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  • The Housing Tsunami's Second Wave
    Written and produced by Richard Benson

    Spokesmen for the Obama Administration and the Wall Street establishment refer to the slight up tic in lower-priced housing prices and existing home sales as a positive sign that we’re close to a bottom. Why is it, then, that housing prices in the mid to high-end range are still crashing? Indeed, if you close your eyes and listen to the happy talk, you could be swayed into believing that the massive credit losses from housing are coming to an end and economic recovery is finally here. But before singing the chorus to “happy days are here again”, you’ll need to open your eyes and take a look at some facts and their relationship to mortgage defaults.

    The first wave of the mortgage credit tsunami (which actually began around 2005 when loan underwriting started to unravel) was caused by hundreds of billions of sub-prime mortgages that defaulted. These loans were made to unqualified borrowers who couldn’t really afford the monthly payments, even if they had a job at the time the loan was made. Because there was so little warning of the approaching tsunami, it took a few more years for the storm to develop but when it did, it bankrupted Bear Stearns and Lehman Brothers and caused the nationalization of Fannie Mae, Freddie Mac, GM and Chrysler. Moreover, the fall in housing prices and the end of consumer refinancing kicked the legs out from under consumer spending, fueling unemployment and a now grim job market. Unfortunately for all, the sub-prime disaster was not the end of the credit crisis in home mortgages, but just the first wave.

    The next tidal wave of losses on home mortgages is testament to a failed housing experiment designed by the Federal Reserve under the false pretense of home ownership. In past years, mortgages were issued to responsible homeowners who took pride in home ownership and paid their mortgage on time. But when so many risky mortgage products, such as option ARMS, interest-only loans, cash out REFI’s, no money down, etc., became available to practically anyone looking to buy a house, regardless of income, these products became the rage (a 20 percent down payment to bind an owner to a property was so yesterday) and home equity literally vanished.

    The assumption that people will continue paying a mortgage without an equity stake in a property worth less than they paid was a false hope. Mortgage losses from sub-prime loans have now spread to Alt-A, Option ARM, and standard prime mortgages. Practically every town, city, and state has been affected in some way by the 16 million homeowners living in homes with negative equity (a home worth less than the mortgage). Buyers of property who experimented and gambled with other people’s money have been caught up in an American Dream that has now become their worst nightmare.

    Analysts at Deutsch Bank have forecasted that the 30 percent of underwater mortgages today could rise to 48 percent by 2011, so you won’t have to look too far to see what will happen to foreclosures and mortgage losses when the number rises to 20 million people. A study done on $1.7 trillion mortgages by Fitch Ratings lays out the cold facts in black and white on how people treat their mortgages:
    From 2000 through 2006 when homeowners actually had equity in their homes, and prices were rising, mortgages were paid on time. In this time frame, the mortgage “cure rate” was 19.4 percent on sub-prime loans, 30.2 percent on Alt– A loans, and 45 percent on standard prime loans.

    In 2009, when housing prices had crashed and home mortgages were under water, the “cure rate” for prime loans is a pathetic 6.6 percent (barely above the “cure rates of sub-prime at 5.3 percent, and Alt-A at 4.3 percent). No wonder over 50 percent of foreclosures are now on prime mortgages!

    The plan by Fannie Mae & and Freddie Mac to refinance loans up to 125 percent LTV is a failure. Very few underwater homeowners are falling for the loan modification government scheme. Even the FHA, which is now making 25 percent or more of all new home loans and will take as little as 3.5 percent as a down payment, has seen late and foreclosed loans jump from about 5 percent last year, to 8 percent today. FHA borrowers generally have lower credit scores, wages, and job skills. Since initial unemployment claims are still averaging 550,000 a week, many of these FHA borrowers will lose their jobs, causing an FHA loan default rate of well over 10 percent.

    In today’s world, homeowners motivated by cold hard economics and common sense are not stupid. When you don’t have any real equity in your house or are underwater and out of work, it’s time to mail the house keys back to the government or the bank! Foreclosures are picking up not only because mortgage holders are walking away, but when many people stop paying their mortgage, they also stop paying their property taxes. Local governments everywhere are strapped for cash and are willing to quickly sell tax liens on properties with delinquent taxes due. The buyer of a tax lien has rights to the property that come before that of the mortgage holder so if the mortgage holder doesn’t pay the tax lien, they could be wiped out when the holder of the tax lien files to get clear title of the property.

    So how big is the next wave in the housing mortgage disaster? Currently, one out of eight mortgages is in foreclosure or paying late, and with unemployment averaging over 9 percent for 2009 and 2010 and peaking in 2011, it’s likely one in five mortgages could ultimately default. Moreover, we have seen that less than 7 percent of those mortgages that are late will get cured and stay out of foreclosure. Over the last six months, notices of home foreclosures have been running about 350,000 a month, which is over 4 million a year. A lot of homes are headed to the auction block with their mortgages headed for the shredder.

    For mortgage losses we should recognize that prime mortgages on average are significantly larger than sub-prime, and it only stands to reason that the larger the house and mortgage, the bigger the loss. With over 50 percent of mortgages failing coming from prime loans, bigger loan losses lie ahead. The total losses to come is anyone’s guess, but the $11 trillion in outstanding home mortgages could easily produce over $2 trillion in defaulted mortgages, and another $600 billion of credit losses! So, until this wave has crashed on the shore, I would recommend staying away from the water!

    Richard Benson


    Disclosure: none
    Jan 06 9:28 PM | Link | Comment!
  • Lex Parsimoniae
    Trading, a skill mastered working around contradictions. Many are summarized by studying the familier trading catch-phrases. But letting profits ride runs the risk of allowing winners turn into a losers. The trend may be your friend but by the time it ends the position is often back in the red. Don't try to catch a falling knife because if price is falling fast and furious trying to play the hero gets expensive. A new favorite is don't be a dick for a tick which can be as financially damaging, leaving the trader sitting on a thumb while price heads off unless he decides to chase price. Only trade with money you can afford to lose but who can afford to lose anything?

    A well known currency trader sends out a weekly letter documenting the alerts sent out with the results of the alert subscription offered. The spreadsheet touts a 400% return since 2008 and a 70% win ratio on profit target #1. Looking over the trade log though the picture gets a little gloomier. The average loser is almost 40% larger than the average winner. We can call it bullshit because it contradicts the 3 to 1 R/R ratio or we can say this trader calls market direction very well and can make allowances on the downside until he is 100% sure the trade is bad.

    Similarly a Forex trading contest I took part in a few years ago had an eye opening result. The winner traded this system: His profit target was 1 pip -- his stop loss was a margin call. He won on the basis of the largest 1 month ROI (over 100%) and smallest draw-down. When interviewed by the contest sponsor, another well known personality in FX circles, the winner said he would never trade this way with real money.

    Pulling the trigger on a trade requires some idea of where price has the potential of going. That potential might represent three times the risk we took on the trade. But all traders have had price get 2/3 of the way there on a good move and turn around just as quickly. Trades have gotten with in one pip and flung back in this traders face. Having 30 or 40 pips in your pocket only to see in turn around is a really crappy feeling.

    Rudyard Kipling refers to triumph and disaster as two impostors in his poem “If”. Triumph is the Ferrari sitting in the driveway and losing, the margin call that causes your wife to throw a frying pan at your head. They are impostors because while we wish for one and dread the other, buying the Ferrari can be and often is a let down. The margin call, if you are able to dodge the frying pan, is often not as bad as you thought. How many traders in the Schwager books haven't recieved on. Not many.

    Everything in trading is about potential. Is a trade that doesn't reach its target really a winner? What about a trade that is stopped out to the pip and turns around just as quickly and races to a finish line that is no longer there. Every time the trader sits down at his station he has the potential to be disciplined and follow his plan or the potential to forget everything he knows and screw up.

    So if things are not working out, it's best sometimes to sit down and try to simplify even if simplifying bucks standard trading wisdom. Call it shaving with Occam's Razor. In the end the concept of fear is often misapplied. Traders must be MORE afraid of not winning than losing. Read below. It couldn't be summarized better.
    If

    by Rudyard Kipling


    If you can keep your head when all about you
    Are losing theirs and blaming it on you;
    If you can trust yourself when all men doubt you,
    But make allowance for their doubting too;
    If you can wait and not be tired by waiting,
    Or, being lied about, don't deal in lies,
    Or, being hated, don't give way to hating,
    And yet don't look too good, nor talk too wise;


    If you can dream - and not make dreams your master;
    If you can think - and not make thoughts your aim;
    If you can meet with triumph and disaster
    And treat those two imposters just the same;
    If you can bear to hear the truth you've spoken
    Twisted by knaves to make a trap for fools,
    Or watch the things you gave your life to broken,
    And stoop and build 'em up with wornout tools;


    If you can make one heap of all your winnings
    And risk it on one turn of pitch-and-toss,
    And lose, and start again at your beginnings
    And never breath a word about your loss;
    If you can force your heart and nerve and sinew
    To serve your turn long after they are gone,
    And so hold on when there is nothing in you
    Except the Will which says to them: "Hold on";


    If you can talk with crowds and keep your virtue,
    Or walk with kings - nor lose the common touch;
    If neither foes nor loving friends can hurt you;
    If all men count with you, but none too much;
    If you can fill the unforgiving minute
    With sixty seconds' worth of distance run -
    Yours is the Earth and everything that's in it,
    And - which is more - you'll be a Man my son
    Diclosure: non
    Nov 19 2:47 PM | Link | Comment!
  • John Riccitiello, CEO of Electronic Arts, Must Be Fired
    By: Mr Eb

    Electronic Arts (NASDAQ:EA) is probably the company dearest to my heart growing up. I had many pleasant childhood memories playing games like One-on-One and Seven Cities of Gold on the Commodore 64 and Populous on the Amiga. They simply made great innovative games then. Somehow however the company lost its way over the years. Last week's earnings report was the culmination of the demise as it announced one-third of its future title pipeline will be cut and another 1500 employees will be laid off on top of the 1100 fired just 9 months ago. Many of its AAA title launches such as Brutal Legend have flopped in the market-place. Even games like Dragon Age Origins and Need for Speed Shift are being discounted with promotional coupons and sales in the retail channel, a clear sign EA games are not selling to expectations.

    Looking back, one of the warning signs was the famous EA Spouse blog, where people internally knew the company was burning people out. The pattern was hiring talent, buying companies, and churning games out. The intense development cycles even as short as one year, bureaucracy, and lack of respect for their employees drove some of their best talent away. Management clearly didn't mind as long as the profits were flowing, but if you squeeze the golden goose too hard eventually the quality suffers.

    A key inflection point in my opinion is when EA decided to pay the NFL hundreds of millions more to get the exclusive on the football license. This told the world that money and power was all that mattered and this company decided it could not compete in the marketplace with Take-Two 2K Sports by making better games.

    Although the seeds of the decline were there for a while, I believe a huge part of the blame has to be laid at the feet of the current CEO, John Riccitiello. John was the chief operating officer of EA from 1997 to 2004. He then went off to co-found a venture capital firm called Elevation Partners until April 2007, when he was brought back to become CEO of EA. From there he had a series of decisions that to this day destroyed hundreds of millions, if not billions of shareholder value.

    1. Infinity Ward
    If you have been reading the news the past week, you know that Activision's Call of Duty Modern Warfare 2 has launched to great fan-fare selling $550 million worth of product in its first five days setting the record for biggest entertainment launch in history. But did you know that Infinity Ward, the key developer team of the Call of Duty franchise, started out making Medal of Honor games for EA? During that time John Riccitiello was a important managerial executive when the key members of the developer team left and joined up with Activision. I do not know the details of the departures, but the simple fact is he was there when the most important, future best-selling billion dollar intellectual property value slipped to a major competitor.

    2. Bioware/Pandemic
    After John left EA to start Elevation Partners, his first major deal was investing $300 million into Bioware and Pandemic in November of 2005. This was a head-scratcher to many people in the games industry. Most of acquisitions to this point have been the low tens of million dollar range from Irrational Games to Bungie which was bought by Microsoft. The only other mega-acquisition was Microsoft's $375 million cash buy-out of Rare, which by this point everyone knew was complete disaster.

    It also didn't make any sense because the market was clearly going to action-oriented first person shooters on consoles like Halo and Call of Duty. To invest hundreds of millions in a primarily niche PC role-playing game developer (Bioware) and a second rate action game developer (Pandemic) was be-fuddling to say the least.

    John became the CEO of VG Holdings (Pandemic + Bioware) until he quit to become CEO of EA in April of 2007. This is where things get interesting because six months into the job, EA announced it was going to buy Pandemic and Bioware for $620 million in cash and $155 million in equity retention. $775 million dollars to buy his ex-firm's portfolio company. The kicker is since John was a founder of Elevation Partners and ex-CEO of VG Holdings, he would make up to $4.9 million from EA buying the company he invested in 2 years ago. If that isn't a huge conflict of interest, I don't know what is.

    EA in their press release said John recused himself during the board meeting where the acquisition was discussed, but that is a total joke. As a newly minted CEO of a company considering a $775 million acquisition, obviously he had to be a driving force in completing this deal. The EA CFO at the time said they expected Pandemic and Bioware to do "in excess of" $300 million in revenue in 2009 and 2010.

    Flash forward today on news that the Pandemic founders of are leaving the firm, hundreds of people are being laid off, and Pandemic studio is essentially being shut down. Pandemic's core titles like Mercenaries 2 were flops. So two years after spending $775 million dollars for two studios, one of them has gone under. We are talking at least hundreds of millions of dollars at least in lost value. The $300 million of revenue projection at time of acquisition? A total pipe-dream.

    3. The9 Limited
    In May 2007, EA bought a 15% stake in The9 Limited for $167 million. Obviously John was excited about the potential of online games in Asia to do this large investment. The problem was The9 really didn't own much in terms of intellectually property. Over 90%+ of its revenue and earnings came from distributing and operating the World of Warcraft game in China which it licensed from Blizzard. Once Activision merged with Blizzard, it decided to pull its WOW license from The9 and give it to Netease. Consequently The9 plummeted in value as it lost over 90% of its revenue. The EA stake is now worth less than $30 million. Over $137 million of shareholder money lost from Mr. Riccitiello's investment skills. As a long-time gaming industry executive investing in a company that had that kind of risk with the WOW license at a sky-high valuation is unconscionable.

    4. Take-Two
    John decided he had to have the Grand Theft Auto franchise. In March of 2008, EA announced a $26 a share take-out offer for Take-Two, a huge premium to the company's stock price. This was a $2.1 billion offer. This time John was fortunate as Take-Two management repeatedly spurned the offer to the point EA gave up trying many months later. One year later, Take-Two was trading under $6 a share a stunning 77% below John's offer. Even at Take-Two's current stock price, if the deal went through, EA would of lost over a billion dollars in shareholder value.

    5. No credibility
    Forecasting one thing and then having reality be different over and over again has destroyed Mr. Riccitiello's credibility to the markets. Every year John goes on the earnings calls and repeatedly states how great games are. A year ago he told analysts how good the 2008 version of Need for Speed was. Last week he said previous Need for Speed games were lacking.

    He also defended the $680 million EA spent for mobile cellphone game maker Jamdat in 2006 when he wasn't even at the compan. Everyone in the industry knows that the mobile cellphone gaming market is moving towards standardized platforms such as the iPhone and Android OS. To argue that Jamdat was a good acquisition when it's core competence is porting games across dozens of cellphone SKUs is becoming obselete is ridiculous.

    After all these failed decisions, the fact that the Board of Directors let's John keep his job and do more over-valued pricey acquisitions is a travesty. Last week EA bought Playfish for up to $400 million for 4-5Xs revenue. Playfish is "the fad" of the moment developing social networking casual games. Given Mr. Riccitiello's investment track record, it wouldn't be surprising this is another disaster in the making.

    The problem here is John is going to make his millions every year even though he destroys hundreds of millions and billions of shareholder value given the decline of the stock price. If the Take-Two deal went through, EA would of even been in worse shape. The people who suffer are thousands of hard-working EA employees who lose their jobs and see how life savings in company stock implode. The madness must end. It's clear that John doesn't know what he's doing. He must go.

    Disclosure: At time of writing, the author does not have any position in Electronic Arts. If Mr. Riccitiello is fired, the author vows to buy EA stock that day. You can contact the author on Twitter: mreb or email: a(atsign)earningsbreakout.com
    Nov 19 2:44 PM | Link | 2 Comments
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