There was an impromptu picnic for the bears on Thursday, with equity investors belatedly waking up to what is going on in the nearby market in toxic CDOs.
Cue a concerted ripping up of all those rosy forecasts, fed by the promise of progressively cheaper money.
Take Morgan Stanley, home of the Super Bull. The bank has simply flipped its outlook on other big banks, swapping an “Attractive” recommendation for a “Cautious” warning across the sector.
Why? Well, Morgan Stanley’s Betsy Graseck and her team now reckon there will be contagion from the subprime housing sector – first to prime housing and then to car loans and then to credit cards.
We are lowering our price targets based on rising probability of our bear case and greatly diminishing probability of our bull case. We see further downside risk to EPS if a consumer credit recession spills into corporates.
It seems that there were four “key inputs” that caused Ms Graseck’s conversion:
First, we did work on bank capital allocation in 3Q07 which suggests that banks are reducing their capital allocated to consumers, adding to the capital market
squeeze that started in July.
Second, we dug into the subprime reset question and now anticipate that subprime delinquencies are likely to rise sharply as $77B of subprime resets are due in 4Q07, $70B above expected subprime loan supply.
Third, home prices are expected to decline 6.5% in July 2008 y/y, suggesting that in 2008 the median household will look like the Florida consumer. This has negative implications for consumer credit quality as Florida contributes 25% of the country’s most
severely delinquent MSAs.
Fourth, conversations with our CDO strategist, Vishwanath Tirupattur and our Chief Economist, Dick Berner, who share our concerns that subprime delinquencies could rise and that a consumer credit recession is probable.
That’s caused the MS team to churn out 35 pages of charts and bank “snap shots,” none of which are particularly easy on the eye. Take this example on Citi — off more than 7 per cent in early trade in New York on Thursday:
We are downgrading Citi to Underweight from Overweight based on concerns we have about its CDO portfolio, subprime consumer exposure, SIV exposure, and thin capital levels. Citigroup is the 2nd largest CDO arranger, arranging $25 billion YTD 2007, just after Merrill’s $31 billion. We are baking in an additional $1.1 billion in CDO writedowns in 4Q07 based on our expectation that S&P’s CDO ratings changes announced on October 19 were not reflected in C’s CDO mark in 3Q07, and another $1.0 billion in 1Q08 based on our outlook for deteriorating subprime consumer delinquency.
On subprime, Citi has the largest subprime exposure in our group at 13% of loans and 5% of earning assets. We have a sharper increase in consumer losses at Citi based on this heavier subprime composition.
On SIVs, Citi is a manager of roughly $80 billion in SIVs. While they do not have liquidity backstops to their SIVs, they will lend at arms-length, exposing Citi to potential losses. Given that there is no disclosure on these loans, it is hard to estimate the magnitude of these potential losses, but we do bake in deteriorating corporate credit in the investment bank.
Lastly, Citi’s capital levels are among the thinnest in the group at 7.4% tier 1 and 3.0% tangible equity/tangible assets, leaving it more vulnerable to shocks and less able to take advantage of market opportunities.