Understanding Credit’s Alphabet Soup

Here’s my understanding of the subprime issue. Your blog helped me piece things together:

Rising default rates on sub-prime and alt-A mortgages have made mortgage-backed bonds and collateralized debt obligations (CDOs) less attractive, and investors are demanding a higher risk premium for these securities. Uncertainty in the secondary mortgage markets has raised interest rates for all homebuyers.

In order to compensate for the risk premium that buyers of CDOs are demanding, banks have raised interest rates and credit standards. Wells Fargo is charging 8% for a prime jumbo 30-year fixed-rate loan that was 6 7/8% late last week:
http://online.wsj.com/article/SB118609866621886776.html

Higher rates for conventional mortgages will place additional pressure on the housing industry and housing prices. (Ms. Studio54 sells real estate downtown, and she’s more concerned with changing demographics than with higher interest rates. She called last month and complained, “I can’t handle the Village anymore. Lesbians and straight people have taken the whole place down…There’s no fashion!…I sold an apartment and they wanted to build a bookcase…”)

Understanding how CDOs were created provides insight as to why foreclosures on subprime mortgages have affected rates for conventional mortgages. (Doug Kass, Gary Schilling, and Barry Ritholz have been sounding the alarm for several months.) Mortgages were packaged into mortgage-backed bonds, and mortgaged-backed bonds were packaged into CDOs. In 2006, only about 15% of U.S mortgages were subprime, but they were packaged into half of all CDOs.
(sources for figures:
http://bigpicture.typepad.com/comments/2007/02/subprime_market.html,
http://bigpicture.typepad.com/comments/2007/06/who-owns-troubl.html
)

CDOs were considered safe investments because the packages of underlying mortgages were thought to be sufficiently diversified to reduce risk. However, default rates rose beyond projections and valuations of highly rated CDOs were hit. A letter from Bear Stearns to clients of two of its hedge funds confirmed that the steep losses were due in part to “unprecedented declines in the valuations of a number of highly-rated [double-A and triple-A] securities.”:
http://online.wsj.com/article/SB118476996682970361.html

Sam Molinaro, CFO of Bear Stearns, remarked that this fixed-income market is about as bad as he has seen in 20 years. He also indicated that the company is not ready to buy back stock, which didn’t give investors a comfortable feeling.

There’s also concern that subprime woes will spread to high-grade debt, leading to higher borrowing costs for companies and reducing their earnings:
http://online.wsj.com/article/SB118549309797479652.html

“The impact of tighter credit is already apparent in the market for high-grade debt. Yesterday, for example, Tyco Electronics, Ltd. pulled a $1.5 billion bond deal “due to unfavorable conditions in the debt markets,” the company said. Selling bonds for a company like Tyco, which has put its past scandals behind it, is normally a routine affair.”

I’m not a veteran Fed watcher, but it seems appropriate that they should state the degree to which they believe that higher borrowing costs for consumers and businesses will affect the economy. They might believe that risk is being repriced to normal levels, but the repricing comes at a cost. Goldman is looking for the Fed to move to a “neutral” stance, in which risks to growth are on par with risks of higher inflation.

Where do bond insurers such as MBIA fit into the mix? IIRC, such insurance allowed some tranches to qualify for AAA ratings.

Wow……yet ANOTHER late day rally that still leaves the market with negative breadth and decliners outnumbering gainers by 6 to 5.

How many more of these 11th hour rally’s are we to be subjected to? No technicals, or oversold bullshit to hoist up this time….plain and utter manipulation. Coincidence that it’s the day before the Fed meeting???? not likely….especially with the (becoming) daily Tresurey “auction” of $5 billion today…..

Ciao
MS

sorry els I missed you
Insurers are the key to the equation
in the main that’s what the rating agencies do (should rely on)
Gretchen must have misread the brochure
rgds pcm

sorry again I keep on rereading this (I’m distracted by the champagne corks popping prematurely popping in Macquarie Banks Boardroom … it’s 7.30am the boys have had a long night)

the second set of graphics neatly leaves out the ubiquitous SPE which facilitates AAA rating and more importantly shields the originating Lender from litigation (look up your Case Law)
rgds pcm

The market has been interesting over the past couple of weeks, this is exactly the kind of turmoil that should have existed throughout last summer and into autumn, but you will recall that things miraculously stabilized and then went into a rather unusual parabolic climb that was sustained more or less thru the latter part of February, then ultimately resumed despite gathering evidence that the subprime debacle was not “contained.” You can attribute this to whatever you like, but I attribute it to Bush tossing the keys to the treasury to Paulson.

Sharing BR’s general outlook, I began buying index puts in March 06 and made out like a bandit during the early summer meltdown- twice. But I did not fully appreciate the potential disconnect between economic reality and the market when Paulson was installed as treasury secretary and made the mistake of swinging for the fences again in mid-july of 06 which proved to be a disaster mainly because of hubris as it wouldn’t have made much difference if I had just been playing with the money that I had extracted.

Anyway, my point is that there is a systemic political and economic bias which dictates that over time, markets go up and not down regardless of the actual damage that may be done to the underlying financial infrastructure. As a consequence, you have to be very careful in shorting a downleg as there are some big players who will and can do whatever it takes to make sure that you lose if you are not nimble enough to get out of their way.

That isn’t exactly the way it’s supposed to be per capitalist economic theory, but we live in a state of corp/govt fusion which is essentially based on the mercantilism of the 16th century. The good news is that with the fullness of time, the game becomes obvious and you can share a few scraps of the winnings by following the big dogs around and betting on them. The bad news is that they will not just enter a market and drive it up, they will drive it down first and you can never be sure where they are in the cycle.

==whipsaw==

Homebuilders are some of the largest originators of the CDO fodder. For those who really do not have the time to read building company annual reports, here is a bullet list of tidbits that all will find interesting, particularly in light of today’s mortgage environment:

1. Joint venture debt and depreciating inventory held off balance sheet, so you and I can’t see it.
2. A significant amount of the non-conforming market has all but seized up, which will significantly reduce the demand for housing, in an environment where the supply demand ratio was totally out of whack to begin with. I know you think you already know this, but wait…
3. Large public home builders are some of the largest non-conforming mortgage originators, funded by warehouse credit lines that have been the source of unprecedented margin calls throughout the non-bank mortgage industry (which the homebuilders are a member). Banks have internal financing such as deposit accounts to fund mortgages, but non-bank entities must rely on credit lines to fund loans. Significant non-conforming mortgage operations that have already been put out to pasture amount to about 60 mortgage companies – totally out of business, and the secondary market has effectively frozen. Reference LEND, American Home Mortgage, New Castle, most recenlty LUM to see how quickly this can bankrupt a company. These are entities that do not have to deal with the cash burn and depreciating assets of the homebuilders as well. In just a few months, Amercian went from the 10th largest lender, to bankruptcy. In just one week, LUM went from rosy managment pronouncements to postponing earnings and halting trading, stating that thier business model has simply been locked up (this is what American did the week it declard bankruptcy). All of these non-bank lenders had margin calls on their credit lines combined with an inability to sell their product. The builders use the EXACT same business model to fund much of thier sales, and in some cases the vast majority of thier sales. Some builders (such as Centex) named the mortgage subsidiary as one of the significant contributors to their bottom line, performing much better than home building. Think about it.
4. From the 2006 HOV annual report: 9.5% of our homebuyers paid in cash and 62.9% of our non-cash homebuyers obtained mortgages from one of our mortgage banking subsidiaries. Mortgages originated by our mortgage banking subsidiaries are sold in the secondary market within a short period of time. (Tell that to LUM, LEND, AHM, New Century, etc.) Even those buyers who do not need mortgages will be hurt if they cannot sell their existing properties (to those who need mortgages) to move up to their newer purchse (this is how most pay cash for the 9.5% referenced earlier). Thus the backlog that is stated in the builder’s financial statements will not, and cannot, be fully realized, and thus is overstated.
5. From the LEN 2006 annual report: “We provide a full spectrum of conventional, FHA-insured and VA-guaranteed, first and second lien
residential mortgage loan products to our homebuyers and others through our financial services subsidiaries,
Universal American Mortgage Company, LLC and Eagle Home Mortgage, LLC, located generally in the same
states as our homebuilding segments and Homebuilding Other, as well as other states. In 2006, our financial
services subsidiaries provided loans to 66% of our homebuyers who obtained mortgage financing in areas where
we offered services. Because of the availability of mortgage loans from our financial services subsidiaries, as
well as independent mortgage lenders, we believe access to financing has not been, and is not, a significant
obstacle for most purchasers of our homes.” For the record, second lien loans are not being bought in any volume for the week ending the day of this writing. It is the second lien loan that is used to get cash strapped buyers into homes. This is a problem for LEN, if it accounts for up to 66% of thier sales. They say they issue FHA and VA loans, but fail to break out a granular analysis. ”
During 2006, we originated approximately 41,800 mortgage loans totaling $10.5 billion. Substantially all of
those loans were sold within a short period in the secondary mortgage market on a servicing released,
non-recourse basis; however, we remain liable for certain limited representations and warranties related to loan
sales.” Can a company that is losing money at the rate of Lennar afford to buy back or get stuck with unwanted assets that have extremely wide spreads such as the $10.5 billion (41,800 actuall mortgages) that they quoted here?”
Increasing interest rates could cause defaults for homebuyers who financed homes using non-traditional
financing products, which could increase the number of homes available for resale.
During the recent time of high demand in the homebuilding industry, many homebuyers financed their
purchases using non-traditional adjustable rate or interest only mortgages or other mortgages, including sub-prime
mortgages, that involve significantly lower initial monthly payments. As a result, new homes have been more
affordable in recent years. However, as monthly payments for these homes increase either as a result of increasing
adjustable interest rates or as a result of principal payments coming due, some of these homebuyers could default on
their payments and have their homes foreclosed, which would increase the inventory of homes available for resale.
In addition, if lenders perceive deterioration in credit quality among homebuyers, lenders may eliminate some of the
available non-traditional and sub-prime financing products or increase the qualifications needed for mortgages or
adjust their terms to address any increased credit risk. In general, if mortgage rates increase or lenders make it more
difficult for prospective buyers to finance home purchases, it could become more difficult or costly for customers to
purchase our homes, which would have an adverse affect on our sales volume.
We sell substantially all of the loans we originate within a short period in the secondary mortgage market on
a servicing released, non-recourse basis; however, we remain liable for certain limited representations and warranties related to loan sales and certain limited repurchase obligations in the event of early borrower default.”
6. Additionally from LEN 2006 report: ”
Our Financial Services segment could have difficulty financing its activities.
Our Financial Services segment has warehouse lines of credit totaling $1.4 billion. It uses those lines to
finance its lending activities until it accumulates sufficient mortgage loans to be able to sell them into the capital
markets. These warehouse lines of credit mature in September 2007 ($700 million) and in April 2008 ($670
million). If we are unable to renew or extend these debt arrangements when they mature, our Financial Services
segment’s mortgage lending activities may be adversely affected.”
7. Pulte relies on internal mortgage financing for nearly 100% of their home sales. This is a serious problem in the current environment. From the Pulte Annual Report: “In originating mortgage loans, we initially use our own funds and borrowings made available to us through various credit arrangements. Subsequently, we sell such mortgage loans and mortgage-backed securities to outside investors. Our capture rate for the years ended December 31, 2006, 2005, and 2004 was approximately 91%, 89%, and 88%, respectively. Our capture rate represents loan originations from our homebuilding business as a percent of total loan opportunities, excluding cash settlements, from our homebuilding business. During the years ended December 31, 2006, 2005, and 2004, we originated mortgage loans for approximately 77%, 75%, and 72%, respectively, of the homes we sold. Such originations represented nearly 100%, 98%, and 92%, respectively, of our total originations. During 2006, 21% of total origination dollars were from brokered loans, which are less profitable to us, compared with 26% and 36% in 2005 and 2004, respectively. The decrease in brokered loans can be attributed to a shift in product mix towards funded production.
8. HOV, as I am sure other builders, have not only SEVERAL mortgage subsidiaries, but off balance sheet mortgage joint ventures that have the potential to add untold amounts of additional liability and exposure to what has put so many non-bank lenders out of business.
9. The homebuilders, due to thier highly negative cash flow, have either violated or come close to violating thier loan covenants. Some have renogotiated them, but have done so with terms that they are not likely to be able to comply with. DHI has already defaulted on thier loans, just to have them bought out by a hedge fund that is charging them 15% interest, up from 9% that the bank charged them for non-invesment grade paper. This is a true junk rate that DHI just can’t afford. Look at thier numbers… They are losing money hand over fist, and the market is getting worse, not better.
10. Some of builders use special purpose (financing shell) companies that banks fund and the builder repays the bank via swaps to fund thier mortgage arms (ex. Centex). Most banks require investment grade swap partners, which most builders will find hard to be identified as.
11. Rating agencies have downgraded most builders to junk status
12. Credit swap spreads are as high as 450 basis points (cost to insure builder debt)
13. Banks have been lenient thus far, but all you need is one to decide that the risk is too great and it will create a run on the builders. The first creditor to move will most likely be the one to get back the most of its lunch money. No one wants to be left holding the bag.
14. Finally, the real estate market, as we all know by now, is entering into a bust, which is most likely to protract into 2 to 3 year range. Do the homebuilders have the cash to last that long, writing down billions of dollars of asset value per year and half of them operating at negative operating earnings (Sans write downs). Will the banks, who have literally ran from non-conforming (loans that cannot be sold to government sponsored entities such as FNMA, Freddie MAC), ALT A, and subprime loans be willing to fund these money losing business that rely on these very loans to unload depreciating inventory for another 2 to three years? It appears that many of the banks have real estate related issues of thier own, and cannot prudently afford to baby sit the homebuilder.

Financials: Worse than they look

On Tuesday, we wondered aloud what the SP500 might have looked like had the true nature of the Financial sector’s true risk-adjusted earnings been known (SP500 ex-Risk ?). We questioned how the Financials looked historically, now that they wiped out so…