Philip Gvinter

Agency Mortgages: Pulling Back the Curtain

Karl,

The amount of trash that FNM and FRE hold is pretty astounding. I agree with you that backstopping their losses by Treasury would be impossible, however that does not seem to be the course of action decided upon by our collective brain trust.

Instead they have decided to allow the Fed, the only entity with a set of books which is not audited to backstop the losses. The Fed will buy up the worthless garbage. The garbage will underperform. The Fed will not report the full scope of the underperformance. The system will remain intact. The price for this is an aversion of deflation and the enrichment of those who perpetrated the scheme. While this is morally reprihensible it is in some ways the least painful course of action from a systemic point of view. The creditors for FNM/FRE are protected. No truly new money is created as the old money which only existed for a temporary period of time is re-created. The inflationary effect will be significant but not uncontrolable. The integrity of the system will remain nonexistent but this lack of integrity will be brought more to light....but not too much more.

I am not a huge fan of this course of action but can think of no other. If we cut off access to reasonable (low down payment but low debt ratio) credit than the housing market will plunge another 40% and the entire global financial system will infact melt down. This is not a superior solution. We do need to gradually raise lending standards but for now FNM/FRE pricing makes it such that any loan with less than 20% down goes FHA. The loans that do go the the GSEs have overly high DTIs (up to 50 rather than the more desirable 33-38 range) and do not ask for sufficient asset reserves (should be at least 12 months but is typically only 2) but are still far better than the loans which lead to the bubble. FHA underwriting standards are overly lax but these lax standards are all that stand between property prices and the abyss. The price to rent ratios and price to median income ratios need to come back in line but that cannot be done overnight. This must be a careful and gradual approach.

So the Perpetrators Are Now Our Saviors?

The short sellers did not cause a run on the bank and the mortgage securities do not have to be worth nothing in order for a bank to be insolvent and ripe for failure. If a bank has a capital ratio of 10% and 30% of its assets turn out to be of dubious quality and only worth 65% of par value that bank is essentially insolvent. This was the case with WM, WB and LEH.

So the Perpetrators Are Now Our Saviors?

The GSEs were the symptom and not the cause of this problem. The issue at hand was not the volume of mortgages originated but rather the quality. While putting in place caps on the portfolio size would have lowered the level of the losses it would in no way have prevented them. The level of leverage and the extremely low capital requirements were what did the GSEs in and no one was discussing this Republican or Democrat. The GSE share of the mortgage securitization market also dropped dramatically as BSC, LEH and others began to act as securitizers for ALT-A and subprime debt that the GSEs would not touch. The real cause of this mortgage crisis are the OCC and the OFTS allowing institutions to drastically lower their credit standards to unsustainable levels along with the relaxation of the leverage limits on investment banks.

Are Bank Stocks Buyable?

A large part of my bearish sentiment stems from the systemic deterioration of underwriting standards in the mortgage and commercial loan markets. Standards were relaxed on all programs including prime and AAA commercial credit. I believe that the true scope of the consequences of radically relaxing loan standards right before the economy heads into an average to severe recession will have. In my opinion default predictions for prime, prime jumbo, auto and credit card loans as well as small business loans, construction loans, and floating rate debt held by large corporations are still too low. From first hand experience I can tell you that a significant portion (greater than 20%) of mortgages underwritten and purchased by the GSEs would not have passed muster under any other period and is far from prime quality. While I agree that the more conservative banks stand to profit handsomely with the elimination of overly aggressive competitors and the availability of prime assets which would otherwise never be for sale at discounted prices. At the same time I feel that the credit contraction is only starting in earnest. The issue holding back a more expedient end to the necessary contraction is the low quality and illiquid nature of the assets which need to be liquidated off of bank and other financial companies' balance sheets. Because there are no willing buyers for the fixed income exotica created over the last four years it is incredibly difficult for institutions to fully clean out their balance sheets. Until we see some stable pricing and a slight increase in the number of large distressed debt deals in order to be able to ascertain the eventual trading prices of these massive piles of securities which will ultimately reveal the state of many banks real balance sheet health. Another key factor is the fact that there is no real way to at this point accurately predict where the unemployment rate and the housing drop will end. Until such data becomes a reasonable topic of discussion I feel that it is entirely premature to look for investment opportunities in the banking sector as the outcome of these macro events make such an investment perilously close to a roll of the dice.

Are Bank Stocks Buyable?

I am very bearish on bank stocks but do agree that these are good screening criteria. There are still four major factors which are likely to mean more trouble for banks.

The first is the negative equity in car leases. All truck and many car and luxury car leases written in the last three to four years have residual values significantly above the current market value of the vehicles, in many cases the difference exceeds $10,000 per vehicle (take a look at the prices of used luxury cars and mid size and full size trucks right now and compare them to what they were a year ago for vehicles of similar age and mileage, the difference is shocking) which is a tremendous hit to the institution which must take back and sell the vehicle.

The second issue is the upcoming recast of billions of dollars worth of Pay Option ARMs. These exotic mortgages allow borrowers to pay less than the interest due while growing the balance to a cap of 110%, 115% or in some cases an insane 125% of the original balance. When this cap is reached the payments more than double. Most of these loans were done with no documentation of income and are therefore as toxic as the subprime loans. This will add more foreclosure inventory to the already weak housing market and will severely punish those banks which hold these loans on their balance sheets. The biggest holder of these loans is WB with over $120B in their portfolio.

The third issue standing in the way in the way of a banking recovery is the performance of credit card debt. Because consumers used their home equity lines to pay down their credit card debt during the housing boom/bubble they have found themselves with one last avenue of available credit. Defaults in the credit card portfolios of COF and AXP have accelerated and in my opinion will continue to do so as cash strapped consumers use the credit cards to continue to fund purchases which they cannot afford. At this point these purchases are no longer limited to lifestyle desires such as eating out or new luxury goods but now include the increasingly expensive price tag of groceries and gasoline.

The fourth and final issue is the rising rate of unemployment. Increased unemployment means increased levels of default across all classes of consumer loans, and at some point begins to seep into commercial lending as a slowdown of consumer spending hurts small businesses. The continued rise in unemployment numbers and the acceleration of this trend does not bode well for the banking industry.

As I said before while I fully agree with the authors methodology I still believe that looking into bank stocks is premature at this point and will continue to be premature until a bottom is found in the housing market and a top has been reached in the accelerating unemployment statistics.