Option Armageddon Tuesday, January 8, 2008
Rumors that the largest mortgage lender in the nation is headed for bankruptcy sent its shares down as low as $5.05 today--off 34% from yesterday's close--before it climbed back a bit. The company denied the rumor.
Who knows where the rumor came from or whether it's true. You've got to imagine there are plenty of hedge funds short this thing and they'd love to spread rumors that CFC is going bust.
But CFC is indeed in a very perilous position. So bad, you have to wonder what Bank of America was thinking when they gave them $2 billion of capital for shares worth about $18.
The company has been scrambling for capital for some time in order to keep its business going. Besides the $2 billion they got from BAC, CFC is offering some of the highest CD rates in the country. The WSJ wrote about increasing competition for deposits today.
What the article doesn't discuss is why banks are scrambling for deposits. You'd think, what with the Fed priming the pump with interest rate cuts, that banks would be able to borrow from other banks to fund loan growth. Remember, banks rely on borrowed capital themselves in order to lend. They can borrow their capital from other banks, or they can borrow capital from depositors by offering CDs, checking/saving accounts, etc.
But guys like CFC are finding it hard to borrow from other banks b/c those banks know the company is in dire straits. Smart lenders don't give money to borrowers who may be insolvent. That's the primary reason short-term lending rates have tended to diverge from central bank target rates here and in Europe. Target rates are what the Fed wants banks to charge one another for short-term loans. But if banks remain scared of loaning to other banks, for fear those other banks may be insolvent, they'll keep rates high.
So if other banks can't be a source of capital for CFC to fund loans, the other choice (besides the Federal Home Loan Bank in Atlanta), is depositors. CFC isn't the only bank having trouble borrowing from other banks, so they're not the only one competing more aggressively for deposits. An increase in demand for deposits causes their price to rise. Hence, you see higher rates on CDs.
So in summary: sky high CD rates are just another indicator of how bad things have gotten for some of these banks. The likes of CFC and IndyMac are offering sky high CD rates b/c they can't get capital from other banks. So they have to pay up for deposits.
That's how these lenders are failing; they run out of capital to fund new loans. The most vulnerable banks, like American Home Mortgage, are those that rely on other banks for their capital. Banks are more capricious than depositors and when they saw AHM get into trouble, they quickly cut off the company's credit facilities. If a bank has no money to lend, well then folks, that's all she wrote.
CFC's underwriting was probably worse than AHM's; reports about the latter said they avoided subprime, yet their exposure to Alt A loans was enough to scare off its lender banks. AHM had no depositors as a backstop to fund its business, so when banks pulled the plug on AHM's credit lines, it went bankrupt in a flash.
But CFC has deposits, and depositors aren't as fickle as other banks. Put less charitably, they're not as smart. They don't see their deposits at risk until the company is near the end. When that happens, depositors all race to their local branch to pull out their money. [Remember last August when there were rumors of CFC's demise and depositors engaged in a mini bank-run? CFC was forced to respond by finding emergency capital from BAC and jacking up CD rates.] In the short-run, depositors respond to sky-high CD rates, providing what amounts to emergency capital to keep funding CFC's business.
But it's only a matter of time for CFC. They're running out of capital. Eventually depositors will see this and the run will be on. More rumors like this may get the ball rolling.
Tick, tick, tick.
Post Script: Remember when so many other lenders were going under and CFC doubled down? Instead of recognizing how dangerous the mortgage lending market had become, they scooped up hundreds of lenders AHM had fired, making a grab for "market share." Of course, there's a much smaller market left to grab, so in hindsight it seems like a foolish strategic decision. IndyMAC did that too by the way.
http://optionarmageddon.blogspot.com/2008/01/countrywide-headed-to-bankruptc y.html?ref
(But note, late news is that Bank of America, already deeply on the hook to Countrywide has been rumored to be in negotiations to buy Countrywide. See http://www.latimes.com/business/la-fi-countrywide11jan11,0,6165126.story?col l=la-home-center)
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