07/04/2002 Ominous portents from the NextBank meltdown *

What appeared near financial system dislocation early in the week ended in a wild stock market advance by week’s end. For the week, the Dow added almost 2%, while the S&P500 was basically unchanged. The Transports dropped 3%, and the Utilities shed almost 4%. The Morgan Stanley Consumer index declined marginally, while the Morgan Stanley Cyclical index added almost 1%. Despite today’s rally, the broader market took it on the chin this week. The small cap Russell 2000 declined almost 5% and the S&P400 Mid-Cap index dropped almost 6%. The NASDAQ 100 mustered a 1% gain, and the Morgan Stanley High Tech index added almost 2%. The Semiconductors also gained 2%. The NASDAQ Telecommunications index was about unchanged, while The Street.com Internet was pounded for 7%. The Biotech rout runs unabated, with the major industry index down 6%. The financials were wildly volatile, with the S&P Bank index ending the week largely unchanged. The AMEX Securities Broker/Dealer index declined 1%, dropping almost 6% over Monday and Tuesday, before surging 5% today. With bullion declining about $3, the HUI Gold index dropped 7%.

General financial tumult led to whipsaw action in the Treasury market. For the week, two-year Treasury yields declined five basis points to 2.89%. At the same time, five and 10-year yields rose five basis points to 4.09 and 4.86%. The long-bond saw its yield increase two basis points to 5.53%. Mortgage-back and agency securities performed well, with benchmark yields generally unchanged to rising 2 basis points. The spread on Fannie Mae’s 5 3/8% 2011 note narrowed four to 51. The benchmark 10-year dollar swap spread widened one to 55. The yield on December 3-month Eurodollars rose three basis points to 2.30%. Spreads again widened significantly in the junk bond market and for other riskier debt instruments. The dollar index gained about one percent this week. The national heat wave pushed spot electricity prices sharply higher. Prices jumped to an 11-month high in New York, with spot prices surging in the West as well. Heat continues to support farm commodity prices. Corn jumped 1.2% this week (marking a four-year high), and soybeans were up 1.4% for the week after falling from yesterday’s 11-month high. Hog prices jumped to a six-week high.

Broad money supply (M3) jumped $39.7 billion last week, increasing growth to $176.1 billion (11.4% annualized) over the past 10 weeks. It was broad-based monetary expansion, with demand and checkable deposits increasing $15.6 billion, retail money fund deposits increasing $2.7 billion, institutional money fund deposits adding $3.4 billion, large time deposits jumping $15.8 billion, repurchase agreements increasing $6.3 billion, and Eurodollars adding $3.8 billion, while savings deposits declined $7.6 billion. Outstanding commercial paper (CP) borrowings declined $5.5 billion last week to $1.322 trillion. Domestic financial sector CP borrowings declined $13.3 billion to $1.024 trillion, and are now down $46.3 billion over the past four weeks. Interestingly, asset-backed commercial paper (ABCP) actually increased $4.5 billion to $713.1 billion. For the week ended June 26, bank holdings of securities increased $20 billion to $1.576 trillion. While holdings of Treasuries actually declined by $3.3 billion to $886.4 billion, holdings of “other securities” surged $24 billion to $690 billion. Bank holdings of “other securities” increased $42.4 billion over two weeks, and are up almost $51 billion since the end of April. With unfolding capital market problems, the banking system will have little alternative than to take up the slack by purchasing securities and increasing lending.

Today’s June employment report confirmed the continued weak jobs market and maladjusted economy. For the month, a weaker-than-expected 36,000 non-farm jobs were created. The goods-producing sector continues to shed jobs, although June’s 10,000 decline is much improved from the five-month average of 78,400. Construction jobs increased by 14,000, while the lifeless manufacturing sector dropped another 23,000 jobs (down from the five-month average of 57,500). “Service-producing” jobs increased by 46,000, the smallest gain since February. Health Services employment increased by 34,000 and the government sector added 23,000. “Engineering and Management” dropped 21,000 jobs.

It is our view that the Credit market fell deeper into dislocation early this week, with an ever-expanding number of companies losing access to finance. While the media is focused on the poor performance of the junk bond market and the inability of telecom companies to borrow, we expect the surprise going forward will be faltering liquidity in the enormous asset-backed securities marketplace. This would be a major escalation in the unfolding Credit market dislocation, one that would significantly impact general Credit availability. Unless the sharp stock market rally is capable of changing the course of Credit market problems, we would expect the surprise going forward to be increased job losses and a faltering general economy.

July 1, Bloomberg: “A failure by WorldCom Inc. to pay interest on its bonds would roil the market for collateralized debt obligations, affecting one out of eight of the securities. Of the 800 such securities in the $350 billion market, at least 100 have WorldCom debt pooled with that of other companies, said Stephen Anderberg, an analyst at Standard & Poor’s in New York. Collateralized debt obligations are bonds backed by other kinds of debt, and are held mainly by pension funds and insurers... Sellers of collateralized debt repackage corporate bonds and credit-default swaps into new securities. They profit from the gap between the interest they pay on the debt and the higher rates they get from the pool. They promise investors who buy the safest part of the fund triple-A ratings and a very low risk of default. They can do this because they put all the security’s risk into a small portion of low-rated bonds and unrated equity that absorb losses first. Fund managers complain the cushions aren’t enough and say defaults in the investment pool put the principal at risk. ‘Some of the synthetic investment-grade collateralized debt

obligations are just too leveraged to deal with one-off-shocks like this,’ said John O’Grady Walshe, who helps manage $3 billion of asset-backed debt for Zais Group Investment Advisors in Dublin.”

Our comment: It has been popular to structure “synthetic” CDOs (collateralized debt obligations) that take leveraged positions in Credit default swaps (aggressively write insurance against corporate bond defaults). Such instruments generally show high rates of return, although their leverage exposes them to the risk of collapse in the event of an atypical number of major defaults. Expecting a “post-Bubble” barrage of major defaults, it’s been our fear that some of these types of structures would soon be in serious jeopardy. We suspect that we have now reached this point, although there is little if any transparency.

If these synthetic CDOs are today at risk of “blowing up,” then the value of the insurance they have written now comes into question. This would mark the commencement of what we expect will be major counterparty derivative issues. There has been too much insurance written, and grossly insufficient financial wherewithal supporting the writers of default protection. Market players (especially the troubled global insurance companies and, likely, increasingly impaired financial speculators) are now backing away from risk, with dire consequences for liquidity in risk markets. Often, the synthetic CDOs were writing Credit default protection for other CDOs and special purpose vehicles. This protection allowed these vehicles to attain triple-A ratings, despite the underlying risk associated with the securities held by the vehicle. The nightmare scenario of escalating corporate defaults leading to busted CDOs, a dislocation in the Credit default marketplace, and a run on higher-rated CDO tranches and asset-backed securities, general Credit market illiquidity, and widespread defaults, is today not as far-fetched as it seemed just a few weeks ago.

July 1, Bloomberg: “WorldCom’s sale of $11.9 billion of bonds last May ranks as the third-largest sale of corporate bonds. WorldCom and other phone companies have borrowed heavily to fund investment in new fiber-optic networks. CDOs snapped up their bonds because they often paid higher returns than other types of corporate debt. ‘Telecom debt is one of the top industry categories seen in many CDO transactions,’ Anderberg said. S&P can’t identify the names of the issues that use WorldCom bonds as collateral either because the pools are ‘blind,’ or because the seller has asked it not to. A ‘blind pool’ means the CDO’s creator doesn’t reveal the names of the companies that have bonds in the collateral pool.”

Our Comment: What? “S&P can’t identify the names of the issues that use WorldCom bonds as collateral either because the pools are ‘blind,’ or because the seller has asked it not to.” This is one of the most disconcerting sentences I have read in some time, and I will leave it at that.

While the WorldCom fiasco and corporate debt woes are making the headlines, we’ll this week skip ahead and remind readers of very serious Credit problems that fester in the consumer-lending arena. We are the midst of a runaway Bubble in mortgage finance, with hundreds of billions of loans today quickly transacted over the Internet. The perception is that contemporary finance, with its sophisticated systems, advanced Credit scoring, and instant Credit checks, has revolutionized the safety and soundness of lending. We are anything but convinced.

The fragile underpinnings of contemporary consumer lending were brought to light this week, as the American Banker reported on the escalating cost of the failure of pioneer Internet credit card lender NextBank. It is now estimated that this failure will cost the bank insurance fund between $300 million and $400 million, rather shocking news (although I don’t believe it was covered in the Wall Street Journal). When the Office of the Comptroller of the Currency closed this bank on February 7th, it’s assets totaled only about $700 million and insured deposits were $554 million. Just a few months ago (April 17th), a spokesperson from the FDIC stated that losses were expected to be about $25 million. This proved an especially poor estimate. The ugly fact is that this bank was closed down only 30 months after NextCard acquired it. At the time, it had only $3 million of assets. NextCard proceeded to aggressively market insured jumbo CDs that enabled it to easily raise more than one-half billion of deposits. We live in an exceedingly dangerous financial environment.

The NextCard fiasco is pertinent today on many levels. For one, the company and investors believed that the company had developed a “better mousetrap” for lending – that its systems and credit scoring allowed it to capture quality borrowers through its 30 second approval process and aggressive Internet marketing. It is now clear that the Internet model of aggressive lending was an unmitigated disaster. This leaves us deeply concerned about the continuing boom in Internet mortgage lending, and how quickly enormous future credit losses can be created in the contemporary environment.

From the American Banker: “Since the FDIC took over NextBank (Feb. 7, 2002), the value of the bank’s $2 billion of credit card loans has dropped 40%, to $1.2 billion, and put the agency into a quandary. It missed its self-imposed goal of finding a buyer within three months, and now chargeoffs in the securitized portion of the portfolio – which holds the lion’s share of the damaged receivables – are about to trigger an early amortization clause, which would effectively prevent NextCard’s credit card holders from making any more purchases on their cards...NextCard, which stormed onto the scene in 1998 with a Visa card that could be obtained only through the Internet...had prided itself on selecting only the most creditworthy customers and screening out marginal or subprime applicants. However, the FDIC discovered that, because of either fraud or a failure in its screening methods, the company had customers who defaulted on their loans. Predicting that the FDIC would be left holding the bag for NextCard’s bad loans, both Standard & Poor’s and Moody’s...last week lowered their ratings on the securitized portion of the portfolio.”

Interestingly, the FDIC and the rating agencies initially expected a relatively quick sale of NextCard’s interest in its securitizations. S&P stated in March “that a purchaser will be found within the next two months.” However, things have deteriorated significantly for NextBank’s receivables, as well as the general Credit system, over the past few months. At 11.56%, charge-offs were high in January, but still provided sufficient cashflow to service the holders of the asset-backed securities. By June, charge-offs had surged to 16.61%, with the trusts now having reached the point where they no longer received sufficient cash to meet requirements (negative “excess spreads”). A negative “excess spread” over a three-month period would trigger a “breach” and force an “early amortization.” From S&P: “...if the base-rate trigger associated with each series is breached and cardholder collections are passed through to investors, [this would make] them unavailable to finance new receivables...principal collections will be passed through to the certificateholders in sequential order. Consequently, these collections would be unavailable to fund new purchases made by the cardholders.”

Let there be no doubt, when borrowers are informed that they will not be able to use their NextCard visas for new purchases, defaults will skyrocket (with rising servicing costs) and the value of card receivables (and related securitizations) will plummet. It is no mystery why there is little interest in acquiring NextBank trust assets. The NextCard experience (with loss estimates as high as 70% of deposits) does not bode well for the FDIC’s exposure to other troubled lenders. Metris ended the first quarter with deposit liabilities of $1.725 billion and managed card receivables of $11.78 billion. Providian ended the quarter with deposits of $14.4 billion and a “managed consumer loan portfolio” of $22.1 billion. How could it have ever made any sense to allow subprime lenders to finance reckless lending with insured deposits? It is also worth mentioning that Internet mortgage king Countrywide Credit ended March with over $2.2 billion of deposit liabilities.

It is interesting to observe the timeline of the NextCard fiasco. From the company’s website: “NextCard was so-founded on June 6, 1996 by Jeremy and Molly Lent…The first NextCard Visa was issued on December 23, 1997. Although many applied, only the best consumers passed the strict credit quality guidelines we established… The NextCard team is “not afraid to take chances.” The company’s founder (Jeremy Lent), CEO and president all learned their trade at Providian.

May 14, 1999: NextCard issues 6 million shares in a public offering at $20, with the stock trading as high as $40.75 before closing its first day of trading at $37. Donaldson Lufkin & Jenrette (DLJ) was lead manager.

June 9, 1999: NextCard shares surge 37% to $44 on buy recommendations from DLJ, U.S. Bancorp Piper Jaffray, and Thomas Weisel Partners.

June 17, 1999: NextCard announces that its loan portfolio has grown to $150 million and is increasing $1 million daily. The stock gains $4 to $39.

August 16, 1999, Bloomberg headline: “NextCard Buys Bank to Gain Access to Cheaper Funding.” NextCard purchased Textron National Bank with assets of less than $3 million and renamed it NextBank. From Bloomberg:“ ‘This transaction will allow us to further diversify our funding sources,’ John Hashman, NextCard’s chief financial officer, said in a statement. Gaining access to the Federal Deposit Insurance Corp.-insured ‘deposits market will further enhance our liquidity position and funding costs.’” Also from Hashman: “We expect to begin originating FDIC-insured deposits soon, and we will focus on developing a unique Internet-based experience for these consumers.”

December 9, 1999: NextCard’s secondary offering of 8 million shares at $35.94 raises $287.5 million. The company sold 4.5 million shares with selling shareholders liquidating 3.5 million shares ($125.79 million). The offering was co-managed by DLJ and Goldman Sachs.

February 22, 2000: NextCard announces $500 million of customer receivables. CEO Jeremy Lent: “We are very pleased to reach these major growth milestones ahead of the market’s expectations. Even more important, we continue to beat our aggressive growth targets while maintaining very strong parameters in the other core elements of our business model…The reason for our continued success is that we are the leaders in applying credit card target marketing techniques to the Internet channel. Our real-time profile-based pricing system, which encourages high credit quality consumers to transfer balances to us from their other credit cards, has been one of the reasons why we have been able to achieve dramatic and sustainable growth with high average balances and good credit quality.”

March 20, 2000: A Bloomberg story has company insiders filing to sell $28 million of stock, part of a record $23.4 billion of insider filings to sell shares during February 2000.

November 2, 2000: Business Wire: “Nextcard, the leading issuer of consumer credit on the Internet, today held its first annual Investor Day, during which the company provided an update on several exciting growth strategies. At the meeting, NextCard announced that it expects revenues of $1 billion in 2003, implying a three-year annual revenue growth rate of 75%. Further, NextCard initiated earnings guidance of $150 million…in 2003 and increased guidance to $75 million for 2002. The company also announced it expects that assets under management will exceed $6 billion by the end of 2003… From company President John Hashman: “We are very excited about our Company’s long term vision and growth prospects. NextCard has built the foundation for a very successful company… The opportunity in front of us is as big as ever. There is no question this works on the Internet. It is fundamentally a better way to provide consumer credit.”

But Mr. Hashman’s words were anything but the truth. From the San Francisco Business Times (Ron Leuty, Feb. 25, 2002): “In the four years since it introduced nearly instantaneous online approval for Visa cards, NextCard grew to 1.2 million accounts with $2 billion in credit card loans. It bulked up on risky subprime customers… Problems started to appear soon after the company bought the former Textron National Bank in September 1999. A routine examination by the OCC in second-quarter 2000 revealed ‘deteriorating’ credit quality… At the OCC’s request, NextCard and NextBank entered into an agreement Oct. 26, 2000, to ensure that the bank’s total capital…stayed above 12 percent of assets.”

July 25, 2001: “NextCard Reports 144 Percent Growth in Second Quarter Operating Revenue; Company Reaffirms Guidance for Fourth Quarter 2001 Profitability... Total managed loans rose over 115 percent to $1.789 billion...”

August 3, 2001: “Lent Family Trust Files to Sell 415,000 shares.” John Hashman files to sell 17,900 shares.

October 31, 2001: “NextCard, Inc. announced today that its Board of Directors has retained Goldman, Sachs & Company to explore opportunities for the sale of the Company to a larger, more established financial institutions with the resources necessary to support the Company’s continued growth. The company’s decision resulted from its belief that, given newly imposed regulatory limitations on its business operations, as well as the current market environment, it can best enhance shareholder value through a transaction with a larger and better-capitalized entity. From CEO Hashman: “NextCard has established a strong leadership position in the Internet channel, which is the fastest growing channel in the credit card business. We believe we have created tremendous value in our business model, and we should be in a better position to unlock that value for our shareholders through a transaction with a larger entity.” The stock drops to 87 cents.

February 7, 2002: NextBank closed down by the Office of the Comptroller of the Currency. “NextBank’s unsafe and unsound practices were likely to deplete all or substantially all of the bank’s capital, and there was no reasonable prospect for the bank to become adequately capitalized without federal assistance.”

February 11, 2002: FDIC mails $525 million of checks to NextBank’s depositors.

April 17, 2002: FDIC spokesman estimates loss to insurance fund at $25 million.

July 3, 2002: American Banker runs story stating FDIC now expects NextBank-related losses to the insurance fund of between $300 million and $400 million.

While off the radar screen, we view the collapse in the value of NextBank’s securitization interests as an ominous portent for the aggressive consumer lenders and their mountains of asset-backed securities. Combining the more than $400 million raised in the equity markets with the $400 million potential FDIC loss is a frighteningly large sum compared to the $2 billion of outstanding receivables. With troubles for the likes of much larger Metris, Providian, Americredit, and others, we would expect a risk-averse marketplace to move away from riskier consumer asset-backed securities. This trouble at the margin will mark a key inflection point for consumer lending generally, with reduced Credit availability at the fringes of subprime Credit cards and autos. That this sector will join the impaired corporate sector only exacerbates already significantly heightened systemic risk. It is no hyperbole to aver that the risk market is today in complete disarray.

It is today especially important to appreciate how quickly things turned sour for NextBank when it was forced to reduce its aggressive lending – how quickly the “better” mousetrap was exposed as ultra-reckless lending (and pretty close to financial fraud). Earlier in the week, it appeared that the U.S. Credit mechanism was sinking quickly into a state of systemic crisis. While a stock market rally does help to stabilize the Credit system, we unfortunately in no way believe the risk of a serious dislocation has dissipated. At the same time, we remain petrified of the disastrous financial and economic consequences that mount from the runaway mortgage finance Bubble. We suggest the Federal Reserve, bank regulators, and the Office of Federal Housing Enterprise Oversight take a cold, hard look at the NextBank Meltdown.