UncleLongHair

Changing Tides at Steak n Shake

The CEO of Biglari's other restaurant company, Western Sizzlin', also just departed. So how he's got two restaurant companies without a CEO. I hope he's got a plan.

Did Fannie and Freddie Cause the Mortgage Crisis?

>>> Freddie and Fannie have untold billions of subprime loans on their balance sheet. BILLIONS AND BILLIONS. <<<

I've heard this hysterical statement uttered frequently in reference to FNM and FRE, which I think demonstrates the basic misunderstanding that many people have, both laypeople and professionals, about FNM and FRE.

First off, FNM/FRE's subprime exposure is not "untold". It's clearly reported in their investor presentations. Here's FRE's latest, from this month:

freddiemac.com/investo...

Page 42 shows their retained portfolio breakdown, and that about 13% of their retained portfolio, about $92B, is in sub-prime mortgages, and these have on average a 37% credit enhancement.

Second, many people hysterically scream "billions and billions" implying that the exposure is endless and fatal. Let's look at the numbers. A billion is a big number. A trillion is an even bigger number. FNM and FRE have guaranteed about $5.2 trillion of mortgages. One billion is 0.02% of that. FRE's $92 billion of retained subprime mortgages is 2% of that. The exposure is simply not enormous.

Subprime issuance has come almost to a complete halt, and subprime mortgages tend to prepay very rapidly, so within a year or two I expect FNM and FRE to have very little sub-prime mortgages in their portfolio.

Bill Ackman's Plan to Save Fannie and Freddie

Successfully shorting another company 5 years ago doesn't give him the moral high ground when trying to line his pockets again. He tries to wrap himself in the shroud of a do-gooder, but he's just out to make a buck.

The SEC just issued subpoenas to short sellers investigating market manipulation, I wonder if Ackman is on the list. I bet he is.

Did Fannie and Freddie Cause the Mortgage Crisis?

You raise some interesting questions, the answers to which I suspect are not cut and dry.

>>> For my part, I have two questions for those who take the position that the GSEs played no significant role in causing our current mortgage problems. <<<

That is not my position, but I've got an opinion on everything.

>>> First, what economic justification is there for the dramatic increase in the share of loans guaranteed or held by the GSEs between 1980 and 2003 that is seen in the first graph presented above? What sense did it make to increase the ratio of such loans to GDP by a factor of 12 over this period? <<<

I guess you're asking why the GSE's increased their market share during this period. I guess the obvious answer was because they could -- they're for-profit enterprises, and increased market share can lead to increased profits if that business is properly written (i.e. proper risk-adjusted returns). Perhaps I'm misunderstanding the question.

To me, FNM and FRE generally guarantee the most conservative and basic mortgage products that exist in the country, and seeing their market share increase is a source of comfort, rather than alarm, because it means that a greater portion of the country's mortgages are conservatively financed and underwritten properly.

In fact, I believe it was the decline in the GSE market share starting in 2003 that foretold the mess that we're in now, because other, more reckless and less stable companies took market share from the GSE's, leading to a higher proportion of risky mortgages in the system.

Another data point to consider is that the default experience on mortgages written from about 2000 to 2005 has been far less than those written in 2006 and 2007 (for a snapshot of these numbers, look at FRE's recent investor presentation which shows cumulative defaults by year). It's the 2006 and 2007 loans that are the major problem. The loans that were written when FNM and FRE were at their recent market share peak are performing well. I think this indicates that FNM and FRE are part of the solution, not part of the problem.

>>> Second, what forces caused the explosion of private participation in a much more reckless replication of the GSE game? A year ago, I suggested one possible answer-- private institutions reasoned that, because the GSEs had developed such a huge stake in real estate prices, and because they were surely too big to fail, the Federal Reserve would be forced to adopt a sufficiently inflationary policy so as to keep the GSEs solvent, which would ensure that the historical assumptions about real estate prices and default rates on which the models used to price these instruments were based would not prove to be too far off. <<<

Once again, it's a free market, and these companies thought they could make a lot of money playing the GSE's game. But they had a permanent disadvantage in funding costs that they had to make up elsewhere, and they tried to do this by inventing new mortgage products and laying off some of the risk to the bond market. This worked for a while, which is why GSE market share declined while the non-GSE profits boomed. But that chicken has come home to roost, and, as the Wells Fargo CEO recently said, things now look normal for the first time in a long while.

Uncle

Fannie and Freddie Are Largely Responsible for the Housing Bubble

Correlation is not causation. FNM and FRE are impacted by the housing problems more than anyone else because they handled more mortgages than anyone else. If simply creating these entities "caused" the bubble, why haven't we had more bubbles over the past 70 years?

Other institutions are just as much to blame, if not moreso, than FNM and FRE, such as the reckless subprime lenders and ratings agencies that blessed their securities. Are FNM and FRE to blame for their actions as well?

>>> Clearly it doesn't take much of a writedown on 5.2 trillion dollars to wipe out any private equity that Fannie and Freddie may have <<<

The $5.2 trillion of mortgages held by FNM and FRE are not on their balance sheet, and thus can't be "written down".

Uncle

The Future for the Mortgage GSEs

These are all ideas that OFHEO has knocked around over the years in their attempt to put handcuffs on FNM and FRE.

1. Geographic diversity is one of the primary ways to reduce risk in investing in mortgages. This was the original impetus for FNM and FRE, as investors in wealthy parts of the country (i.e. Boston) could invest in mortgages in emerging parts of the country (i.e. Arizona). This allowed the country to grow in a stable and self-funded way and allow investors to spread risk. Later, it allowed regional banks to avoid being taken down when trouble hit their local economy, since they could sell their loans into nationwide loan pools. Restricting FNM and FRE to a certain region would be a major step backwards in risk control and add, not remove, risk from their business.

2. "I can't honestly say that buying a $450k home instead of a $600k home is a legitimate hardship." Unless there are no houses for sale in your region for less than $600k, in which case you must rent or move. FNM and FRE recently increased the conforming limits for certain counties, and some counties have a limit nearly twice the average (i.e. $730K vs. $417K). The country has a very wide range of property values, and FNM/FRE should have a presence in every market to maintain diversity (see #1). A high property value does not de facto lead to a riskier loan. If there are concerns about unsustainable home prices, they should enforce a lower LTV in those cases.

3. The OFHEO caps have been a disaster because they can't figure out a way to apply caps that adjust accurately to changes to the economy and mortgage environment. A fixed number cap does nothing but benefit the competitors of FNM and FRE, since the loans have to go somewhere, who are far less regulated and capitalized.

4. It isn't at all clear that FNM and FRE are undercapitalized. The people saying that the GSE's are undercapitalized are the short sellers who make money when the stock falls. The officials from the Fed, Treasury, FNM and FRE are unanimous in saying that the companies are adequately capitalized. Running through the actual numbers to QUANTIFY losses indicates that they are. This may change in a few quarters or years, but today the concerns are way overblown. That said, FNM and FRE could reduce their overall leverage ratio, and the $2.25 billion of emergency capital pledged to them by the government decades ago could be adjusted for inflation and growth in the mortgage market to make it a meaningful backstop instead of a token.

5. The GSE's were never intended to prop up or protect the economy. They were created to add liquidity and diveristy to the national mortgage market, which is both essential to the economy and cyclical. Without some kind of national support, regional economies would blow up again and again as local lenders accepted local deposits and lent the money locally and then had no recourse when the local economy went sour. No mortgage investor wants to invest in a basket of mortgages 100% on a California fault line or in the Florida hurricane path. Providing diversity and liquidity to the market reduces overall risk.

The main things the regulators could do to benefit FNM and FRE (and thus the national economy) would be to 1) ensure the "go-go" mentality that caused the overstated income and accounting scandal never returns, and ensure that the institutions are managed conservatively, 2) provide more transparency into the companies, it was only recently that they had to file the same financial statements as other major financial firms, 3) ensure that FNM and FRE are adequately compensated for their risk.

On that last point, FNM and FRE are basically insurance companies, accepting a "g fee" up front in exchange for guaranteeing a risk (mortgage default). If they are posting huge losses, they were not being compensated sufficiently for the risks they were taking, and many of these fees and risks were quantified by the government regulators. Warren Buffett recently noted that the government was asking (requiring?) FNM and FRE to take too much risk on their balance sheets. If they want them to thrive and survive, they need to reduce that risk.

Bill Ackman's Plan to Save Fannie and Freddie

FNM and FRE aren't insolvent and don't need a bailout. They're earning gobs of money on the higher spreads, lower risks, and increased market share starting a year ago when all of the fringe players in the mortgage industry were dealt fatal blows. FNM and FRE were never bottom feeders in the industry, they deal primarily in the cream of the US mortgage crop. Most analysis on the companies, like Ackman's, doesn't even take a passing glance at quantifying the default risk and how FNM and FRE can afford it, because if it did, people would realize that the situation is nowhere near as dire as the short sellers want you to think.

Everyone throws around the number of $5 trillion of mortgages guaranteed by FNM/FRE. Even after the widely publicized increase in defaults and losses, default rates are still well below 1%. Even at 1%, that is $50 billion of losses, spread over many years. This assumes default recoveries of 0%, though recoveries will be well above zero with their conservative assets. FNM and FRE currently have total capital of around $95 billion and have plans to raise another $10 billion, and have many options for raising more capital including retaining earnings (i.e. cutting the dividend). They have plenty of capital to withstand current losses, and the ability to raise more.

Ackman's plan makes sense only to himself. It looks like a teenager threw together his slide show after school, he may as well have drawn it with crayons. It is outrageous that he can short the stock, and then go on TV and politely suggest that everyone get together to restructure a company that needs no restructuring just so he can make an enormous return on his investment. The thing that would "benefit America" would be to have investors and journalists laugh in his face when he tries to pull the wool over their eyes.

The timing is no surprise, as Ackman is cranking his publicity machine during the company's quiet period, as the Q2 numbers are probably nearly done but not yet reported, and they can't comment on Ackman's stupid allegations. Ackman is all too aware of the unlevel communications playing field, where executives are limited in how and when they communicate and he is not. He also knows that simply creating fear, uncertainty and doubt (FUD) around a financial company is enough to destroy it, as happened with Bear Stearns and IndyMac.

Ackman is simply trying to initiate a "run on the bank" at Fannie and Freddie, by undermining the investment community's confidence in their obligations. This is all an extremely thinly veiled attempt by Ackman to rape the capital markets for more ill-gotten gains. Analysts and investors should simply ignore him.

Uncle

The SEC Panics

Ackman's plan makes no sense for anyone but himself. FNM and FRE are not insolvent, don't need a bailout, and certainly don't have to have their short term debt wiped out.

This is just another attempt by Ackman to create a crisis in a company that he has shorted. I'm astonished by the gall of someone who goes on CNBC, states that he is short a stock, and then politely suggests a restructuring plan that sends that stock to zero in order to "benefit America". Give me a break. I hope he loses his shirt.

Crystal River’s Q2 Write-Downs Could Bankrupt the Company

>>> Finally another point about the press release. The company did not disclose interest payable and other forms of very short-term liabilities, or the amount of unrestricted cash. For all we know, these may be higher and lower, respectively, than in Q1. <<<

Well they might also be lower and higher, respectively. It's pretty obvious that cash is going to be higher than Q1 for example. But really we have no idea, because we don't know what has transpired in what was certainly a very busy Q2. Clearly they are keenly aware that they need to eliminate their short-term liabilities.

In April 2008 they disclosed $100M of "unencumbered" assets, $45M of net cash, and the repo lines were down to $28M, and all of the agency MBS were gone. Some of that happened after the end of Q1, so the Q1 balance sheet doesn't reflect all of this. Surely they continued the sales into Q2.

>>> 1. Do you concede that it is likely that the equity reported as of 6/30/08 will be below $100 million? <<<

Possible, but not likely, and I don't mean that as an evasive answer, really we don't have enough data. CRZ management is all too aware of the $100M equity limitation and was clearly willing and able to sell assets at a loss to preserve equity.

You're basing your book value write-downs on the movement of the indices and the assumption that they hold much the same assets at the end of Q2 as Q1. The first assumption is maybe the best thing analysts have to go on, but is nothing more than a wild-ass guess, and some liabilities will change along with the assets. For the second assumption, I would not be surprised to find that they have sold all of their non-agency RMBS and a signficant portion of their real estate loans, about 62% of which they reclassified as held-for-sale in Q1. That could represent another $100-200M of de-levering during the quarter.

To the extent that they have a strategic focus (note that I am not really that positive on the company to begin with, I mean hey, Lou Ranieri is on the board, you just gotta love that), they seem to want to focus on agency MBS, A-credit CMBS, and direct ownership of commercial property. So that clearly puts the non-agency MBS and residential loans in the jettison category.

>>> 2. Do you concede that, to the extent that Brookfield is willing to excuse a default, it will do so on terms that are in the best interest of Brookfield rather than CRZ? <<<

Of course not. BAM is going to watch out for themselves, but as long as they feel there is some long-term value in CRZ, they're going to strike a balance between all of the respective interests.

I am more familiar with BAM than CRZ and have seen the way BAM supports its distressed offspring during rough times. If you think that CRZ has been a bloodbath, I direct your attention to Fraser Papers. The losses there have truly been awe-inspiring (or perhaps awww-inspiring), yet BAM has steadfastly supported the company. Aside from backstopping a rights offering and helping them to convert debt to equity, they've lined up financing deals to help Fraser monetize some assets and gain business from other BAM affiliates. BAM has done the same with several other companies in similar situations, and certainly has the resources to help CRZ in the same way. One advantage that CRZ already has is access to BAM's deal flow, which is world-class. This is not 100% predictive of what BAM will do with CRZ, but they have long shown the willingness to support their subs and affiliates, and have plenty of motivation to do so here.

To look at it another way, what does BAM have to gain by foreclosing? They would go from being the senior lender secured by a bunch of squishy assets to the direct owners of the same. Is their exposure diminished or accounting treatment any better after foreclosing? No. They are not dumb enough to foreclose and then try to liquidate the assets into a terrible market, and the ~$50M of debt is not meaningful to their ~$100B asset base. More likely they'll convert their debt to equity ownership so they reduce their downside risk and increase their share of the upside if and when things turn.

It is telling that CRZ has chosen to pay off the repo lines with BAM's line of credit, instead of the other way around -- clearly they believe that BAM is a friendlier party than their repo lenders.

>>> In the past, when companies with toxic real estate debt have sought to go to capital markets, the results have been horrible for common shareholders. cf TMA and BKUNA. <<<

Yes but TMA and BKUNA did not have well-heeled parent companies, nor did Homebanc, New Century, Delta Financial, or the whole host of other blow-ups. A few billion of liquidity in the hands of a friendly party can go a long way during rough times.

>>> Since you are the only person commenting here who has made any intelligent bullish comments, I'd love to also hear your general case for this stock. <<<

Well really I am neither long nor short, but I've been following cRZ pretty closely for about 4-6 quarters looking for an oppotunity to go long. When the fit first hit the shan, they had a fair amount of "dry powder" in the form of agency securities that I thought could be sold and redeployed into higher yielding assets, but that didn't really pan out so well, because agencies didn't hold up as well as anyone thought they would. Then things really started to go pear-shaped, and they started to sell agencies for survival rather than redeployment.

However, the market should be rife with opportunities for those with capital to deploy, and many participants are talking about mid-teen unlevered yields in A or higher rated securities. Of course an A or even AAA rating doesn't mean what it used to, and maybe it's all crap at this point.

Generally, I don't like MREIT's of any type or variety because they don't have any balance sheet to them, and generally don't add any economic value -- they are just a passive portfolio. I prefer REITs that are direct owners and operators and those that add value through expertise and redevelopment. Even moreso, I like property management companies that are not obligated to pay out all of their income as a dividend so they have more balance sheet and liquidity (examples are BPO and FCE). So, in light of all that, I'm never going to get excited about going long CRZ unless the situation is more stable than this one is, though the discount is starting to look pretty compelling. I'll definitely wait for the Q2 report to come out before making any calls.

Uncle

Redwood Trust: From $30 to $4 by Year-End?

Hi Greg, I hope you don't think I'm stalking you, I noticed this other article of yours and I happen to have been watching RWT along with CRZ. Really I don't have any position in either.

I feel that RWT is in a much better position than CRZ because, with no short-term financing, they can wait for their assets to run out if need be, and they'll naturally de-lever as loans prepay. If there is any discrepancy between today's panic-driven market value and actual intrinsic value of these assets, as I strongly suspect there is, RWT should be fine in the long term.

However, as you point out, I've been wondering about the quality and valuation of some of their assets, including the credit enhancement securities. The big question mark is how bad the default experience will be on prime loans. So far it has gone "from a very small number to a small number" but still basically within historical norms. If it breaks for the worse, the valuation of RWT's assets may see another leg down. But if it doesn't, which would be consistent with long term trends, maybe nothing will happen. I think this is a really tough call, and very little to use as the basis for a short position IMHO.

Regarding your concern over accounting treatments, I don't agree that non-recourse borrowings could end up being recourse. Even in the most catastrophic meltdown scenario (and there have been many over the past 12-18 months), in no situation did any mortgage bond holder have recourse to the originator's equity. That is a legal and financial firewall that has never been breached, nor should it be. The securitization markets might be dead for now, but a done deal is still a done deal.

Secondly, regarding FAS 159, I too had some questions about the prompt adoption of this by certain companies (RWT and CRZ to name two). On one hand, as you point out, one could envision some abusive scenario where a company quickly issues debt and then doesn't have to account for its full liability because paradoxically they made themself a poor credit.

But on the other hand, it doesn't seem right to me that a company's assets could be marked down severely due to temporary market fluctuations while their liabilities would not. Their liabilities, after all, are someone else's assets, and the other party is probably writing down the assets due to market fluctuations, whereas the liabilities are unaffected. So you've got one party marking down something on the left side of their balance sheet, but some other party, who has the very same financial instrument on the right side of their balance sheet, not making any changes. From this perspective, I think it makes perfect sense to mark both assets and liabilities to market in some situations where the two are directly related and well matched.

There is clearly some severe volatility going on in market valuations of financial assets of every kind. There are things to be worried about, but I also think that the valuations are overblown. Prime mortgages would have to default at many times the worst level in history in order for many of these valuations to make sense. The financial press thinks the sky is falling, but that doesn't mean that it is.

Crystal River’s Q2 Write-Downs Could Bankrupt the Company

>>> The mere fact that they can borrow the 70MM means that Q2 equity didn't drop below 100MM. <<<

Actually I thought of that too. The timing of that release is interesting -- after the end of Q2, but before the Q2 numbers are released. They specifically said that the revolver "can be used to address" the other liabilities (i.e. present tense). Could they make that statement knowing that their book value is already below the covenant? Can they accurately estimate their book value at this point? Many tantalizing questions... but no answers yet.

Uncle

Crystal River’s Q2 Write-Downs Could Bankrupt the Company

>>> Regarding your other point, I again don't see why a company in this environment would allow a $100 million loan to save an illiquid investment of $5 million. <<<

First of all, to use accurate numbers, the company announced that they had $70M of undrawn capacity on the revolver, implying that they are now $30M drawn. There are $22M of repos coming up, plus CDO swap exposure of $3M, totaling $25M. If they drew down their revolver to cover these liabilities, they'd be $55M drawn, not $100M, and would then have no other pressing liabilities.

Now let's say for argument's sake that this happens, and book value comes in below $100M, let's say $75M just to have a number to discuss. Would Brookfield force a margin call on $55M loaned out against a company with book value of $75M, when they also have a 7.5% equity interest? I suppose they could, but they'd lose their equity investment, and then go from being a lender to direct owner of the assets. Would this put them in a better situation? I don't think so. Remember that the assets are already managed by a subsidiary of theirs, and the three management teams (BAM, CRZ, and Hyperion) have many people in common. They'd certainly make no friends by forcing the margin call.

Instead they'd almost certainly amend the terms of the agreement to give CRZ some more breathing room, but they'd want something in exchange for that. A higher interest rate would only exacerbate the liquidity problems, so the obvious solution is equity of some kind.

I dunno, a whole lot of unlikely things have to happen in a row for them to hit the liquidity wall. I think they still have plenty of room. If the secured revolver were not with an affiliated party, I think that would be a major risk. It is usually a margin call on the medium-term financing that puts the MREIT's under. But in this case they don't have that risk.

Crystal River’s Q2 Write-Downs Could Bankrupt the Company

>>> unless you have some reason to think the % of the writedown in assets that will be offset by a M2M in liabilities is going to be dramatically higher in Q2 <<<

They de-levered substantially during Q2, which you're also omitting. I think extrapolating Q1 results to Q2 doesn't make sense for this reason. I agree that they're cutting it a bit close if they want to stay above $100M since they only have $32M to spare. But there are a lot of moving parts. We should know soon as they put out their quarter. Again, I'm here for the analysis, since I don't have a bet on the table, but I don't think book value is going to change much at all.

I would also assign a very high probability to Brookfield NOT delivering the death blow. If book value goes below $100M, they will just amend the credit agreement. As I mentioned, this might mean dilution for CRZ, but ensures survival.

Crystal River’s Q2 Write-Downs Could Bankrupt the Company

>>> If Brookfield is like just about every other financial institution these days, it does NOT have spare capital to throw tens of millions of dollars away at a mere LIBOR + 2.5% at a troubled company, just to save a very small investment in the borrower's common stock. <<<

The best thing to do in this situation is to convert the debt to equity, which both protects the debt-holder's investment and also gives the investee more breathing room, and allows them both to experience upside if and when the market recovers.

Aside from Fraser Papers which I mentioned earlier, Brookfield did the same with Maax. One of their bridge lending funds held a senior debt position, and in a restructuring they converted that to a control equity position. There are numerous other examples of similar transactions.

This makes good business sense, but part of the motivation is not direclty tied to short-term results. If Brookfield gains a reputation for leaving its children out in the cold during a storm, they will be in a decreased negotiating position when trying to make new acquisitions.

Crystal River’s Q2 Write-Downs Could Bankrupt the Company

>>> Our master repurchase agreements with Credit Suisse First Boston, LLC and Credit Suisse First Boston (Europe) Limited and our secured revolving credit facility *each contain a restrictive covenant that would trigger an event of default if our stockholders' equity declines ... below $100.0 million.* <<<

The 10-Q goes on to say:

"If our stockholders' equity decreases below $100.0 million, we would be in default under these borrowing arrangements and *if we were unable to obtain a waiver or an amendment of those terms*, the lenders under those facilities would have the right to accelerate the maturity of the indebtedness and we could be forced to repay such indebtedness..."

The $100M secured revolver is provied by an affiliated party (Brookfield Asset Management, publicly traded as BAM). CRZ is managed by Hyperion Brookfield, a subsidiary of BAM, and BAM holds 7.5% of CRZ equity. If BAM were to force a margin call on their revolver with CRZ, they would further jeopardize their own investment in CRZ.

Much more likely is that they would provide a waiver or amendment, and I would guess converting some or all of their indebtedness into equity. This might mean dilution for CRZ but would also mean survival. BAM did the same thing for Fraser Papers, another of their small subsidiaries who is struggling.

In any event, IMHO the major hole in your analysis is that CRZ's liabilities are likely to be marked down along with the market indexes along with their assets, so the hit to book value is going to be a lot less than you predict. Generally, any impairments to the assets that are primarily market driven are likely to be matched with impairments to the liabilities (this was the whole point of the new accounting treatment after all), resulting in minimal change to book value. The hits to book value would have to come from asset-specific write-downs such as defaults at specific properties. Which isn't to say that there won't be any, but that is likely to be far less than you estimate.

I don't have a dog in this fight though, I'm neither long nor short CRZ, though I'm familiar with it and have been following it for a year or two.

Uncle