The Garrett, Watts Report (March 2, 2010)

To Our Clients, Colleagues and Friends,

The Cal basketball team just clinched the Pac-10 championship, their first since 1960. In the intervening years 50 years, UCLA won 26 Conference titles, Cal zero. It’s been a long, long wait.

You hear older Cal fans tell each other “Y’know, I could die in peace if we could just get back to the Rose Bowl one more time before I croak.” Isn’t it amazing, 26 Nobel Prize winners and they haven’t been to the Rose Bowl since 1959!
Most of you have your audited financials back, so here’s a very simple and a very accurate way to assess the past year. Take your pre-tax earnings and add back any losses from buy-backs or from adding to loan loss reserves. Now, divide that by your total loan volume. The average we saw last year was around 65-70 bps. The top performers made 90-100 bps, and the best ones made 120+ bps. This assumes you sold your loans on a mandatory basis. If you sold best efforts, add about 50 bps to your number, 50 being about what you would have made in additional revenue if you had sold mandatory.
If you made, say, 40 bps selling best efforts, add the 50 that you would have picked up had you sold mandatory. Your adjusted number is now 90, and that’s pretty good.
If you sold mandatory and made much less than 65 bps, you’d better find out why you didn’t do better. With volume and margins dropping, you don’t have much wiggle room.
The movie Orange County is about the smartest kid in class whose counselor sent the wrong transcripts and SAT scores to Stanford. What follows is his attempt to convince the Stanford admissions office that they got the wrong file and that they should reconsider him. One problem is that the kid’s brother helps make the trip up to Stanford to make the pitch, and the brother is a stoned Jack Black. This is just one piece of it at Youtube.

It’s funny, but it’s also sweet. And it shows all the anxieties and absurdities of the college admission process. We rate this a Garrett, Watts A+.

Mortgage companies may have a great Quality Control department, but if that’s all they have, they’d get a D- or F+ if they were a bank. Regulators look to bank-owned mortgage banking operations as needing strong internal controls which allow the Board to identity, monitor, and mitigate risk. What you call QC completely misses the need for oversight of all the functions in your business.

The key to a good Internal Audit Program is to evaluate the risk at all control points in the mortgage banking operation including (1) accounting policies and practices, (2) loan sales, (3) rate locks and hedging (4) pipeline management, (5) management of loans in process (6) loan production practices, (7) due diligence on loan officers, (8) hedging exposure and outsourced vendor management (9) underwriting (10) financial controls and financial reporting, (11), I.T., (12) accounting treatments (13) appraisal process, (14) re-purchases, and (15) investor report cards. We’ve done internal audits on bank or thrift-owned mortgage companies, and these 15 items are really just a small part of what we audit.

Mortgage bankers and commercial bankers have lived with benign interest rates for quote some while now. Are you prepared for real volatility? How will your business look if rates shoot up very quickly? Look at the following, where rates went up 200 bps in six months in 1987

April 1	7.75%
May 1	8.00%
May 15	8.25%
Sept. 4	8.75%
Oct, 7	9.25%

We’ve attached a little something we wrote a few years ago on the Flat Tax. It’s worth the quick read.

We just learned from a reader that someone named Garrett Watts fought for the United States in the Revolutionary War. Young Watts fought with the North Carolina contingent, and this young patriot may actually have been related to Corky Watts. The McAuley’s were farmers in Ireland at the time and the Garretts were using a less-Anglicized name as peasants in the Ukraine and Romania .
It looks more and more like GM (sometimes referred to as Government Motors) could have an IP0 in the next quarter or two with analysts believing it would give the company a $50-60 billion market cap. The U.S. government owns 60.8% of the company, so an IPO would go a long way to getting the government paid back.
Good line: “The stock market is essentially an argument over the future, staged over six-and-a-half hours each weekday, among people who can’t even agree what’s most important to be arguing about.” You could even shorten it to “The Stock market is essentially an argument over the future.” Isn’t that a great way of putting it?
The city of Detroit is suffering, and the mayor wants to take lots of the empty and abandoned space and zone it so that people can farm it. No matter how often you’ve seen this photo, it’s still shocking. It was once a crowded, thriving neighborhood.

From Vernon Hill on the idea that deposits don’t matter and that you simply get your funding through FHLB borrowings, brokered deposits, and CD’s over the internet: “Wholesale funding is cheaper…. but the real value of a bank is in its core deposits. Deposits come with customers who build a banking business. Wholesale funding is an opiate that feels good, is unsustainable, and leaves just when you need it most. The current crisis has again revealed the value of deposits and the risk of wholesale funding.” Amen to this!
Do you ever wonder what the heck HSBC stands for? High Standards Banking Corp? Till not too long ago, it was the Hong Kong and Shanghai Banking Corp., and in ways we don’t fully understand, it acted once as the Central Bank for Hong Kong and actually issued the currency.

HSBC used to (and may still) publish their financials in Pound Sterling , U.S. Dollars, and Hong Kong Dollars. It’s now based in London , still has its roots in Asia , and is truly a global bank.
Three years ago you’d have been doing your TBA trades with Credit Suisse, Merrill, UBS, Goldman and Lehman, and today it’s mostly companies you never heard of. How much do you really know about Broadpoint, Mesirow or Jesssup & Lamont? Have you checked out their financials? Have you been to their offices? We don’t even know them well enough to be certain we’re spelling their names correctly! This is counter-party risk at its purest. Know whom you’re doing business with!
Quick, which five pitchers have the best career winning percentages? Pedro Martinez (.691), Dan Foutz (.690), Whitey Ford (.690), Bob Caruthers (.688) and Left Grove (.680). Those are amazing stats.
We were skimming through one of those books where colleges get to write two pages on how terrific they are. This is from Chapman College : “Our mission is to provide a personalized education of distinction that translates into you knowing us and us knowing you.” Somebody get Strunk & White on the phone. It should be “…that translates into your knowing us and our knowing you.” Where are the Grammar police when you need them?
Interesting bank factoids: (a) The average coverage ratio of reserves to noncurrent loans fell to 58% by year-end, the lowest since 1991. (2) Only 31 new charters were granted in 2009, the lowest number since 1942. And (3) We ended the year with 6,839 commercial banks and 1,173 savings institutions. We couldn’t sleep last night and read the FDIC Quarterly.
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We finished a Strategic Review and FOCIS-plus Review of a company that was doing well, but which wanted to do better. We looked at over 70 areas of their operations, tearing the company apart and putting it back together, looking for areas lacking strong controls, trying to find better ways to manage risk, and in the end, recommending better ways of utilizing their capital. The Plan will allow them to increase earnings by well over $2 million, probably more. Its projects like these that make us love what we do.
It’s drizzly and windy outside, but April’s less than a month a way, and isn’t Spring about the greatest thing in the world? By the way, lots of people follow directions and plant their daffodils in the Fall, which means they’ll flower in the middle of cold, rainy February and March. Our little secret is to keep them somewhere cool (like your refrigerator) all Fall and plant them on New Year’s Day. That way, they start flowering in April when you’re outside and can enjoy them more. See you soon.

Garrett, Watts & Co.
Helping lenders increase revenues, control costs, and better manage risk.