Countrywide's Final Days

This post first appeared on Minyanville.

Countrywide (CFC) has suffered a spectacular fall from grace.

Once the largest private mortgage lender in the country, Countrywide has been at the epicenter of the credit crunch since it first began last summer. The firm’s subsequent implosion was swift, culminating in a bailout-style takeover by Bank of America (BAC) late last year.

Shareholders will meet today to vote on that deal. By all accounts, however, the meeting is merely a formality: The merger has the support of the entire board as well as 14.7% owner Legg Mason (LM). Shareholders have little choice but to accept the bid.

Many observers -- myself included -- wrongly predicted the takeover would fall apart before it got this far. Countrywide’s balance sheet is littered with home equity loans and mortgage-backed securities of dubious quality. Its legal department is swamped by investigations and lawsuits. Layoffs, disturbing headlines about rampant fraud and a drop-off in business have decimated the once-proud company.

Not without irony, the Wall Street Journal reported this morning that Illinois would become the first state to formally file charges against Countrywide for its role in the mortgage crisis. The lawsuit alleges the company -- and CEO Angelo Mozilo -- engaged in deceptive lending practices, duping borrowers into taking out mortgages they had no hope of repaying.

Illinois Attorney General Lisa Madigan said the company disregarded borrowers’ inability to repay loans and issued new mortgages with the sole intention of gaining market share and feeding Wall Street’s hungry securitization machine. The state is seeking an injunction to stop all pending foreclosures and is demanding that all loans issued through “unfair and deceptive” practices be modified or canceled outright.

Mozilo, already under investigation for suspiciously timed stock sales, is named personally in the suit. Madigan says the CEO had intimate knowledge of the company's policies and procedures and should be held accountable for his firm's actions.

On a conference call last summer, Mozilo described the mortgage market as a battleship, one it would take years to turn around. Indeed, during much of the boom, Countrywide acted as if it were the ship’s commander: throwing its weight around, bullying competitors with its sheer size and dominating each market in which it played.

Now it’s under attack, besieged on all sides by the homeowners it claimed to serve and the regulators who looked the other way during its years of excess.

The company Mozilo founded with his life savings 40 years ago was once revered as an exemplar of virtuous capitalism. It will now be remembered as the most ruthless of corporate marauders - a case study in unchecked power and a losing battle fought by corporate ethics against the bottom line.

Fannie, Freddie Can't Stop Housing Freefall

The following post first appeared on Minyanville.

Fannie Mae (FNM) and Freddie Mac (FRE) aren’t turning out to be the housing saviors Congress hoped they’d be.

In an attempt to lower mortgage rates and bolster plummeting property values, Congress recently expanded the reach of the two government-sponsored entities (GSEs) to include so-called jumbo mortgages. The plan, pushed through despite heavy criticism, allowed Fannie and Freddie to enter the market for loans beyond their previous limit of $417,000.

Regulators hoped that the GSEs would use this massive influx of cash to thaw the frozen housing market, jumpstarting lending and bringing interest costs down for struggling borrowers. Much to the chagrin of both bureaucrats and real estate lobbying groups, Fannie and Freddie opted instead to improve their own financial condition, rather than that of the American homeowner.

Bloomberg reports that the GSEs used looser lending restrictions and lower capital requirements to buy their own mortgage-backed securities, buoying prices and soothing their ailing balance sheets.

The National Association of Realtors -- the trade group which aims to single-handedly save the housing market through the sheer inaccuracy of its upbeat forecasts -- predicted that the GSEs would buy $150 billion of jumbo loans this year. Analysts at UBS put the figure at only half that number. Recent data from Fannie and Freddie indicate that both predictions will be above the mark.

According to Bloomberg, jumbo mortgages accounted for almost 30% of the $2.4 trillion in new mortgages last year. Freddie estimated it would purchase a mere $10-15 billion in jumbo loans in 2008, and Fannie hasn’t yet offered an estimate. Both GSEs claim to be helping their markets, but the aggregate effect of their actions will probably be marginal at best.

Despite being virtually the only remaining source of liquidity in the mortgage market, Fannie and Freddie are simply too weak to create the unnatural market floor Congress hoped they could. Fannie and Freddie’s respective stock prices took another beating yesterday, and are down almost 30% since the announcement of their new, looser guidelines.

Earlier this year, as the GSEs followed the likes of Citigroup (C) and Merrill Lynch (MER) into the write-down abyss, Professor Depew and others at Minyanville argued that regulators were paving the way for their eventual nationalization.

Nationalization doesn’t typically bode well for shareholders.

With housing market conditions continuing to worsen and with no end in sight, investors should seriously be asking themselves what will happen if the GSEs are indeed brought home to Washington.

Deutsche Bank Gambles on Casino

This post first appeared on Minyanville.

Bloomberg reports Deutsche Bank (DB) is trying its hand at interior decorating.

The German banking giant is now the proud owner of the 40% completed Cosmopolitan Resort & Casino, the latest project going up on the Las Vegas strip and adjacent to The Bellagio and MGM Grand (MGM).

After New York developer Ian Bruce Eichner defaulted on his $760 million loan in January, Deutsche Bank took over the multi-billion dollar development. Bank representatives are getting their hands dirty, touring the site and even critiquing plans for a black-and-white décor, according to Bloomberg.

Deutsche Bank is one of the many financial firms now sifting through the rubble of its self-inflicted real estate woes. Although defaults on commercial real estate loans are still relatively low, Wall Street banks like Lehman Brothers (LEH), Morgan Stanley (MS) and Merrill Lynch (MER) are being dragged down by eroding value of commercial mortgage-backed securities, or CMBS.

And while CMBS holdings are wreaking havoc on already battered balance sheets, defaults on bridge and construction loans may cause bigger headaches for the banks.

When these loans go sour, lenders end up owning properties. Unfamiliar with how to build a massive resort-casino or soaring condo complex, banks are now begrudgingly becoming real estate developers and property managers.

The trend is mirroring a similar one on the residential side of the fence, as foreclosures leave banks holding thousands of individual homes and condos. Property upkeep and sales efforts are creating huge cost centers, not to mention absorbing precious human resources badly needed to address a myriad of other problems.

Whether it’s a McMansion in California’s central valley, a condo in Miami Beach or a casino on the Vegas strip, banks are faced with a difficult choice: Pony up millions in development costs or dump assets at fire sale prices. The former creates a slow bleed of cash, while the latter means banks take a big hit now. Without the infrastructure to handle owning properties or the balance sheet to absorb more losses, most banks are ill-equipped for either choice.

The result will be years of real estate supply, both commercial and residential, that owners aren’t crazy about holding on to. Seasoned developers are readying themselves for the opportunity of a lifetime to snatch up unwanted properties. The catch, of course, is that there may be no one left to lend them money to do so.

FCC Probes Product Placement

This post first appeared on Minyanville.

In the movie The Minority Report, commuters are bombarded with strikingly personalized advertisements. Steven Spielberg’s adaptation of the 1956 short story by science fiction visionary Philip K. Dick depicts retinal scanning billboards that speak to customers by name. Protagonist John Anderton (Tom Cruise) is told, “John Anderton, you could use a Guinness right now.”

Indeed, being hunted by the Washington D.C. Precrime police, he could have.

Habitually anti-establishment, it’s not surprising sci-fi authors frequently take jabs at increasingly pervasive ad campaigns. Now, The Federal Communications Commission (FCC) seems to be jumping on the bandwagon.

According to The Wall Street Journal, the FCC is taking a hard look at product placement and whether consumers deserve more disclosure when companies surreptitiously hawk their wares. With the advent of TiVo (TIVO) and other ad-skipping technology, advertisers are scrounging for ways to better reach their clientele.

Perceptive television-watchers have undoubtedly noticed name brands creeping into their viewing experience. The Journal cites Coco Cola’s (KO) prevalence on Fox’s (NWS) American Idol, where judges carefully display their refreshments logo-out. Meanwhile, NBC’s (GE) The Biggest Loser is the most saturated show on network television, with 3,977 instances of product placement in the first three months of 2008.

The FCC is concerned such ads don’t give consumers sufficient information about which companies are subliminally vying for their discretionary dollars. Advertisers contest product placement isn’t done with malicious intent, and that such promotions are done in a clear and straightforward manner.

Digital video recording, however, isn't responsible for the advent of product placement in television and film. After all, who can forget Reese’s Pieces (HSY) undeniable pull on a certain memorable extra-terrestrial or Wayne and Garth’s shameless product-placement parody.

Well-targeted spots are advertisers’ raison d’être. Online stores like Amazon.com (AMZN) offer detailed recommendations based on past purchases and analysis of consumers with similar preferences. Google (GOOG) even scans email content to deliver ads that better fit users’ interests.

Surely the FCC has more important issues to tackle than this one. The recent spike in product placement is a natural response to a technology that renders traditional advertising ineffective.

If consumers are unable to discern between a prominently displayed soda can and a 30-second ad spot, advertisers should consider theirs a job well done.

Sky-High Fares Here To Stay

This post first appeared on Minyanville.

Would-be travelers are keeping their fingers crossed the air will soon seep out of what many are calling a bubble in crude. Certainly, that will bring relief from sky-high fuel prices. Airlines can then drop all those silly fees. Life can return to normal.

If only it were that simple.

Earlier this week, Scott Kirby, President of US Airways (LCC), shed some light on the future of fare hikes and fees. Given its current cost structure, the airline needs to charge $700 per passenger per flight just to break even - well above its current average ticket price. Whether it's fare hikes or surcharges (for additional luggage, meals, pillows and blankets), prices are either going up or airlines are going down. Some believe both will come to pass.

Oil prices have remained stubbornly high, despite interventionist political rhetoric, offshore drilling proposals and ineffective summits in Saudi Arabia.

Then yesterday, a change in China's energy policy offered a ray of hope that surging global demand may begin to taper off. Chinese authorities are scaling back oil subsidies and pushing up domestic fuel prices. Analysts hope bigger tabs at Chinese pumps will slow what many believe is the unnaturally high demand such subsidies create.

But even if crude tumbles, it will offer little solace to travelers.

Not only has persistently high crude doubled fuel expenses over the last year and all but eroded the industry's already thin margins, but the lion's share of cust-cutting was undertaken after 9/11, leaving airlines with few options going forward.

Competitors like Northwest Airlines (NWA), United (UAUA) and Delta (DAL) are trimming the fat where they can, reducing capacity and canceling flights simply because they lose money each time a plane takes off.

Consider that the next time your flight is canceled due to “weather” just as the sun shines and a gentle breeze blows in off the putrid swamps of Secaucus, New Jersey. Yet another failed attempt to fly out of Newark International Airport.

Finding the Bottom in Housing

This post first appeared on Minyanville.

The Holy Grail de jour of financial market prognostication is predicting the bottom in housing. It's a fool's errand, however. Investing based on a perceived end to declining property values has so far been a losing proposition.

Unlike equities and futures, the housing market has no central clearing house: The Plunge Protection Team's reach doesn't extend to real estate. Try as they may, Beltway bureaucrats can't create a false bottom in home values.

Nevertheless, economists at UCLA are out with a report that uses a single data point as evidence that California's housing market may be recovering. They call a recent upswing in sales in Riverside County (east of Los Angeles) a "very dim flicker of the light at the end of the tunnel."

That a few bargain hunters are testing the waters isn't a sign of stabilization. Witness Billionaire investor Joe Lewis' failed attempt to call a bottom in Bear Stearns. Values can't fall forever, but to say the market will recover "eventually" isn't terribly helpful.

To hazard an educated guess about when home prices will stop falling, it's necessary to understand the mechanics of a real estate transaction and what still needs to happen for property values to put in a meaningful bottom.

Homebuilders like KB Home (KBH) and Toll Brothers (TOL) continue to clamor for handouts from Washington to stem the decline. Rational market players, on the other hand, recognize that until prices return to more traditional levels of affordability, said bottom will continue to be elusive.

Contrary to what's reported in the mainstream press, the fundamental factor putting pressure on home prices isn't the rising tide of foreclosures. The National Association of Realtors and politicians who pander would like us to believe that banks, saddled with impaired assets, are unloading properties at below market value and exacerbating the downward spiral.

Bureaucrats aren't necessarily wrong in trying to prevent repossessions (the impact of a family being forcibly removed from its home is on many levels costly), but targeting foreclosures is characteristic of government policies that address the symptom rather than the cause.

Minyanville's Mr. Practical has long argued the most visible manifestation of the current financial malaise -- illiquidity -- is just a symptom of the true problem: bad debt. Likewise, foreclosures are the most visible part of a phenomenon that's preventing meaningful price discovery in the residential real estate market.

Goldman Sachs estimates that 30% of U.S. homeowners will be upside-down on their mortgages by the end of the year. Also known as being "underwater," being upside-down puts a borrower in the unenviable position of owing more on his home than the home is worth.

For the market to find a sustainable bottom, sellers need to reduce their asking prices to levels average homebuyers can afford. For upside-down homeowners, this isn't an option.

To repay the bank in full, an underwater borrower must put up the difference between the sale price and the outstanding balance on his mortgage. Refinancing would require the same out-of-pocket cash - something most troubled homeowners don't have. Many are choosing to simply walk away, a trend Professor Shedlock has covered in detail.

As a result, properties sit on the market for months, the seller unwilling to budge for the simple reason that he can't. This adds to the latent supply on the market and further depresses prices.

The latest in a wave of housing bailouts now making its way through Congress attempts to address this issue. Meanwhile, the free market, as it's apt to do, is solving the problem itself. Market-based solutions will get the job done regardless of the bickering and posturing that goes on in Washington. Those eager to call a bottom and snap up distressed assets would be wise to exercise patience; these workouts take time.

Mortgage market participants are solving the problem of upsided-own borrowers in two primary ways. First, opportunistic investors are buying delinquent mortgages at a discount to par and forgiving part of the borrower's loan balance. They then write a fresh loan for less than the new, lower property value.

If that didn't make any sense, don't worry. If it were easy, everyone would be doing it. Here's an example of how it works.

Let's assume in 2005 Snapper the Turtle bought a brand new McMansion from Cassidy's Craftsman Cottages for $500,000. He made a $50,000 down payment and took out a $450,000 adjustable rate mortgage (ARM) from the Bank of Boo. Unfortunately for Snapper, his lovely 5,000 square foot model home on a 5,500 square foot lot is now worth just $400,000. Snapper's ARM just reset and he's fallen behind on his mortgage payments.

The Bank of Boo's balance sheet is loaded with delinquent mortgages just like Snapper's and management is actively jettisoning non-performing loans. The bank auctions the loan to investors, who bid based on the property's resale value and Snapper's credit profile. Their goal is to buy the mortgage on the cheap and restructure it, turning a profit.

Hoofy's Hedge Fund, a specialist in distressed debt, snaps up the loan for a mere $0.60 on the dollar, or $270,000. Now the owner of Snapper's loan, Hoofy forgives part of Snapper's debt and writes a new mortgage for 80% of the value of the house, or $320,000. Hoofy covers the amount he paid Boo for the mortgage and pockets the difference: $50,000.

So, Hoofy turns a profit, Boo gets a problem loan off its books and Snapper gets a second chance. Since the transaction was completed prior to foreclosure, Snapper's credit is even salvaged.

Hedge funds and other vulture investors have raised vast pools of money to invest in distressed mortgage assets, some trying to execute this strategy with hundreds of millions of dollars. But Ph.D.'s in Greenwich, Connecticut dreaming up complicated structured finance models don't know the first thing about loan workouts. So, hoping they can make up for sloppy implementation with scale, they outsource the logistics, use valuation models to approximate home prices and lower profit expectations. The logic sounds eerily familiar to what got us into this mess in the first place.

As they're extraordinarily labor intensive, loan workouts, like the one described above, work best on a small scale. Successful firms take it one loan and borrower at a time and are conservative in their property valuations. The home's value represents not only the maximum amount for the new loan, but an investor's downside risk should the deal go sideways.

The second method for handling upside down mortgages is old fashioned litigation. Lawyers reach out to troubled borrowers and offer to negotiate with lenders or mortgage servicers on their behalf - for a hefty fee. However, this segment of the market is wrought with fraud, as slick attorneys and shady mortgage brokers can easily prey on desperate homeowners at risk of losing their homes.

Respectable firms, on the other hand, are doing a brisk business. The most successful are targeting lenders who wrote so-called "liar loans," where borrowers weren't required to provide verification of income or assets. The lender (or servicer) then has two choices: Forgive enough principal to bring the loan balance below the new property value, or take a trip to the local courthouse.

The threat of lawsuit hinges on the borrower and attorney proving the bank unfairly coerced the homeowner into taking out a mortgage they could never reasonably afford. The borrower effectively pleads ignorance. With the complexity of exotic loan products cooked up during the boom by the likes of Countrywide (CFC), Bear Stearns and Washington Mutual (WM), it's not a hard case to make. Fearful of the lousy headlines, many banks are more than willing to settle and give the borrower a second chance.

Simple loan modifications like the ones proposed by Hope Now and Project Lifeline don't address the root of the problem. They delay the inevitable, as borrowers are stuck making loan payments despite being upside-down. Houses just sit on the market, which prevents healthy price discovery from clearing out the glut of supply.

Until this inventory is worked through the system, home prices will continue to fall. Rather than watching publicly released housing data for signs of a bottom, watch the spread: When the difference between asking and selling prices returns to rational levels, we've found the bottom.

Until then, let the prognosticators prognosticate, forecasters forecast and economists make educated guesses about bottoms they can't predict. Savvy investors will take advantage of truly undervalued assets. It's just a question of who can be patient enough to wait this out.

LinkedIn Cashes In

The following post first appeared on Minyanville.

Social networking is moving from infancy to adolescence, as the market landscape evolves and competing business models vie for superiority.

Venture capitalists are betting LinkedIn can thrive in an increasingly crowded space, as a consortium of investors are pouring new money into the company. According to The Wall Street Journal, a $53 million capital raise brings the company's total value to $1 billion.

LinkedIn targets professionals looking to keep in touch with their peers, enabling users to find past colleagues, recruit new employees and troll for potential business partners. In contrast to rivals Facebook and MySpace, LinkedIn charges for access to the site's most valuable information. The company claims it's profitable, earning money from subscription fees, online advertising and recruiting services offered to big companies.

The new investment is the latest in a trend of money being thrown at social networking sites with the hope they can turn eyeballs into dollars. News Corporation (NWS) scooped up MySpace for $580 million in 2005; in October 2007 Microsoft (MSFT) paid $240 million for a tiny stake in Facebook; and just last month Comcast (CMCSA) bought address book management site Plaxo for $175 million.

LinkedIn CEO Dan Nye claims the company plans to remain independent, but speculation is swirling about an outrigh purchase or IPO.

Meanwhile, competing networks jockey for users. Facebook and MySpace are seeking pure scale, offering everything to everyone, attracting customers with a myriad of services and products. Capitalizing on their user base is proving to be difficult, however, as the companies are struggling to turn a profit. In a slowing economy, the banner advertising business model is increasingly hard to maintain.

LinkedIn, along with other niche players like Plaxo and Minyanville's Exchange, are trying a more targeted approach. They aim to connect users with like interests and look to capitalize on productivity instead of the creation of a virtual cocktail party.

The debate then hinges on whether users prefer one catchall network, or individual memberships to a series of more exclusive clubs. Think velvet ropes versus free shots, a debate rages with no apparent end in site.

Chiquita Slips on High Costs

This post first appeared on Minyanville.

Food-makers are struggling to maintain margins as persistently high commodity prices pressure already slim margins. Some firms are even shrinking boxes to sustain profitability. Unfortunately for Chiquita Brands (CQB), it can't sell half bananas.

Yesterday, the purveyor of bananas and other fresh fruit warned investors of an ugly third quarter. The company said higher input costs, bad weather in Latin America and weak seasonal demand for fruit will push it to a loss for the quarter ending July 31st. Shares traded down sharply, off 28%. Competitor Fresh Del Monte Produce (FDP) also took a beating, tumbling nearly 16%.

Chiquita said that although its banana prices are steadily rising, tepid demand and thinner margins are eating into profits. The company expects to return to profitability later in the year, indicating an expectation that higher fertilizer and fuel costs will subside and more normal buying patterns will return.

In an effort to fend off skyrocketing commodity prices, food makers like Chiquita are being forced to pass higher input costs along to consumers. Professor Depew notes some firms are resorting to smaller sizes in an attempt to bring their offerings more in line with shrinking demand. General Mills (GIS) is reducing cereal box sizes, Wrigley (WWY) is dropping the number of sticks in each package of gum and Coca-Cola (KO) and Pepsi (PEP) are ditching the 20-ounce soda in favor of the smaller, 16-ounce size.

Other companies, like Kraft (KFT) and Sara Lee (SLE) are simply raising prices.

Fruits and vegetables aren't what one would normally consider discretionary purchases. Unlike plasma TVs and Nintendo Wiis (NTDOY), humans don't survive very well without vitamins and minerals. But as consumers trade down and opt for more affordable food items, nutrition often suffers. If this trend continues, we could see our already abysmal diet slide further into the deep fryer.

AIG Sends CEO Packing

This post first appeared on Minyanville.

Reeling from huge losses in its financial products division, a federal inquiry over questionable accounting and a barrage of angry shareholders, American International Group (AIG) is the latest big financial services firm to shake up its top brass.

The Wall Street Journal reported over the weekend that AIG's board of directors forced out CEO Martin Sullivan, replacing him with its chairman, Robert Willumstad. Sullivan had been under pressure for months ater unexpected writedowns and faltering shareholder confidence overwhelmed the insurance giant.

The company joins a dubious group: Citigroup (C), Merrill Lynch (MER), Bear Stearns, Wachovia (WB) have all sent their chief executives packing since the credit crisis began 12 months ago.

Late last year, AIG assured investors its balance sheet was safe and that its investments were sound and well-hedged. Months later, the firm announced massive losses and raised $20 billion in fresh capital. Shares plunged and now hover at levels not seen since 1998.

Professor Shedlock notes that, according to the Financial Times, AIG had written $78 billion in credit default swaps on ill-fated collateralized debt obligations (CDOs). Translated into English, AIG was on the hook if the CDOs went sour. They did, it was.

AIG's largest shareholder, Hank Greenberg, who ran the company for four decades, led a group of angry investors in slamming management for its missteps. Regulators joined in, alleging the company misrepresented the value of various mortgage-linked assets. The board succumbed to the pressure, ousting Sullivan at a special board meeting yesterday in New York.

Willumstad now has the herculean task of repairing the massively complex company Greenberg engineered from what was once a relatively simple insurance business. According to The Journal, AIG has its fingers in insurance, derivatives, asset management and aircraft leasing. The former Citigroup president and co-founder of private equity firm Brysam Global Partners hopes to draw on a long banking career to turn the firm around.

AIG is emblematic of the far-reaching effects of the credit crunch. The company didn't originate or securitize subprime mortgages, but it played an active role in the shadow banking system. What was once a significant profit center is now a cancerous tumor, destroying the firm's balance sheet from the inside. As we enter the second year of the ongoing crisis, we can expect the fallout to extend outward, ensnaring companies further and further from its epicenter.


Position in WB

Exxon Latest in Gas Station Exodus

This post first appeared on Minyanville.

Despite record fuel prices, the painfully large sums we're spending at the pump aren't affording gas station operators an early retirement.

Most operators barely turn a profit on the gas they sell, raking in a whopping 11 cents per gallon, according to The Wall Street Journal. Stations buy the gas from refiners, who purchase crude on the open market or drill for it themselves. Oil prices have been rising faster than refined gasoline prices, so margins have been shrinking for the retail operators.

Exxon Mobil (XOM) announced yesterday it's had it with the measly returns on selling gas to consumers. Following the industry trend away from the retail gas station business, the oil giant plans to unload the 2,200 stations it still owns.

The move may come as a surprise to gas guzzlers familiar with Exxon's brand, but the industry has been gradually shifting away from the retail market for years. Most stations are actually run by distributors, who simply get the gas and logos from Exxon and other big oil companies. BP (BP) expects to be rid of its company-owned stations in the U.S. by the end of next year and Conoco Phillips (COP) is nearly out of the business all together.

Further pressuring pump profits are retail stores looking to use their clout and existing customer base to take business away from traditional station operators. The Journal reports cheap gas sold by Wal-Mart (WMT), Costco (COST) and Home Depot (HD) has further depressed stations' margins.

Gas stations ultimately make most of their income from convenience stores. Their precious pennies of profit on actual gas sales are eaten away by credit card fees, so they depend on customers wandering into their mini-marts. Professor Depew notes, however, consumers are shifting away from some of these discretionary purchases. Coca Cola (KO) and Pepsico (PEP) are getting rid of their 20-ounce soda bottles, as consumers do less consuming. Tighter credit conditions and the economic slowdown are reducing purchases like candy and soda, so gas station operators may be further squeezed.

Gas prices have reached such heights that demand at the pump has finally started to wane. This means stations have less pricing power, as more customers are choosing to take public transportation or ride their bikes to work. In what may be the ultimate irony of the U.S.' current bout with oil prices, we may see gas stations going out of business en masse - just as the dollars dumped into their coffers bring the consumer to its knees.

This Bid's For You

This post first appeared on Minyanville.

Lost in the travails of Wall Street's latest round of executive downsizing, a $46 billion takeover could place one of America's most iconic corporations under foreign control.

Belgium-based Inbev, the world's largest brewer, made an unsolicited bid late yesterday for American beer-maker Anheuser-Busch (BUD). Bloomberg reports Inbev has strong support for its $65 per share bid from a consortium of banks, including Banco Santander, JP Morgan (JPM), Deutsche Bank (DB) and others. The offer will be financed with $40 billion of debt, reducing the amount of stock Inbev would have to sell to raise capital for the deal.

Inbev's stock popped on the news, rare for a suitor in a takeover situation. Typically an acquiring company will see its shares fall on such news, as investors fret about the cash it may have to shell out to complete the deal.

Despite some public statements opposing the sale of his great-great grandfather's firm, Anheuser-Busch CEO August Busch IV may not have much choice in the matter. The family owns less than 4% of the company's stock, a smaller share than Warren Buffet's Berkshire Hathaway (BRK-A). In an email sent to vendors and employees, Busch said the decision on whether to accept Inbev's offer would be made in the shareholders' best interests.

Attempting to assuage concerns about the status of the Budweiser brand in the U.S., Inbev will reportedly adopt the Budweiser name and has promised not to close any domestic breweries. Still, the transaction faces stiff opposition from labor unions (and those who stubbornly refuse to drink beer that doesn't taste like elephant urine).

The takeover would follow recent consolidation in a beer industry hell bent on collapsing competition. According to The Wall Street Journal, SAB Miller is set to combine its U.S. operations with Molson Coors (TAP) and Heineken NV and Carlsberg AS are buying and splitting up the assets of U.K. brewmaster Newcastle PLC.

With shares of Anheuser Busch trading just shy of the $65 offer, investors are voicing their approval for the deal. And with battered banks backing the bid, the deal supports the thesis -- long-proposed on Minyanville -- that consumer staples will be pockets of strength as consumers focus on needs, not wants.

Beer is a classic recession-proof consumer item. Their questionable taste notwithstanding, Budweiser and Bud Light are poised to capitalize on these shifting consumer priorities. The two already account for more than half of the beer consumed nationwide, and with a little help from their Belgian friends, they may someday actually taste like, well, beer.

CalPERS Rolls Dice With Retirement Money

This post first appeared on Minyanville.

For years, federal and state workers, along with employees of large corporations, relied on the security of their pension funds for retirement. But facing demands for higher returns, fund managers have opted for riskier and riskier investments. For the California Public Employees' Retirement System, or CalPERS, one such investment has turned sour.

The Wall Street Journal reports LandSource Community Development LLC, a partnership in which CalPERS owns a majority stake, filed for bankruptcy late Sunday. Although it secured a $135 million credit line from Barclays Bank PLC (BCS) to pay for bankruptcy-related expenses, LandSource's future is still uncertain.

In February 2007, CalPERS dumped almost $1 billion into the venture, which owns a vast amount of undeveloped land just north of Los Angeles. The transaction netted $660 million apiece for homebuilder Lennar (LEN) and hedge fund Cerberus Capital, which had previously shared ownership of the investment.

CalPERS' timing couldn't have been worse.

Raw land was in high demand during the housing boom. Homebuilders churned out McMansions miles away from city centers as buyers were willing to travel long distances to and from work for bigger, safer, cheaper houses. Now, with the real estate bubbled popped, fuel prices at record highs and the economy slowing down, that same land is being dumped at pennies on the dollar.

Homebuilders, strapped for cash and incurring huge losses on falling land values, are trying desperately to unload unused tracts. Financial Week reports that last month Centex (CTX) sold three properties with a book value of $528 million to a group of hedge funds for $161 million. According to Moody's, big homebuilders like D.R. Horton (DHI), Pulte Homes (PHM) and Toll Brothers (TOL) have written off almost $20 billion in land impairments.

All this adds up to a mess for CalPERS - the fund could lose its entire investment. The developer claims LandSource will emerge from bankruptcy and turn a profit when the real estate market stabilizes. It neglected to mention, however, when that impending stabilization would occur.

Defaults On Prime Mortgages Spike

This post first appeared on Minyanville.

Economic data in the past two days supports the view that the American consumer may finally be rolling over.

This morning's non-farm payroll data showed the biggest jump in unemployment since 1986, from 5.1% to 5.5%. While job losses were in line with analysts' expectations, the increase in joblessness caught investors off guard. Yesterday on The Buzz & Banter, Mr. Practical hinted the data would be worse than expected.

As for mounting evidence the economic malaise is spreading up the socio-economic ladder, data released yesterday from the Mortgage Bankers Association shows prime mortgages are following their subprime brethren into the abyss.

According to The Wall Street Journal, 39% of subprime borrowers with adjustable rate mortgages are at least one month past due, while 10% of prime adjustable rate mortgages, or prime ARMs, are late on their payments. Prime defaults, however, are rising more rapidly. Earlier this year I discussed how this trend would lead to the next subprime.

The prime market dwarfs that of subprime loans. While many are looking at Alt-A -- the market between prime and subprime -- as the next shoe, prime is far and away the bigger risk.

Prime mortgage-backed securities, especially those backed by Fannie Mae (FNM) and Freddie Mac (FRE), are structured to handle very few losses. Even though prime default rates are still much lower than subprime on an absolute basis, deviations from historical trends blow up securities, no just high delinquency rates.

Mathematical models used to create mortgage-backed securities analyze historical data to predict default rates and movements in the prices of homes. Property values have already fallen more than expected, reducing the worth of mortgage-backed bonds. As delinquencies rise relative to historic norms, prime securities will face the same cash shortfalls that have destroyed the value of subprime bonds.

Money center banks like JPMorgan Chase (JPM) and Bank of America (BAC) have thus far skirted many of the same subprime-related losses that ensnared Citigroup (C) and Merrill Lynch (MER). Their focus on borrowers with better credit has helped keep them out of the mire.

As economic conditions worsen and home prices continue to fall, prime securities will become increasingly toxic. The fallout is likely to materialze in 2008 or early 2009, but its a very long train, running down a very steep hill. Investors would be wise to step aside and let it pass.

Mortgage Companies: A Courtroom Drama

This post first appeared on Minyanville.

The City of Baltimore and Wells Fargo (WFC) are engaged in a legal fight over who's to blame for the city's foreclosure problem. The row highlights the broadening search for guilty parties in the collapse of the mortgage industry.

MortgageDaily.com reports Baltimore has filed a lawsuit alleging the San Francisco-based bank is responsible for "tens of millions of dollars" in lost tax revenues. During the past seven years, Wells Fargo accounted for 313 of the 33,000 foreclosures filed in Baltimore. The city claims Wells intentionally marketed predatory loans to minorities, many of which ended up in foreclosure.

As a result of the increased foreclosure activity, Baltimore lost tax revenues, incurred property maintenance costs and had to boost police and fire protection in the affected areas. Despite the relatively small share total foreclosures, the city claims Wells should shoulder part of the burden.

For its part, Wells Fargo dismissed the claim as unfounded. It also countered with the assertion that the city is responsible for its own troubles, largely stemming from its policy of assessing liens for unpaid utility bills. The city sold the tax liens to investors, who then forced borrowers to pay exorbitant fees to keep their homes. In its motion, the bank said homeowners were forced into foreclosure for unpaid water bills as low as $272.

States and municipalities are stepping up legal proceedings, looking to recoup cash and punish lenders that may have been involved in predatory lending. The State of Massachusetts just filed a similar lawsuit against Option One Mortgage Corporation, a subsidiary of H&R Block (HRB).

Many of the court cases focus on the effect of predatory lending on minority communities. Plaintiffs assert that lenders targeted minorities for loans with higher interest rates than comparable white borrowers. Such discrimination lawsuits have ensnared many of the country's biggest lenders, including Wells Fargo, Option One and Countrywide (CFC). The lenders vehemently deny any wrongdoing.

The lawsuit parade in the aftermath of reckless subprime lending has only just begun. In January of 2006, privately held Ameriquest Mortgage coughed up $325 million to resolve a predatory lending class action lawsuit. Despite the settlement, the company denied the allegations.

Although much of the focus on mortgage-related losses is centered on delinquencies stemming from adjustable rate resets and eroding economic conditions, the potential for massive class action lawsuits could further impede the industry's recovery efforts.

The storm brewing on the horizon is in the form of Option Adjustable Rate Mortgages, or Option ARMs. These loans allow borrowers to choose from a variety of interest payments, some of which result in negative amortization (see number five).

Complicated loan terms were in many cases not fully explained, and falling home values are exacerbating borrowers' already precarious position. Impending rate resets (see chart below, courtesy of Credit Suisse) will set off another wave of delinquencies. Borrowers -- and their attorneys -- will demand retribution.

Click to enlarge image

It's no coincidence that the biggest issuers of these loans, Countrywide, Bear Stearns (BSC) and Washington Mutual (WM), have suffered the most during the mortgage crisis. Wachovia (WB) is also in the hot seat, as its ill-timed and now well publicized purchase of Golden West saddled the Charlotte-based bank with over $100 billion in Option ARMs. 60% of that portfolio is located in California, where property values are falling precipitously.

Future litigation will shape the regulatory response to the mortgage crisis. State authorities are already clamping down on the previously unregulated mortgage brokers and other small originators. Tighter restrictions will thwart some of the predatory practices prevalent during the boom, but they will also increase borrowing costs.

Mortgage industry professionals counter that overly restrictive regulations will lock out borrowers with mediocre credit. Faced with a web of rules and potential legal liabilities, banks just won't lend to anyone on the fringe of traditional loan qualifications.

Lenders need to be held accountable for their transgressions, especially if it can be proven they unfairly discriminated on the basis of race. Regulators will overreact, as they're apt to do. Despite its best efforts to rationalize away the need for tighter lending requirements, the mortgage business will feel the pain from its excesses for longer than many would like to believe.

Rating Agency Overhaul Falls Short

This post first appeared on Minyanville.

So much for accountability.

The Wall Street Journal reported yesterday of the striking of a preliminary deal between New York Attorney General Andrew Cuomo and Standard & Poor's (MHP), Moody's Investment Corporation (MCO) and Fitch Ratings.

Under the proposed settlement, the three major debt rating firms will change the way they're paid for evaluating non-prime mortgage-backed securities. No fines will be imposed for their role in the collapse in value of bonds they once rated as investment grade. Despite the billions of dollars lost as a result of their shoddy reviews, the agencies will not admit (nor be forced to admit) any wrongdoing.

Cuomo hopes the new plan allows rating companies to be tough on issuers, while still generating income. Simply, agencies will charge issuers for reviewing potential securities and, if selected to rate the deal, earn an additional service fee. Additionally, agencies must disclose on a quarterly basis which deals they've reviewed. It's expected the increased transparency will help investors better evaluate the relationship between issuer and rater.

While the new fee structure is a step in the right direction, it fails to address the root of the issue. As I noted earlier this year:

The problem is one of incentives. As long as rating agencies are paid by the issuers of securities rather than investors, they'll be financially motivated to hand out generous ratings. In the for-profit business of rating debt, business is awarded to the firm that provides the best ratings.

Any marginal benefit from increased transparency will be wiped out by the impact of higher borrowing costs. The new fee structure is likely to increases ratings-related expenses, which will no doubt be passed on to investors. Investment banks like Lehman Brothers (LEH), Goldman Sachs (GS) and Merrill Lynch (MER) -- already under intense pressure to sustain profit margins -- aren't about to shoulder the extra burden alone.

The rating agencies were an integral part of Wall Street's debt experiment gone wrong. Regulators had the opportunity to make a bold statement: That those responsible for the implosion of the credit markets would be held accountable. Instead, the lack of material change in the relationship between issuer and rating agency demonstrates the ongoing unwillingness of regulators to police the very markets they're charged with monitoring.

Professor Macke's take on Moody's and S&P is perhaps blunt, but not unreasonable: "[The rating agencies] don't have to justify the myriad 'one off' mistakes they've made over the years, but rather their very existence."

LIBOR On Shaky Ground

This post first appeared on Minyanville.

One upshot of the ongoing credit market turmoil has been a sharp increase in new acronyms added to the financial lexicon. The London Interbank Offer Rate, or LIBOR, is one such noteworthy addition.

LIBOR measures the rate at which banks lend to one another. When banks become skittish and seek higher return for additional risk, LIBOR goes up. Conversely, LIBOR moves downward when fear abates and lending loosens up. Depending on whom you ask, the rate is tied to $150-$350 trillion in financial assets.

In recent weeks, the integrity of the data collected to determine LIBOR has come into question. Banks were accused of misrepresenting their borrowing costs to contain fears the financial markets were unraveling. As the demise of Bear Stearns (BSC) proved, those concerns were warranted.

Each morning, the British Bankers' Association, or BBA, surveys 16 banks -- including Bank of America (BAC), JPMorgan (JPM) and HSBC (HBC) -- about their borrowing costs. It tabulates the results by tossing out the four highest and lowest values and taking the average of the remaining data points.

After weeks of deliberation over the alleged misrepresentations, the BBA announced Friday it wouldn't change its methodology. Bloomberg reports the BBA said it would "increase oversight" and called the issue "very serious."

That LIBOR's integrity has come under scrutiny is somewhat worrying. That an unregulated body responsible for the maintenance of the most widely used benchmark in finance can't be bothered to safeguard its practices is cause for outright alarm.

One expert told Bloomberg, "LIBOR is an inherently flawed index. [It's] an unresolved problem as it's not based on actual trades and actual borrowing costs but on people's guesses. Either it will die or it will change."

But the likelihood of LIBOR going away is slim. According to The Wall Street Journal,
in addition to the trillions of dollars in complex derivative investments based on the benchmark, $900 billion in subprime mortgages are tied to LIBOR.

If the myriad of failed mortgage bailouts has proved anything, it's the inability of the mortgage servicing industry to coordinate its way out of a paper bag. Servicers have the thankless job of collecting mortgage payments and chasing down borrowers if they don't send in checks.

It was fantasy to assume the industry could have affected such broad change with any degree of success. Even if regulators had concluded LIBOR's flaws were serious enough to warrant a switch to another benchmark, little could have been done. Any attempt to alter such a vast quantify of mortgages would be a disaster.

The financial markets are already crippled by mounting losses that don't appear to be abating. They now must creep along on a shaky foundation, one which fewer and fewer participants trust to weather even a mild storm. Landfall, indeed, will be a doozy.

Fast Food Wins, Diets Lose

This post first appeared on Minyanville.

Whether on the latest iteration of Playstation (SNE) or Xbox (MSFT), parents spend a sizable chunk of their disposable incomes on gaming. But a new study by market research firm the NDP Group reveals parents of childern under 15 spend even more money on fast food than they do on books, music, movies and, yes, video games combined.

This is bad news for proponents of a healthy lifestyle and the children themselves, but music to the ears of fast food chains McDonald's (MCD), Burger King (BKC) and Wendy's (WEN).

Sure, fast food chains are pushing healthier menu items, but a quick scan of the nutrition data reveals that "healthier" is relative. For example, McDonalds' Grilled Snack Wrap, a seemingly benign combination of chicken, lettuce and tortilla, has twice the fat of even the most indulgent six-inch sandwich from Subway.

Rising food prices are squeezing the budgets of families around the country and indeed the world, making lower cost options at meal time more and more attractive. While investors in the aforementioned chains may chear, their doctors -- and arteries -- will not.

For a longer-term opportunity, investors may want to look at Pfizer (PFE), maker of the popular cholesterol drug Lipitor.

Investigation Into Crude Manipulation Too Little, Too Late

This post first appeared on Minyanville.

The announcement of deeper investigations into the manipulation of oil markets raises more questions than it answers.

Recent testimony on Capitol Hill suggests that in addition to fundamental factors, bets placed by institutional investors are partly to blame for record fuel costs. Meanwhile, executives from Big Oil companies like Exxon Mobil (XOM), Chevron (CVX) and Conoco Phillips (COP) contend constrained supply and increased demand are the culprits.

The Wall Street Journal reports the Commodity and Futures Trading Commission (CFTC) isn't just examining the effects of pension funds and other large investors on commodity markets. Several ongoing investigations are exploring whether traders exploited nuance in the disjointed crude markets to illegally take profits.

In a statement, the CFTC tried to assuage concerns it's failed to properly monitor the oil markets: "It's important that people who are paying high gas prices understand the CFTC is on the case."

Oil prices peaked last week at above $135 per barrel, pushing gasoline to nearly $4 a gallon. After almost doubling in the past 12 months, persistently high crude prices have finally garnered real attention from Congress. Washington is considering imposing restrictions on crude traders, limiting their ability to speculate.

Fresh off a series of ineffective mortgage bailouts, regulators and bureaucrats alike are clamoring to demonstrate their aptitude for -- and commitment to -- consumer protection ahead of November's election. That the CFTC is just now getting around to keeping tabs on oil traders points to the ongoing inability of regulators to police the very markets they're charged with monitoring.

The Securities and Exchange Commission and the Federal Reserve ignored the mortgage business while it spiraled into a speculative bubble. Failure to enforce their own rules is one of the primary factors that contributed to the current crisis: billions of dollars have been lost, millions of homeowners are losing their homes and property values are in a free-fall with no signs of stabilization.

Now, only after high gas prices have started to seriously threaten the broader economy, are regulators bothering to take action.

If the CFTC follows the pattern of the SEC and the Fed, their efforts to protect consumers from financial markets gone mad will come too little, too late.

Exxon's Activist Shareholders Fall Short

This post first appeared on Minyanville.

Sometimes $40 billion just isn't enough.

Yesterday, Exxon Mobil (XOM) shareholders failed to pass a measure that would have created the role of independent chairman at the world's biggest refiner. The influential Rockefeller family led the push -- as it's done for several years -- which it hoped would encourage the company to focus more on environmental concerns.

In responding to the proposal, The Wall Street Journal reports Rex Tillerson, Exxon's chairman and chief executive, said the company has a "corporate responsibility to see that the world has enough fossil fuels for its growing energy demands." He acknowledged, however, that the company needs to do more to reduce its environmental footprint.

Even though the measure garnered the support of less than 40% of shareholders, some analysts still expect Exxon to split the chairman and CEO roles in two. The measure's popularity among activist shareholders may be enough to convince the company that, in order to avoid a more serious fight, decisive action is needed.

At issue is the disconnect between one company's legal responsibility to shareholders and its efforts to be a responsible environmental steward. Oil companies like Exxon and Chevron (CVX) regularly find themselves embroiled in conflicts over the impact of oil extraction. Pointing to fat bottom lines, dividends and consistent returns doesn't appease eco-minded shareholders.

Or, for that matter, all profit-minded shareholders. Some argue their push for change isn't just environmentally driven, its focused on the bottom line as well. Exxon, they argue, isn't doing enough to position itself for the future, when potential carbon legislation and supply constraints will force the company to do more to diversify away from its dependence on oil and gas revenues.

The vote may have failed to produce immediate change, but it should embolden shareholders of other companies to renew similar efforts. As owners of the companies, they do in fact have a say over how they're run.