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Five Things You Need to Know: The Smoke Bomb Puppet Show; What Is the FHLB System?; PMI Defaults Rise 22%; MasterCard: The Good News; MasterCard: The Bad News


What you need to know (and what it means)!


Minyanville's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:

1. The Smoke Bomb Puppet Show

At 2:15 p.m. EST this afternoon, someone from the Federal Reserve will lob a smoke bomb out from somewhere behind a desk. As smoke spews from the cannister, some will franticly seek cover, eyes burning, tears streaming down their faces. Others will don gas masks and stand tall in imaginary market-making pits, shouting out orders for pieces of finance paper, and taking them. And the rest of us will wonder what in the hell just happened as these pieces of finance paper gyrate wildly around some made-up level of value that corresponds to a peg of virtual nothingness, all masked by a cloud of smoke.

Reality is nothing like this. But oh how we love our pyrotechnics, even the small ones. Bombs bursting in air, after all, even smoke bombs, suggest a flag is still there even if - no, especially if - we can't see it. Maybe some things are better left unseen.

Meanwhile, perversely, the diversionary smokescreen of Federal Reserve interest rate policy today, and subsequent movements in stock prices, will serve to obscure what's really taking place; increasingly, the only way the government can get new credit into the system is to buy the risk away from the market.

It turns out hundreds of banks and mortgage lenders have tapped the credit offered up by the 12 Federal Home Loan Banks for a whopping $163 billion over the past two months, bloating the FHLB's balance sheet, all at our risk, by more than 20%. And here you thought a credit crunch was on? According to Bloomberg, the sales pushed outstanding debt up 21% to a record $1.15 trillion, almost half of which comes due before 2009.

This is business. Wait, no, it's government. Is it government business? Apparently. But doesn't that makes it our business by default? No one can really be sure anymore, mostly because asking questions, especially in public in this day and age, is indicative of severe mental illness. Enjoy the puppet show this afternoon.

2. What Is the FHLB System?

To know and understand the Federal Home Loan Banks System, we have to go back to the Great Depression. One consequence of the Great Depression was the inability for Americans to obtain credit from banks that had been undermined by poor lending standards - a result of aggressive monetary expansion - and, later, defaults on those bad loans, all of which sounds vaguely familiar from where we sit today, but are told is really nothing to worry about. The FHLB system was established in 1932 to provide funds to savings and loan institutions and to make mortgages more affordable.The 12 Federal Home Loan Banks are government-sponsored enterprises, federally chartered but privately capitalized and independently managed.

  • The 12 banks are owned by more than 8,000 financial institutions from all 50 states.
  • Equity is held by these owners/members and is not publicly traded, so it's a bit trickier deciphering all the financials.
  • Anyway, these FHLBs provide on-demand, low-cost funding to American financial institutions, mostly for home mortgage loans, and represents the largest collective source of home mortgage and community credit in the country.
  • Sounds reasonable enough.
  • But note that FHLBs have more mortgage debt on their books than Freddie Mac (FRE) and Fannie Mae (FNM) ...combined.
  • And, as Bloomberg notes, "Federal Home Loan Bank obligations, when combined with the $1.5 trillion debt and $4.7 trillion in bond guarantees of Washington-based Fannie Mae and Freddie Mac in McLean, Virginia, are 46 percent more than the $5.04 trillion of Treasury debt held by the public."
  • Here are some questions to consider:
    - If the FHLB is now the lender of last resort for many of these financial institutions, some of them extraordinarily weak, what if in the course of loaning money to weak members, who in turn used that money to shore up weak positions, we begin to see the strong members of the system back out?
    - If confidence in the FLHB system weakens, prompting investors to get rid of FHLB debt, could this cause the collapse of one of the banks?

3. PMI Defaults Rise 22%

U.S. homeowners last month defaulted on 22% more privately insured mortgages than a year earlier, according to Bloomberg.

  • According to monthly data from the Mortgage Insurance Companies of America, the number of insured borrowers more than 60 days late on their payments climbed to 54,699 in September from 44,791 a year earlier, Bloomberg reported.
  • Defaults represented a 4.9% increase compared to August, while 2.9% fewer loans returned to good standing.
  • What is private mortgage insurance and why should we care?
  • Here are the basics:
    - Private mortgage insurance, usually known by the acronym PMI, is insurance paid to a lender that is sometimes required when taking out a mortgage loan.
    - Usually, anyone who can't afford to put 20% down on a home they are buying would be required to also get PMI, which usually adds anywhere from 0.19% to 0.9% to the total loan value.
    - Basically, it's insurance in case you can't repay the loan, and if the lender can't recover its costs after foreclosing on the property.
  • Ok, so why should we care?
  • First, these mortgage insurers represent a line of defense for banks against defaults.
  • When the line of defense breaks down, others are drawn into the financial deterioration.
  • The two most largest private mortgage insurers are MGIC Investment Corp. (MTG) and PMI Group (PMI).
  • What does the market say about the health of these two companies?
  • PMI is down 64.53% year-to-date, and MTG is down 69.3%.

4. MasterCard: The Good News

First the good news. MasterCard (MA) reported a 63% jump in profit. Revenue rose 20% to a record $1.08 billion from $902 million a year ago.

The stock is up 17% this morning, and is up more than 25% over the past week.

  • The good news for MasterCard is there is no bad news in this release for MasterCard.
  • As the world's second-largest payment-card processing network, the company has virtually no exposure to credit quality or payment issues.
  • In fact, as far as MasterCard is concerned, the more people rack up on their credit cards, the better.
  • They get a slice of each transaction. Period.

5. MasterCard: The Bad News

So what's the bad news? The bad news (for us), ironically, is contained in the good news (for MasterCard):

  • How so?
  • For one thing, we need to consider what it means that the stock is up 60% year-to-date.
  • As Minyan Peter noted on the Buzz and Banter this morning, the hot spot for financial services investors right now is any non-credit area.
  • As a processor, not a lender, MasterCard is squarely in the middle of the non-credit area.
  • And one final glimmer of bad news from their results: U.S. charge volume growth fell to 7.7% for the quarter. Debit card growth slowed to 12.1%.
  • This is a sign credit appetites are waning... just when the Fed needs them to perk up most.
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