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A “Sour Sixteen” Thoughts on the Real Estate Markets

Before I begin this evening, let me just mention that I have expanded my blogroll. These are the blogs that are on my RSS reader at present. As I add more, I will add them to my blogroll. One more thing before I start: the comeback on Friday was nice, but I don’t think this is the end of the troubles; the leverage issues still aren’t dealt with, though the money markets (CP, ABCP) may be getting reconciled in the short term. Tonight’s topic is the mortgage market:

  1. Reduction in capacity is the rule of the day. Who is shrinking or disappearing? Lehman’s subprime unit, Thornburg (shrinking), Luminent (cash injection under distress), American Home (what were the auditors thinking?), Capital One (closing Greenpoint), Countrywide (layoffs), Accredited, HSBC’s US mortgage unit, and more.
  2. Who has lost money? Who has decided to pony up more? Carlyle ponies up, Bank of China, speculators including Annaly, and many others, including IKB, BNP Paribas, and British, Japanese and Chinese banks. The losses are mainly a US phenomenon, but not exclusively so.
  3. Thing is, in a credit crunch, before things settle down, everyone pays more. The CEO of Thornburg suggests that the mortgage markets aren’t functioning. Well, if excellent borrowers aren’t getting loans, he is correct. After risk control methods are refined, new capital finds the better underwriters, who underwrite better loans. For those with good credit, any imbalances should prove temporary.
  4. Now what do you do if you are a surviving mortgage lender, and you can’t get enough liquidity to lend? Raise savings and CD rates. (A warning to readers: no matter how tempting, do not lend to mortgage lenders above any government guaranteed threshold on your deposits.)
  5. Could the Truth in Lending Act cause loans to be rescinded? As I commented, If TILA claims are successful, there would probably be a breach of the reps & warranties made by the originator. I think there is a time limit on the reps and warranties though, and I’m not sure how long it is.
    If a securitized loan has to be taken by the originator, the AAA part of the deal will prepay by that amount. Losses will be borne first by the overcollateralization account, and then the tranches, starting with the most junior, and then moving in order of increasing seniority. If a bank goes insolvent as a result of this, any claims against the bank by the securitization trust would be general claims against the bank.

    Very interesting, Barry. Thanks for posting this. It’s just another reason why in securitization, it is better to be a AAA holder, or an equity holder. They have all of the rights — the AAAs when things are bad, and the equity when things are good to modestly bad.

  6. Or, could Countrywide, and other lenders run into difficulties because they might have to buy back loans that they modify the terms, if they are pre-emptive in doing so, rather than reactive to a threatened default? On the other hand, modifications are generally allowed for true loss mitigation, or if they are loss neutral to the senior investors. But what if the servicer offers modification to someone with a subprime loan who really doesn’t need it? Not likely in this environment. Almost everyone who took out a subprime loan expected to refinance. Modification is just another way of getting there.
  7. What could fiscal policy do to get us out of this mess? Maybe expand Fannie and Freddie, or FHA? Or have a bailout from some other entity, as Bill Gross or James Cramer might suggest? I’m a skeptic on this, as I posted at RealMoney on Thursday:

    David Merkel
    Every Little Help Creates a Great Big Hurt
    8/23/2007 5:09 PM EDT

    So there are some that want the US Government to bail out homeowners. Need I remind them that on an accrual basis, we are running near record deficits? Never mind. In another 5-10 years, it won’t matter anymore, because foreigners will no longer fund the gaping needs of the US Government as the Baby Boomers retire.But so as not to be merely a critic, let me suggest an idea to aid the situation. Income tax futures. We could speculate on the amount the US Government takes in, and the IRS could use it for hedging purposes. One thing that I am reasonably sure of: tax rates will be higher ten years from now, and I would expect the futures to reflect that.

    Position: long tax payments

  8. Beautiful San Diego, where my in-laws live. What a morass of default and foreclosure, as is much of California. Good blog, by the way.
  9. For those who have read me at RealMoney, the troubles in residential real estate came as no surprise to me, though many at Wall Street were either surprised, or feigning surprise.
  10. One other easy way that we can tell that we are in a residential real estate bear market is the incidence of fraud. Face it, in a bear market, the scams play to the fear of people, whereas in a bull market, they play to their greed.
  11. What effects will the increase in consumer debt, including mortgages, have on the economy? Well, the Fed Vice-Chairman wrote a piece on it, and the answer is most likely slower growth in consumer expenditure, and greater sensitivity of demand to interest rate movements.
  12. What happens when the equity and debt markets get shaky? Commercial landlords in New York City and London get nervous. Personally, I wouldn’t be that concerned, but perhaps some of them overlevered? (Hey, remember how MetLife sold a large chunk of their NYC properties for record valuations? Good sales.)
  13. How much value will get wiped away before the residential real estate bust is done? $200 billion to several trillion (implied as a worst case by the article)? I lean toward the several trillion figure, but not strongly.
  14. Something that trips people up about the mortgage troubles, is that little has been taken in losses so far, why is there such a panic? Markets are discounting mechanisms, and they forecast the losses, and bring the currently expected present value of losses to reflect on the value of the securities. Beyond that, weak holders of mortgage securities panic and sell, exacerbating the fundamental movements.
  15. Why are credit cards doing well when mortgages are doing badly? This is unusual. What it makes me think is that there is a class of homeowner out there thinking: “The mortgage? I’m dead, no way I can pay that. I have to look forward to renting in the future, and I don’t want to destroy access to my credit card.”
  16. Finally, ending on an optimistic note: even if housing is so bad, in a global economy, it may not mean so much to the stock market. That’s my view at present, and why I am willing to be a moderate bull, even as I continue to do triage on my portfolio. (PS — that graph entitled, “Trouble at Home,” is scary.)

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3 Responses to A “Sour Sixteen” Thoughts on the Real Estate Markets

  1. Follow the paper, commercial paper, to assess the damage

    If you’re not holding securities backed by subprime mortgages, that is if you’re 98% of all investors, this summer has been a wacky ride for your portfolio but hardly a killer. The major stock indexes are still in positive ground…

  2. James Dailey says:

    I think your 2nd item is mistaken regarding Annaly Capital Management. There has not been any public disclosure of any losses for NLY. I have listened to their quarterly calls for several years and based on their last release and rhetoric, they have been in AAA gov’t guaranteed GNMA and FNM/FRE paper. They announced an IPO for a vulture company Chimera, which seems to me to be a move made from a position of strength to take advantage of the inevitable overshoot in the mortgage market.

    Would you care to clarify what you are referring to regarding losses at NLY?

  3. Annaly is in the “pony up more” category. They see bargains in the mortgage space, and no, I haven’t seen any losses. I think they are being opportunistic.


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.

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