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I'm a banking bear



July 01, 2007 – Comments (1)

I was asked why I rated Citigroup, a banking stock that is paying a 4.2% dividend and has a P/E of 11.39 as under perform and I thought it a question exceptionally worthy of an answer. 

I do not usually rate under perform for a stock paying a good dividend and having a low P/E, however, I do not believe any financial institution will ride out the subprime fallout very well and I think the consequences of the sub prime lending market will be felt for years.  These mortgages have been repackaged and sold and repackaged and sold again.  They are hiding everywhere in financial institutions and investors would be very hard pressed to figure out any individual institution's exposure to risk.

I think there will be more than one wave of people in trouble with their sub prime mortgages, estimated to be at about 30% of mortgages.  First wave is those that are not meeting interest payments now.  Their mortgages are essentially increasing every month as unpaid interest is added onto principal.

There are lots of people who have bought on plans that offered lower interest rates the first 1, 2 or 3 years.  These people are at risk as their interest rates readjust.

There are people who were barely able to make their payments and may be increasing credit card debt every month right now just due to the increase in the price of gas alone, and so many other costs have gone up.  Expenses are increasing faster than wages and they lack any buffer zone in their income.

There are people who have been living off equity, borrowing more as their equity increases.  If they've put the money into other investments they'll probably be ok.  If they've been doing this to pay off their credit card debt that gets out of control every 2-3 years, well, obviously they already have money management problems and this is going to be big trouble for them.

Many have variable mortgage rates and coming into the market at a low rate and then finding the rate increases is an enormous negative leverage for the household budget.  I worked out that each $100,000 of mortgage costs $474.21 per month at 3% for a 25 year mortgage.  It costs $527.84 at 4%, or an increase of $53.63/month per $100k of mortgage, and that is an 11.3% increase in mortgage payment.  I don't know about you, but that eats up 4.5 years of wage increases for me.

I do not believe that any banking institution will ride this out without taking some pain, as will the shareholders of banking stocks.

I would also like to point out what I believe to be a difference between Canadians and American because of public policy.  In Canada you can not deduct mortgage interest from your taxes and if you buy a home with less than 25% down you must pay up to 2.5% mortgage insurance.

I believe that you are ultimately better off by paying off debt even if you get a tax exemption on interest paid, but I think there is a perception of getting something for nothing, or getting more if you have more debt, almost stick to the government, taxes are so ultimately evil and I figured out how to pay less.  That's probably an exaggeration, but ultimately this policy that allows you to deduct interest has lead to a higher acceptance of debt and even a strong shift towards public perception that a level of debt is ok and perhaps even a level of debt relative to assets is wise... (Ekkk!!!!...)

Canadians are more motivated to pay off debt as there is no perceived benefit from holding debt and they are also much more motivated to try and have a larger down payment.  That isn't to say they manage the 25% down, but what will typically happen is they might come up with say 15%-20% down, find another 5-10% through short term debt and finance their first home with a highly aggressive debt repayment plan for the first 5 years or so as they work to pay back that 5-10% in a short term.  If they can only come up with 10% down they just fork out that 2.5% insurance because they don't have hope of paying back that short term debt in a reasonable timeline.  It is difficult to get a subprime mortgage with Canadian law.  You have to have 5% down and have to pay that 2.5% insurance.

I don't believe the differences in behaviour is universal, no people or countries are monolithic in all things and I didn't say that this is a universal thing, but I do believe that if you look at the facts you would find a greater percentage of Americans borrowing against their equity than Canadians, and this is one of the ways that public policy affects behaviour to the detriment of the economy as a whole.

And even another point, the policy of allowing interest to be deducted has leveraged an ever higher level of hyperinflation in the housing market, but that's another topic

1 Comments – Post Your Own

#1) On July 12, 2007 at 4:05 PM, billddrummer (38.81) wrote:

The analysis of the subprime "tranches" is right on target.  As I was reading your blog, I was struck by the realization that I fell into each of those groups during the period I owned my home. 

I bought my first home with an FHA loan.  The FHA program allows you to purchase a home with as little as 3% down.  You do end up paying mortgage insurance, but at the time mortgage insurance was deductible, as was mortgage interest and real estate taxes.  The payments were a struggle, but I managed to keep the mortgage current.

As my income rose and the house appreciated in value, I decided to refinance to get rid of the mortgage insurance.  I simultaneously converted the loan to a 15 year mortgage to speed up the payoff on the loan.  That worked for awhile, until my wife quit her job.

Then, I refinanced again to lower the payments and get some cash out to pay off credit cards and car loans.  Back to a 30 year loan, with low payments.

After a couple of years, values ratcheted up dramatically, and my marriage went south.  Elected to refinance again to cash out the appreciation and give my wife her cut of the equity.  This was a subprime deal.   She moved out, and I stayed in the house.

Then I lost my job, couldn't make the payments, loan went into foreclosure, property nearly got auctioned, and will go back to the lender later this year. 

During this 19+ year saga, I moved from first-time homebuyer, to A+ credit, to cash-strapped homeowner, to subprime fodder, to a person who needs to rebuild, personally and financially.  I think you are absolutely correct about the continuing fallout from the subprime situation.  The next 3 years will wring a lot of appreciation out of the market.  But when things stabilize, bargains will abound.

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