August 10, 2007
Disruption is a Euphemism for Armageddon
The most read story on the Bloomberg this afternoon (Beijing time) is: Bernanke, Paulson Were Wrong: Subprime Contagion Is Spreading. Here are 28 key words from it:
“… firms borrowed money from banks to buy loans to create securities. When investors stopped buying the securities, the banks that made the original loan demanded their money back.”
But isn’t the whole mess simply a crisis of confidence? There’s no way that most of these mortgage-backed securities, even sub-prime ones, are worthless … it’s just that no one is willing to make a bid for them. When you mark to market and there’s no market, then you’ve got a problem, I guess.
Cat: | Time: 5:36 pm (utc+8)
August 10th, 2007 at 7:36 pm
“When you mark to market and there’s no market, then you’ve got a problem, I guess.”
That pretty much sums up the housing/condo market in many areas. There is no bid.
Countrywide Financial (CFC) now coming forth and saying they have more problems.
August 10th, 2007 at 8:23 pm
I see no easy way out. Few are going to want to make bids for mortgage-backed securities until they have a better idea of how likely people will continue to pay their mortgages. This is unlikely to happen until foreclosure rates stop going up.
August 10th, 2007 at 8:56 pm
“But isn’t the whole mess simply a crisis of confidence?”
Yes, it is. Lenders don’t have confidence that folks will be able to pay the nut when all those ARMs reset.
And they’re right, they haven’t nor will they be able to pay. As The Chairman said recently, ‘book value is a moving target’. Right now that target is moving too fast to draw a bead.
August 10th, 2007 at 8:56 pm
Todd & Brian: But how high are the delinquency rates now, let alone default? I thought things were very stable (but whadda I know).
August 10th, 2007 at 9:11 pm
That’s the way it seems to me. The main real fallout will happen as lending conditions toughen and house prices start to seriously fall as a result. I was just looking through the 10-Q from NCT (Newcastle Investments) and the rates don’t seem to have picked up in any serious way. The main impact on their accounts is the unrealised losses on the securities they hold. They seem pretty confident stating that this fall in book value has no effect on their earnings (which it doesn’t if they hold to maturity). The unrealized losses are about 30 times the permanent impairments that they have recorded in the last quarter.
August 10th, 2007 at 9:40 pm
I agree with the Chairman. After all, these are asset-backed loans we are talking about, and even in worst case housing market conditions, most of the principal should eventually be recovered.
As usual, on the backs of some poor “suckers”, who will lose their homes.
August 10th, 2007 at 9:54 pm
Todd: I meant a crisis of confidence in the secondary market … that’s where the demand has evaporated. I think the delinquency rates (let alone default), even on the subprime junk, are not the least bit alarming.
August 10th, 2007 at 9:57 pm
chairman - foreclosures in my area (90 miles north of nyc) have been high for 1+ years. just not reported much.
btw, the volatility on nyse (and a ton of smaller naz) stocks has been absolutely insane. the nyse stocks more so, intraday. i’d like to say i’ve been cleaning up, but i can’t. doing well, but not ordering any cristal or anything.
August 10th, 2007 at 10:01 pm
bob: I’ll pay for the Cristal with the dividend check I get from WaMu. ;-)
August 10th, 2007 at 10:02 pm
CM
I understand. But the question is who is going to take the hit when these things get re-priced ?
They can’t even place an accurate value on these instruments because the underlying assets have decreased (and are STILL declining) in value to the extent that it’s very difficult to price them accurately.
August 10th, 2007 at 10:06 pm
Foreclosure rates in the U.S. are already growing in the high double digits year on year. The default numbers are starting to exceed the threshold that funds used to value the risk of mortgage-backed securities.
Bear in mind that the majority of ARMs have yet to reset and foreclosure rates will most likely continue to go up. If you think that housing prices have more room to fall then the situation is even more bleak.
Funds are now unlikely to make bids for mortgage-backed securities until they have a better idea of what new default numbers to use for their valuations. This is unlikely to happen until the majority of ARMs have reset and foreclosure rates stabilize.
In my view, the credit crunch that we are seeing now is not caused by the market collapse in mortgage-backed securities, but is triggered by it. We are having a credit crunch because the majority of funds were overleveraged.
When subprime problems started to surface with increased foreclosure rates, banks started to increase margin requirements for funds with positions in mortgage-backed securities. Investors also wanted to withdraw funds to rebalance their portfolios.
If a fund has enough cash to meet margin requirements then everything is fine and well, and the unrealized losses stay hidden. But if it does not have enough cash then it is forced to sell some of its assets or borrow money to generate cash.
The most notable example was Bear Stearns’ canceled auction of mortgage-backed securities a few months ago, due to a lack of bids. That was basically the wakeup call. It made people aware that there was basically no market for mortgage-backed securities when things start to go wrong.
It’s a domino effect that is hard to stop.
August 10th, 2007 at 10:11 pm
Todd: I guess that’s the rub, how do you value these loan portfolios? Especially when they’ve sliced and diced junk in with quality and bundled it all together. Anyway, it seems to me that someone could make a pretty good estimate of a fair value and be an eager buyer … it’s a psychological thing that is holding buyers back, not a valuation thing, I think.
August 10th, 2007 at 10:18 pm
Chairman, don’t you think the subprime mess is the tip of the iceberg. When financial engineers (and I use the term generously) create financial instruments without liquid markets, finding those instruments’ true market value will create problems. I think these kinds of things have permeated the debt markets.
To me, interest rates have been artificially low for years (read bond market bubble)!
Run for the hills!
August 10th, 2007 at 10:19 pm
Brian: Are the default rates really that high? Call me clueless. ;-)
August 10th, 2007 at 10:22 pm
drgood: I thought the MBS markets were very liquid … that is they were until they weren’t. :-/ I still think any first year finance student can come up with an excellent valuation of a loan portfolio if you tell her about its holdings.
August 10th, 2007 at 10:30 pm
CM said: “I still think any first year finance student can come up with an excellent valuation of a loan portfolio if you tell her about its holdings.”
Who is she ? One your ‘girlfriends’? :)
August 10th, 2007 at 10:32 pm
Todd: She Who Must Be Obeyed (who is a CFA) could probably value most asset-backed securities without the aid of a calculator (she’s sharp).
My girlfriends, on the other hand, are good at sitting there quietly, looking pretty. ;-) (They’re all CPAs incidentally, like me, lol. I’m good at sitting there loudly, looking ugly.)
August 10th, 2007 at 10:36 pm
CM
RE: default rates
I think the idea is that they’re relatively low (albeit rising) considering all the attention this story has been getting in the media, but as Brian pointed out, there’s a huge reset of ARMS coming forth soon.
The default rates will quite possibly rise dramatically once that occurs, and that’s why traders involved in these financial instruments are concerned.
August 10th, 2007 at 10:38 pm
Todd: Yeah, I understand that the market anticipates events, but in this case it’s way overreacting… the sad thing is it’s causing a kind of “bank run” that doesn’t make a bit of sense from where I sit (12,000 miles away in a highrise).
August 10th, 2007 at 10:43 pm
C. Maoxian: Who knows? People count differently, and that’s part of the problem as well. ;)
I think another problem is that nobody holding mortgage-backed securities is quite sure what exactly is in there because they are so well packaged in order to ‘diversify’ the risk.
“Hey, the MBS I’m selling may or may not contain a house or condo anywhere from LA to SLC to NYC, that its owner may or may not have stopped payments on, and may or may not sell for under mortgage value. But fear not! Default rates are historically low and it pays high interest!” ;)
August 10th, 2007 at 10:50 pm
Brian: Isn’t the MBS market clearly defined into residential mortgage-backed and commercial mortgage-backed, or am I being naive? I guess it would get a lot trickier if they packaged mortgage-backed together with other asset-backed stuff (like credit card receivables etc.) and bundled it all together, but how common is that?
August 10th, 2007 at 11:13 pm
C. Maoxian: I have no idea. The banks and funds are certainly staying tight-lipped about everything.
But even if the MBS market is clearly defined into residential and commercial mortgage-backed, it’s still quite difficult to come to a price or risk value that most would agree to, when the numbers are heading outside of historical norms and everyone counts differently. ;)
Especially in the midst of a credit crunch.
August 10th, 2007 at 11:44 pm
@ least 2 significant things going on here beyond the headlines:
a) the carry trade has provided a lot of grease for quite a while now- there are some preliminary indications that a fair amount of these pools were bot by non-US investors reaching for yield- including Japanese banks. this is very complicated gargantuan, so hard to quantify right now.
b) there is a distinct possibility that the MBS/subprime problem is merely the canary in the mine. witness: credit spreads have spiked across the board. thus, not only are mortgage brokers saying the window has slam shut, but we are also seeing other forms of cheap money leave the scene. this part of the current episode is easier to track, but an equally gargantuan amount of grease we’ve taken for granted.
a) and b) might be wrapped around the axle short term (that’s the confidence/psychology thing)… but the longer term problem is the decline in the underlying real estate prices that had been fueling a big part of the credit expansion. I’ve lived through a real estate crash and there is a magic moment when people look at their property, then look at how much they owe, and then say to themselves… “screw it. I’m so totally upside down I’ll never see the light of day again.” Not only does that happen to marginal borrowers tangled up in punitive ARMs, it can also happen to Mr. Middle Class Jones (and the neighbors that were trying to keep up).
August 10th, 2007 at 11:56 pm
Jeff, your third point is spot on. The drop in the underlying real estate prices, and the inability of those who own those properties to pay their bills is ultimately the crux of the problem, IMO.
You can package and then re-package and then bundle bits and pieces of those packages together and sell them like hotcakes while the skids are greased … until the underlying asset values decline to the extent that the buyers of these instruments step back and ask - what the hell is it that I’m buying?
August 11th, 2007 at 12:24 am
It looks like the Fed added liquidity today by buying billions of mortgage-backed securities, and short sellers are backing off.
I agree with Jeff and Todd. There is a point where home buyers will simply opt for bankruptcy and let the house go into foreclosure rather than keep something with negative equity.
August 11th, 2007 at 12:25 am
The dealer community has met demand for yield by investors by compunding risks and therefor returns (”alpha” for dummies). Mortgage-based product is but one form. Today’s trading is the result of mortgage payments evaporating in sub-prime and alt-a mortgagecd product (prime mortgages continue to perform). MBS/CDO models assume 5.5% default rates on average anticipating historical norms. 2006 sub-prime production is now forecasted at 6% for 06-1 vintage paper, 9% for 06-2, and 13% for 07-01. Alt-a paper is no better. Consider that through the miracle of tranching cashflows these risks have been concentrated in lower-rated tranches, and then fully leverage compliments of the selling banks. You now have securities that are highly leverage — effectively twice. And these risks are still inherent in highly-rated (AAA) tranches of CDOs and CDO-squared that are constructed from underlying sub-prime and alt-a paper. The sensitivity of these securities to increased default rates is extreme. Dealers, who finance the paper for investors, have given out optimistic marks to keep investors at ease and their own marks stable. Problem is when you seek a BID you get a vastly lower number. When BearStearns liquidated paper the the real market became transparent for a moment. Inventories had to be marked down to reflect these levels — and traders found themselves outside of their VaR limits. Risk managers — and margin calls — forced selling. Further selling pushed prices down, marks down, and forced more selling. The problem is that you can’t make margin calls selling paper for 10 cents so you sell what you can. Now you have a contagion. A look at AIG’s earnings shows that this is far from over. They have $20ish billion in sub-prime paper (think 10-20 cent bid) and $64ish billion in alt-a paper (which is underperforming sub-prime in some recent vintages). Their press release suggests that they are holding those securities at PAR! Others are doing what they can to avoid mark-to-markets too. Capitulation can only come after everyone marks their positions to the bid-side. We are far from that day. In the meantime investor confidence plumments after wave-after-wave of selling and negative headlines. When will it end? At the minimum not until all the underlying mortages reset at their much higher rates, amortization kicks in on IO’s, higher gas prices, higher real estate taxes come home to roost, and the home equity refinancing consumption-kiting scheme is found to be over — which it is. Afterall, homes in the US are now depreciating, not appreciating. The gig is up. Today hedge funds and dealers are forced into margin calls by value depreciation exacerbated by high leverage. Tomorrow it will be the consumer. Oh, and the consumer is 2/3 of US GDP, right?
August 11th, 2007 at 2:27 am
Meanwhile, Lewie Ranieri of ‘Liar’s Poker’ fame has been buying shares in Franklin Bank Corp. At least I assume it’s the same guy. $4 million worth in June and a smaller purchase a few days ago. Other insiders seem to be buying also. Very interesting, to me at least.
August 11th, 2007 at 2:44 am
Oh no the sky is falling! When in doubt, run around, scream and shout!
August 11th, 2007 at 3:51 am
The town baker in the town of Chernobyl probably thought the negative comments emanating from the nuclear scientists at the power plant were hyperbole too.
August 11th, 2007 at 5:03 am
No bid, that is kind of good news because the funds that own these securities can just price it at “good faith”. The problem then is with shareholder withdraws. Stop the withdraws. Now there is panic.
The question: why no bid? A loan, if nearby, one would know the home owners’ income, the dependability of this income, the maintenance of the house…etc all signs/factors needed for the loan. But it is hard to bid on something that is so “diversify” that no one know what is real (is the appraisal real, is the claimed income real or just accepted so the bank/mortage company can earn the points, etc…
For years people think mortgage federal agencies are good as the “full faith and backing of the US government”. At that time “pricing” is easy. Congress have changed and Time have changed as the real estate is mortgaged until mortgage no more. Some of these securities are not the mortgage itself, but are securities back by mortgages.
I really do believe no investor in these securities really know what they are investing in. What mortgage they hold as to what mortgaged to what house? what is the earning power of the borrower?
I think this might force Congress to revert to the publics’ believe as “full faith and backing of the US”
August 11th, 2007 at 6:48 am
I remeber the NeoCons not so long ago were shouting to the four winds that home ownership was the highest in american history and how that was proof of the american dream coming true under the bush admin. and bla bla bla. They don’t seem as cocky now.
August 11th, 2007 at 7:53 am
CM, Hugh explained it well and that’s why looking at default rates does not mean much in this case.
The dude at Sudden Debt (http://suddendebt.blogspot.com/index.html) has been explaining for months why these CDOs cannot be accurately valued.
In short, the bankers said that not all sub-prime loans are risky. Since the historical default rates are in the 5% neighborhood then 95% of those loan can be deemed as “investor grade” ranging from just barely to AAA. So the story went.
They then grouped the CDOs into CDO Squared and used similar historical “norms” to rate the bulk of those as investment grade.
The hedge funds then used large leverage to buy these “investment grade” instruments.
Thus a $1 in sub-prime equity is supporting over $100 in “investment grade” hedge fund holdings.
Now, if the default rate goes from 5% to 6% then you have a problem. If it goes from 6% to 10% then you have a disaster.
This reminds me of the Nasdaq bubble days. I decided that it was all crazy and opted to put my money in the safe hands of Janus funds instead of .com stocks.
I got screwed royally.
This time around i decided it is all crazy and put my money in mid-cap growth companies that have nothing to do with the MBS. I am getting screwed yet once more.
The idiots at the Hedge Funds are liquidating their longs and covering their shorts, sending everything out of whack and killing my swing trades.
I am going to sit on the sidelines for few weeks till we get a decided trend in the market.
August 11th, 2007 at 10:14 pm
I am with B2C. I am on the sidelines and am heavier in cash then i have ever been. After all, when assets go on sale in a big way cash is required in order to go shopping. For me this is not a fear trade — it is the greed trade draped in the robes of fear. I like my holdings long-term. But I have sold many anyway. When the pain is unbearable we will be able to lock in terrific value. This will require patience as many financial institutions are sticking to their mark-to-model methodology — sort of like modern day Neros. But as with Nero’s soothing strategy, the fiddling did not stop the flames from engulfing all. This continuing contagion will be the source of great stocks being sold at silly prices. I for one am ready.
August 11th, 2007 at 10:47 pm
Sorry to hog this space. I have other thing i want to share related to the mortgage mess. The banks and I-banks are purveyors of leverage to little structuring/asset management companies that have popped up all over. They give these folks lines of credit with which to purchased collateral (RMBS, CMBS, CLOs, and sub-prime loans, etc). These shops then re-tranche the securities into new securities capturing the “arb” and a fee. Turnaround time is 3-5 months. Deals will average around $500mm. Each bank has many of these “warehouse” lines out there. These shops were in the process ramping up to capacity via buying securities into their warehouses right when the mortgage mess hit. When the securities collapse in value the banks make margin calls. When the 15 person shop doesn’t have the money for the call they get their lines pulled — and the banks end up with the securities! Voila…the banks are getting longer and longer the worse performing securities just as they fall in value. This compounds their exposure. All this just as the banks are getting jammed with underwritten bridge loans from m&a deals. Not a good time to be a bank.
August 11th, 2007 at 11:48 pm
Hugh: I think we’re already there, but I could be wrong. I’ve already loaded up, especially on these regional banks which I think are already at “silly prices.”
August 12th, 2007 at 1:23 am
According to a piece from The Deal: “LBO shops circle ravaged loan desks”
“Sensing opportunity amid the credit markets’ woes, several private equity firms are angling to purchase buyout-related loans and bonds at steep discounts from banks’ trading desks, sources said.
“Ironically, these are often the same private equity firms that have forced the banks to honor loan and bridge financing commitments that the banks now seek to unload by selling them at a discount.
“According to several market sources, firms such as Apollo Management LP, Bain Capital LLC, Blackstone Group LP, Carlyle Group, Kohlberg Kravis Roberts & Co., Thomas H. Lee Partners LP and TPG have been mulling moves to step into the loan and bond secondary markets to buy bank debt and profit from fire sale prices.”
Me, I’m bargain hunting now.
August 12th, 2007 at 2:33 am
CM, I agree with the regional bank comment provided they don’t have structured products desks. I plan to buy banks AFTER they report their losses. I expect that this will scare the daylights out of the market and make them momentarily very attractive.
August 12th, 2007 at 3:57 pm
Moe: It’s true, the smart money guys I’m acquainted with have been extremely active (buyers) these last two weeks.