Monday, July 23, 2007

Wall Street's "mortgage monster"

You should read Tom Petruno's column in Sunday's LA Times, "Wall Street can't cage its mortgage monster". It's both a vivid description of what's blowing up (familiar to most of us), and significant that the Times's usually-bullish main business commentator is this bearish. Here are some highlights:

When the rocket scientists on Wall Street outsmart even themselves, very bad things can happen.

Today's version of Frankenstein turning on its creator is the mortgage loan mess. Wall Street in recent years has taken a simple concept — bundling mortgages and selling them to investors as interest-paying bonds — and concocted an alphabet soup of securities so incredibly complex they defy understanding by all but a handful of PhDs.

That complexity now is coming back to haunt the buyers of those securities, who for the most part are hedge funds and other big investors, not individuals. If you aren't sure what it is you own, you can't be confident about the thing's value. And in financial markets, if confidence dies, little else matters.

What's more, the line went, the trouble would be "contained".... Those assertions were all but blown away last week, after brokerage Bear Stearns Cos. on Tuesday disclosed that investors in two of its hedge funds that owned mortgage-backed securities had lost virtually all of their money.

It wasn't that the bonds became completely worthless overnight. Rather, the funds were victims of their heavy use of borrowed money to boost their bond bets.

Investors are losing faith in mortgage bonds up and down the quality chain because the major credit-rating firms — Standard & Poor's, Moody's Investors Service and Fitch Ratings — this month have begun to warn that loan delinquencies may be worse than what the firms had anticipated.

Certainly, most Americans will make their mortgage payments, as they always have. But the $1.5 trillion in sub-prime mortgage bonds sold from 2003 through 2006 tells you that a huge number of high-risk borrowers were financed in that period. Some of those loans already have failed; more assuredly will fail.

What's more, in the sub-prime loan market it's now clear that fraud played a big role in the ease with which loans were granted as the housing boom peaked in 2006.

As confusing as things are for mortgage bonds, it's worse for Wall Street engineers' crowning achievement in fee-generating securitization: collateralized debt obligations, or CDOs.

A CDO is, in effect, a bond backed by other bonds. And in a wondrous bit of alchemy, a CDO creator can take a pool of bonds backed by mostly sub-prime mortgages and turn it into securities that have AAA credit ratings.

It's all in the slicing and dicing of the underlying portfolio. In theory, the holder of a AAA-rated CDO slice owns a security that has almost no chance of losing principal.

But what, exactly, is backing that CDO slice?

That is likely to be the unfolding story of the rest of this year and the first half of 2008.

The fire sale in mortgage securities has yet to begin. But it's coming. The implications for the rest of financial markets aren't clear, but when confidence is shaken in one market there usually is collateral damage.

Once again, Wall Street's rocket scientists have created a monster they can no longer control.

I'd also suggest Niall Ferguson's July 16 column, "Owning on borrowed time".

1 comment:

Anonymous said...

This problem global!

And Now... Today's Pfennig!

Subprime Woes Go Global...

Good day... Without any data in the U.S. and a slow data day in Europe, the currency markets continued to track along their recent trend lines, which are US$ negative. The mood of the markets continues to be one of trepidation as traders wait to see just what the subprime mortgage mess will bring next. Traders continue to come to the realization that the U.S. housing slowdown and subprime mortgage mess will not go away quickly.

Data due out today and tomorrow will do little to calm their fears. The ABC Consumer Confidence number and Richmond Fed Manufacturing Index are the only two reports which will print today, and neither is expected to show much strength. Tomorrow we get a snapshot of the housing market with the release of MBA Mortgage Apps. & Existing Home Sales in the morning, followed by the release of the Fed's Beige Book in the afternoon. Existing Home Sales will be the driver of the markets and are expected to show a month-on-month drop of 2.1% in June.

With the markets nervous about this week's housing reports, the dollar weakened against all of the 109 most active currencies. Even the Japanese yen got in on the fun as it strengthened to a two-month high vs. the greenback. The dollar's slide accelerated after the dollar reached levels that triggered automatic sell orders.

News released yesterday shows the subprime rout is going global, as Reuters reported that Basis Capital Fund Management Ltd., an Australian hedge fund, is hiring Blackstone Group LP to advise the fund on limiting its losses. It seems Basis Capital Fund bought into the CDO markets, and these investments are falling fast. I also read that Japan's nine biggest banking groups have more than 1 trillion yen of combined holdings in products backed by U.S. subprime mortgages.

This is an interesting twist to the mortgage mess, as foreign investors are starting to feel the pain. These foreign investors have been pouring money into the U.S. markets, supporting our deficits and keeping our dollar strong. We have been talking about how these foreign investors will start moving away from their U.S. investments on interest rate differentials, and this latest report of subprime losses will only serve to accelerate these sales.

In the category of 'what is he smoking,' U.S. Treasury Secretary Henry Paulson was on CNBC yesterday and said that problems in the subprime mortgage loan sector could be contained and would not hurt the overall economy. I think Mr. Paulson should try and tell that to investors in his former firm's hedge funds! Confirming our assertion that the Treasury Secretary must have been on something, he followed up his subprime comments with a statement that a strong dollar was in the best interest of the U.S. Tell that to the manufacturers who are trying to compete with Asia!

Dollar losses vs. the euro were limited as offsetting economic reports released this morning made it difficult for traders to establish a direction in early trading. The conflicting data started on the consumer side as French consumer spending surprised to the upside rising 1.6% from the .7% which was expected. This was the best reading since August 2006 and was buoyed by a sharp reduction in French unemployment. On the other hand, Italian Retail Sales showed a far more tepid rise of just .1% vs. .3% projected.

Other data this morning showed growth in Europe's manufacturing and service industries slowed more than economists expected in July. The Royal Bank of Scotland Group Plc's combined index fell to 57.3 from 57.8 in June as reported by Reuters. While this index did fall, any reading above 50 indicates expansion. This negative data was offset by German import prices, which increased more than economists expected in June. German prices rose 1.3% in the year, the biggest gain since December of 2006. These price gains will continue to put upward pressure on the euro.

The pound sterling rose to the highest in 26 years against the dollar on further speculation the BOE will raise interest rates at least once more this year. Much of this recent movement in the pound is due to momentum as data released today should have been somewhat negative for sterling. British factory orders unexpectedly fell in July, but currency traders largely ignored this data and continued to make bets the pound will rise. The BOE will meet next on August 2nd but will probably wait until September to make their next move up.

Two other currencies which have been benefiting from interest rate differentials are the New Zealand and Australian dollars. The New Zealand dollar moved over .81 cents for the first time last night before moving back down in early European trading. The Australian dollar also continued to gain and hit a new 18-year high. Both currencies continue to benefit from some of the highest interest rates in the industrialized world. The New Zealand central bank is expected to boost its key rate a quarter of a point this week. New Zealand's dollar will extend its rally to 83 cents, said John Key, the leader of the nation's opposition party and former European head of global foreign exchange at Merrill Lynch.

The Aussie dollar gained yesterday after a govt. report showed producer prices rose by more than economists expected in the second quarter. A report tomorrow is expected to show Australian inflation accelerated last month. Australia's consumer price index probably gained 1 percent in the second quarter, compared with .1 percent in the first three months of the year. These higher inflation numbers will continue to push the Reserve Bank of Australia into raising its overnight cash rate at their next meeting on August 8.

In preparation for my presentation later this week at the San Francisco Money Show, I ran a spreadsheet calculating the currency returns for all of our different Index CDs. I was happy to see that all of these indexes had returned over 9% annualized on a year-to-date basis. The Commodity Index was the top performer, with a currency-only return of 9.63% during the first seven months. Our new WorldEnergy Index was second with a currency return of 9.29% and the Prudent Central Bank was number three at 8.54% so far in 2007. Even more impressive are the total returns (including interest) for these Index CDs. The Commodity Index was still the top at 14.38%, followed by the WorldEnergy at 13.61% and then the Prudent Central Bank at 12.09%. GREAT STUFF!!

Currencies today: A$ .8847, kiwi .8082, C$ .9565, euro 1.3812, sterling 2.0602, Swiss .8298, ISK 59.15, rand 6.8237, krone 5.7313, SEK 6.6390, forint 178.15, zloty 2.7226, koruna 20.4079, yen 120.80, sing 1.5059, HKD 7.8217, INR 40.2325, China 7.5685, pesos 10.7742, dollar index 80.22, silver $13.335, and gold... $682.97

That's it for today... We are back at full staff this morning, so it should be a better day on the desk. The big boss Frank Trotter emailed me from Vancouver last night where he is one of the key speakers at the Agora Wealth Symposium. He is expecting some great crowds out there. I still have to finish the presentation for San Francisco, so got to get to work! Hope everyone has a great Tuesday.

Filling in for Chuck Butler:

Chris Gaffney, CFA
Vice President
EverBank World Markets