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Bank Stocks Headed Lower Until Asset Valuations 'Get Real' - Research Note on Banking Sector by Oppenheimer Research - Prepared by Meredith Whitney, Joseph Mack and Kaimon Chung

Bank Stocks Headed Lower Until Asset Valuations 'Get Real' - Research Note on Banking Sector by Oppenheimer Research - Prepared by Meredith Whitney, Joseph Mack and Kaimon Chung

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Research note by team at Oppenheimer Research (CIBC) led by Meredith Whitney laying out a strong case why US bank stocks still had some ground-scraping to do.

The report was issued in July 2008.

To read Meredith Whitney's [in]famous and prophetic note on Citi (downgrade from Strong Perform to Strong Underperform) issued on October 31, 2007, please see:

1) Is Citigroup's Dividend Safe - Downgrading Due to Capital Concerns - Analyst Report by Meredith Whitney of CIBC: http://www.scribd.com/doc/17204493/Is-Citigroups-Dividend-Safe-Downgrading-Due-to-Capital-Concerns-Analyst-Report-by-Meredith-Whitney-of-CIBC
Research note by team at Oppenheimer Research (CIBC) led by Meredith Whitney laying out a strong case why US bank stocks still had some ground-scraping to do.

The report was issued in July 2008.

To read Meredith Whitney's [in]famous and prophetic note on Citi (downgrade from Strong Perform to Strong Underperform) issued on October 31, 2007, please see:

1) Is Citigroup's Dividend Safe - Downgrading Due to Capital Concerns - Analyst Report by Meredith Whitney of CIBC: http://www.scribd.com/doc/17204493/Is-Citigroups-Dividend-Safe-Downgrading-Due-to-Capital-Concerns-Analyst-Report-by-Meredith-Whitney-of-CIBC

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Categories:Business/Law, Finance
Published by: Customs Street Advisors on Jul 09, 2009
Copyright:Attribution Non-commercial

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07/08/2009

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Meredith Whitney
212-667-6897
Meredith.Whitney@opco.com
Joseph Mack
212 667-7285
Joseph.Mack@opco.com
Kaimon Chung, CFA
212-667-7675
Kaimon.Chung@opco.com
See "Important Disclosures and Certifications" section at the end of this report for important disclosures,including potential conflicts of interest.See "Price Target Calculation" and "Key Risks to Price Target" sections at the end of this report, whereapplicable.
July 15, 2008
FINANCIAL INSTITUTIONS/US Banks
Bank Stocks HeadedLower Until Asset Valuations "Get Real"
SUMMARY
For the financial markets to stabilize, we believe banks need to swiftly address trueasset values and adjust their books accordingly. As assets have repeatedly beenmarked down over the past year in what seems like a constant game of "catch up,"investors have grown understandably wary of valuations and accordingly haverevalued bank stocks with significantly lower valuations.
KEY POINTS
We believe that banks' carrying valuations on mortgage related assets are stilltoo high, but it varies by degree. While Case-Shiller is currently pricing 33%peak to trough house price declines, banks like Wachovia are using 12.9%(OFHEO index) assumptions. We note, even FRE and FNM no longer useOFHEO as a guide post as it has been proven far more unreliable than anyother estimate. While banks such as BAC and JPM (through 2008) are using30% and 24% peak to trough declines, respectively, banks such as C are using just 20% peak to trough assumptions. Note, Case-Shiller is already pricing over 15% declines from peak levels to date.
Within this report, we build on our prior themes, notably the issue of downwardpressure on home prices driven by growing supply of housing inventory anddramatically diminishing demand created by a notable lack of availableleverage. As we do not expect the "buyers strike" for structured products whichhas lasted now for a year to end anytime soon, we do not expect thissupply/demand phenomenon to change anytime soon.
Because the securitization market provided close to 85% of U.S. mortgagesfrom over the past decade, its absence means a commensurate absence of available funding. Since 70% of U.S. homes are mortgaged, a shutdown in sucha crucial part of the lending market has enormous consequences. Put simply,less demand and more supply translates directly into lower prices.
Due to the fact that Housing Price Appreciation assumptions are the mostimportant variable assumption in a mortgage asset valuation, the fact that allbanks under our coverage have unrealistic HPA assumptions will in our opinionlead to a material and protracted writedown and capital pressure scenario for the banks well into 2009.
EQUITY RESEARCH
INDUSTRY UPDATE
Oppenheimer & Co Inc. 300 Madison Avenue 4th Floor New York, NY 10017 Tel: 800-221-5588 Fax: 212-667-8229
 
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 
 
For the financial markets to stabilize, we believe banks need to swiftly address true assetvalues and adjust their books accordingly. As assets have repeatedly been marked downover the past year in what seems like a constant game of “catch up,” investors have grownunderstandably wary of valuations and accordingly have revalued bank stocks withsignificantly lower valuations.We believe that banks’ carrying valuations on mortgage related assets are still too high,but it varies by degree. While Case-Shiller is currently pricing 33% peak to trough houseprice declines, banks such as Wachovia are using 12.9% (OFHEO index) assumptions.We note, even FRE and FNM no longer use OFHEO as a guide post as it has beenproven far more unreliable than any other estimate. While banks such as BAC and JPM(through 2008) are using 30% and 24% peak to trough declines, respectively, banks suchas C are using just 20% peak to trough assumptions. Note, Case-Shiller is already pricingover 15% declines from peak levels to date.Within this report, we build on our prior themes, notably the issue of downward pressureon home prices driven by growing supply of housing inventory and dramaticallydiminishing demand created by a notable lack of available leverage. As we do not expectthe “buyers strike” for structured products which has lasted now for a year to end anytimesoon, we do not expect this supply/demand phenomenon to change anytime soon.Because the securitization market provided close to 85% of U.S. mortgages from over thepast decade, its absence means a commensurate absence of available funding. Since70% of U.S. homes are mortgaged, a shutdown in such a crucial part of the lendingmarket has enormous consequences. Put simply, less demand and more supplytranslates directly into lower prices.Due to the fact that Housing Price Appreciation assumptions are the most importantvariable assumption in a mortgage asset valuation, the fact that all banks under ourcoverage have unrealistic HPA assumptions will in our opinion lead to a material andprotracted writedown and capital pressure scenario for the banks well into 2009.
US Banks
 
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Bank Asset Valuations Show Dramatic Divide in UnderlyingAssumptions
Below we present the Case-Shiller 10-City Composite Index, our banks’ (and FNM andFRE) assumptions for peak to trough declines of the Index, and the traded futures of theIndex. Each and every financial institution currently estimates a lower decline in housingprices than the futures market.
Exhibit 1. Bank HPA assumptions
 
BAC is 3% more optimistic than Case-ShillerFuturesCase-Shiller Futures forecaset33% peak totrough decline in housing pricesC and FRE are 13% more optimistic than Case-Shiller FuturesWB (using OFHEO) is 20% more optimistic thanCase-Shiller FuturesJPM (thru 2008) 10-12% and FNM 8-13% moreoptimistic than Case-Shiller Futures
100120140160180200220240
   J  a  n  -   0   0   J  u   l  -   0   0   J  a  n  -   0   1   J  u   l  -   0   1   J  a  n  -   0   2   J  u   l  -   0   2   J  a  n  -   0   3   J  u   l  -   0   3   J  a  n  -   0   4   J  u   l  -   0   4   J  a  n  -   0   5   J  u   l  -   0   5   J  a  n  -   0   6   J  u   l  -   0   6   J  a  n  -   0   7   J  u   l  -   0   7   J  a  n  -   0   8
   I  n   d  e  x   P  r   i  c  e
BACC and FREJPM (thru 2008), and FNM peak to troughWBCase-Schiller Housing Composite IndexHousing Futures for Nov-2009
 
Sources: Chicago Mercantile Exchange, Company Reports, Oppenheimer & Co. Inc.
The banks under our coverage universe: BAC, C, JPM, and WB predict smaller declines,varying by degree, in home prices per 1Q08 earnings calls and 2Q08 statements, as doFNM and FRE. Although both FNM and FRE each use their own indices that are more intune with their respective portfolios, both provide Case-Shiller index equivalents.
Exhibit 2. Peak To Trough Declines of Case-Shiller 10-City Index
Expected Peak To Trough DeclinesFutures Market-33%
BAC-30%C-20%FNM-20-25%FRE-20%JPM~14-16% in 2008 (or ~23-25% from peakto 2008)WB (uses OFHEO index)-12.90%WFCNA
 
Sources: Chicago Mercantile Exchange, Company Reports, Oppenheimer & Co. Inc.BAC: per discussions with managementC: 1Q08 Earnings Call on 4/18/08FNM: 1Q08 Earnings Call on 5/6/08.FRE: Conference Call on 5/20/08. 15% decline in FRE portfolio equals ~20% decline for Case-Shiller IndexJPM: 1Q08 Earnings Call on 4/16/08WB: 1Q08 Earnings Call on 4/14/08WFC: No Forecast Provided, Conference call on 5/29/08
US Banks

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