Michael Shulman's Sell Short

I have not written for a long time - roughly a month - as the market has turned me into a hermit. I am afraid of the people in my industry, recommending or buying stocks based on what the person next to them just bought. My service, ChangeWave Shorts, only recommends puts so short term momentum can kill a fundamentally sound position. That being said, I sense the beginnings of a turn to rationality - a light turn, a hesitant turn, but a turn - and the first place the market should and will get rational is the banks. They led us into the mess, they led us out, and they will lead us to stagnation and decline as reality sets in.

And the bank I really don't understand - excuse me, the bank stock I don't understand - is Wells Fargo, an $8-$10 stock masquerading as a $28 plus stock and trading at a multiple well beyond the rest of the banking segment. It isn't that Wells should be valued alongside the segment; it should be valued lower than the segment due to current and future problems in its business, led by its balance sheet.

I have spent weeks pulling apart their balance sheet and reading other analysts deciphering of their financial Esperanto - a universal language no one understands. And what I present below may include mistakes but they are not of my own making - they are due to what at best can be considered willful obfuscation - a time honored practice in most financial reports - of extremely complex financial statements. But I gave it a shot using my fourth grade math and common sense.

First, let's look at the garbage - excuse ne, am I being too negative? - on the balance sheet as it is written as of March 31 according to the TARP oversight folks. The garbage bin is called Level III assets, their dodgiest class of assets (the Brits know how to con a phrase, don't they?) which according to recently and frantically revised accounting rules, is an asset without a market, leaving management free to assess and declare its value based on a model. Wells had, as of March 31, and I am using these numbers because they have been blessed by regulators, $61.7 billion in Level III assets. What are they really worth? Who knows - but even if it is 50%, which I believe would be very high, that is 23% of the company's market cap.

Second, they are using arcane - and perfectly legal - rules of purchase accounting to mask loan losses. A Wall Street Journal article (September 21) had a nice discussion of these rules. Under the rules of purchase accounting, and these came into effect when Wells purchased Wachovia, losses must be accounted for in the purchase price and subsequent paper write off and cannot be incurred after an acquisition, with the loans on the books now set at a new and lower value to reflect the write off at the time of the Wachovia acquisition. They must have been busy with Christmas because this year they have adjusted these write offs and increased them by $7.1 billion in the first half of 2009 - write offs that do not hit current earnings. This wonderful accounting chicanery can continue for one year after the merger date, so they have until New Year's eve to "discover" new losses.

It gets better. The company acquired $110 billion in what it calls Pick and Pay and everyone else calls option ARM mortgages with the purchase of Wachovia. These were valued at $90 billion and change when the deal was closed. Wells shoved a big chunk under the umbrella of purchase accounting and using these rules then got rid of $20 billion in losses. Remember that write downs under these rules do not hit your current books. Some percentage of the remainder, $38.9 billion, can still be adjusted retroactively under purchase accounting - I think, I am not sure, don't quote me - and ain't life grand? Of the option ARM mortgages still held by the company the loan to value ratio based on quarterly adjustments is 87.2% but with home prices still falling I am willing to bet - as is Meredith Whitney, who is predicting another sharp drop in nationwide home values -- this is 100% in a year. And that means owners have no incentive to stay in their homes as mortgages reset. More importantly, while the company assumes future losses on these mortgages in a manner I literally cannot fathom, but I think they are assuming a 31%-35% default rate, analysts from Goldman Sachs see almost 61% of option ARMs originated in 2007 will fall into default. The Goldman guys assumed a 10% decline in home prices, and, over time, these same analysts estimate more than half of all option ARMs ever issued will eventually default. If Goldman is correct, or close, that is 25% of, well, what? They can write off a lot of this stuff via purchase accounting. But let's be kind to me and my hard work and say it will cost them $5 billion more than they are assuming.

Third, proposed accounting rule changes would force banks, including WFC, to put off balance sheet assets on their balance sheet. WFC has more than $2.0 trillion of this off balance sheet nonsense - using the same acronyms, I might add, used by Enron (and that other great bank, Citigroup). Some healthy percentage of these assets can be assumed to be headed to the balance sheet if the FDIC says they agree with the FASB rules and insist banks live by them. In theory, and based on history, WFC would then have to raise enormous amounts of capital or dump assets to stay within regulatory guidelines. They cannot dump assets - they would have done so if they could have - which means pounds of new shares and shareholder dilutions. Of course, the FDIC is free to ignore GAAP rules when creating regulatory requirements and it is possible they will do so again. But the cat, let's say the cat's name is transparency, will be out of the bag and lazy investors who have yet to consider Wells off balance sheet follies will now get a closer look at them.

The off balance sheet assets are almost impossible to decipher let alone explain. The company claims, in its second quarter financial statements, that only $155 billion - or maybe 7% - of off balance sheet assets will be forced onto their balance sheet. Games and more games, mainly due to the ability to loosely interpret the proposed FASB guidelines. They have concluded, and I quote their earnings statements, that "$1.1 trillion of conforming residential mortgage loans involved in securitizations are not subject to consolidation under FAS 166 and FAS 167." They do not say why--just because these are insured mortgages and they according to someone's interpretation of the new rules, do not have to hit the balance sheet (I was unable to locate an FDIC or FASB opinion on this). I spoke with someone on the staff of the Senate Banking Committee - in relation to the off balance sheet assets held by Citi - and the first thing I heard was government guarantees, which shut down the conversation, so it is possible this rule, when and if implemented, will be faked, like the stress tests. But investors will have a much better idea about WFC's real exposure to the real world. If $155 billion hit the balance sheet, that would be 12% of current assets and 19% of their current loan portfolio and to my mind that means the capital base would have to increase 12%.

The company does provide a caveat to what I view as their generous analysis of the new FASB regulations. Again, I quote their second quarter 10Q. "FAS 166 and 167 are principles based and limited interpretive guidance is currently available. We will continue to evaluate QSPE and VIE structures applicable to us, monitor interpretive guidance, and work with our external auditors and other appropriate interested parties to properly implement these standards. Accordingly, the amount of assets that actually become consolidated on our financial statements upon implementation of these standards on January 1, 2010, may differ materially from our preliminary analysis..."

What about the rest of their business? They hold $330 billion plus in commercial and commercial real estate loans - one third in California and Florida - and $450 billion plus in consumer loans, including more than $117 billion in home equity lines that are second tier to primary mortgage holders and end up in the junk bin after a foreclosure. And 37% of these home equity line are in California and Florida. Need I say more?

I do not want to go through their balance sheet and earnings statement ad nauseum so let's leave it at this - their loan loss reserves are, to my mind, completely out of whack with the reality facing these portfolios, as are consensus earnings estimates. I quote that second quarter 10Q again. "We believe our balance sheet is well positioned given the current economic environment. Our allowance for credit losses was $23.5 billion at June 30, 2009, compared with $21.7 billion at December 31, 2008. Our allowance covers expected consumer loan losses for approximately the next 12 months and inherent commercial and commercial real estate loan losses expected to emerge over approximately the next 24 months." Translation - on more than $800 billion in balance sheet assets, two trillion in off balance sheet assets and in the face of 10% unemployment and contracting GDP, an all time high for mortgage defaults, credit card defaults, home equity defaults, not to mention commercial real estate problems that are beginning to accelerate, they increased net reserves less than $2 billion.

Let's go on - I may be wrong because reading their SEC filings could give a dead man a migraine, they had $3 billion in non-performing loans in Q2 that they had yet to reserve against (see what these reports do to my grammar?). To simplify, let me quote one of the only clearly written parts of their report. "The ratio of the allowance for credit losses to total nonaccrual loans was 149% and 319% at June 30, 2009, and December 31, 2008, respectively...." They saw an increase of non-accrual loans - busted loans - of $5 billion in Q2 alone, which they blamed, perversely, on purchase accounting. True, but not of the real world. And Wells had $16.6 billion (with a b) in loans more than 90 days past due - more than $10 billion without guarantees by the taxpayers. So let's say the dearth of reserves is worth another $12 billion they need to raise this year or soon.

And what about operating earnings going forward to compensate for the probable need for far more reserves? It is hard to imagine they will duplicate the $3 billion in mortgage origination fees they had in 2Q - and even if they pull it off in Q3 it should not happen in Q4. Meredith Whitney said as much the day she turned the market around with her call on Goldman Sachs, the same market that missed the last half of here statements on CNBC saying bank earnings this year would not be matched next year. Stumpf recently pounded the table, calling out Uncle Sam for messing things up and saying they were going to pay Uncle Sam back and oh, by the way, can you have Freddie and Fannie buy jumbos so we can make more mortgage origination fees.

Wells was one of the companies told to raise capital after the fake stress test results showed you can only fake something so much. They claim they can raise that capital by the end of Q3 by internally generate d means - including, in Q2, $2.7 billion in deferred tax liabilities, the same accounting gimmick that bit Fannie Mae big time.
Do they think we are stupid? Yes - and they are pretty much right. Maybe it is Buffett- but remember he values businesses based on cash and cashflow and brand, and Wells is a great consumer bank, arguably the best in the country and has no problem with cash or cashflow. Maybe it is the bellicose statements by CEO Stumpf - maybe it is their legendary customer service - maybe it is fear - but no one is calling them out. Line up ten thousand more readers and maybe we can start the hue and cry.

What will we cry out?

You need more capital.

To write off more Level III assets, someday - maybe as much as $30 billion.

To support off balance sheet assets coming on - maybe as much as $15 billion.

For greater loan loss reserves - maybe as much as $12 billion.

For more option ARM losses - maybe as much as $5 billion.

To pay back Uncle Sam - no maybes, $25 billion.

Total: $87 billion. (Maybe)

I use the word maybe because this analysis is based on financial statements that make Vladimir Putin's inner soul seem transparent. November and beyond may provide some market support for this skeptic's view of their balance sheet as FDIC guarantees of bank bonds goes away and Wells will eventually go to short term capital markets and raise money based on what people know about Wells.

The bottom line: subtract current reserves of $23 billion and you get $64 billion in new capital of some sort. Sure, I am mixing apples and oranges but in the bars around the world where real analysts do their best work, this is how calculations are done and decisions made. Slightly less than half their market cap. Cut the stock in half and you get $15 and change. Bring the multiple down to the rest of the segment and voila - $8-$10.

Simple math - works for me.

Disclosure: I have recommended to subscribers to buy puts on Wells and I have no position in the stock.

Yesterday's existing home sales numbers - down - and the new home sales number today - up less than one point - and KB Homes outlook - not so good, guys - shook some people up, especially those unwilling to use third grade math or read a balance sheet. Shorting the home builders made my subscribers a fortune and then took some of those gains away when irrationality, tax policy ad traders pushed the stocks up. And now, since all I recommend is puts, I avoid them due to volatility and outstanding short interest in many home building names. That being said, today's housing data may be the beginning of a re-adjustment on Wall Street - and as reality sinks in, the home builders should fall and a couple could - should - go bankrupt.

Where to start? How about the quotes common on the Street for the past twenty five years - "when new home starts fall below a million, they are at a bottom, cannot get worse." Housing starts have been at a half million and change for a long time. How about this one - "when inventories are above six months, the home builders will start to fall." Inventories are at nine and a half months, not including all the foreclosed homes not on the market, and the stocks have not really fallen. So, conflicting data based on historical norms.

And that is the thing to base your short position on - historical normal's do not count any more, at least not any from the past twenty years, perhaps more. Here is why. A brief summary:

• Home prices have never fallen this far, or this fast - and will continue to fall, I believe another 15%, so does banking analyst and diva- a real one, not a flash in the pan CNBC pundit - she earned it - Meredith Whitney. Housing analysts Ivy Zelman is also still very bearish.
• Foreclosures have never been so high, and are climbing, and will not peak, based on mortgage origination data, until the middle of 2011. And that means....
• Inventories will continue near all time highs and prices will continue to fall.
• Oh, did I mention, one third of all Americans would like to sell their house if they could get the right price. Makes sense - about one sixth want to every year and the market has been frozen for at least a year, more in many places.
• Combine this all with the tightest mortgage standards in living memory and you have the next chapter of home builder Armageddon.

Let's do this with some detail.

Supply

Inventory - Like all markets, the housing market for new homes is driven by the supply of new and existing homes and demand for these homes. The supply of homes, despite two years of very low rates of home building, is still way above historical norms despite the headlines. Drops in inventory do not account for the number of homes yet to hit the market but already foreclosed or in the foreclosure process. The 3.6 million existing homes in inventory represents and 8.5 month supply. Add foreclosures being held off the market - my estimate is 600,000, minimum, lowball, whatever and the 8.5 month supply is 10 months, near historical highs.

Foreclosures - The blow dried experts on CNBC with a coupe of exceptions, are all saying we are nearing a bottom - we must, new home starts are so low! They have it backwards - new home starts are low because inventories show no sign of bottoming due to foreclosures, many of them of relatively new homes. Foreclosures are accelerating as moratoriums on foreclosures, resets, and unemployment hit home owners harder and harder. To quote my favorite housing analysts, Ivy Zelman (on the CNBC blog Realty Check) "Over the past several months, we have witnessed many data points indicating stabilization and improvement in the housing market. While these data points are certainly a welcome reprieve after three long years into the housing downturn, we cannot help but focus on the elephant in the room - the ever-growing pent-up supply of foreclosures in-process... the next wave of foreclosures is not a myth, but is instead the key to the direction of the housing market over the next 6-12 months..... In total, foreclosures in-process are 88% higher than the year ago, led by prime non-jumbo (up 159%) and prime jumbo (up 152%) mortgages."" Actually, this is going to go on far longer than 6-12 months. According to Amherst Capital, seven million homes are going to be foreclosed in the coming year or two - 16 months supply at the current rate of sale, not including all other homes to go up for sale. And if you trace mortgage originations by type of mortgage, geographic area, and classification - subprime, Alt-A, prime, etc - it is easy to see foreclosures will not peak until the middle of 2011. Even if I am off six months, that is a year long than most optimists. Once a house is foreclosed, it takes 3-12 months to get it on the market - right now, it is taking longer but I am assuming this speeds up - so assume six months. That puts peak foreclosed homes into the market around the middle or end of 2011 - and with 3-6 months to sell them, you are looking for a market bottom in the first half of 2012 and inventories will not adjust until the end of that year - maybe.

Back to Inventories - As foreclosures peak, then begin to decline, and prices firm, pent up demand to sell existing homes will hit the market - remember that one third number? By 2011/2012 it will be 40% or more - four in ten Americans that own a home will want to sell it. This will add homes to inventories, depressing demand for new homes and home prices - for five to ten years.

Demand

These inventories will face vastly reduced demand for homes across the United States due to an end to massive speculation in second homes, a slowdown in hew household formation due to lingering unemployment, tightened credit standards and a much smaller shadow market for jumbo mortgages. The little blip up in home sales this past summer was due, in part, to the $8K tax credit you and I are providing to people - some analysts estimate one third of demand these past four months has been due to this credit.

Speculators: In 2006, using Freddie and Fannie and third party data, more than 40% of mortgages were for subprime and/or second homes, most of them speculative. That market is gone - for at least a decade, maybe more.

Credit Standards: At present, credit standards for mortgages other than those originated through the FHA - our money - are the toughest in a generation, perhaps more. And that is for conventional or conforming loans insured by those two paragons of financial management, Freddie Mac and Fannie Mae. The jumbo mortgage market has completely disappeared when the shadow banking market evaporated after Lehman collapsed. It ain't coming back any time soon - a few days ago the world's most highly paid cry baby, John Stumpf, asked the Feds to leave him and his bank alone, and he would figure out to how to pay them back, doggoneit - but please use Fed and taxpayer money to buy jumbos because I need the mortgage origination fees, fast. I know a two times seven figure a year attorney who cannot get a home renovation loan. This tightening of credit will cut another 10%-20% from core demand for homes from the 2006 level.

Core Demand: Real demand - people wanting to buy homes - is also shrinking as unemployment takes its toll on hopes and dreams - not to mention national income. Forget the affordability index the real estate industry mouthpieces tout on TV - it is not just what you can afford based on government statistics, it is also what you can afford if you think you might lose your job, have your hours reduced, your commissions cut or your health insurance premiums increased. It is also based on what you can put down - and if you have less equity your current house, have less ability to save because of the recession, well, the house you want is not as affordable as the real estate flaks are saying they are "RIGHT NOW!." I think reduced demand by customers is about 10% of the demand we saw in 2006 for homes.

Bottom line - core demand for housing - new homes - by people who qualify for a mortgage will be less than half of peak demand in 2006 for 3-5 years.

Home Prices

Too much supply and too little demand means fewer new homes built and lower margins. Meredith Whitney says home prices will fall another 25% -- she has been right about everything else, why not now? Barclays says 13%. Split the difference you get 19% or the median home price falling to roughly $145K. That is a very low target for many home builders. In August, home prices for new homes fell 12% year over year.

The Builders

The builders problems can be found in operating earnings - or lack thereof - and their balance sheets.

Earnings: In the last quarter of published financial data, the seven largest publicly held home builders lost $1.2 BN - and that includes $376 million in tax rebates from Uncle Sam. Since they have all refinanced recently, it is hard to measure real cashflow from operations and after interest expense. That being said, the long term debt is $16.72 billion and this should cost them at least $500 billion - perhaps more than twice that - in interest expense per year.

Balance Sheets: The balance sheets are much worse. They are, simply put, a wreck.

• The balance sheets of seven publicly held home builders shows $16.72 billion in long term against $5.4 billion in cash (cash plus AR minus AP). The current market cap is $13.96 billion - so these seven companies are worth, in the market, about $30 billion. As I mentioned, debt service will soon rise significantly - at current rates - and will rise again as rates rise. A good deal of this debt has been re-done recently but a good deal needs to be re-financed in the next 1-3 years.
• Many home builders are now carrying land on their books at the price they paid for it because this land is supposedly under development. Drive to a home site near you and take a look at what accounting driven development looks like - three people with the names Mo, Larry and Curly are working on a fence surrounding a 500 home site plot with tow homes built and a model home that has no electricity. And they have been working on that fence for two years - I have seen this three summers in a row at the same home sites in North Myrtle Beach, in Ft. Myers, in Orlando. Well, someday this land has to be written down to its real value and the builders will not only take a hit on their balance sheet but stand a good chance of violating loan covenants.
• Since you and I as happy taxpayers love paying for greed and incompetence, Congress and the IRS obliged us by letting the home builders apply for tax rebates for taxes on profits they made during the boom. These rebates supplied vital cash in 2009 and are ending. No more free cash from illusory profits made by selling homes financed by mortgages we, as taxpayers, now own also!
• The bottom line - many home builders are nearing a point in time where write downs and operating losses will lead to negative equity and to an end to liquidity - and home builders, like banks, need to borrow to build and to survive.

Of course, Wall Street traders have ignored most of this as green shoots (scallions to my mind) and momentum and technical indicators and flashing technical indicators have primed the Buy side of trades in home building stocks. Well, as Bob Zimmerman and now Will I Am sing, the Times They Are-A Changin'. And it may be a good time to short the home builders.

Let's go back to the market cap plus long term debt number - that is $30 billion. Value analysts and other people thinking Winston Churchill is still alive say this is a low price for their collective assets. Sure, right - these assets are being held at inflated values and no one knows what their current holdings are worth in the real world. These same analysts are ignoring the reality not just of no current earnings but no earnings power going forward, a coming rise in interest payments,
more write offs against current assets, not to mention falling demand for homes for a long time.

Biggest Losers

Which ones? Balance sheets and high end homes point out the first potential losers and/or bankruptcies. I measure balance sheet like the simpleton I am - long term debt divided by net cash. Hovnanian has nine times long term debt to net cash, Pulte 6 to 1, KB Homes 5.5/1, Beazer is at 3 to 1, DR Horton at 2.5 to 1, Toll Brothers at 2.2 to 1 and Lennar at 1.8 to 1.

And Hovnanian has a focus on high end homes. Best place to go short - short term.

Other candidates - those companies who have lived and breathed in the starter market - a market to be dominated by foreclosed homes in the coming 1-3 years. That puts Pulte and Beazer in harms way, medium and long term.

Longer term, the XHB, the home builders index (which does include building suppliers and like companies) should go down.