders that would
suffer at least a 90% drop, according to S&P’s test.

Each of the stocks on this table suffers severe losses in
earnings from a housing bust, losses that would virtually
wipe out their entire quarterly net income and harm their
financial health. In S&P’s bubble bursting scenario, for
example, IndyMac would suffer losses more than six-times
its first quarter net income – a scenario that would surely
devastate its stock price and affect its capital position.

The magnitude of the losses would depend mostly on the
product mix within each lenders loan portfolio. IndyMac,
for example, has a lot of construction loans on its books,
which tend to fare particularly poorly in bad markets.

In a real bust, the losses would fall unevenly across the
country. Standard & Poor’s chief economist David Wyss
believes a 20% fall in average price would consist of
something like a 30% drop on the coasts and a 10% drop in
the Midwest.

The top five booming markets, according to the FDIC, are
Los Angeles, New York, Boston, Washington, D.C and San
Diego. We can infer that these markets, and the
institutions that serve them, would be more vulnerable than
Midwest counterparts.

And with the widespread acceptance of unconventional and
riskier mortgages on an unprecedented scale, there is a
further wild card in the mix. A real full-scale housing
bear market has not yet tested these products.

In any event, these tables may provide fresh new candidates
for those looking for plays on the housing bubble finding
its pin.

If only those clocks had hands!

And the Markets…