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Five Things You Need to Know: Existing-Home Denial; Wells Fargo's Good News/Bad News; Speaking of Risk Aversion...; Why Do We Care About Bond Insurers?; Orange County II?


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


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

1. Existing-Home Denial

The National Association of Realtors this morning reported that Single-Family Existing-Home Sales were "stable" in October as the mortgage situation "improved significantly." Unfortunately, they were then forced to report their own statistics immediately after making those weird claims. Statistics such as:

  • Total existing-home sales down 20.7% year-over-year.
  • The national median existing-home price was down 5.1% year-over-year, the most on record.
  • Total housing inventory rose 1.9%, which represents a 10.8 month supply at the current sales pace.
  • Existing condominium and co-op sales fell 9.1 percent in October, and are down 20.2% year-over-year.
  • Taken together, rather than showing "stability" and "improvement," the data show weaker sales and rising inventory despite the largest price decline on record, a direct result of credit conditions continuing to tighten.
  • In the real world this would be called full-blown existing-home deflation.

2. Wells Fargo's Good News/Bad News

Speaking of credit contraction...

Wells Fargo (WFC) this morning announced a $1.4 bln loan loss. After listening to the company's conference call I wanted to go through what I think are some important takeaways.

The stock is trading up nearly 5% on the news, and this may be confusing to some people. Why, after reporting a $1.4 billion loss, would the stock be trading higher? Ironically, what looks like bad news for WFC is actually good news for WFC, but bad news for others in the sector. Let me explain what I mean by that.

First, WFC does not make markets in subprime mortgages or securities, they have no sponsored structured investment vehicles (SIVs) housing off balance sheet assets, the company has little exposure to hedge funds and minimal exposure to collateralized debt obligations and asset-backed commercial paper.

So, why the $1.4 bln loss? Where did it occur? The loss occurred in WFC's warehouse pipeline, mostly indirect home equity loans which were predominantly prime. Simply put, deterioration in the real estate market (not subprime) resulted in higher losses on home equity loans.

WFC said it will continue to tighten what were already disciplined underwriting standards, at least compared to peers. This is a hallmark of credit contraction, plain and simple. It is a smart way for WFC to manage their business; good news for WFC and for long-term shareholders. But it is bad news from a macroeconomic standpoint because tighter credit conditions beget tighter credit conditions.

But what about the Fed rate cuts? Again, this is why LIBOR is so important. (See Five Things Primer on LIBOR here, and yesterday's update here.) LIBOR remains 50 basis points above the Fed Funds rate and has actually risen 20 basis point since the October rate cut. This is evidence that Fed "liquidity" is being absorbed by banks - they are hoarding cash - and isn't flowing into the economy as it did during the 2001-2003 rate slashing spree.

Remember, the economic story is not about liquidity, liquidity, liquidity the way it is so often presented. It's about liquidity plus velocity, velocity, velocity.

Overall, WFC has avoided much of the exotic and, frankly, bizarre businesses their competitors have engaged in, so the writedown, although it is indicative of credit contagion (the bad news), also looks like a cleansing event for WFC (the good news).

Ironically, it is precisely because WFC has avoided some of the more exotic lines of business that makes it possible for the company to come clean with a $1.4 bln loss. Many of WFC's peers would probably like nothing more than to come clean with their losses.

3. Speaking of Risk Aversion...

Staples (SPLS) is up more than 15% over the past two days after reporting earnings yesterday morning that beat analysts' awful expectations. Fair enough.

Take a look at the chart, however, and you'll see that the movement is really just more of the same trend of lower lows and lower highs stretching back for months. More on that in a moment.

The conference call certainly didn't paint any pleasant macro pictures. Same store sales were down 3% for the quarter. Customer traffic was "slightly negative" and average order size was lower.

COO Michael Miles said, "We have experienced a real slowdown in the purchase of durable goods, which seems to be driven by some of the general economic trends, particularly in the housing market. Furniture has been weakest, which is a category of retail that is disproportionately skewed toward residential customers with that hardware and even computers also down in the quarter."

Overall, the message was somewhat mixed. The company performed well in terms of margin and particularly against their competition. But as Miles noted, Q4 is the most important for the company as most of their money is made in January. The company has built in a relatively soft view with their guidance, but there are risks because, even with lower comps, any macroeconomic recovery is a second half 2008 story, not first half, the company said.

Last but not least, there was one interesting question on the call that hits directly at corporate risk aversion. SPLS has $1 bln in cash on their balance sheet. Heading into today the stock was at 2005 levels and is on an absolute PE ratio cheaper than it's ever been on a valuation basis, so why hold onto all that cash? CFO John Mahoney said, "We've seen many occasions when companies have regretted large share buyback programs and as a result we think that slow and steady is going to win the game in the end."

But, since SPLS bought back 180 mln shares in the current quarter, which is 720 mln annualized, Colin McGranahan from Bernstein pressed the issue further: "That's not even using your free cash flow, let alone deploying the excess $1 bln in cash. So it seems like slow and steady is maybe a little too slow here." Mahoney's reply? "We appreciate the feedback."

4. Why Do We Care About Bond Insurers?

MBIA (MBI) and Ambac (ABK) are among as many as eight bond insurers facing potential credit-rating downgrades by Moody's, Fitch and Standard & Poor's.

This is not new news. In fact, all three credit rating agencies have taken somewhat unusual measures to warn the market of potential forthcoming downgrades, which Minyanville outlined on the Buzz back on November 5.

Ambac appears more likely than MBIA to face a credit-rating downgrade, according to Fitch Ratings. Ambac CFO Sean Leonard, while speaking at a Bank of America (BAC) conference yesterday morning, noted a number of things that, while meant to be confidence inspiring, were actually worrisome because of the levels of stress the comments conveyed.

Leonard said the company is in "capital maintenance mode" to "defend the AAA credit rating." The company has therefore scrapped a planned share buyback, which is certainly not what shareholders wanted to hear.

Meanwhile, MBI is considering reinsuring assets, as well as possibly selling debt or equity, and the bad news for shareholders is that the company will probably reduce new business to allow capital to rebuild.

Why do we care what happens to these bond insurers? Until recently, had you even heard of Ambac or MBIA? Consider what it is that bond insurers do, as a business. They guarantee the interest payment and principal on debt in the event of a default.

Ten to 12 years ago, we used "Insured by MBIA" as a selling point for retail investors. It was part of the term sheet we would show to potential clients. In those days bond insurers mostly focused on municipal bonds.

However, in recent years they've branched out to insure asset-backed securities and collateralized debt obligations. Why? Because insuring asset-backed securities and CDOs was an attractive, high-margin business with apparently little risk. After all, bond insurers for the most part only guaranteed the highest-rated portions of the CDOs, the AAA-rated tranches. Unfortunately, we now know those AAA rated tranches were not quite as risk-free as they seemed.

Fitch's, Moody's and S&P rating agencies have downgraded some AAA tranches in CDOs the bond insurers guaranteed to junk status. More downgrades are likely to follow. The ratings cuts are important because a downgrade by the ratings agencies can trigger "payouts" by the insurers. The concern is that the bond insurers are not adequately capitalized in the event of defaults.

In a conference call this morning, ABK CEO Robert Genader said Ambac and MBIA together have over $14 billion in claims paying resources available.

5. Orange County II?

Speaking of CDO and asset-backed securities insurers...
Who might want an insurer such as an MBIA or Ambac to provide credit enhancement for their structured finances? The Florida State Board of Administration, for one, might like to have some insurers backing their short-term structured finance investments.

According to Bloomberg, Florida local governments and school districts pulled $8 billion out of a state-run investment pool after learning that the money-market fund contained more than $700 million of defaulted debt.

The State Board of Administration manages about $42 billion of short-term investments, including the pool, as well as the state's $137 billion pension fund. Almost 6%, or $2.4 billion, of its short-term investments consist of asset-backed commercial paper that has defaulted, Bloomberg reported.

Florida's pool, the largest of its kind in the U.S., may have to consider filing for bankruptcy protection if withdrawals from other investors continue.

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