"The More Things Change' - A Guest Blog

For many years while managing the mortgage backed bond trading desk for Goldman Sachs I had the pleasure of working with today's guest blogger - Frank Pallotta. Frank covered some of the countries largest mortgage bankers as well as Fannie Mae. Few people know more about the mortgage origination business than Frank. Frank has recently founded his own firm, Steel Curtain Capital Group, which advises clients on the sales and purchases of distressed assets. Thanks to Frank for his insightful commentary on the crisis in the credit markets.

"Few things in life are as certain as death and taxes; except maybe the occasional catastrophic dislocation in the financial markets. But one thing is certain - financial markets are cyclical. What goes up will eventually come down. And as recent events have shown, if they go up too far or too fast, they will come down faster and harder than you can possibly imagine. Since the early eighties, we’ve heard about turmoil in the capital markets with names like: The S&L scandal, the RTC crisis, the stock market crash (both of them), the “dot.com bubble”, the real estate crisis, Enron, the Russian Debt Crisis, LTCB, “Orange County” and the list goes on (and on). Most, of these “dislocations” were a direct result of, or exacerbated by Wall Street’s desire to trade through, around, or in front of these anomalies.

The latest crisis to reach the top of the charts (as the equivalent of rock and roll’s “Stairway to Heaven”), is what’s come to be known as “The Subprime Crisis”. The reality is that labeling this a subprime issue is about as absurd as calling baseball’s steroid scandal the “Barry Bonds scandal”. Don’t confuse the symptom, for the disease. This crisis goes way beyond subprime. For starters, the finger of blame can point to the borrower who took out a mortgage he knew he could not afford, to the mortgage company who looked the other way during the application process, to the Investment Bank who packaged this “stuff” to the rating agency who provided a stop-loss level of 4% to AAA, to the CMO buyer who said “55 to swaps sounds cheap”.

The good and the bad news is that no one is doing anything stupid – for now. It’s probably a good thing that virtually all non-standard mortgage origination has come to a halt while the markets attempt to readjust. The reality however, is that this asset class (residential housing) will not go away. The economy will eventually stagger to its feet, and blood will start to flow again through the Global Residential cadaver again. Another certainty is that Subprime and Alt-A loans will return to their rightful place in the financial system. Subprime and Alt-A loans existed long before this current crisis began. Subprime loans will return again, and will carry a rate commensurate with the borrower’s ability to repay that loan. Alt-A borrowers will again come to understand that “Alternative A” truly means alternative documentation, and not an alternative “borrower”. And that both of these loan types will return to their past risk/reward profile. Lower documentation and credit scores must be offset by more equity. Less equity will be offset with substantial, verified reserves, and any mortgage application with the word “stated” in it will be relegated to bird cage liner, kindling and toilet paper. Investors will also have to do a bit more homework (on their own this time) and not rely solely on Wall Street stress analysis, legal opinions and rating agency models.

The bursting of the “Technology Bubble” didn’t destroy the technology sector. As such, the “US Housing Bubble” will not destroy the US housing market ebay, Google, and Yahoo proved that technology wasn’t dead, just the irrational exuberance surrounding that sector. The Global residential markets will go through the same transformation. Most loans types (NINA, and SIVA, POA), and their originators will go the way of World.com, theGlobe.com, and Pets.com. While others will emerge as sound safe and sane."

The Challenges Continue

The first half of the year was obviously not a good one for the financial markets, and my prediction is that the second half is not going to be much better.  There is simply just way too much uncertainty around a large number of factors.  Here is a short list:

-      -- The impact of  the huge rise in commodity prices globally – i.e. inflation.  I have read a number of articles recently that challenge how we measure inflation and most of the thoughtful ones seem to indicate that such measures are way underestimating it.  My personal experience would have to agree.  A quick example.  We spent the summers in Kelowna BC Canada where my family runs an orchard producing approximately 500,000 pounds of fruit a year.  My father came in the other day fuming because the price of a bottle of chemicals he needs to spray the fruit went up from $600 last year to $1,000 this year.  A bag of fertilizer, $35 last year, $60 this year.  Even if oil settles down just north of $100, the impact is just beginning to work it’s way past the fuel pumps and in to the system. 

-        - The financial chaos.  More banks and other financial institutions will go under and the effect of that is hard to measure but it will be costly.  Moreover the write-offs will continue as delinquencies are still relatively low and on the rise.  Look at Wachovia’s reported earnings as a hint.  Fannie Mae and Freddie Mac? Personally I don’t do naked short selling but if I were too anyone who has spoken to me on this topic would know that there two stocks have been on the top of that list for years.  Their business model went awry a long time ago right under EVERYONE’s noses.  A publically traded company, which invests in mortgages to the advantage of everyone else because they were implicitly backed by the triple A rating of the US gov’t?  People responsible will, years from now, or maybe tomorrow, be asking themselves, what the heck were we thinking?  IndyMac, Countrywide  blah blah…. All business models that evolved in to banking on the stupidity of others and the idea that the party would never end, but if it did, the people again responsible would be long gone or somehow would have figured out a way to reverse the trade. 

-        - The housing collapse.  Again not over.  There is still a lot of adjustment that has to take place and all this takes time.  Foreclosures are on the rise which will continue to cause massive dislocation.

-        - Global growth.  Just a lot of uncertainty and huge differences across countries.

-        - Geopolitical risk.  I am going to ask  my husband to do a guest blog on this topic. 

-        - Election year in the US and more generally a big risk that a lot of not well thought out regulatory changes happen in response to all the problems that are out there.

This list is not exhaustive of course, and each bullet point is in itself extremely dense.  The point is again is that there is a lot of uncertainly which creates a whole lot of possible outcomes.  From an investment perspective that means much higher risk, and for that, investors should demand a lot of extra return.

 

Fannie and Freddie

I woke up at 6 am to pack up for a trip to Lake Louise (we are currently in BC) and my husband ran upstairs yelling, "Honey, you had the call." He predicted years ago that GM was going to go in to bankruptcy, and I had basically the same call for these Fannie and Freddie. As a mortgage backed bond trader I understood their business, and though a great business when times were good, there was simply no way to hedge the risks if the housing market were to turn, and turn it did. A government bailout is inevitable. I have not yet called around to see where mortgages are trading, or agency debt, or or..... but as I have said many times over on this blog, this is not over.

Happy July 4th!

This is the first July 4th I have celebrated in the United States for a long time. I forgot what a big holiday it is in this country. Although I live here and have for twenty years, I am a Canadian, and we are fortunate, as a family, to travel to Canada for the summer. We are leaving later this year as we just returned from a trip overseas and needed to touch down to regroup. As I turned on the television this morning, a man from India was being asked if he knew what holiday America was celebrating today, and he answered confidently, “Independence Day.” Probed further he was asked what that really meant. Equally confidently he responded, “Freedom.”

Freedom is a big word. One of the biggest words there is. Perhaps the most likely definition involves the concept of someone acting “according to his or her own will”, but the concept is so much bigger. It applies to both the individual and the collective. Freedom is good, but it is not all good. Without a rule of law or without a moral compass freedom enables horrible atrocities. Freedom without opportunity, specifically economic opportunity, may too result in horrible outcomes. Constrained freedom, enabled freedom, freedom for the greater good is what really should make us proud.

Does America represent the best that FREEDOM has to offer? I would say it comes pretty close. Certainly there are other countries that are up there with us, including my home country, but America is pretty, darn amazing.

Enjoy your July 4th holiday and celebrate with family, friends, neighbors and even strangers, the best that is America.

Arriving at JFK

The lack of entries the past two weeks was because I was on a family trip to France! Our family of four met up with my sister's family of four in Provence for a week and it was a truly a great vacation. We rented a house in the small town of Pernes De La Fontaines, and explored the local areas. ( more on what to see in Provence in an upcoming entry) We flew in and out of NICE and what was so striking was the arrival back in to the US after the 8 hour flight home. We got off the plane and through customs in record time but then there was the wait for the bags. In a tiny area, with low ceilings and dingy walls we waited, for over an hour for our bags to arrive. There was no one around to ask what was going on, and frankly no one seemed to care. Kids were crying, exhausted parents were pacing, and people were cursing in multiple languages. Just as an observation came in to my thinking, one of the disgruntled passengers said it out loud - "This is worse then any third world country I have been to, and I have been to many." He went on to say that "why is is that things in America, every day things seems to be getting so much worse here, while in most every place else I go they seem to get getting better?" It seemed so sad to me that for the many people arriving to America for the first time, from Nice, from Kiev, from Berlin.... this is what they see first. They see a place worn out, crowed, congested, with no one around to offer them assistance or seemingly even care.

Well our bags finally, finally arrived and we crawled on to the Long Island Expressway for the long drive out to the far reaches of Long Island to pick up our dog Sunnie who was on her own vacation with my in-laws. Hours later once the traffic was behind us, it did feel very good to be home.