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Tony Rochel
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Tony Rochel is a Senior Financial Analyst at Eaton Corporation and an MBA graduate from the University of Minnesota. He has an undergraduate degree in engineering, is a registered professional engineer, and worked as a project manager in the land development field prior to obtaining his MBA. He... More
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Eaton Corporation
  • Policy Review: Should the US government promote spending and homeownership?
    Most recently the United States has promoted spending and homeownership.  This added to the fuel for what we now call the great moderation and the dot-com and housing bubbles.  Was it really necessary to manipulate consumer preferences to stoke the economy?  Who really won out and at what cost?  First off, in order to compare the effects on an economy it is important the 6 major factors that affect the decisions for consumers’ decision when it comes to saving and consumption.  These factors are the stability of the economy, home ownership, the maturity of respective credit market, standard of living, savings interest rates, and government emphasis on consumer spending.

    The United States has had a strong economy for over 30 years; this is evidenced by a steadily increasing per capita GDP and strong economic growth.  As a comparison both Germany and India had strong economies over the same period and have exhibited better growth most recently.  Strong economies result in strong consumption patterns, mostly because of expectations of future earnings.  For instance, in a recession, people tend to save and in a growth cycle, people are more likely to spend.

    With respect to home ownership, The United States government has very aggressive policies to accommodate and encourage home ownership.  They back two quasi-governmental organizations (now fully governmental) that own mortgage backed securities as investment vehicles and insure credit risk.  Also, the federal government backs loans for first time home buyers and low-income home buyers so that they can purchase a home through the Federal Housing Administration.  Further, the government provides a home interest tax deduction which promotes the use and leverage of mortgage loans to acquire property instead of renting.  This government intervention tends to have a negative impact on savings because homeowners are more inclined to purchase a home which typically takes more disposable income than renting, the result being less saving than a comparable country that does not have such programs.  For instance, the German government does not promote home purchasing as much as the United States, rather, the German government focuses its effort on renters which likely results in more disposable income per household and thus more income available to contribute to savings.  Although the typical housing unit in India is not an apples to apples, a comparison to the US and Germany is still helpful.  In India, homeownership was at 82% in 1990, as compared with 68% and 41% for the US and Germany respectively .  Also, in India more than 80% of the homes are self financed .  This means that a significant majority of the population is saving or has saved for a home; this trend explains one large factor of the high savings rate in India.

    Another governmental factor involved is that the US Government does not promote its citizens to save.  This is due largely to the fact that the US Government is the largest recipient in the world of foreign direct investment, thus it is not as important that its citizens provide the capital necessary to promote future growth.  One area that this is evident is in the US monetary policy.  For the past 8 years, the US has had a remarkably low discount window target rate.  This is intended to promote spending, not saving.  Germany on the other hand, cannot independently change its monetary policy since it is a member of the European Union and Central Banking measures must be approved by the EU, not only Germany.  That aside, Germany it encourages personal savings by having a tax exemption for workers savings accounts.  Unlike the US tax preferred accounts, Germany’s Employee Saving Bonus only requires savings to be held for 7 years, allowing citizens more flexibility and making the program more attractive.  As can be seen, Germany has had a higher savings rate than the US in the recent past.  The current recession is causing Americans to increase their savings thus decrease consumption.  Playing catch up with savings will create a drag on US GDP and will likely delay the recovery from recession.  Germany’s higher savings rate may be a result of a couple of factors, one of which being the fact that Germany has had lower GDP growth than the US over the past 20 years.  As for India, the government does not directly influence savings, however it has strict restrictions on direct foreign investment, so it is more reliant on savings.  The high savings rate in India helps finance capital spending resulting in high GDP growth.
    The US economy is more dependant on consumer credit in the German economy, as can be seen, the US has 18% higher consumer credit outstanding than Germany and 40% higher mortgage credit outstanding where India has only 8% of GDP .  The higher outstanding consumer and mortgage credit in the US is a result of a number of factors including a more mature credit market and more widespread securitization of consumer credit .  Since the US economy is more dependant on consumer credit, the US is also more sensitive to financial market fluctuations and economic cycles; the credit essentially leverages consumption.

    The policies have been outlined and compared to both Germany and India.  The choice to use these two nations was to compare 2 very different population profiles with the US.  The result of these policies is now apparent, our GDP was increased to an unsustainable level by the overleveraging of the American consumer, but the effect to GDP was only one or two points.  The government intervention in the mortgage market has had worldwide consequences.  Both of them combined has resulted in a harsh and protracted recession that has put millions into foreclosure, hundreds of banks out of business, and millions of people out of work.

    The small increase in GDP does not warrant the US government promotion of spending and homeownership and is ultimately bad for society.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Dec 22 5:37 PM | Link | Comment!
  • What lies ahead in the residential real estate market?
    In order to forecast future real estate market conditions, it is important to understand where it was, where it is and what the contributing factors for the future are.  It is agreed across the board that in aggregate, home prices were inflated.  There are several contributing factors to this phenomenon including decreasing lending rates and underwriting standards as well as the herd mentality towards real estate investing in the early 2000s.  Interest rates were at all time lows and had been on a downward trend for 25 years enticing activity in the market.  Lenders were loosening their underwriting standards and providing products like ARMs and interest only loans.  The result of these activities was a significant increase in the median home price, while median income stayed somewhat level.  In other words, the cost to buy a home increased yet the income used to pay the mortgages did not. After 2001 the spread between median income and median home price began to increase significantly, this should have been an early warning sign that home prices were inflated.

    Median home prices and median income have moved together since the 1970s with a slight diverging trend; however in the mid 2000s this divergence became radical.  For instance the average home price increased 12% in 2005 while the median income increased less than 5%.  The result was a significant increase in median home prices and relatively flat median income growth from 1999-2005.  Over the course of these 6 years the median home price increased over 50% and real median income decreased slightly.  This should have been a significant warning that something was awry.

    What Happened?

    One of the factors that made this possible was a significant loosening of underwriting standards across the mortgage lending industry.  Quite simply, people that could not afford loans were given loans anyway in hopes that the increases in real estate values would negate increased credit risk; if a borrower defaulted, the servicer would be able to sell the property higher than the purchase price and have the loan satisfied in full.  Mortgage bankers were quick to sell ARMs because interest rates had been falling for years and significant increases were nowhere in sight. Interest only loans became popular for “investors”, or rather unwitting buyers looking to cash in on the craze with unimaginably high leverage.  Low-doc and no-doc mortgages were available for a minimal premium – imagine that today, a real estate loan with no income verification, it sounds ludicrous as it should.  The allowed household debt to income ratio shot up to over 50% in some cases from a standard 30% in the years before the bubble.  All the while buyers of the underlying securities (residential mortgage backed securities) were standing in line to invest in these purportedly safe investments.  In fact, there was so much demand that financial engineers actually created synthetic instruments to mimic the behavior of these securities and fill investor demand.  So, homeowners were spending more on homes as a share of income, the dollar was buying less of a home because prices were going up, many buyers were not paying off any principle because of new loan products, and all the while real median income was actually dropping.
    Here we are at the end of 2010 and median home prices have fallen dramatically since 2005 – the spread between home prices and income is near to what it was in the late 90s which is thought to be a sustainable level.  However there are a significant number of factors that are going to keep pressure downward.  In the late 90s the US economy was very strong, growth was high and unemployment was low.  Today that is not the case, although GDP growth is on the rebound, unemployment is very high has been staying steady.

    It seems that the median home price has experienced a quick and efficient reset.  This is likely due to the nature of the entry level segment.  There are approximately 4 million people that turn 18 every year, which essentially means that there are roughly 4 million entrants to the market.  However it is not that simple, home ownership is around 20% for 20 year olds, 40% for 25-34 year olds, and the national average is near 66%.  In other words home buyers don’t simply buy a home at 18; there is an age ramping effect.  Either way, there is a positive effect from millions of entering the market every year.  The second significant factor that contributed to this quick reset is a quick reversion in lending standards.  Currently there are practically no private label mortgages, essentially the federal government backs about 99% of all mortgages issued today.  The federal government realized very quickly some of the issues in the underwriting practices and adapted its policies accordingly.  This is good for the real estate market as entry level home prices and volume are the basis for the upper segments, and having a stable and sustainable entry level market is essential for the move-up market and so on.

    Other Factors

    The current foreclosure crisis, dubbed “foreclosure-gate” is and will continue to depress home levels.  In November, 1/3 homes sold was a foreclosure, the liquidation of the foreclosed properties adds to supply, and adds at discounted price.  Additionally, the “phantom inventory” of homes that have been foreclosed but are not on the market will need to be eliminated thus increasing the downward pressure on home prices.  Also, there have been foreclosure moratoriums at large servicers while they review their foreclosure practices, this means that there are homes that are going to be foreclosed but have not been yet.  All three of these factors combined will add significant downward pressure to home prices, depending on how quickly these properties come to market.

    Currently the Federal government backs 99% of residential mortgages through Fannie Mae, Ginnie Mae, Freddie Mac, VA, FHA, or one of its various other programs.  Private lenders (and investors) are simply not willing to take on credit risk in this market.  Two things will need to happen, private lenders will need to increase their appetite and some of the governmental entities (Fannie and Freddie) will have to be converted back to a private entity.  In order for private label mortgages to return to the market it will be necessary for underwriting standards to become standardized and for the securities to become more transparent (see previous post for more info).  All of these scenarios will likely result in higher interest rates for buyers thus reducing purchasing power and increasing downward pressure on home prices.

    The unemployment rate is at highs not paralleled since the Great Depression, home prices will not resume on a sustainable path until this decreases to at least 6%.  Decreasing unemployment will be a positive force on home prices for a few reasons.  The unemployment rate for those under 20 is around 20% indicating many would be first time home buyers are unemployed.  Thus, decreasing unemployment will release pent up demand.  Also, decreasing unemployment numbers will reduce the drag on the economy and contribute to economic growth and increasing household wealth thereby adding to upward pressure across the board.

    So What?

    The combination and timing of these forces will likely drag prices down for 1-3 years and as unemployment and economic conditions improve and foreclosure-gate goes away an upward trend will be likely, I expect this to begin 3-5 years out. 

    What to Watch?

    According to the Case-Schiller housing index, property prices have been bumping along the bottom for over a year, most recently the market saw another drop in prices.  Case-Schiller is an important index to watch, but two other solid indicators of value are the multiple between median income and median home price and the multiple between rent and home price.  Historically the former multiple has resided around 3 and the latter around 20.  A buying opportunity will likely arise where the multiples fall below those levels and if unemployment and other indicators are strong and positive.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Dec 22 5:26 PM | Link | Comment!
  • Residential Mortgage Backed Securities – Today and Tomorrow
    What are the specific issues plaguing RMBS Securitizations?

    The “credit crisis” of 07-09 has exposed some weaknesses in the way that securitizations are structured and handled.  As of Q3 2009 there have been $1.2T in MBS issued, this is up $1B over the same period of 2008, but down from an all time high of $2.1T in 2006.  Another interesting point is that only 1% of the issuances are from private label issuers, down from 23% in 2006, meaning 99% of issuances have some sort of governmental guarantee .  It can be concluded that there has been a decrease in demand for residential mortgage backed securities (NASDAQ:RMBS) and virtually zero demand for private label RMBS.

    The appetite for the AAA securities is primarily driven by investors that are interested in safe, liquid, long term investments such as insurance companies and pensions.  These investors typically rely on ratings provided by credit rating agencies (CRAs) and purchase based on the rating.  However, as evidenced in the current state of affairs of the financial industry – the role of CRAs in the securitization process and as well as their modeling techniques resulted in investors taking on more risk than intended.

    The role of the CRAs in the structuring process is problematic.  First, they provide guidance but are not considered “investment advisors” and are not regulated as such.  Second, since they are merely offering their “opinion”; they assume no responsibility nor do they provide any guarantee of the risk.  Third, the fact that CRAs receive compensation from issuers for the ratings they provide poses two significant problems.  Problem one, the CRAs are inclined to err on the issuers’ side to ensure future work.  Problem two, issuers shop the deals to get the highest ratings, thereby creating rating inflation.  There are also concerns with the methods CRAs use to rate securitizations.  For instance, the technique used to determine the probability of default in RMBSs is based on statistical modeling.  Using these statistical models, CRAs guide the structuring of the securitizations.  Using point estimates, they opined how large the AAA tranche could be and how much subordination would be necessary.  Using point estimates is flawed since there is a statistical distribution associated with each point estimate, unless it is heavily skewed, a portion of the AAA tranche should actually be classified as the next lower tranche .  Also, widespread reliance on these ratings and governmental endorsement of CRAs resulted in investors relying too heavily on ratings instead of performing their own due diligence.  In fact, some governmental agencies, investors, and regulations rely explicitly on ratings provided by CRAs for their assessment of investments.  An inherent conflict of interest exists when ratings are paid for by issuers and relied upon by governance of outside parties.

    Further, once a securitization is rated, CRAs are paid large sums of money for monitoring.  Even so, they often downgrade too late, downgrade “too much”, and downgrade the entire deal when only certain tranches were not performing.  In short, the role of CRAs in securitization will have to be revised or removed for securitization markets to move more freely in the future.

    Another problem related to assessing risk within a certain tranche is the lack of relevant data. When an originator sells a mortgage, they are provided with significantly more information than an investor or CRA has a number of years later.  An originator has more precise information about the borrower, including an up to date credit score, an open window of recent borrowings and earnings, knowledge of the exact property to be purchased, and knowledge of the local real estate market.  Security investors don’t have this same information.  For example, anybody looking at the pool some years later would not have access to the actual property information on the underlying real estate, only the zip code.  Further, all of the data recorded by the originator is dated by the time investors receive it and is likely different than at origination.  Proxy information can be used in some cases; however, the accuracy of any risk or pricing model is hindered by stale information.  Historically, the credit risk of a mortgage loan depends on three factors: (1) collateral coverage, as measured by the proportion of loan to value (LTV);(2) borrower credit history, as measured by a credit score such as FICO; (3) and borrower capacity as measured by the proportion of debt to income (DTI).  Other factors such as the type of loan and type of property also affect the riskiness of the residential mortgage loan .  Without current data on the mortgage pool there is a significant number of unknown variables and assumptions made to fill in the gaps.  In general, assumptions on inputs result in less reliable outputs; more specifically these assumptions can contribute to mispricing and inaccurate risk assessments.

    Additionally, there is a misalignment of goals of originators and investors.  Several factors contribute to this, currently originators and their employees receive bonuses primarily for volume not quality, and certainly not based on the performance of the product over the course of the product’s life.  Another factor that contributes to the misalignment is the fact the fact that originators benefit from adverse selection at the expense of investors .  As a result of their role in underwriting, originators that are aware of a bad vintage at the onset and are likely to sell off their Z tranche immediately rather than receive the future cashflows.  Conversely, if the originator has confidence in its underwriting it may hold its first loss piece.

    External credit enhancements are costly and don’t always help; they come in different forms are also included in many securitizations.  With this type of enhancement a swap or letter of credit or other type of financial guarantee is provided to protect against losses.  They are typically structured such that if a certain loss is experienced a pre determined sum is paid in to protect the payments to the higher rated tranches.  This type of enhancement is expensive and results in another layer that needs to be analyzed – the seller of the protection.  With the freeze in the private market and the current activity in Government backed RMBS it could be inferred that investors are not satisfied with external credit enhancements of this nature.  Further, as time goes on these types of enhancements are often a waste of money as AAA RMBS tranches tend to converge towards default or AAA.  Thus the costly external credit enhancement on the securities that remain AAA is wasted .

    Can we resolve these issues?

    Over time, securitizations have become more opaque on several different levels.  For private-label securitizations to become popular once again this opacity needs to be removed.

    Currently there is no appetite for MBS unless the credit risk is underwritten by the US government.  At the root of the problem for investors is the opacity of the securities they are purchasing.  Insurance companies and pensions want a AAA security without the cost of sophisticated analysis.  Investors in mezzanine level tranches may have the staff necessary to analyze the securities, but they are plagued with stale data.  In addition problems with opacity of RMBS, the misalignment of interests between originators and investors results in originators having a greater incentive to favor quantity over quality of mortgages.  To combat these issues, originators have provided external enhancements as an added layer of protection; however external enhancements are often expensive or unnecessary.

    The role of CRAs in the securitization process will have to be reformed.  One stance would be to provide more government involvement and more regulation for the ratings agencies.  However, there will always be a way to game the system and work around a roadblock.  Another approach would be to eliminate the role CRAs in SEC and banking regulation, thereby removing the implicit endorsement of their ratings and thereby reducing the role of government in the rating process.  Also, CRAs should not be considered journalists regarding their role in securitizations; they offer advice on how to structure deals and a rating that investors and regulators rely on in valuing and assessing risk.  They may be merely providing an opinion, but they should not be able to hide behind the first amendment.  A more apt situation would be where an underwriter provides coverage meeting certain requirements relating to risk profiles allowed by investors.  For instance, if an insurance company is interested in a tranche of AAA securities, it could provide a legal judgment of credit quality to determine whether a tranche is equivalent to a AAA bond rating, and the entity providing the legal judgment would back their assessment with a type of performance bond.

    Additionally, more clarity would make RMBS securities an attractive investment once again; two potential remedies are as follows.  The first would be to have more up to date information on the underlying assets.  For instance, it is possible to obtain quarterly credit scores for each borrower.  From that it is possible to determine much debt they have outstanding and with collaboration with the IRS, yearly income data could be obtained to complete their borrowing capacity.  Also, there is already a large database used for refinancing guidelines that can estimate property values before an actual appraisal is completed, this could be reconciled with property tax records on a yearly basis and an approximate LTV could be accessed.

    The second approach would be a database where holders of securities share information for their respective securities.  A project is already underway by the American Securitization Forum (called Project RESTART) to complete this.  Their model relies on originators and servicers to update up to 135 data fields of loan and pool level information on a monthly basis.  The data will then be provided on a fee basis to investors interested in the information for valuation purposes.  A few of the major goals of this initiative are increased reporting, uniform standards, and a mechanism for owners of a 1st lien mortgage to be notified when a 2nd lien mortgage has been originated on the same property.  Having current information on underlying mortgages, as well as similar and subordinate securities will provide a significant amount of help in valuing the securities.  In addition to providing a database for the information on performance of the securities and underlying mortgages, providing data on the ownership and size of the first loss piece would be helpful in assessing the underwriting of the pool and may help reduce the effects of adverse selection by originators.

    The compensation system for originators needs to be restructured.  First off, in order to align the interests of investors and originators a bonus-malus system could be employed.  This system would reward long term performance rather than rewarding volume of transactions.  Another option would be to force originators to hold a first loss piece as a form of their compensation thereby enticing them to have tighter underwriting standards.  If nothing else, requiring registration of who holds the first loss piece and it status should be required by the SEC.  This information alone provides vital information regarding the quality of the deal and the confidence of the originator.

    With regard to credit enhancements, much work must be done to address investors concerns.  One avenue to take would be to eliminate the use of external credit enhancements, they are expensive and they are only as strong as the seller.  This situation requires investors to assess and account for the strength of the enhancement provider.  Moreover, external enhancements complicate the structure of the securitization and add opacity.  Instead, it may be more useful to increase the role of internal credit enhancements by increasing subordination, over-collateralizing, or having larger first loss pieces.  All of these will likely result in smaller high-rated tranches which will ultimately erode the efficiency of the securitization and ultimately increase the price of mortgages to the end user. 

    All said, there is work to be done by all of the parties involved.  The government needs to end its relationship with CRAs, CRAs need to provide guarantees or take a step back, issuers and servicers must provide more information, investors must require an overhaul of originator compensation structure, and credit enhancements need to be revisited and revised.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Dec 22 5:21 PM | Link | Comment!
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