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  • Subprime Credit Crunch Could Trigger Collapse

    Mortgage Lenders: The three bears come home

    by Aaron Krowne


    Some of you might have seen my new informational site, the Mortgage Lender Implode-O-Meter. But for those who haven't, I started this site to coherently track a story that is otherwise only quietly developing on a smattering of disparate finance blogs and message boards, with little treatment in the mainstream media (MSM). That story is the collapse of mortgage lending finance, especially in the subprime sector.

    I and others had been expecting this for the better part of the last year (many, even longer, but I'm a newer observer). The subprime shakeout is predicated on the deterioration of subprime mortgages and mortgage-backed securities (MBS), which is in turn caused by rising delinquencies, which is in turn caused by the deteriorating financial position of most Americans. So really, it was a no-brainer, except apparently to the brilliant boyz of finance who listen to too many talking heads telling them what they want to hear about the "goldilocks" economy.

    Well, I've got news for the goldilocksters: the three bears are home.

    The effects of these deteriorating economic fundamentals are now starting to show up in the finance world–which is not the same as, but all too often confused with, the real world:



    The chart is a graph of the value of BBB (subprime) mortgage-backed securities dated as of the second half of 2006. I've been following it for months, yet the latest move of just the past couple days still surprised me: it's almost going vertical... downward. Not good.

    If you go to MarkIt's ABX credit index home, you can pull up charts for other classes of mortgages (above BBB are A, AA, and AAA), and different date issues, and see how they're doing.

    It's a fascinating exercise. You can see that immediately when subprime (BBB) 2006-02 started to crash, there was a "flight to quality" into the As. But as BBB continued to collapse, A began to follow, and then AA, and then even AAA. The effect also began to spread to earlier and later issues; a veritable "shockwave" emanating out from the BBB-2006-02 subprime issues -- ground zero.

    I can't quite stress how much this is not good. That's because it gets more complex than just a bunch of holders of mortgage-backed bonds ending up with crappy returns: enter derivatives.

    In recent years, derivatives began to be used more heavily, to "buy insurance" on various investments and trades, in case of default or other unexpected moves. Derivatives such as these have skyrocketed to a notational value of somewhere around $400 trillion, by some reports. Why? Because they became so cheap... because nothing financially "bad" had happened in a while. Tremendous quantities of liquidity will do that... until one day exhaustion bursts the bubble. Well, the regular folks down in the "real economy" are seeming quite exhausted.

    The tie-in to MBS is as follows: banks and other holders of MBS (like hedge funds) wanted to book their gains immediately ("marking them to market"), so they bought insurance on their MBS in the form of derivatives ("credit default swaps" or "CDS"), and then were able to sell them with a slight markup or use them as "guilt-free" collateral for other speculative plays. Aside from some flogging of these securities to foreigners and the general public (e.g. pension funds), the major financial institutions just sold these things to each other: last I heard, US banks still hold well over 50% of their assets in the form of real estate-related securities.

    All this MBS trading and CDS insuring amongst the same pool of entities seems apt to be a setup for a disaster: if MBS returns widely suffer, then someone must pay up on the CDS "insurance". But since retail banks, mortgage banks, investment banks, hedge funds, and private equity have all been both buying selling these things amongst each other, you end up with an undifferentiated soup of liability with no distinct bearers of risk.

    And by the way, since derivatives encourage more spending and speculation, they in essence are liquidity (as outlined above), so they essentially beget more of themselves. The credit bubble becomes a self-fulfilling prophecy... for a time.

    In sum, the entire financial economy looks vulnerable to a rout here, as the baseline level of default is suddenly becoming much higher. This failure is already cascading through the various grades and vintages of MBS, but as returns fall and CDS obligations must be made good on, there will likely occur a credit crunch that will begin to drive down financial asset prices in general. This will, of course, further harm returns and trigger derivatives obligations, becoming a self-reinforcing, downward-accelerating feedback loop.

    The Fed is clearly already trying to stop it, with the accelerated M3 money growth (as was also done in 2000/2001), but it's already too late. The stock market is obediently being inflated, but that does little to distribute wealth to the suffering masses in debt, who are the source of these rising MBS defaults.

    New subprime lending is shutting down fast, as reported on the Implode-O-Meter, but not just because of companies going out of business: the risks are now becoming obvious, so financial firms (even large ones, like JP Morgan) are scaling back or eliminating their non-prime lending activities. But this sort of lending, as of late last year, accounted for nearly a quarter of total loan activity. Can anyone guess what is going to happen to the housing market when you forcibly remove at least a quarter of total demand?

    I sure hope it all doesn't turn out to be as bad as it looks like it will be.

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    Last edited by FRED; 02-02-07, 10:19 AM.

  • #2
    Re: Subprime Credit Crunch Could Trigger Collapse

    Thanks Aaron, for keeping us informed on this stormfront.

    Should this continue, it should test some of the risk management strategies (ha!) of the clowns writing those trillions in credit derivatives. While I'd like to see the reckless get what they deserve, unfortunately innocent bystanders will likely pay the price.

    Comment


    • #3
      "scratch and dent" loans

      http://calculatedrisk.blogspot.com/

      Originally posted by calculated risk
      Tanta on "Scratch and Dent" Loans

      Note from CR: A friend sent me an excerpt from Fleckenstein's newsletter yesterday and I forwarded it to Tanta. First, from Fleck:
      Turning to the subprime industry, once again I heard from my friend who has been staggeringly accurate. He continues to feel that things are about to really get worse. In an email to me, he wrote: "Scratch and dent loans are killing everybody. Bids that were 92 or 93 are now low to mid-80s. It is a bloodbath, and is pressuring even strong companies to buckle. NO ONE is making any money in the market right now. We are at a point of no return for many. The next two weeks will be wild."

      I've been in the investment business over 25 years, and again, I have rarely seen someone so accurately call a turn in the market as he has done. Remember, we are just now witnessing a change in lending standards, and these will ripple all through the lending food chain, though thus far only small changes have occurred.
      And the following are Tanta's comments:

      Thanks for the tidbits--a former colleague of mine used to get Fleck’s newsletter and you could frequently hear some serious snickers from that cubicle—we’d all have to go over and hear what Fleck said this time. Mortgage punks—the Secondary Marketing ones, at least--aren’t, in my experience, mostly permabears, but they’re cynical as the day is long. It comes from constant exposure to the underbelly of the credit monster.

      “Scratch and Dent” is a real industry term. The approximate meaning is “loan with incurable defect.” “Curable” is a real industry term and indicates something like a loan that closed with too little MI coverage (a kind of “bad stuff that happens”): you can “cure” that by buying more coverage. If you can’t get the customer to pay for it, though (usually because you didn’t disclose the correct MI on the regulatory docs, and so if you start charging the borrower more MI, you then provide yourself lawsuit or pissy regulator material), the loan has a serious long-term yield problem and qualifies for a “scratch & dent” pool. A loan that once had a 30-day late but then made the last six payments is just “seasoned,” unless the late was EPD (Early Payment Default), in which case the loan, assuming it’s performing again, is S&D. (You can’t “cure” an EPD. It’s the mortgage equivalent of the unforgivable sin.) The stuff the rating agencies call “reperforming” is S&D. 99% of performing loans that are repurchased from an investor are sold by the repurchaser as “S&D.”

      The actual industry term for seriously nonperforming loans (in BK, 90 days, nonaccrual, in FC, etc.) is “nuclear waste.”

      I suppose you could get someone to take a loan with certain kinds of “misrepresentation” evidenced as S&D or NW—the ones, say, where income has been proven to be “exaggerated” but there is no other evidence of fraud that could mean a payable claim for the property seller or some other party. The ones with incurable title problems? No exit. If nobody can convey title, you can’t foreclose. Your only possible recovery comes from criminal prosecution, if you’re lucky enough not to be an unindicted co-conspirator yourself and therefore have standing in the courts. That will, of course, take longer than a lot of these folks can stay solvent.

      Fleck’s informant is saying that scratch & dent is getting nuclear waste bids. This implies that nuclear waste is probably heading for “no bid.” In any case, one is generally made to repurchase a loan at par (you might have to give back any actual premium paid if it’s an EPD, depends on the contract). So passing it off to a junk dealer, in turn, at a bid in the 80s is a painful thing. Hanging on to it, if you’re as thinly capitalized as your average subprime mortgage banker, is out of the question. Hence the “bloodbath.”

      If it hits an outfit like Fremont—which is an FDIC-insured thrift and can therefore hang onto this stuff a lot longer than a mortgage banker can—we’ll be out of “thinning the herd” and into “decimation.” One reason it’s so hard to tell at the moment how bad this might get is that it’s hard to tell how many more “pending” repurchases we have out there. The EPD garbage is just the first wave. Every NOD in that big pile you see reported has been most thoroughly examined for other potential rep and warranty “issues” if the investor is any kind of awake, and they seem to be waking up. There used to be this idea that you didn’t push so hard on your correspondents and brokers that you broke their backs—you need a counterparty to keep having a business model. That’s a “normal” downturn idea. The current one seems to be more like “close the gates of mercy, shoot the wounded, and sink the lifeboats.” That does imply—as JPMorgan also implies—that the Big Dogs have more cooties on the balance sheet than they’re prepared to tolerate. Looks like total war to me.

      Comment


      • #4
        Re: Subprime Credit Crunch Could Trigger Collapse

        Spotted over on BrokerOutpost:

        DANKA
        Posted - 01/31/2007 : 8:34:24 PM

        With new lenders closing daily, and even the big giants trying to get out of the mortgage business, its getting very scary to think of the future....

        Real estate is flat, now for a spring market to start booming, a huge amount of clients will be now eliminated from the home buying market.

        A/E's that made money before at sub prime lenders will not, because there won't be any niche products to offer, basically if you have a sub prime borrower with 5 to 10 percent down, you will just shop rate and go with the smoothest going sub prime lender

        I wonder if and when guidelines will every loosen up. I wonder when new players will come into the mortgage business. I just think eventually all of the CURRENT sub prime lenders will slowly disappear.

        They have been burned and who knows if anyone new will want to entertain this market...

        Why doesnt the fed lower rates...Rates have been going up non stop...that doesnt help the market either
        This is interesting for two things. The first, of course, is the evidential description of what is going on and what is in store for the housing market due to the subprime breakdown.

        The second is more subtle: it's the attitude embodied in hope that standards will be loosened again, and that the Fed will raise rates.

        The standards, as we were seeing, were insane. I don't know how else to put it. They were nuts. They both accomodated and fueled inflated values, which required getting a huge fraction of the population in over its heads. Standards coming back to this level ever would be too soon.

        And the Fed has little choice to do what it's doing, or the dollar might suffer an extreme rout. And maybe someone over there knows what's really going on with inflation. The other day I opened the AJC and there was a nice table of cable rate increases for the last half decade. Despite the fact that the cable company is heavily-regulated, the rate increases were approximately 6% a year.

        Why would that be, if inflation was not at least at that level?

        In fact, real estate finance people should be thankful for 5.25%.

        Comment


        • #5
          Re: Subprime Credit Crunch Could Trigger Collapse

          Originally posted by akrowne
          Spotted over on BrokerOutpost:



          This is interesting for two things. The first, of course, is the evidential description of what is going on and what is in store for the housing market due to the subprime breakdown.

          The second is more subtle: it's the attitude embodied in hope that standards will be loosened again, and that the Fed will raise rates.

          The standards, as we were seeing, were insane. I don't know how else to put it. They were nuts. They both accomodated and fueled inflated values, which required getting a huge fraction of the population in over its heads. Standards coming back to this level ever would be too soon.

          And the Fed has little choice to do what it's doing, or the dollar might suffer an extreme rout. And maybe someone over there knows what's really going on with inflation. The other day I opened the AJC and there was a nice table of cable rate increases for the last half decade. Despite the fact that the cable company is heavily-regulated, the rate increases were approximately 6% a year.

          Why would that be, if inflation was not at least at that level?

          In fact, real estate finance people should be thankful for 5.25%.
          I follow a watchlist of symbols--many of which I do not even know the name of the company--that I've collected from one article or another that listed the company as a homebuilder.

          The symbols for anyone who would like to watch them are:
          BHS SPF HOV RYL CHCI MTH MDC TOL PHM NVR DHI BZH $HGX WCI CTX LEN KBH DHOM.

          I don't closely scrutinize them, but in general these buggers continue to go up and up from their correction back last year. Today as example they are all up, the least 1.25%, the highest 9.59% as I write.

          If things are so bleak. Someone seems not to be noting it in the homebuilders.
          Last edited by Jim Nickerson; 02-02-07, 11:28 AM.
          Jim 69 y/o

          "...Texans...the lowest form of white man there is." Robert Duvall, as Al Sieber, in "Geronimo." (see "Location" for examples.)

          Dedicated to the idea that all people deserve a chance for a healthy productive life. B&M Gates Fdn.

          Good judgement comes from experience; experience comes from bad judgement. Unknown.

          Comment


          • #6
            Re: Subprime Credit Crunch Could Trigger Collapse

            There is a good bit of bottom-spotting driving the rebound of the homebuilders.

            A key aspect to watch is book value, which will be determined by inventory and could be fiction. Looking at a few (PHM, LEN, TOL) they're trading less than 50% over book value. Seems not too many of us are buying the "worst is over" story.

            Comment


            • #7
              Re: Subprime Credit Crunch Could Trigger Collapse

              Aaron, just a point of clarity, the chart you posted is for BBB- not BBB.

              Here is the chart for BBB. Still Ugly.

              Comment


              • #8
                Re: Subprime Credit Crunch Could Trigger Collapse

                Excellent piece, as always, Aaron.

                Anyone who is curious about the rise in home-builder stocks (and I'm surprised Tet hasn't already chimed in): The Boyz need to lay the groundwork for the lastest sales trip by treasury head and ex-Goldman employee Paulson and co. to find more suckers to buy U.S. bonds. It's a tough sell when the U.S. stock market is confirming a declining U.S. economy, and it's trivial for a few investment banks to hold up the price of a few stocks for a while for optics. All of the reports you are reading are designed to support the lastest effort to unload the cost of the Iraq War on Asia. (See The Coming End of the US Foreign Investment Bubble: What if we lose?) The rising gold price seems to be hedging the success of this latest trip. Sales are clearly getting harder and harder to pull off.

                I strongly recommend this lecture by Michael Hudson. (Warning for Jim Nickerson: Michael makes me sound like a Wall Street cheerleader!)



                Comment


                • #9
                  Re: Subprime Credit Crunch Could Trigger Collapse

                  Thanks, Eric!

                  This article may aptly compliment Nouriel Roubini's post for the day, where he points out parallels to the 1998 financial crisis (similar if not more extreme vulnerabilities) and asks where the catalyst might be.

                  I say, it might be right here, in the supposedly staid and solid US financial economy.

                  Comment


                  • #10
                    Re: Subprime Credit Crunch Could Trigger Collapse

                    I personally don't have the guts to short any market or individual stocks, but wouldn't this make a great time to short the homebuilders?

                    Also, the fact that the stock market is being inflated to me seems like a short to mid-term reason to stay in stocks for the time being (yes I know I'm playing with fire trying to time the market, but individual stock valuations of the Dow30 still haven't reached even half of dot.com bubble levels, so I still see a margin of safety there).

                    Again, this is why stocks seem to me to be a safer investment than almost everything... why bet against the House when you can bet with it?

                    Comment


                    • #11
                      Re: Subprime Credit Crunch Could Trigger Collapse

                      Originally posted by EJ
                      I strongly recommend this lecture by Michael Hudson. (Warning for Jim Nickerson: Michael makes me sound like a Wall Street cheerleader!)
                      My browser says the link above cannot be found.

                      edit:
                      http://www.michael-hudson.com/audio/...ealEstates.mp3

                      This works but it takes a few minutes to load.
                      Last edited by Jim Nickerson; 02-02-07, 05:26 PM.
                      Jim 69 y/o

                      "...Texans...the lowest form of white man there is." Robert Duvall, as Al Sieber, in "Geronimo." (see "Location" for examples.)

                      Dedicated to the idea that all people deserve a chance for a healthy productive life. B&M Gates Fdn.

                      Good judgement comes from experience; experience comes from bad judgement. Unknown.

                      Comment


                      • #12
                        Next Dominoes to Fall

                        Originally posted by jk
                        It is a bloodbath, and is pressuring even strong companies to buckle. NO ONE is making any money in the market right now. We are at a point of no return for many. The next two weeks will be wild."
                        Any ideas, anyone, on what those potentially buckling strong companies are?

                        I'd like to take a look at their put options.

                        Comment


                        • #13
                          Re: Subprime Credit Crunch Could Trigger Collapse

                          Originally posted by Jim Nickerson
                          If things are so bleak. Someone seems not to be noting it in the homebuilders.
                          And that's also a classic sign that a top is approaching, timing issues notwithstanding.

                          The $DJR for example just last September or so moved into its 3rd (and to my mind final for years to come on an inflation adjusted basis) increase of slope of its trend line.
                          http://www.NowAndTheFuture.com

                          Comment


                          • #14
                            Re: Subprime Credit Crunch Could Trigger Collapse

                            Originally posted by akrowne
                            Thanks, Eric!

                            This article may aptly compliment Nouriel Roubini's post for the day, where he points out parallels to the 1998 financial crisis (similar if not more extreme vulnerabilities) and asks where the catalyst might be.

                            I say, it might be right here, in the supposedly staid and solid US financial economy.
                            Yes, right here. Circa 2005:

                            "What I want to make sure I get across here, in case it's not obvious, is that I'm fairly certain that an unseemly economic turn of events is more likely to happen than not, probably in the next three years, and it's going to happen here, in the U.S."

                            That means by 2008, if not sooner.

                            Comment


                            • #15
                              Re: Subprime Credit Crunch Could Trigger Collapse

                              Originally posted by EJ
                              ...
                              Anyone who is curious about the rise in home-builder stocks (and I'm surprised Tet hasn't already chimed in): The Boyz need to lay the groundwork for the latest sales trip by treasury head and ex-Goldman employee Paulson and co. to find more suckers to buy U.S. bonds.
                              ...
                              The big growth from foreign central banks has been in government agency bonds, not Treasuries as you know.

                              They're reflected in the burgundy lines in the chart below, and have been dropping rate of change wise since early 2006 (and one of the major reasons for the trip you noted), although they're still growing at over a 20% rate.




                              "Custodials", for those who may not know, is a just a fancy word to describe the accounts that the Fed used to funnel money from foreign central banks into the various US markets. The Fed has "custody" of that money.


                              Here's the full picture of custodials for the last few years, showing over a trillion dollar flow from abroad in about the last 5 years.

                              http://www.NowAndTheFuture.com

                              Comment

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