How Regulatory Capture Turns Doo Doo Deadly

First off, some definitions:

• The Doo Doo, as in the Doo Doo 32: A  list of 32 banks that I created on May
  22, 2008 which set the stage for my investment thesis of shorting the
  regional banks. At that time, I was one of the very few, if not one of
  the only, to warn that the regional banks would hit the fan.
• Regulatory capture
  (adopted from Wikipedia): A term used to refer to situations in which a
  government regulatory agency created to act in the public interest
  instead acts in favor of the commercial or special interests that
  dominate in the industry or sector it is charged with regulating.
  Regulatory capture is an explicit manifestation of government failure
  in that it not only encourages, but actively promotes the activities of
  large firms that produce negative externalities. For public choice theorists,
  regulatory capture occurs because groups or individuals with a
  high-stakes interest in the outcome of policy or regulatory decisions
  can be expected to focus their resources and energies in attempting to
  gain the policy outcomes they prefer, while members of the public, each
  with only a tiny individual stake in the outcome, will ignore it
  altogether. Regulatory capture is when this imbalance of focused
  resources devoted to a particular policy outcome is successful at
  "capturing" influence with the staff or commission members of the
  regulatory agency, so that the preferred policy outcomes of the special
  interest are implemented. The risk of regulatory capture suggests that regulatory agencies
  should be protected from outside influence as much as possible, or else
  not created at all. A captured regulatory agency that serves the
  interests of its invested patrons with the power of the government
  behind it is often worse than no regulation whatsoever.

About a year and a half ago, after sounding the alarm on the regionals,
I placed strategic bearish positions in the sector which paid off
extremely well. The only problem is, it really shouldn't have. Why?
Because the problems of these banks were visible a mile away. I started
warning friends and family as far back as 2004, I announced it on my
blog in 2007, and I even offered a free report in early 2008.

Well, here comes another warning. One of the Doo Doo 32 looks to be
ready to collapse some time soon. Most investors and pundits won't
realize it because a) they don't read BoomBustblog, and b) due to
regulatory capture, the bank has been given the OK by its regulators to
hide the fact that it is getting its insides gutted out by CDOs and
losses on loans and loan derivative products. Alas, I am getting ahead
of myself. Let's take a quick glance at regulatory capture, graphically
encapsulated, then move on to look at the recipients of the Doo Doo
Award as they stand now...

A picture is worth a thousand words...

• Sun Trust: Recipient of government/taxpayer bailout, share price collapse
• Popular: Literal share price collapse. down 83%
• Countrywide: Total collapse, purchased by Bank of America. Collapse was forewared nearly a year earlier. See
  Yeah, Countrywide is pretty bad, but it ain’t the only one at the subprime party… Comparing Countrywide
• WaMu: Total corporate collapse, saved by last minute (and contested)
  rescue by JP Morgan (as was Bear Stearns, which also collapsed under
  its own weight after I clearly stated it was done for - see  Is this the Breaking of the Bear? I
  also explicitly warned about WaMu's issuess in the Countrywide link
  above. It's mortgage division took 5 consecutive quarterly losses
  starting in 2006 before the company started having corporate-wide
  issued.

• Wells Fargo: Recipient of multi-billion bailout
• KeyCorp: share price collapse
• Synovus Financial Corp: share price near total collapse
• Marshall & Ilsley: share price near total collapse
• Associated Banc: share price near total collapse
• First Charter: near collpase

You should be seeing trend by now. Here are the rest of the banks on the old Doo Doo list. Pick you poison!

M&T Bank Corp -
Huntington Bancshares -
BB&T Corp -
JPM Chase -
U.S. Bancorp -
Bank of America -
Capital One -
Nara Bancorp -
Sandy Spring Bancorp -
PNC -
Harleysville National -
CVB Financial -
Glacier Bancorp -
First Horizon -
National City Corp -
WAMU -
Countrywide -
Regions Financial Corp -
Citigroup -
Wachovia Corp -
Zions Bancorp -
TriCo Bancshares -
Fifth Third Bancorp -
Sovereign Bancorp

Now, how is it that I saw ALL of this happening and yet the regulators
didn't? Well, I posit that, due to regulatory capture, the banking
industry convinced the regulators to look the other way, not only until
banks started collapsing, but afterwards as well. We all know that the
regionals are in trouble now. Much of the trouble is due to 2nd lien
loans, and high CRE concentrations. On that note, the Reggie Middleton 2010 Commercial Real Estate Outlook whitepaper has
been updated with a few minor changes. Please feel free to download the
new version here:  CRE 2010 Overview.

So, what is being done to mitigate these problems??? Well, besides
weakening the mark to market rules which caused bank valuations to jump
in the face of continued credit deterioration in their assets, the
regulators have allowed banks like those of the Doo Doo persuasion to
gain leverage provided by the new rule FAS
115-2 (on recognition and presentation of other-than-temporary
impairments)
which came into effect in early June 2009. What does this mean? Well
for one Doo Doo bank with a very high CRE concentration, nearly 50% of
the losses are hidden from the public.  Let's walk through the
particulars...

·        
Zions has been transferring majority of its losses on valuation
on stressed debt securities to accumulated other comprehensive income (loss)
i.e. recognizing losses as a reduction in shareholders' equity.

·        
Over the last nine months till September 30, 2009, Zions has
charged 58% of its impairment losses on securities as ‘noncredit-related
losses' on securities (which are recognized in other comprehensive income
(loss)). The remaining 42% is charged through the income statement.

·      However, the company is able to do this in view of the leverage
provided by the new rule FAS 115-2 (on recognition and presentation of other-than-temporary
impairments) which came into effect in early June 2009. The company adopted the
new rules (from 1Q2009) prior to the mandatory deadline of adopting it from
2Q2009 to pop up its bottom line. Under this new rule, if the owner does not intend
to sell the security, the impairment for these debt securities is separated
into the credit loss amount (which is recognized in the income statement) and
non-credit loss amount (which is recognized in the other comprehensive income.)

The key is that the company
has a lot of discrimination in deciding the share of credit-losses and
non-credit losses, which provides a lot of leeway to the company in
terms of
the amount of impairment losses that can be transferred to "Other
comprehensive
income (loss)". As before the rule was implemented, if certain debt
securities lose market value, the losses can be recognized as a
reduction of shareholders' equity. Regulatory capital typically doesn't
count such losses. But previously, if the losses persisted into future
quarters, they usually had to be charged against income over time,
where they would deplete regulatory capital.

With the most recent "regulatory capture" adoption, management has
discretion to shuffle losses if the value drop is deemed to be that of
an market movements that are not based on the fundamentals. Management
also has leeway in determining if the securities will collect the
expected
underlying future cash flows, and if not then they have to book a
credit impairment, which does effect earnings and regulatory capital.

As illustrated in "The Doo Doo 32, revisited" and "New Research Available on the Doo Doo Bank List",
many banks are at risk from exposure to preferred securities issued by
other banks, whether directly or through derivative structures and CRE.
In the case of Zion, a CDO with initial exposure of $2.12 billion; it
now has a market value of $1.1 billion, according to WSJ - just about
half!
The WSJ also reports tht Zions has taken $712 million of market losses
on the CDOs through equity.
However, the bank's total credit-impairment charges on all of its
CDOs—not just
those backed by banks—appears to be about $315 million. This management
discretion thing is the kicker. When United Commercial Bank was seized,
its preferreds were essentially reduced to nill, yet (again according
to the WSJ), the Zion CDO model has a failure probability rate of 35%.
100% is a far cry from 35%. Zion's management states that the models
are difficult to tweak due to fraud in underwriting. Well, if you know
there is fraud, it should be modeled in. It is not that hard. If you
need help, contact me and I will help you out. This goes for any bank or investor who has an interest.

Moreover, had the company not
transferred the "non-credit losses" to "Other Comprehensive income" it would
have reported even higher losses for the last three quarters of 2009. Shown
below is the calculation for net earnings (loss) applicable to common shareholders
including the non-credit-related losses:

Of course, thestreet.com suggests this as a speculative buy. I don't think so, but what do I know.

 
Zions Bancorporation:
·         The bank commercial real estate loans to tangible common equity of 4.68x.
·         The banks’ Eyles test (a measure of banks loan loss reserve strength) is at 32.7% (i.e).
·         The bank has negative cushion of 19.8% as of September 30, 2009.
·         The banks NPA’s to equity as of 3Q09 stood at 96.9% while non
performing loans plus 90 days past due loans to equity stood at 69.9%.
·         The banks NPA’s to loans is at 6.6% while non performing loans plus 90 days past due loans to loans is at 4.8%.
·         The bank has high adjusted leverage of 18.3x.

·         The bank has market cap of $1.9 bn, share price of $13.76 and
recorded a one month return of 5.0% and one year return of -46.2%,
however the concern is that the share is already trading at low
Price-to-tangible book value of 0.7x, thus I am releasing this
information to the public.

There is another Doo Doo bank with a very high level of CRE exposure (see CRE 2010 Overview.
for more on this) that is showing cracks and is trading at a premium to
book value. Subscribers can download a snapshot and statistics here: Doo Doo 32 Member with high CRE concentration snapshot 2009-12-16 11:29:09 284.39 Kb.

Comments

[I need more asshats]

Is Zions giving away free toast-ers for every account opened?

Zions it's a shoe-in for a direct injection from Ben Shalom, JPM style.

[Anonymous]

Thank you Reggie for totally helping us get the &^%$ outta that southern fried regions bank. I just worry about the thousands in my area who are blissfully unaware.

[gjervis]

Respect for Posting Reggie, good work as usual.

[butchee]

Reggie

When are the FASB rules supposed to go back to the pre-crisis standards?  And what is your guess for when they will get another year long (better yet, indefinite?) extension?  X-mas Eve?  Boxing day?

Thanks for your always interesting posts.

[Reggie Middleton]

You know, there is this joke that is often told amongst us poor people.

A man who just lost his job gets a phone call from a bill collector.

Man: "Hello"

Bill collector: "This is Acme Collections Agency. You currently owe our client $2,000. When can we expect payment?"

Man: "Well, you can 'expect' payment whenever the hell you want!"

FASB has shown that they will bend over for special interests and political pressure. They appeared to have shown some heart a few months ago, but I wouldn't hold my breath on a constructive result.

I think the market will enforce discipline on those who hide from true market values way before FASB does. Just ask Bear Stearns, Lehman, WaMu, IndyMac, Countrywide,,,,

[tradertim]

Well, if you know there is fraud, it should be modeled in. It is not that hard. If you need help, contact me and I will help you out.

you're a smart and funny guy reggie. luv your research. you have so much energy. keep up the great work.

[agrotera]

I second that emotion

[Reggie Middleton]

thanks.