The Market Ticker

What an odd day in the markets.

Overnight the Nikkei was down fairly strongly, along with the other Asian markets.

Then this morning we got two numbers that the market took as positive - but weren't. CPI, which came in good "ex-food and energy", but of course, as I keep pointing out, who doesn't eat or use gasoline? With food and energy, it was quite hot.

The second was housing starts. And here things got really bizarre. The headline was up.

But - behind that were declines in all regions except the Midwest, which claimed a more than 40% increase. Excuse me? You expect me to believe a forty percent increase in a region where just a couple of weeks ago we had news stories telling us you could buy foreclosures at auction for less than the price of a used car?

But of course you know the deal by now. Bad news is good news, no news is good news, good news is even better news.

So up the market goes. Off the headline - again.

Ok - cool. But now we start to see some discontinuities in the market. Countrywide is up strongly at the open, others flirt around, but there's no longer a strong bid across the sector - now its getting more specialized.... or..... tired.....

Countrywide comes up against the 50DMA and can't penetrate. That was a former technical channel indicator - what's it mean for tomorrow? Let's see what tomorrow brings - but the failure to penetrate the 50DMA is not particularly positive for upward movement from here.

The DOW bounces off the highs and promptly retreats. Technically, that's not so good. The Naz was down a bit, and the S&P up a few. The failure to penetrate resistance in the DOW is not particularly bullish, nor is the lack of strong follow-through in the other two indices.

On top of this the dollar continues to go straight in the ditch. You now need two of them to buy one British Pound. That hasn't happened in a very long time. The index is solidly below 82, down almost a half-point today, and it looks inevitable it will decline below the magic "80" index point. That's bad, by the way. The 10yr bond yield dropped on rate bigtime to 4.69% - from 4.74 yesterday. That's a big move for a day.

Into the close I noted some BIG price deterioration in WM, which was due to report at the close. And report it does.

The headline is that they hit the number, but down 20% YOY from 2006. But then some dead fish start to show up. The instant response of the aftermarket was to pop the stock by a good buck and a quarter - apparently everyone expected a honking big miss. A quick analysis of the numbers shows big downward changes in loss reserves in their credit card portfolio, which was used to offset the (far bigger than it appears on a per-share basis) loss in the mortgage portfolio.

Hmmm.....

So I go at the facts, because something just doesn't look right. And when I do, heh, look at that. Math trumps headlines.

Non-performing loans were up. Way up. 25% increase in one quarter. But they dropped the "doubtful" account number by 0.01? How's that? Oh, and that's against net-chargeoffs which jumped 34% - in three months. Yet the bank's percentage of doubtfuls go down? Equity drops due to a big share buyback (which, by the way, on the conference call they hinted they may continue), and the capital reserves decreased. So let me see if I get this right - equity is down, capital reserves decrease, you vaporize performing loans (booking a GoS) so you can shift reserves and effectively take two credits to the balance sheet (so your mortgage business doesn't look like the huge stinking turd that it was), you take big charges but decrease the percentage of accounts you flag as "doubtful", and then with all that you raise the dividend.

But.... as Monty Hall used to say..... it gets better!

The really big hidden number was the approximately $360 million in capitalized negative amortization in the quarter. That goes to earnings, but as I've noted, its "funny money" - it may get paid, it may not, but really guys..... hitting numbers this way when that segment of the market is known to be a ticking bomb in a declining home value market? And of course that was nowhere in the quick PR releases - you had to go dig for it. Big surprise - NOT.

Take this out and you get about half of the reported value for real earnings - about 40 cents. Ya. Now let's not forget folks - January and February were all "normal" months. So all this damage to the balance sheet was done in one month out of the three! Can you imagine what it would look like if the entire quarter sucked?

The conference call was not full of dummies. They got a few softballs, but also a couple of really good kicks in the nuts. Merrill Lynch was particularly good - their analyst drilled management on the reserve changes, and pointedly asked for the metrics they were using to justify the change. The company refused to give him a straight answer, instead telling him to "focus on the non-card piece"! The last time I heard a company pull that sort of answer out of the hat to a question was during the Internet Bubble. Heh - let the market decide if all this matters. That's how it works - I guess.

In other news YHOO missed expectations bigtime, and got chopped to pieces in the aftermarket. Tomorrow will be interesting for them, and not in a good way. Expect blood in the Internet space. The underperformance, from what I can determine, appears to be company-specific - but I have low confidence the market will take it that way.

Tomorrow morning we have BPOP, CNB and DSL (theoretically on the latter) in the morning, and then ETFC and more after the close. They, along with the market's response to WM's report, will be the "prime movers" tomorrow.

If there's any form of rationality to the market WM has to weigh on trading tomorrow across the board. That sort of hit to earnings off one month, and the one-time accounting shenanigans to dress the pig, would raise all sorts of red flags in any rational market.

But - as has been the case with so much this week, I wouldn't be surprised if we trade higher! Not just WM either - all of the market.

Nonetheless, the cracks are showing up. WM's "lipstick on the pig" was most interesting. The accounting games they played are completely legal - but the bet they made looks to me to be very dubious and extremely likely to blow up in their face next quarter. Among other things they can't pull it again - now the money's gone. They've pulled loss reserves for credit cards they will need if the economy softens or rates rise. They've made comments about the mortgage market implying that they're basically betting on at least a flat (if not up!) - not down - market - yet their major concentration, California, is seeing big year-over-year price decreases in Real Estate.

Cracks in a market tend to start one company at a time. Contrary to popular belief psychology changes that actually stick rarely are initiated by things like the China Surprise in February. Those sort of external events are good for big plunges but they're irrational - and thus, the usual path is a recovery, like we've now seen. Instead, psychological damage to a market as a whole tends to come one company at a time, until people wake up one morning and start wondering if their holdings will be the next to do something like this. That's the "cold sweat" thing that, when it reaches critical mass, causes people to reach for the big red button.

This is the first conference call that I've listened closely to in this sector during this earning's season. I would call a good part of the macro economic look that WM is using for their "forward outlook" somewhere between fanciful and outright magical thinking - oh sure, they can almost certainly grow deposit accounts and credit card holders, and they might even get away with raising fees (their 15% YOY fee increases were eye-poppers - but apparently they got their customers to swallow!) but if they can't earn money off their loans it doesn't really matter.

The $64,000 question is when does the dam break? I don't have an answer to that. But I don't see how WM gets through next quarter's earnings report without a major disappointment in the earnings department, given the housing outlook that we have from all objective sources. If others in this sector are playing with a similar deck of cards and are stacking them in a similar order then that would put the "oh crap" date somewhere in the next three months - certainly before the July earnings releases come out - unless there are some very serious positive changes in the underlying economic facts and housing market.

The error band appears to be getting narrower....

Tomorrow morning's earnings are going to set the tone for the session. I am looking forward to CNB's in particular, as they are over-concentrated in Florida construction loans - I can't imagine those are doing "Sweet Florida Orange" well given the Real Estate market down here. I suspect its more like raspberries.... with thorns.

Oh, as I write this, Mr. Sushi is up about 120 and headed to lunch. There's some color to the Asian markets in general. I'm off to bed early this evening - its going to be a very busy and analytical morning for me with CNB, DSL and BPOP reporting before the bell (among those I care about)

See 'yall in the AM!

Disclosure: I hold WM puts, both short and long term, and also have PUTs on CNB, DSL, BPOP and ETFC. Good trading to you!

PS: I just couldn't resist adding to this. You HAVE TO check out this article over at The Journal regarding Fremont. They "exited" the subprime biz all right - but still have a whole boatload of construction loans on condos in Florida (and elsewhere!) Oh my God! This is the sort of stupidity that the lenders have done themselves in with...... and people wonder why I'd short a BANK? :->

C'mon guys.

Yesterday Sallie Mae got a takeout bid that pumped certain lenders HARD. Chief among them was Countrywide, with Cramer (among others) banging the table that "there's too much money flying around - private equity!" being screamed again and again.

Guys, are you really that dumb? This is a serious question.

Sallie Mae makes college education loans. These are, on balance, pretty damn good investments. After all, you go to college, you earn more money, right? So that means you can probably pay those loans back. In addition, you don't have to start paying until you leave school, so you don't get buried during the time you're learning - and spending the money.

There really isn't much risk here in the portfolio, other than the raw credit risk.

ALT-A paper is an entirely different matter. Let's examine why.

First, we'll break out the mortgage universe into roughly three components:

1. Prime loans. These are 30/fixed conforming, Jumbos (too big for Freddie and Fannie but otherwise 30/fixed), and combinations of 30/fixed and an ARM (usually 5/1) to get around the higher rate on Jumbos. They are all full documentation with a back end ratio of no higher than 36%. They don't make a lot of money; spreads are small because default risk is low.
2. Subprime loans. These are typically 2/28 loans ("debt bombs") but are also typically verified income and assets. The problem is that the borrower has crap credit. Bad FICO, missed payments, etc.
3. ALT-A paper. These loans are "high FICO, claimed good credit" loans that do not fit the requirements for prime paper. PayOption ARMs, Stated Income (SIVA), Stated Income and Assets (SISA).

Now some people are pointing to the "detachment" of LEND and FMT's subprime portfolio as "proof" that ALT-A is "turning around."

Beware with that analysis. It is fatally flawed.

The bomb in the ALT-A space is not credit quality. It comes from the stated income piece of it.

According to a small study done by HUD, half of all those "stated" loans have incomes overstated by 50% or more!

This is a really big deal, because lenders either can or should require you to sign an IRS form 4506-T when you take such a loan. That allows the data that was stated on your "1003", which is the foundational document for mortgages, to be verified by the lender through the right to pull your tax returns.

The issue is that the lenders aren't pulling the returns, because (1) it takes "too long" and (2) it takes too much work!

Unfortunately, any loan that has a fraudulent statement on the 1003 can potentially be put back on the lender until the loan is retired!

Now sit back and think about that for a minute. You turn $500 billion worth of loans over a five year period. Half of them are stated income. Half of those have the income overstated by 50% or more.

That's $125 billion worth of loans you might have to take back. And guess what - the ones you will be forced to take back won't be the ones that people are making the payments on!

What's worse is that the "swap" and "insurance" you think you bought to limit your risk on defaults will not pay on these, because fraud voids all contracts. You can't make an agreement to do an illegal thing; that's against public policy and void on it's face.

Now with certainty, the insurance companies and swap writers won't go quietly into the night and the originators of these loans won't take 'em back without a fight either. There will be lots of litigation on this - bet on it.

Now, if you're thinking M&A, are you going to buy a company with a potential one hundred and twenty-five BILLION worth of contingent liability?

Forget about it - until this issue is resolved - which it will not be for quite a while.

MORNING Earnings


M&T Bank (MTB)

Net income falls 13%, $1.67 .vs. $1.84. Damage appears to be in net interest margin and credit losses, nonperforming loans up almost double.. Lots of loans to automobile dealers (credit quality problems won't spread outside housing eh?)

Key Corp Bank (KEY)

Key Corp beat earnings, but their stock is getting hammered (down almost 6%.) Some credit quality deterioration is evident. Key has a lot of boat loans that have two or so years of life on them (since issue) at this point - there's not been much activity in the boat market lately, but they were, a couple of years ago, a big lender in that space. Apparently the street doesn't like the internals (the headline looks damn good).

AFTERNOON/EVENING Earnings

USANA Health (USNA)

Missed big but showing a lot of bravado. We'll see what the street thinks of this one - the instant reaction was WAY down, then it popped back up. We'll see what the morning holds. This is a popular short target - these guys sell "network marketing" vitamins and such, and lots of people think they're crazily overpriced.

Washington Mutual (WM)

Down 20% earnings, 86 cents .vs. 98 cents, 1Q Net down 20%. Increased dividend to 55 cents. Somehow I don't think the market is going to like that miss very much..... Loan loss revisions up BIG - $234m .vs. $82M. Cutting subprime market portfolio value bigtime as well (looks like close to half!) Big increases in non-performing loan numbers, but interestingly enough, reserve percentages dropped. Hmmm..... Instant reaction aftermarket was a pop of about a buck - we'll see what we get on a followthrough basis once the full report is out and people can read it.... plus the conference call. I suspect the CC will be more than a bit interesting as this smells like engineered earnings to me. The morning will be interesting too, I'm sure. Hope you didn't place any really BIG bets in the aftermarket before the CC.... CC notes.... EPS cont ops claimed up 36%; dividend increased by 1 cent. "while not at our full earnings potential..... quarter that was challenged by environmental factors...." "very strong account growth and customer growth in retail banking" "home loans we were encouraged by improved performance in our prime business; increased subprime credit spreads, driving the loss of 113m in subprime loans..... totalled $164mln after tax including writedowns" "grew managed card receivables by 18%" "increased efficiencies by 7% including a cut in employees by 18%" "largest and most profitable business retail banking - up 4% from 4Q2006." "attracting customers with free checking then cross-selling them other products (obviously not free :) ) has proven successful" "increased depositor and retail banking fees - up 15% (heh, if you can get people to pay higher fees, I guess that's good)" "Card services group net income up 24% YOY, influenced by higher than average level of securitizations (hmmmmm...)" "Added 720,000 new credit card accounts" "CC 30+ days delinquencies 5.15%; net credit losses of 6.31%, up from 5.3% on linked quarter basis" "Expect that as the economy slows both delinquency and loss rates will increase in coming quarters." "Home loans group recorded net loss 113m 1Q, 120ish in 4Q. Driven by subprime" "GoS in prime loans improved, app volume increased (how about fundings?)" "Longer term, we will benefit from the shakeout of weaker, irrational competitors" "Long term asset growth opportunity remains limited so long as the inverted yield curve remains." "Loans held for sale were significantly impacted by liquidity - totalled $160mln pretax" "Subprime residuals decreased by $88mln pretax; now $105mln (holy shit, that's a MAJOR haircut!)" "Subprime pricing now has a weighted average coupon of 9% and no loans over 95% LTV" "No performing assets was 1.02% as total, up 80 basis points QOQ" "Net chargeoffs of $183mln, up 43mln from Q4" "Subprime non-performing is over 7% (aieeee!)" "Actual chargeoffs remain relatively stable" "Other portfolios have strong credit" "Provisions for loss decreased in CC from 275mln to 106mln (card securitization claimed as the reason - here's the bomb kids - that's how they got the "nice" earnings number)" "Net chargeoffs increased both for morts and HELOCs and is expected to increase somewhat going forward." "The forward curve does not anticipate rate decreases by the FED" "Further softening of the housing market provisioning for loss must be increased - 1.1-1.2b to 1.3-1.5b" "Other fee increase expected to remain up 10-12%" "Subprime not expected to recover in the near term" "Housing market contracting - market price corrections are inevitable." "Secondary market liquidity has been reduced for all players. Essentially all 2004 and 2005 subprime residuals have been sold." "1Q 2007 subprime production was down 51% from 4Q 2006" "We will continue to provide credit to consumers who need and deserve it" "Our cardservices and commercial portfolios are performing very well" "Subprime: Delinquency probs increase, taken appropriate steps - totals $20.4 bln - LTV 66% on remaining balances, only 2% over 90%" "ALT-A: Originated for sale. Vol 25.3bln, 21.4bln sold, 6.1bln held for sale, residuals just 21mln. Limited credit exposure claimed" "Option ARMs 58.1bln, FICO 699, estimated LTV 59% as they sold 2/3rds of production volume. Only 1% has LTV over 90% at origination (how about now?) HELOC: 53.4bln, original LTV 71%, FICO 729." "Delinquencies expected to rise over the year but are satisfied with credit performance" Q&A: "Morgan Stanley: Home mortgage had losses one would not expect to continue; should we expect it to return to profitability in 2Q Ans: There is uncertainty out in the marketplace, we are seeing encouraging signs in the prime business; early signs of credit in subprime looks better. The variable we cannot control is what happens to capital markets and credit spreads which have widened to extreme levels; we will not speculate what the capital markets will do. Expect return to profitability in loans later in year." "Piper Jaffrey: More color on prime side of business; big chunk sold a year ago, margin improvement requests, continuing into second Q, etc ANS: Sold volume include hybrid loans, will take down absolute level of GoS; GoS margins improving on OptionArms (they call this prime?) - added - home loans group has been working to make this a more efficient business. Claims evidence of "lfight to quality" in prime products - NOTE - THEY APPEAR TO BE IDENTIFYING OPTION ARM AND ALT A AS PRIME! "Home equity loss provision lowered due to methodology change - ANS: Absolute level of reserve was not changed, we don't give specifics on methodology" "Lehman: Annualizing most recent chargeoff numbers and splitting off about 8 basis for loans, 34 for HELOC (notes big jump in HELOC chargoeffs), 100 for subprime; is provision down in 08 assuming no negative economic change? ANS: Lots of things have changed this quarter and while we're seeing increase in NPAs we're trying to factor that in - we will have to wait and see how economy continues to perform. Too early to comment on 2008." "No plans to shut down subprime channel" "We're pretty comfortable but cautious" "Card Svcs Bus: Securitazation impact - fee income much stronger than expected - ANS: gain on sale through securitization, provisions down $167mln, reflects timing of securitization. Did no securitization in 4Q, all done here" "Charge off / credit quality on card business - ANS - Feel good about the credit and card business; correlated to unemployment, trends and roll rates are quite good. Expect net credit losses will be somewhat higher over time than this quarter." "Receivables growing 2-2.5x industry average - explain? ANS: Related to Providian merger; marketing cost cheaper to Wamu customers than reaching out, WAMU skews to higher FICO than Providian, WAMU customers perform at higher than stated FICO" "Merrill: Portfolio restructuring impact reconcile higher NPAs and lower provisioning for losses (hahaha - there it is! Now - what's the answer?) Answer: Recommend you focus on the non-card piece, did go up, in total it looks like the provisioning is going down which is due to the timing of securitization of the credit card receivables. (In other words, it wasn't REALLY as good as it looked - thanks for catching us) " "We're not prepared to discuss the level of severity of impairment of subprime writedowns in the future" "Subprime second portfolio - do you intend to dispose? Answer: Production that was FICOs over 700, good sized LTVs, put in that bucket, is high-quality portfolio, we feel good about it" "UBS: Clarity on NIM - half came from restructuring (!) 2 basis from non-interest bearing, rest from repricing" "GIC: Credit card losses; if I take the managed and on-balance sheet I think I get more losses than you provided for (!!) ANS: Losses have actually done well; net credit losses were up slightly. (that sounded like a non-answer to me?)" "Valuation of residuals - what assumptions are you using for losses? Ans: We do not go through specifics on valuation. Took haircut in 4Q, took another this quarter." "Prepayment speed on OptionARM ANS: Has slowed down a bit, does not have numbers; has not changed significantly from last year." "Charge off rates - how do you account? ANS: Schedules WM15 and 16 pointed to, amount is growing, approx $220m of increase was subprime (rest that they call "prime" but is really ALT-A! - house price appreciation?! considered?! uh, prices are DECREASING!) " "HELOC CLTV update, and are piggyback? ANS: Not piggyback, HELOC FICO 729 (not what he asked), chargeoffs current 20bp, 32% have over 80% CLTV." "Are you done downsizing staff and outsourceing? ANS: Never done improving productivity; major restructuring is over; we selectively add jobs offshore and consider best location to locate people domestically"

IBM (IBM)

Net income up 8%. Up fairly strong in the aftermarket. Not enough detail to know where the increase came from - is it here, or is it overseas? IBM has a lot of overseas exposure, so the business mix will tell us quite a bit.

Yahoo (YHOO)

Q1 Revenue $1.67b .vs. $1.57b, Non-GAAP EPS 17 cents; "Real" EPS 10 cents. Guidance for Q2 is inline. First blush on the street doesn't like that report at all; they're getting shellaced in the aftermarket right now, trading at under $30! 7% haircut instantly. Apparently people expected far better.

xxxxx

First, CPI - its as expected....... 0.6 headline, ex food/energy 0.1. 2.8% annual run rate.

Housing starts.... not as expected. Rose 0.8% .vs. 7.6% in February.

Interesting.

Futures instantly responded with a gain, as expected.

Housing starts - you have to wonder - what are people doing in the homebuilding sector? We can't sell homes so we'll build more of them? Hmmmm....

The 10yr bond moved down instantly by about 4 basis points, now at 4.71%.

Of course traders will focus on the headline (ex-food/energy) - but let's look at what's moving it.

Drug prices down - why? WalMart's prescription program. That certainly helps.

This also puts the dollar in even more jeopardy, because it cuts the probability of a rate increase - and that will play poorly with the dollar index.

Housing starts are certainly surprising. Where is that coming from? Everyone's trying to cut down inventory - so was this nothing more than normalizing due to bad weather in the winter? Hard to tell. But it doesn't make a lot of sense, given the inventory, as a core change.

Drilling into the housing numbers, the increase was all in the Midwest. Everywhere else - it was down strongly.

And Industrial Cap down 0.2% - not good. Capacity utilization decreases = slow economy.

Oh, let's not forget oil - still over $64/bbl.

So this is what 'ya got - now its up to psychology, and that's a tough call for the morning and into the day. The headlines are what everyone will read, instead of drilling into it - as usual.

The real fun with earnings in the mortgage and bank sector starts this evening.