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Sub-prime mortgages have been at the top of the air-waves for about a year now. The collapse of two hedge funds run by Bear Stearns (NYSE:BSC) started the procession. Numerous Wall Street executives have lost their jobs and banks have been writing down about $250B in losses attributed to products linked to sub-prime mortgages.

Last week, two major chief executives at two major Wall Street firms made some encouraging statements about the current situation. Goldman Sachs’ (NYSE:GS) CEO Lloyd Blankfein feels that the markets are probably in the late stages of the credit crisis, though he did not predict when exactly the crisis will end. Morgan Stanley’s (NYSE:MS) CEO John Mack was more definitive in his statements. He used a baseball analogy to say that the sub-prime crisis is at the bottom of the eighth or the top of the ninth innings. He feels that the broader crisis will go on for a few more quarters.

These views are significant since both these firms made headlines during the crisis. Goldman Sachs was adroit in circumventing the crisis and booked handsome gains in betting against sub-prime mortgages. Morgan Stanley also bet against sub-prime mortgages, but its strategy underestimated the magnitude of the problem, and the firm ended up taking losses of more than $9B. It also led to the departure of an entire chain of executives from the MD leading the desk, all the way up to the company’s co-president Zoe Cruz.

Sub-Prime Rate Reset Shock: No Longer a Major Issue

A note by Morgan Stanley research has reduced the reset cash-flow step-up (extra payments needed after resets) by 50% from what it estimated last year. The lower interest rates are making a difference since the mortgages are no longer resetting to a significantly higher rate. A bulk of the sub-prime loans were 2/28 ARMs which reset after two years to a rate equal to LIBOR (6m) + 6%.

The initial so called teaser rates were in the range of 7-9%, significantly higher than what a prime borrower would have paid. During 2006 and 2007, the 6m LIBOR was in the range of 5-6%, which meant that after resets, the rate went up to 11-12%.

With the housing market slowing down and a lot of home owners caught with little or no equity, the sub-prime borrowers could not refinance into better priced mortgage products and were stuck with monthly payments which were significantly higher than their original teaser rates. Sub-prime borrowers whose mortgages reset during this period were stuck between a rock and a hard place, and many were unable to keep up with their mortgage payments.

However, over the past year, the Fed has cut the discount rate significantly and after some hiccups, the LIBOR rates have also followed in. At this point, LIBOR rates are between 2.5 and 3%, and the rate after reset is often equal to or even less than the original teaser rate. So, as long as sub-prime borrowers' income has not fallen, they will be able to make the payments as before.

This means that home owners who truly want to stay in their homes will be able to, often with lower payments than before. There are several federal government programs in the pipeline which will assist sub-prime borrowers in refinancing into fixed-rate mortgages with lower payments than before. Speculative buyers who got in with little money down will continue to walk away from their homes.

Alt-A Mortgages: Reset Shock Much Less

There has been a lot of media attention on Alt-A mortgages, which are taken by home buyers whose credit is not prime or income is not substantiated. Since the income is stated, these loans have been labeled ‘liar loans.’ The bubble in housing encouraged speculators to sign up for these loans. Many market watchers believe that Alt-A is the next shoe to fall.

However, a lot of these loans are made to self-employed professionals, especially those in the early stages of their career. These loans are unlikely to have a significantly higher default rate.

Many speculators who took Alt-A loans are existing home owners who do care about their credit-history. Though the default rates are going to be higher, many of these folks will not walk away from these homes since they have a lot more to lose over time with a mortgage default on their credit history.

Furthermore, these buyers are naturally bullish about housing as an investment and will be more willing to take the short-term pain for the long-term gain. Like the sub-prime borrowers, the lower interest rates mean that once the Alt-A mortgages reset, the change in monthly payments is unlikely to be significant.

A U-Shaped Housing Bottom

In February 2008, the US Housing Affordability index published by the NAR reached 135, its highest level in 5 years. The increase is a result of falling home prices, lower interest rates and rising incomes. This is significant, since 2003 was in the early phase of the housing boom, and with affordability rising to that level, it means that the excess has leaked out of the bubble. Home prices are gradually coming to harmony with wages and the cost of mortgages.

Though the ability to pay has risen, there is still a big supply overhang which will continue to put downward pressure on home prices. The increasing number of foreclosures will dampen the market further. Prices are likely to fall more, but the rate of price decrease will reduce in the latter half of the year. Home builders are cutting back on new construction, home sellers are cutting prices to move homes and first-time buyers have started coming back to the market.

I expect the prices to start stabilizing by the end of the year and form a U-shaped bottom where the prices will not go up much but stop falling. The bottom of the U might be quite long (2 years perhaps), but the end to the decline should be visible soon. Rising private sector interest in buying foreclosed properties this spring is a good indication of the beginning of the bottom.

Credit Crunch: CMBS

The expected fiasco in the performance of Commercial Mortgage Backed Securities has yet to materialize. Fitch Ratings reported that the February CMBS delinquencies rose to 0.30%, a whopping 0.03% higher than the historic-low of 0.27%. Banks and other holders of CMBS paper have been rushing to hedge their exposure and have pushed the cost of protection on these instruments to absurd highs. For example, on March 22 the WSJ reported that:

Securities are priced at levels that imply default rates could reach 80%, or even 100%, of their underlying loans, they say. Historically, though, the worst period in the commercial-real-estate debt market saw defaults on those bonds reach roughly 31%.

This action reminds me of the way banks have taken write-downs on their sub-prime holdings, often estimating that the collateral is worthless. Typical commercial loans have significantly lower loan-to-value ratios than home mortgages. Furthermore, most of them fund income-producing properties with a steady cash flow. Borrowers have huge financial incentives to keep the loans current since they run the risk of losing all their equity. Even if the bonds default, long term principal losses are not as severe since there is a big equity cushion.

The recent market action is not based on any observable change in the fundamentals of these bonds, but a result of the panic in the market surrounding the Bear Sterns debacle, which was exacerbated by hot money from hedge funds swinging in to make a quick buck.
Though CMBS will suffer during an economic slowdown, they cannot be compared to sub-prime mortgages; both the losses and the total outstanding amount are significantly less.

GE Results: The Credit Crunch Strikes

The equity markets were rudely surprised by the big earnings miss by GE (NYSE:GE), the company that never misses. The results were down due to a big miss in the GE’s financial segment, with some minor misses in Healthcare and Appliances. All the three under-performing segments are a direct fall-out of the housing related credit-crunch. Due to the dysfunctional Muni Bond and Auction Rate Securities markets, public institutions at the state and local level have been unable to obtain credit to finance big-ticket items purchases like the expensive medical equipment GE sells (e.g. MRI machines).

GE’s Commercial Finance division took a major hit since GE was not able to close on certain real-estate sales since the buyers could not obtain financing on time. GE has been timing the sale of its real-estate assets to smoothen out the earnings over time, and the credit-crunch caught the company on the wrong foot.

Transient or Permanent?

GE’s results make it clear that the credit crunch will affect the performance of companies who rely on big-ticket transactions by US-based buyers. The credit crunch was at its worst towards the end of March, the last few weeks of the quarter. As a result, the effects on earnings will be magnified since companies did not have any time-cushion to close deals which were stuck in the pipeline.

I believe that the credit-related misses we will see this quarter are a transient phenomenon and not a reflection of a fundamental shift. The credit-markets are opening up and such extraordinary events like the collapse of Bear Stearns are unlikely to reoccur with an activist Fed.

However, CEOs are going to be cautious with their forecasts since we have just come off a major dislocation. The equity markets are likely to react negatively to the coming misses and cautious comments. We might see another test of the lows and a wash-out capitulation in the coming weeks. I believe that this test will be a great buying opportunity, perhaps the last of this bear market.

Inflection Point

Last week, Dennis Gartman’s letter noted that tax receipts at the W-2 employee level are now showing signs of strength, in contrast with the slowdown in growth observed in the second half of 2007. He believes that they are best estimate of the current income of the American consumer and signals the start of the recovery is here. I agree with him, and will be aggressively buying US equities after this earning season disappoints.

Source: Housing, Credit, Economy: At an Inflection Point