Thursday, December 27, 2007

Econorama - Sub prime mortgage

I've been playing with the math on sub prime. I can easily come up with $50 billion of total announced write-downs - and I'm sure that I don't have them all. However, I'm skeptical of two things: first, that the losses will really be this big; and second, that the losses are entirely related to mortgages.

If we assume that the typical sub-prime loan is $250,000, then 200,000 homeowners would have to default, pay nothing, and the houses sell for less than the disposal cost - i.e. - so that the bank receives none of its principal back, for the losses to be $5o billion.

I can see more than 200K homeowners defaulting, but it is harder to imagine that they (that is, the lenders) get zero proceeds from foreclosure sales. In researching this, one thing kept coming up - it isn't clear that all the loans that are being reserved are related to mortgages. The terms in the bank and security firm press releases and filings are more than a little murky. So, don't be surprised if it eventually comes out that some of these reserves actually covered other bad loans - e.g. LBO's etc.

Or, as the markets gradually recover over the next 2-3 years, that banks get to take some of this back into income. Not an unusual tactic: e.g. the stocks have already been hit; no matter what performance you as a bank CEO turn in, the market will overlook it because your group is out of favor, so take the biggest reserve you can justify. This will juice results in future periods because your reserves are so flush that you don't have to reserve as much, say, in 2008-2010, raising earnings in those years, and further, if those reserves prove unwarranted, release them back into earnings in a future year.....

If I'm right, then the beaten-down banks should be a good play - except that they are sourcing new capital at extraordinary costs. I'll post on that in a bit.

FD: I'm long JPM, MS, WB, and BAC.

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