Annaly (NLY) CEO Mike Farrell is nobody’s fool. His is the one mortgage REIT that got it right. In the face of a scoffing Wall Street that thought he was nuts, he positioned his company to take advantage of the very economy we’re now in: A pretty dysfunctional one with falling rates.
What now? Let’s just say inflation is the least of his worries. If you think this housing “thing” is overblown, the credit crunch is “contained” and the markets have discounted the bad stuff, grab a bottle of Maalox, sit back, put up your feet and read some excerpts from what he told his shareholders the other day after announcing third quarter earnings:
On October 15th, 2007, Federal Reserve Chairman Ben Bernanke addressed the Economics Club of New York. After his prepared remarks, the Chairman took a question from Henry Kaufman, who wanted to know what kind of information he would like to receive from the risk takers who were both lenders and borrowers in the structured markets. Bernanke thought for a moment and then replied, with an air of resignation in his voice, Id like to know what those damn things are worth. The thousand or so participants in the New York Hilton ballroom thundered their applause.
Numbers can be seductive. They can speak breathlessly in low, hushed tones of certainty, make loud cries of success, or whisper of potential opportunities. Many people love numbers because they seem to have a final, conclusive nature about them. They seem so solid, so predictable. They are the basis of every relationship in the universe. Human beings have always sought to quantify, compare, analyze, study and reach definitive conclusions with numbers. Indeed, the famous adage, Numbers dont lie, summarizes much of what motivates and ultimately satisfies us.
We are about to explain to you why numbers are not always what they seem to be, even when they add up. Financial engineering, to boil it down to its essence, is applying assumptions to numbers to arrive at conclusions. For instance, in the case of collateralized debt obligations: If house prices always gain an average of 5% per year then the over-collateralization of mortgage cash flows will provide support for the cash flows of the structured, tranched debt. AAA assets are assumed to be protected with cash flows from lower tranches, which are protected by risk-takers who would receive any excess cash flow in exchange for taking equity risk.
Certainly, in deals that have billions of dollars of assets in them, mathematically at least, these cash flows provide outcomes which give comfort to investors in all of the different levels of the CDO capital structureAAA, AA, etc. Structurers, traders, rating agencies, regulators, investors all became enamored with the same super modeling techniques at the same time. The profiles sculpted by this financial engineering were alluring.
The affair lasted longer and was more passionate than many skeptics could believe. But what happens if the key assumptionhome price appreciationthe single criteria by which all of these cash flows are vetted is not a valid assumption. When all of this occurs, and the affair ends at every level, you dont get the summer of love. Essentially, you get the summer of 2007.
Today, the ultimate vision that must be dealt with is that the largest asset in most Americans lives, their home, is dropping in price, while the cost of financing their largest liability, their mortgage, is rising. When we survey the world from our corner of the credit markets, and view the disruptions that are happening globally, we assemble all of the pieces of the puzzle and come to one logical conclusion: We are witnessing the piercing of a worldwide debt bubble. The central banks of the world are simultaneously being forced to shift fronts from being inflation fighters to fighters of the evil that dare not speak its name .deflation. Or to use the words of Ben Bernanke, Id like to know what those damn things are worth. This is the definitive statement in a deflationary environment
And if you think this housing “thing” is really no big deal, especially when you look at the bailout of the Resolution Trust in the early 1990s, Farrell, who likes doing the math, has some news for you: The mortgage crisis equals about 15% of the country’s GDP; Resolution Trust was more like 6%. “Even if we are wrong by 50%, it is 7.5% of GDP, still larger relative to the economy than it was in the early 1990s.”
The beat goes on…