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Far Beyond Subprime: As Lehman Brothers FSB Goes, So Go Mortgage Assets
March 14, 2007

Far Beyond Subprime: As Lehman FSB Goes, So Go Mortgage Assets

As House Financial Services Committee Chairman Barney Frank (D-MA) fretted about the manifest dangers of subprime lending, we recalled the metaphor about the horse that already escaped from the barn. It is too late for members of Congress or regulators to do much of anything about asset quality problems facing the financial sector from the mortgage bubble, but it certainly is not too late for Frank and other MCs to posture about the issue, hold hearings, threaten legislation and thereby raise money from industry lobbying groups.

Running a close second behind Rep. Frank in terms of irrelevancy and chutzpah were the great men of finance who appeared before the Committee, led by former NY Fed President and Goldman Sachs (NYSE:GS) systemic risk honcho E. Gerald Corrigan. All intoned that the Congress does not need to legislate additional regulation of hedge funds, the chief and most profitable clients of GS and other major Street prime brokers, supporting the view by the Bush Administration and the Federal Reserve Board that a "hands off" approach to hedge funds is best.

Listening to officials of large funds and brokers dealers talk about the need for regulatory restraint, this when the US financial markets are on the verge of a serious "correction," strikes us as more than a bit surreal. But hey, as our old friend Jim Lucier likes to remind us, this is Washington, a city where every day is Halloween.

After all, with a former GS chief as Treasury Secretary and other GS minions sprinkled throughout the Executive Branch, "hands off" Wall Street is obviously the preferred policy position -- at least until another LTCM-scale fiasco erupts and threatens the solvency of a money center bank. See our previous comment in The IRA ("Will Sub-Prime Loan Defaults Create Another Amaranth?" February 14, 2007)

We're glad to hear that our friends at GS so far have escaped the ill-effects of the subprime meltdown, one of the benefits of having a strong fixed income sales desk. Unfortunately the same cannot be said for GS peers like Lehman Brothers (NYSE:LEH) and Bear Stearns (NYSE:BSC), two key Street firms when it comes to the mortgage sector. We don't know how either firm will do when they announce earnings this week, but we do know that the mortgage sector, and the dealers and the Buy Side accounts who own the lion's share of the risk, are headed for a significant correction that goes far beyond subprime, a fact that will affect the market perception of Sell-Side firms like GS, LEH and BSC in coming quarters.

Indeed, while the Sell Side is still celebrating past achievements, the outlook for the future is less rosy, especially if you look at the components of these investments houses which gain their profitability from the mortgage securitization business. One of the interesting indicators we watch for clues regarding the forward prospects for the condition of the mortgage sector is the largest of the three thrift subsidiaries of LEH, Lehman Brothers Bank, FSB ("LBB").

Click here to see a profile for LBB from the IRA Bank Monitor

At the end of 2006, LBB reported $19.1 billion in assets, including $14 billion in first lien mortgages and $615 million in "junior" loans. Funding for LBB comes from $15 billion in deposits and $1 billion in advances from the Federal Home Loan Bank system, all of which sits atop $2 billion in equity capital.

LBB is remarkable because during the 2000-2005 period of "irrational exuberance" in the mortgage origination sector, the largest thrift subsidiary of LEH was the best performing member of the FDIC's mortgage specialization peer group. In fact, during some quarters over the past five years, LBB was the best performing thrift in the US, period, and by a considerable margin.

LBB reported virtually no defaults in 2006 vs. 16bp for the peer group, which we generate using data from the FDIC and the powerful analytical engine inside the IRA Bank Monitor, which assigns LBB a "AAA" rating in our Basel II default probability simulation. The low loan default rate is a reflection of the fact that the loan book turns over frequently. Other clues regarding the vintage of the portfolio are the fact that LBB's assets have been slowly declining since reaching a peak of $24 billion in Q3 2005 and that that almost 30% of LBB's income comes from loan securitization, down from a peak of almost 35% in Q2 2005 and a full standard deviation ("SD") above peer.

With a gross loan yield of 802bp, LBB is over a SD above peer in terms of profitability, an impressive metric which translated into an ROA of 1.73% and an equally buoyant ROE of 18.52% as of year-end 2006. But more remarkable is the fact that 2006 was LBB's worst performance in five years in terms of ROE even though it continued to lead the FDIC mortgage specialization peer group.

Measured by ROE, LBB's performance peaked in Q1 2003 just a hair below 50%. The bank's ROA stayed in the 2.5-3% range from 2003 through the end of 2005, but then plunged down to almost peer group levels in Q1 2006. Along with the peak in asset growth, the sharp decline in ROA was a signal that the party was over in the mortgage sector. Indeed, had you been watching the deterioration of LBB's financial performance during 2005-2006, you would not have been surprised by the mortgage origination market collapse in Q1 2007.

With mortgage bankers reporting loan foreclosures at an all time high, it is only a matter of time before the markets realize that the troubles in the mortgage sector go far beyond just the subprime sector. If there were opportunities in the mortgage sector, conduits like LBB would be growing, not shrinking. In the months and years ahead, members of the mortgage specialization peer group like LBB will provide a good indication of when conditions in the mortgage sector start to improve, but it could be a long wait.

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