Diving for Pearls in a Sewer

[EJ]

April last year we warned in Risk Pollution that the banking industry had for years externalized credit risk costs the way chemical companies externalized toxic waste costs in the decades leading up to the chemical pollution crisis of 1960s.

A year later, as a few thousand carefully modeled but carelessly made property loans turn turtle, the toxic risk is starting to ooze out of the bottom of the credit market sea, in the form of sub-prime market loan defaults. As our qwerty pointed out, anyone trying to find good debt plays in the current risk polluted sea of bad credit is diving for pearls in a sewer.

Our Aaron Krowne's lender implode-o-meter site got some press this week from Bloomberg. Listed among his news links is this story from HousingWire, Mortgage Risk Exposes CDOs to Significant Potential Losses.

Risk in the U.S. mortgage market may have been severely understated for years, according to market analysts in a paper presented late Thursday at Hudson Institute, a public policy research organization.

Drexel University’s Joseph Mason and housing analyst Joshua Rosner from Graham Fisher & Co. unveiled new research which raises concerns that mortgage-linked collateralized debt obligations (CDOs) are exposed to significant and unanticipated losses if the U.S. housing market continues to stagnate.

CDOs are structured derivatives that aggregate existing securities, and the authors argue that MBS pools have become the predominant class of assets backing a majority of collaterized debt obligation issuance.

“The FDIC reports that 81 percent of the $249 billion of CDO collateral pools issued in 2005, or $200 billion, was made up of residential mortgage products,” the study said. “Moody’s CDO Asset Exposure Report for October 2006 reveals that 39.5 percent of the collateral within the 678 deals covered by Moody’s consists of RMBS, just over 70 percent of that in subprime and home equity loans and the other 30 percent in prime first-lien loans.”

Next week we publish an interview of Jim Finkel, CEO of Dynamic Credit. Dynamic compiles collateralized debt obligation (CDO) packages for investors, specializing in bond portfolios and hedge funds. Mr. Finkel has been in the CDO market for more than twenty years. He Numera Securities lead banker in starting 1992, helped form Bear Sterns' structure products group 1995, was a pioneer in the euro CDO market in 1998, and founded Dynamic Credit in 2005. Jim explains the current market for CDOs, and tells us what be believes is likely to transpire in the CDO market as the market for sub-prime and second homes goes through stress.

The highlights are that vintage 2006 mortgage loans are ugly, that the risks are in the sub-prime and second home markets, but that the CDO market will hold up if home prices nationally do not decline more than 15%, and if they decline 20% or more, all bets are off. Robert Shiller predicts such a 20% decline nationally is likely, and the lesser known Karl Case, as reported here, believes a greater than 20% price correction is virtually guaranteed.

Makes for an interesting interview. Look for it next week.

Our Sean O'Toole's proprietary data from his new company Foreclosure Radar–released today and only available here–shows the dollar volume of properties returned to lender at auction. Volumes were $543 million in September last year and... $1.3 billion in January 2007.

On careful inspection, it doesn't appear that this particular set of defaults conforms to model. Sean reports that vintage 2005 loans dominate the 3000 properties in January's count, not 2006. That makes sense, as three year ARMs are just starting to adjust from 2005. What does this bode for the 2006 vintage? Even worse, we'd guess.

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[akrowne]

Re: Diving for Pearls in a Sewer

The zillow numbers for bubble markets like DC already show 15%.

[jeffolie]

Re: Diving for Pearls in a Sewer

Most readers of iTulip must take it for granted that the housing crash will take years. Already the subprime mortgage derivatives are down 20%. The defaults are spreading to the prime borrowers. In 9 months the US will lose one million jobs related to real estate and construction. The economy will sink like a stone.

The Fed will lower rates and expand the money supply. This will not work because you can not make the people buy into a falling market. The psychology of the housing buyer has already changed to a 'wait and hold for a lower price' point of view. The Fed will be pushing on a string.

CDO will suffer as the collateral, housing mortgage securitized bonds suffer.

I have no doubt that housing will decline more than the 20% line in the sand as stated in the original piece.

[Jim Nickerson]

Re: Diving for Pearls in a Sewer

John Mauldin 2/17/07 http://www.safehaven.com/article-6932.htm

Some 79% of the loans by FirstFed Financial were so-called stated income loans, in which the borrower's income did not have to proven with W-2's, tax statements, or payroll checks. The list of institutions with such problematic loan policies is long. And the result is that there are going to be a lot of new homeowners getting into financial difficulty. The Center for Responsible Lending estimates that as many as 20% of the subprime mortgages made in the last two years could go into foreclosure, or about 5% of the total homes sold. If just half of those homes come back onto the market, it will cause home prices to fall, limiting the ability of people to borrow, causing valuations to fall and a reduction in MEWs.

Compound that with probable legislation sponsored by Democratic Congressman Barney Frank and Senator Chris Dodd to tighten up lending standards and disclosure rules, and you could see loans at the lower end of the market dry up. And by the way, full disclosure requirements would be a very good thing.

The subprime mortgage market is going to be a scandal by the end of this year, as these loans have been packaged and sold as investment-grade bonds by numerous investment banks, mostly to European and Asian institutions. Some of these Collateralized Debt Obligations, or CDOs, are going to default and there is going to be a major wave of lawsuits.

So, will there be a recession? I still think so, and I think the culprit is going to be the housing market, which is going to trigger a slowdown in consumer spending, the first such slowdown since 1991. If Fisher is right and the housing market is getting ready to take off, then I am going to be not just wrong, but really wrong. We'll see.

[akrowne]

Re: Diving for Pearls in a Sewer

The Fed will lower rates and expand the money supply. This will not work because you can not make the people buy into a falling market. The psychology of the housing buyer has already changed to a 'wait and hold for a lower price' point of view. The Fed will be pushing on a string.

I'm not entirely sure the Fed will lower, but if they do I agree with the rest. I am now beggining to think of 2000/2001 as a failed attempt to prevent recession by pushing on a string. 95% of the possible financial loosening was already spent by the mid-90s.

The only reason there was no consumer recession the latest time was because China stepped in, like a knight on a white horse, to fuel HELOC (the Fed did some things, but by and large China's influence on 10-year Treasuries had to be the predominating factor).

[Jim Nickerson]

Re: Diving for Pearls in a Sewer

In support of jeffolies matter-of-factually stated opinion

The Fed will lower rates and expand the money supply.

I ran across an article by Paul Kasriel who is someone who strikes me as generally rational in his interpretation of data. He wrote an article: The Fed Probably Thinks It Is On Hold for All of 2007, February 7, 2007 http://www.financialsense.com/editorials/kasriel/2007/0207.html in which he posits that the next move by the Fed will be later this year "perhaps on August 7" and will be a rate cut.

His article is devoted to contradicting the title of it. To me his arguments seem solid. He thinks the bottom in the housing market decline of real residential investment expenditures could go a bit further from about the -13% so far from their Q3:2005 peak, and notes that the average peak to trough since WWII is about 25% unless this time it is milder.

[qwerty]

15% drop in what kind of properties?

The zillow numbers for bubble markets like DC already show 15%.

That 15% fall in property values which damages the CDOs, do you think it's 15% of ALL properties, or 15% of the kind of properties that ARMs tended to buy.

Looking at Zillow averages for a city or area might not be the most accurate wy to guage the price changes for, let's call them, "ARM-class properties".

Would they tend to me found in certain zipcodes? So that the Zillow average for a zip code with a certain socio-economing rating would be a good monitor of ARM-class property prices?

Would they tend to be the lower priced properties? In which case a sample of 10 houses at the low end within a zip might be interesting to compare against the average.

Anyway, I'm just thinking that in certain zips or cities, the average can contain high-end properties holding their price, which smooths out the change in price of a certain class of properties ("ARM-class")

[lewman]

Re: Diving for Pearls in a Sewer

I have no doubt that housing will decline more than the 20% line in the sand as stated in the original piece.

If you meant a 20% decline in nominal price than I have to say I'm not so certain.

I used to believe it would be the case and that was until I looked at the housing index (using Los Angeles as an example) in the 1980s. Following a period with double digit gains in the 70s, LA housing prices basically stayed flat during a correction period from 1980~1985 before prices resumed its up trend from 1985 to 1990.

I was told by someone the reason prices stay flat (instead of down) was because it was duing a period of high inflation. Hence, while nominal prices stayed flat, real prices actually went down a lot, as reflected by the long term Schiller housing index chart which I'm sure a lot of us have seen.

I was under the impression that Volker had killed (or at least contained temporarily) the inflation beast by the early 80s so I wasn't sure if the above explanation was reasonable, but for argument's sake let's say that was it (but pls feel free to suggest otherwise). So history seems to have shown that housing market COULD correct by having flat nominal prices while real prices revert to the mean. And if this happens again perhaps we could avoid the CDO / debt default catastrophe. To repeat history we need high inflation again. And this is a scenario that is not inconceivable as per the Ka Poom theory.

Sound possible ?

[jk]

Re: Diving for Pearls in a Sewer

If you meant a 20% decline in nominal price than I have to say I'm not so certain.

I used to believe it would be the case and that was until I looked at the housing index (using Los Angeles as an example) in the 1980s. Following a period with double digit gains in the 70s, LA housing prices basically stayed flat during a correction period from 1980~1985 before prices resumed its up trend from 1985 to 1990.

don't forget what happened to long-term interest rates over the course of the 80's. i don't think exotic mortgages existed back then, and i'm not sure whether arm's were even available. the rate that counted was the 10yr treasury and that rate dropped markedly over the course of the decade. the recession of the early 80's ended and the stock market began its take-off to the '87 peak, drop and renewed rise. affordability was supported by dropping mortgage rates and economic strength.

looking ahead, it's hard to see 10yr moving a lot lower, though they might during a deflation [not the assumption we're analyzing] or if directly controlled by the fed [possible]. our assumption is that short rates will drop markedly in response to the ka, and that will make arm's more affordable. the ka is already tightening lending standards, and presumably that process still has a while to go. summary- dropping short rates means the availability of arm's will tend to cushion real estate prices unless unemployment shoots up to further reduce the pool of buyers.

[grapejelly]

Re: Diving for Pearls in a Sewer

So history seems to have shown that housing market COULD correct by having flat nominal prices while real prices revert to the mean. And if this happens again perhaps we could avoid the CDO / debt default catastrophe. To repeat history we need high inflation again. And this is a scenario that is not inconceivable as per the Ka Poom theory.

Sound possible ?

These cycles tend to go on a lot longer than anyone imagines.

We may just be at the beginning of a 1970s inflation.

So far CB credit expansion has hit financial assets and real estate and commodities. Next stop wages and goods? I think it is very possible.

Of course, with higher wages, debt service of existing mortgages becomes possible and housing prices do not fall in nominal terms.

[housingwire]

Re: Diving for Pearls in a Sewer

Eric -

Thanks for noticing the work going in to the news put out on Housing Wire. I'd like to think we're reporting what's really going on - and that we're ahead of other news outlets ... this story was definitely one of them, as I'm seeing much more discussion of the risk of housing to CDOs appearing in other outlets this week.

What hasn't been discussed -- yet -- is that servicers have been unloading residuals very profitably, which has not only pumped up the balance sheet a little more, but helped mitigate risk. With CDO managers pulling back from subprime RMBS junior tranches, loan servicers are not only losing a source of income but are also gaining additional risk at a time when they can ill afford it.

Call it getting hit from all sides.

best regards,
P. Jackson
Publisher, Housing Wire
http://www.housingwire.com