Highlighting FHA Exposure
In light of today's news about BAC hindering the HUD foreclosure investigation, we are revisiting Bank of America's exposure to potential losses from the FHA insured loan pool.
Bank of America currently holds $20B in 90+ days delinquent FHA-insured loans on its books, up from just $400 Million two years ago. When a loan defaults from a GNMA trust, BAC buys it out of the trust to minimize the servicing advances on the loan. Since these loans are insured by the FHA, Bank of America should theoretically have no associated liability. However, we doubt that this will be the case.
Return of the "Fantastical Stretch"
Our primary concern around BAC's exposure is that they would be subject to a suit analogous to the May 4, 2011 Dept of Justice suit against Deutsche Bank. As we wrote when the lawsuit hit the news in early May, "The US Attorney said in the press conference that it would not be a "fantastical stretch" to expect other institutions to face lawsuits, while the general counsel for HUD added that HUD would make "appropriate referrals" to the DoJ wherever they suspect underwriting fraud."
Recall that the DoJ sued Deutsche on behalf of the FHA under the False Claims Act, which permits triple damages. The treble damages is a punishment clause intended to dissuade businesses from defrauding the government. As the GSEs are not technically government entities this law did not apply to them, but the FHA is a direct government agency. The FHA alleged that Deutsche had lied about its underwriting policies on 39,000 loans originated between 1999 and 2009, of which 12,500 later defaulted. The FHA had paid out $386M in insurance on the contested loans. If all $386M in insurance payments was a False Claim under the law, Deutsche's liability could be more than $1B.
Afterparty at the FHA
As the chart below demonstrates, credit quality at the FHA deteriorated significantly in 2007-2008. At the same time, volume increased sharply on both a market share and absolute basis. This is a classic case of adverse selection. The subprime party ended in 2006/2007 and the party then migrated to the "afterparty" at Fannie and Freddie where it carried on for about 18 months. Beginning in early 2008 and continuing still today the "after-afterparty" has been at the FHA. If anyone doubts this, have a look at the loss curves associated with late vintage FHA loan books. The bottom line is that the FHA will ultimately get around to seeking recourse on what was clearly terrible underwriting. The Deutsche case was the first shoe to drop, but there will undoubtedly be others.
GSE Putbacks as a Model - Liability Likely $4.5B+
To get some idea of the magnitude of potential losses from FHA loans, we can use the GSE experience as a guide. Bank of America has disclosed that the GSE delinquent loan pool is $109B. The table below walks through the steps to determine ultimate loss content. Bear in mind that this methodology is predicated largely on BAC's own numbers and estimates, which likely understates the problem. The bottom line is that BAC will likely end up paying $8B+ on $109B in delinquent Fannie/Freddie loans, or a loss rate of 7.3%.
Looking at only the $20B in 90+ FHA loans currently on BAC's balance sheet, and applying a 7.3% loss rate, the minimum liability would be $1.5B. This doesn't take into consideration defaulted loans no longer on BAC's books (where the FHA has already paid the insurance claim).
Keep in mind that if the Department of Justice were to pursue BAC under the False Claims Act, as they have with Deutsche, BAC would be exposed to triple damages. On our math, that works out to at least $4.5B. This would be in addition to the $25 billion we already think they're on the hook for (see our table below for details).
Chinese Water Torture
For Bank of America, housing exposures keep adding up. We estimated in our 5/10/2011 note ("BAC: Another Big Charge is Coming in 2Q11 as Home Prices Fall Faster") that BAC is likely to see another $1B write-down related to the GSE settlement in 2Q, based on ongoing declines in home prices. Further, the PCI book is significantly exposed to downside in home prices - we estimate potential further losses of 10-30% on the $41.7B book, or $4-12B, over the next several years. Again, all of this is in addition to the $25 billion itemized in the table above and the $4.5 billion enumerated on the FHA front. Moreover, Bank of America will have a substantial share of the eventual servicer settlement (we estimate $6.7 billion here), when it is finalized in the likely not-too-distant-future. For those keeping score, that's a sum total of $45.2 billion.
Given this magnitude of loss content coming down the pike, we think it goes without saying that it's justified for BAC to be trading well below tangible book value until some clarity emerges to contradict these estimates.
Joshua Steiner, CFA
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Conclusion: Inventories of nickel are set to increase due to more tepid demand and increasing production, which will lead to lower prices. Deflation of the Inflation is bad for commodity producers, but positive for consumers.
In the 1940s, the nickel industry was a monopoly in the literal sense of the word as Canada’s Inco controlled more than 90% of the global nickel market. Today, the production of nickel is much more diversified with the largest producer, Russia’s Norlisk Nickel, holding roughly 20% of the global market share. Just behind Norlisk in terms of market share is Vale SA, a Brazilian company, which acquired Inco in 2006. While still a concentrated industry in terms of production, the price of nickel is very much driven by supply and demand, especially as its correlation with the U.S. dollar weakens. (Incidentally, the United States has no active nickel mines.)
Nickel is a metallic element and is the fifth most abundant element in the earth, after iron, oxygen, silicon and magnesium. Close to two-thirds of new nickel is used to make stainless steel. Alloys containing nickel are known for their strength, toughness, and corrosion resistance. These attributes make nickel critical to many industries. Construction and transportation account for 37% of nickel demand and 18% is used in machinery and electrical applications.
Similar to many commodities, China is a primary driver of global nickel demand given the vast urbanization trends. Specifically, China consumes about a one-third of the world’s nickel and is the world’s largest producer and user of stainless steel due to its rapid growth and urbanization. Not surprisingly then, much of the recent decline in the price of nickel, and really many commodities, can be attributed to slowing growth in China. In the chart below, we show the price decline over the past month, though it is still above its estimated marginal cost of $17,500 to $20,000 per metric tonne.
In the short term, decline in demand for nickel from China is being attributed to stainless steel mills being shutdown, Chinese power shortages (see a note by Darius Dale on this point from June 1st, 2011, “Asia’s Power Struggles Part 1”), and monetary tightening by Chinese authorities. In fact, Chinese steel giant Baosteel indicated that they expect Chinese steel consumption to grow 5-7% over the next five years, which is a deceleration, but consistent with the most recent 5-year plan from China. This is also consistent with recent comments from Norlisk, whose Chief Analyst indicated:
“Primary nickel usage will expand more than 5 percent this year, compared with 15 percent in 2010.”
More broadly, we’ve charted below Chinese steel imports and nickel and alloy imports, both of which highlight a decline in demand from China in 2011 versus 2010.
Interestingly, nickel inventory, as measured by the London Metals Exchange, has actually been trending down since the start of the year, which is obviously a bullish factor for price. That said, over the past three years, the trend of nickel inventory has been up and to the right, as we show in the chart below. Looking past the short term drawdown in nickel inventory, there are two factors that should drive a growth of inventory: 1) growing use of nickel pig iron by China and 2) accelerating global nickel production.
On the first point, Chinese production of nickel pig iron, which is a low cost substitute for refined nickel, is set to increase up to 50% this year from 160,000 tons in 2010 to 240,000 in 2011. Production of nickel pig iron will continue to accelerate into 2012. To the second point, there are a number of projects that are coming over the next five years that will add significant production. In fact, according to Wood MacKenzie, the largest five projects alone will produce 220,000 tons of nickel, with the bulk coming online in 2012 and 2013.
As commodities prices continue to trade more in line with their fundamental supply and demand drivers, nickel is a commodity that is increasingly looking like it has price downside over the intermediate term.
Daryl G. Jones
Conclusion: Keith just shorted JCP in the Hedgeye virtual portfolio. And I quote... "Very few things are easy in the life of a short seller - but re-shorting iJCP here is." People are looking for a 'transformational change', but they'll need to wait til Spring 2012 for a clear articulation -- and it will need plenty of capital. Margins going down before they go up again.
I’m not saying that the guy is not a retailing genius, but when you have the best content in the world, no competition, a customer that has no price boundaries, and an unlimited SG&A budget, it does make it a bit easier to be a ‘visionary’.
JC Penney, on the other hand, has some of the worst content (over-indexed to mid-tier private label), endless competition, a cash-poor customer, and the most limited SG&A budget in retail. I don’t care if you took the equivalent of what Sam Walton was to retail when he founded Wal-Mart in 1962…if you don’t deploy capital, you can’t grow.
Look at JCP over time. Can anyone explain to me how JCP grew square footage by 12% over the past 8 years (after they sold Eckerd to CVS), but held SG&A flat at $5.7bn? This thing has been cut bone dry. Opportunities to cut more costs to improve margins are extremely slim. It needs to invest in SG&A, Capex and the right working capital (which is tough to do without the R&D/marketing [i.e. SG&A] to back it) in order to turn JCP around. All of the ‘retailing 101’ best practices have been put in place.
I cannot imagine that anyone coming in from a place as high-profile as Apple with such a wide-open checkbook would come into JCP and not demand the same.
Heck, maybe Mr. Johnson a retailing god, and he does things in a way that none of us can imagine (a la Apple). But it won’t be without taking JCP’s margins down – by a long shot – to make it happen.
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