Markets & Finance

Subprime City Confidential: Nov. 28, 2007


Freddie cuts its dividend and investors applaud. Wells Fargo's No No Song. And just how big are those CDO losses?

We're ba-a-ack. Like the crisis for which it's named, Subprime City Confidential has decided to return after an extended absence (feel free to swap in similes of your own choosing, e.g., "like a herniated disc" or "like a long-forgotten creditor"). The waters are teeming with risk-challenged financial giants in varying degrees of distress, so let's dive right in.

Freddie Mac Shares Make a Comeback

Here's a role-playing game for you: You're Freddie Mac (FRE), the big mortgage finance company, and you've just watched your stock price get pummeled after announcing a $2 billion loss on Nov. 20 (BusinessWeek.com, 11/20/07). What do you do next? Why, of course, you cut your dividend in half and arrange for the sale of $6 billion of preferred stock to shore up your capital, diluting shareholders' equity in the process. And then you steel yourself and wait for…a 14% bounce in your share price.

That's right, investors bought the shares by the vanload on Nov. 28, perhaps on the speculation that like Elvis, the worst of Freddie's capital crunch has left the building. (Kool-Aid comes in many flavors on Wall Street.)

Standard & Poor's equity analyst Stuart Plesser didn't share in the bullishness on Nov. 28, keeping his sell rating on the shares. (S&P, like BusinessWeek, is a unit of the McGraw-Hill Companies (MHP)). Plesser said, despite the potential for $6 billion in new capital from the proposed stock sale, he doesn't expect Freddie to be a major factor in the mortgage markets, as he expects the government-sponsored entity to continue to incur losses and to have to be wary of its of capital levels. Plesser cut his 12-month target price on the shares by $2, to $22. The stock closed at $29.42 on Nov. 28.

Wells' No No Notice

A big lender takes a $1.4 billion pretax charge, largely because of higher losses it expects in its home-equity loan portfolio. Yawn. This dog-bites-man story wouldn't be worth the wear and tear on any keyboard in Subprime City except that it a) involves mortgage heavyweight Wells Fargo (WFC) and b) contains an amusing Beatles reference you'll just have to wait for.

Wells said it was exiting certain correspondent channels where the majority of its problem home-equity loans were sourced. S&P Ratings notes that based on the third-quarter reported net income of $2.3 billion, this special provision could reduce Wells Fargo's fourth-quarter earnings by 56%. But S&P Ratings said, thanks to Wells' strong capital base and business and earnings diversity, the charge will not affect the credit ratings on the company. The shares gained 3%, to $30.72, on Nov. 28.

In a Nov. 27 press release, Wells Chief Financial Officer Howard Atkins seemed to be channeling Ringo Starr in his No No Song days. "We did not offer consumer loan products that were inconsistent with our responsible lending practices, such as option adjustable rate mortgages (ARMs) and negative amortization ARMs. Below certain credit scores, we did not offer stated income, low, and no documentation mortgages, other than a negligible amount of such loans held in portfolio after Sept. 30, 2007. …Because of our conservatism, we lost market share in the subprime segment the past three years and we're glad we did. We have minimal exposure to collateralized debt obligations."

Atkins detailed more of Wells' positive negatives: The bank does not hold in its money market mutual funds any collateralized debt obligations, any commercial paper obligations directly backed by subprime debt, or any single-seller commercial paper programs sponsored by mortgage originators. It wasn't a significant participant in any large, leveraged "covenant-lite" buyouts. It didn't sponsor any structured investment vehicles to hold assets off its balance sheet.

Also on the list of nontransgressions: Wells said it never made a market in subprime mortgage securities and had "minimal" direct exposure to hedge funds. "Avoiding these problems has enabled us to maintain one of the strongest equity capital positions among large bank holding companies," said Atkins.

But for all Wells' prudence, it still has $71.5 billion in its home-equity loan portfolio and a large exposure to the California housing market, according to S&P Equity Research.

Citi-BofA: A Marriage of Inconvenience

The subprime crisis has brought a daily parade of improbable, astonishing, and just plain weird headlines. We don't quite know where to put this one: A Nov. 28 Wall Street Journal report said Citigroup (C) was approached by a prominent investment banker who suggested the company merge with fellow behemoth Bank of America (BAC). According to the Journal, Citi's board dismissed the informal approach "totally out of hand," and no discussions have taken place, citing a person familiar with the matter.

Further, BofA says it never authorized a formal overture to Citi, according to the story. Perhaps BofA—after having watched its recent investment in Countrywide (CFC) turn sour—doesn't have the stomach for any of its trademark megadeals these days.

CDO Speedwagon

Apparently, getting a handle on potential losses from collateralized debt obligations (CDOs)—a class of securities that investment pros used to invest in subprime mortgages—is like trying to nail down Jell-O. But Wall Street analysts are charged with the solemn task of trying to name the unnameable.

The latest to take a swing at the amount of CDO red ink: Chris Flanagan, head of U.S. asset-backed securities for JPMorgan (JPM). According to a Bloomberg report, the firm says losses on CDOs at the world's biggest banks may double to $77 billion. For the overall market, losses on CDOs linked to U.S. mortgages will reach about $260 billion.

"One of the benefits of securitization is the offloading and global distribution of risk," said the JPMorgan report quoted in the Bloomberg story. "Ironically, this is now a capital markets hazard, since no one is sure where subprime losses lurk."

Comforting words indeed.


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