Quote of the Day: “We didn’t lose, we just ran out of time.” – Vince Lombardi. The bulls lament?
A huge apology at the length of today’s missive…but TB feels it is important and not being said. This is getting quite serious and will affect our way of life and standard of living (already in decline) for decades.
Today’s Topics:
1. Friday’s options expiration and the Northern Rock bailout by the BOE
2. Paulson’s follies – three failed programs and the new improved fiscal stimulus
3. Auction Rate Securities and monoline insurers
4. Conforming, super conforming and jumbo mortgages
1. …TB feels like Bill Billichek (aka Trader Bill Billichek…the traitor of the Patriots?), known for sneaking films of sideline signals from the other teams (nothing strange in that if you work on Wall Street, right?), or General George S. Patton when he exclaimed: “Rommel …I read your book!” Look, TB isn’t all that bright…he just paid attention to trading patterns and what happened a month ago at options expiry…incredibly similar even to the point have preceding a national holiday. If you recall, Europe imploded that Monday while today it is up by a similar amount and then it tanked on Tuesday preceding the emergency rate cuts by the Fed that were then followed by a formal rate cut at the meeting the following week. Not so this time…why? Well, over the weekend in utter frustration in its efforts to find a buyer for Northern Rock (such an appropriate name don’t ya think?), the Bank of England nationalized them…nationalized them! OMG…and we thought Bernanke had gone round the bend in a panic over the fraud at SocGen which triggered that European selloff…only to find it had more to with the coming payrolls report…and TB still believes with the monoline insurers problems…which are rapidly becoming everyone’s problems! What if the Fed had bailed out Countrywide? Irresponsible and improper.
2. Now let’s look at that ill-conceived and ill-fated fiscal stimulus package along with two failed mortgage bailouts by our Treasury Secretary who is losing his ability to make coherent sentences…now there is a clear sign of stress! Paulson first:
Recall his Super SIV program that would have benefited BofA, Citi, and all those others saddled with subprime debt they needed to finance…it went bust…why take a rate even 5% above money market rates if the value could decline by 10% when it came time to roll it…result: nobody bought in. It took the Fed with their Treasury Auction Facility to provide liquidity which after a month is now up to $120 billion…far short of the $500 billion the ECB injected in one day…but they had more problems…more of their banks had exposure to the toxic waste created on Wall Street…now we are told all is well…uh huh.
Then came Project Hope…a hot line…hope you hit the right numbers or it might have been dial a porn where some confused woman might have had to listen to you babble about how you couldn’t make your mortgage payment for 5 minutes but heck, it was costing you $5 a minute to rail. Then it came out last week that this successful program had helped lots of people stay in their homes…good job, Hank! Yep, as he muttered under his breath in that Ben and Hank press conference, 869 families have been helped out! Hank…those are individuals not your Goldman Sachs corporate clients…it is a drop in the bucket! Ok, give him his due…there are people no longer out on the street. So not to be out-trumped, he came up with…another drumroll please (TB is using a lot of these lately), Project Lifeline! Yep, that’s the ticket! Give ’em another 30 days so the realize the banks were serious and they can call the lender…er, servicer…that’s the only one they know. The servicer meanwhile only knows a Wall Street firm, who in turn knows a bunch of hedge funds and global banks who in turn stuffed them into their own SIV’s or sold them to little towns in Norway who still don’t understand how they lost their money.
But people not only need the ability to pay but have to have the motivation to pay. Fair Isaac & Co. (FICO) says that for the first time ever people are paying their credit card debt while they are delinquent on their mortgage. Not so hard to figure out is it? Your home is underwater, your credit card is being used for gas and food, the bank will likely take seven months to foreclose…8 now(?), and you can walk away from that huge home debt and be free as a bird…albeit with no credit for five years…but that is a business decision…want proof? Look at the banks and private equity firms trying to renege on those buyouts they made just a few months ago? You do what you have to do! So sue me! Lastly, in an FT article “inexplicably,” banks are taking longer to foreclose,get it? No more OREO’s on books!
An old friend of TB’s (not age…just known for a long time), is an attorney and says about 6-8 calls a day come from lawyers proactive holders (like hedge funds) wanting to know the status of a foreclosure. But due to attorney client privilege (if you watch Law and Order or The Sopranos you know what that is), has to refer to the servicer…who in turn hasn’t a clue who they are so can’t talk to them either. Thanks to MERS, a deed recording system…another brainchild of Wall Street similar to a depository trust company (except with DTC they know who all the owners of bonds or stock are), nobody knows who owns what…and you don’t know who owns what they don’t know they own which creates a major problem in sorting out the debts.
3. Oh yes, and that morphs into auction rate securities where corporations, municipalites, hedge funds, institutional investors and others are tied into one giant borrow short, lend long program. Now before you panic as everyone else is…including some auditors who are making investors write down the entire value of the ARS (if this makes no sense think of how we got to this point…it was in the interest of Wall Street to create this crap as it was for the banks and mortgage companies to generate those subprime mortgages for one simple reason: there is a ton of money in doing so…if you are an auditor, there is a ton of exposure in trying to set a value when you don’t know what it is comprised of). Who would have thought that staid old Bristol Myers Squibb would have held nearly a half a billion of ARS? …or that there would be a problem with it?…not their CFO who lost his job or a hundred other CFO’s who now want out so they don’t lose their jobs. Heck, they were all AAA rated due to monoline insurers (that is now becoming a buzzword…even hearing the term monoline banks now…means just one line…like Starbucks is a monoline retailer…see it includes related lines…insuring muni’s and mutual funds and foundations). The problem is that this worked so well for more than a decade that everyone felt it would work well forever…it even survived in the banking crisis of the 1990’s…and that was a bad one as rates were rising, driving down the value of the underlying collateral. Now, theoretically the collateral if it is muni’s, is appreciating while short term rates are coming down…then it was vice versa. As for it workiing for so long…BofA succeeded for decades in borrowing short (huge core consumer savings accounts plus cheap funds from their correspondent banks), and writing 30 year fixed rate mortgages…which almost put them out of business and eventually due to a weak economy, like First Interstate and others forced them to merge.
But when fear enters the equation, all bets are off and there is more than enough fear to go around and when that happens we all know what follows: cash becomes king…not mutual fund cash but real cash and treasury bills!
On Friday, TB discussed how the indenture impacts the rate on ARS in a failed auction. Some like the NY/NJ Port Authority are great for the investor…20% till next reset…don’t know if that is for 7 days or 28 or 35 but do know that Goldman has likely lost a huge account for not supporting the auction…but it tells you that even they have capital problems…more on capital later. On the other hand some like the Nuveen 28 day reset at a spread to LIBOR…close to 1% now…and that is the worst of all worlds since you can’t get your money back and you are earning a below market rate. TB has some at 4.50-5.50% tax free that you could borrow against and still have an arbitrage. The problem would have been much worse had it been at yearend but the tax season is the only other period where liquidity if an issue for ARS. So TB feels that this problem will rectify itself in one to a maximum of three months and as long as the underlying security is good…as with NY/NY Ports or the one’s TB owns no problem…if it is lesser quality collateral there may be a problem…so let’s look at the consequences.
Many issuers of ARS such as charitable foundations (Metropolitan Museum of Art, San Franscisco’s de Young Museum, Deerfield Academy – where the Kennedy’s go), will suffer as they will lose that arbitrage which helped them maintain their activities in a low interest rate environment. So along with decreased demand there will be decreased supply and that means downward pressure on other money market investment eligible yields. Even if, as TB suspects, the monoline insurance problem is solved, investment guidelines will be rewritten decreasing demand as well as now we know the unthinkable has happened: Wall Street firms failing to defend auctions which are their bread and butter.
The other fallout may be the long municipal bond market. Through ARS, states and municipalities were availed the option of issuing long term debt or creating a derivative with say a 30 year maturity that auctioned weekly or monthly lowering their borrowing cost…other investors did the same thing. The mechanics are simple: say buy $100 million of a 30 yr bond, create two new securities with it, one for $50 million with same terms as the original, and $50 million of floating rate debt. If the coupon is 5% and the rate is less than 5% they earn more (i.e. 3% 35 day rate vs 5% coupon rate + .5 x [5% – 3%] = or a 6% yield…only above 7% financing would they earn less than a market yield. IF that happens for one or two times you re-link the issue into a $100M 30 yr bond and you can then sell $50 million and you are no longer leveraged. BUT what if hundreds of issuers are doing the same thing. You are double whammied by seeing the market value of what you decline and the prospect of a lower return in the future…so far due to their penurious indenture, they are making even more money but creating a lot of investors who will never buy them again unless the terms are more favorable…consequently the yields on the underlying Nuveen funds will fall significantly…especially if the market value on long muni debt falls sharply. Hope that example is clear to you but be sure you know what is in your mutual fund and how highly it is leveraged. Also note that most have a current yield well above the underlying yield to maturity as they typically buy high premium bonds to inflate returns…while eroding your principal.
One way to avoid this is to invest in muni ETF’s (although if there is heavy selling of long muni’s the value could also decline but not as much). There are three issued by iShares (national, Cal, and NY), and another issuer has similar…TB prefers the iShares due to their experience and total transparency.
4. In the beginning there were mortgages…then the Govt. Sponsored Entities (GSE’s) were created to keep the housing market going. Fannie and Freddie were then spun off as quasi-government agencies whose job was to create even more mortgages without requiring more government debt. It worked and generally well for investors until a series of incompentencies and frauds occurred. Then it wasn’t fun any longer. To their credit, and Wall Street’s (although the originator was the World Bank wit Citicorp), a new instrument or Collateralized Mortgage Obligation (CMO) was created. Rather than appeal to just long term investors like public and private pension funds there was something for everyone…especially for parsing them up into bits and pieces. Over time they became more exotic with Interest Only (IO’S) and Principal Only (PO/s), that speculators could buy depending on whether there view was of rising or falling interest rates. Then we morphed even further and finally subprime mortgages were packaged into CLO’s with the factor being rating rather than maturity. Ah but there was now risk…no problem as Wall Street then created the Credit Default Swap (CDS) which like the earlier CMO’s parsed risk protection out creating a market between those who felt they could divine the degree of risk…those securities grew to the point (as TB wrote earlier they weren’t retired but the other side, say selling insurance vs. buying it,
created layers and layers of swaps. Those swaps now total $45 trillion or so and while they may appear to be hedged as they create them on the spreads between buying and selling insurance, the weakest link can create an unhedged position which could cause a chain reaction especially when the players are highly leveraged and think they are hedged. That is why liquidity is so important here. Worse, nobody knows where the risk lies and that is why this situation is out of control of governments or their central banks. One day soon you will see someone fail…and probably unexpectedly like finding out the exposure to ARS of Bristol Meyers Squibb…and the multiplier effect…also like the ARS market will kick in. Now here is the clincher: the increase in the conforming loan rate for one year to $729,750.
$417k is now the minimum but depending on the area you live in (your SMSA, not county), the limit is 125% of the median home value up to $729,750. Great! …uh, not so fast. See since this is just for a period of one year and to curtail refinancing. FNMA/FHLMC will not allow a re-fi on a loan they have held for less than one year…after all they are the lender of last resort (recall there is also a move by the Dems in Congress to let a bankruptcy judge change the terms of a mortgage…a really bad idea). So it sounds good…loan consolidation you name it but remember you have to have at least 10% equity (might be higher for the higher conforming loans…hence super conforming), and no more than 35% of your income can be spent on the mortgage payment. Also remember these are 30 year amortizing loans. So?
Here are the problems:
1. the higher limit is for one year…what happens after one year since banks only want to make conforming loans so they can get them off their books? But they do want to continue to service them!
2. Not only the restrictions but the rate is higher on the larger superconforming…think the old conforming and jumbo…and we now have super jumbo (above $1MM)…so that makes four classes with subprime now a relic.
3. While FNMA/FHLMC may have the desire to buy the mortgages they not only need the money (of course they can resell them), and that requires more capital…they already have common stock, not a talking point, Preferred which they stupidly issued for stock buybacks and the new high interest preferreds which mean new classes will require even higher rates, as well as their senior and collateralized debt and subordinated. TB has said and had concurrence from some that nothing but the senior and collateralized debt will be paid under moral obligation in a bankruptcy…forget about too big to fail…only what the government guarantees is too big to fail…shareholders and preferred bondholders don’t count…recall Continental Illinois!
4. All of this will drive long term debt levels higher. According to the Mortgage Bankers Association, despite the rapid easing by the Fed as of Feb. 8, 30 yrs loans were 5.72% vs. 6.24% a year ago and vs 5.49% on Jan 18…the Fed is pushing on a string. 15 yr fixed is more promising at 5.18% vs 5.94% but also bottomed out at 4.96% on Jan .18. Only 5 and 7 year balloons continue to decline…4.78% and 4.34% respectively vs 5.93% and 5.31% a year ago. Now look at this 1 yr Treasury ARM’s: 6.80% vs 5.80% a year ago…they too bottomed out at 5.51% on Jan. 18…two 50 basis point easings ago! What will happen a year from now after the new limits revert down?…or will they be extended?
In conclusion, until we recognize the problem and get out of our state of denial, we cannot solve it. To do so, like with the dealers and ARS, requires the unthinkable: cut back consumption and raise the savings rate…if that happens a secular bear market is assured…yet that (along with World War II) got us out of the Great Depression. Do you really need four cellphones and four cars for your four person family? Cable with all the options…plus XMSR or Sirius with Howard Stern, the NFL and Baseball? For 25 years we have borrowed from the future to feed our habit. That has just come to a halt. Like with financial engineering which gave back decades of revenues in less than one year, it will take years to work off the excesses of the past 25 years…yet we will get through it. Talk to people who lived through the Depression…almost uniformly they will say they were never happier…friends and family meant everything…friends and family ARE everything. Do you even know your neighbors? We will survive!
As many of you know TB’s daughter lives in Minneapolis. She works at Children’s Hospital in St. Paul. A girl who works with her went with her aunt to tryouts for Deal or No Deal. The aunt wasn’t selected, but TB’s daughter’s friend, Katie Hinsler was. She holds two jobs, the other working for a church while her husband started a new business a year ago. She not only went on the show but it was the first ‘Million Dollar Mission’ where have the suitcases were $1 million. While that may sound easy, they made it harder by lowballing the deals thus pushing her towards going all the way. At the last two suitcases she had either won $1 million or $200…she took the deal nearly $500,000. It was great! Everyone affiliated with the show said she was the most worthy and nicest contestant they had ever had on the show. Only bad news? Her suitcase was the $1 million…so what, she played it right! Last night she held a party to watch the show…she couldn’t say how much she won…at a hotel there. See TB can tell an upbeat tale or too.
Hope good things happen to you too this week. Again, sorry about the length but it could save you $.
TB
Trader Bill thinks it is clear to anyone reading these missives that they are merely commentaries…as he sees it…and in no way reflect the views of anyone other than himself. Information is gathered from sources he has found reliable, but no guarantees of accuracy are implied. No fee…nothing to sell…merely observations of events in the marketplace offering a non-mainstream viewpoint…sometimes…usually? Hope you find it useful.
Copyright TBD Capital LLC February 19, 2008
Copyright TBD Capital LLC February 19, 2008
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