At its worst, subprime lending consisted of giving loans to people that probably couldn’t pay on low or no-doc terms. These people were initially targeted because they were on the economic margins of society. They were the itinerant laborers, ne’er-do-wells, and seasonal employees, the kind of people that couldn’t qualify for mortgages or other loans on conventional terms.

Subprime loans, by definition, are made to borrowers who are unqualified, so lenders demand higher interest rates to compensate for the risk. The problem is that this strategy doesn’t work. If a borrower who is already on financially shaky ground is charged an above-market rate, the excess payment that such a borrower has to make means that she becomes an even greater risk than before. The act of subprime lending creates the very problem it is supposed to solve.

People who could pay on their loans were then, in effect, subsidizing the ones that couldn’t. In the words of wise underwriter Jack Ringwalt, “Subprime products were fit for only crooks and deadbeats.”

The supposed cure for subprime payment problems came and was another monstrosity, adjustable-rate mortgages. ARMs offered low teaser rates to qualify people for loans that they really couldn’t afford. The incentive consisted of submarket rates for a period of time, typically two or three years. It’s just enough time for a loan to get seasoned, while the monthly payment was temporarily affordable. 

Beneficiaries of such loans had an artificial incentive to pay on time to keep the low rates, at the expense of running up their credit cards for nonmortgage items. After the rate resets, the incentives run the other way, explaining the recent stabilization in consumer credit and the rise in foreclosure rates. Overextended home borrowers were made to appear as better credits during the teaser period than they actually were.

This was an example of the “lend now, collect later” mentality that pervades today’s banking system. So much for the old J.P. Morgan dictum of a “first-class business done in a first-class way.”

Unfortunately, the problem of stupid lending could not be confined to the lenders and the so-called investors that act as their backers. That’s because the abnormal spending that was made possible by the housing “ATM” effect is now coming to a screeching halt. Normal consumer spending that would have occurred if the consumer were not severely loaded down with debt would soon be severely crimped.

Borrowers will probably not wind up going hungry or unclothed, but we may see a rise in the sales of Spam, sloppy Joes, and secondhand clothes. Not to worry, this will last for only the two or three decades that it will take to pay off their homes — just like their grandparents 70 or 80 years ago.

There are no solutions likely to provide any relief. One idea is to penalize the lenders. Suppose that a legislative or judicial consensus formed around that proposition that loans with teaser rates for the first two years and market rates for the remaining 28 years were deceptive to the consumer. The legislators might decide that those low teaser rates should remain in effect for the life of the loan. That form of interest subsidy would certainly provide relief to the consumer, but lenders would suffer as a result. A large number of banks and hedge funds would ultimately go bust.

As bad as this was domestically, many of these bad loans were packaged and sold to foreign investors, meaning that they now contaminate the banking systems of our major trading partners. German banks, for instance, were shocked to find that their tranches of loans carried properties more characteristic of options, a much riskier security. Such paper is now often acceptable as collateral stateside for back-to-back loans from the discount window, thereby establishing a near-equivalence between shaky loans and Treasury paper.

This comes at a time when the Fed is lowering its benchmark rates toward teaser levels. What happens when foreign investors wake up to the fact that they are being paid teaser rates to hold paper of a very questionable quality? Will the U.S. Treasury then be able to roll over its debt, or will there be a default event that can occur only once before other nations wise up?

Although their grandparents presided over steadily improving U.S. credit, baby boomers may end up ensuring that the generations that succeed them will have impaired credit in global markets for at least a century.

The U.S. government can’t prevent someone from taking losses on the foolish borrowing practices discussed above, because those loans have already been booked. What the government can do is determine who gets to eat the losses. Be it borrower, lender, taxpayer, or foreign investor, there is no question that the piper is about to be paid. The question that remains is who will pay, and how?

Regards,
Thomas Au, CFA

October 19, 2007

Sub Standards — A Metaphor for the U.S. Financial Market was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Certain areas of the credit market are frozen, and until they thaw, the global stock markets are rediscovering their volatility. The U.S. economy is addicted to credit just as it is addicted to foreign oil. This could be the equivalent of a temporary oil market embargo.

Fortunately for U.S. debtors, help is on the way. The Federal Reserve will swoop in for the rescue by doing what it always does: promote inflation. Like a shotgun blast, the Fed will inject the type of liquidity we saw after the Sept. 11 terrorist attacks. This time, however, this blast will have a hard time making its way down the chain of lending to the credit-starved subprime mortgage market.

The Fed’s announcement of this type of monetary policy will be cautious. Global investors have a tendency to react quickly to minuscule changes made by the Fed, but one message will ring loud and clear: Deflation is unacceptable and the Fed will fight it with every tool in its kit. It’s saying that the U.S. dollar is expendable.

Credit Inflation Raises Borrowed Liquidity

The stocks of high-quality companies exposed to energy and metals eventually will settle down, but I think we’ve still seen only the beginning of what will eventually be huge damage to the securitization market. The securitization phenomenon has allowed all debt to be packaged and sold off to investors around the world. It fueled the blowoff top in the housing market. It enabled homebuyers to purchase homes that they clearly could not afford.

Thanks to securitization, misunderstandings of the risks involved with collateralized debt obligations (CDOs), and incompetent ratings agencies, those involved in the mortgage-backed security (MBS) markets were largely ignorant of the risk they were taking. Just like the “dumb money” day traders powering the peak of the NASDAQ bubble, the complex mortgage funding setup allowed way too many bad loans to be stuffed into the MBS channel. This just inflamed the peak of the housing market.

The idea of new savings is becoming rare, and this means that all liquidity creation is borrowed. It is borrowed against rising asset prices, and once asset prices stop increasing, the liquidity evaporates.

Once this happens, selling without buyers begins, and this already hit the CDO market. As far as the housing market is concerned, inventories keep building and foreclosures keep increasing, but we haven’t seen the type of panic you may expect. People are not yet overreacting to the point at which asking prices begin to be slashed by 30-40%.

This type of panic could develop and may happen by the middle of 2008, coinciding with the peak in ARM resets. Economists and strategists argue that since the dollar amount of ARM resets is small relative to other figures, there has been no recent panic. They have a point, but what do they think will happen to market psychology when there’s another huge spike in foreclosures and housing inventory?

The Fed Faces Difficult Choices

Recently, Bernanke considered the subprime crisis to be contained. He appears to be incorrect in the face of today’s interconnected world. Fear in one market usually spills over into several others. Bernanke also believes that a global savings glut will keep the long-term interest rates low forever, but he seems to be missing the point. As we’ve already seen, what is perceived as a savings glut is turning out to be borrowed liquidity, liquidity that can disappear into thin air.

Wall Street’s pleas for serious Fed action grow louder with each hedge fund that goes under. In August, the Fed rolled out an emergency 50 basis point cut to its discount rate. This change will stay put until the Fed decides that market liquidity has improved.

This action set off a short-covering stock market rally, but I think it’s hardly enough inflation to cover all the problems that will crop up from the massive volumes of ARM resets in the pipeline. Banks like Countrywide have had their impending short-term funding crunch eased, but they won’t be prompted to start writing a lot of mortgages again. Plentiful easy mortgages are exactly what the housing market needs to avoid another big price decline, but that’s not going to happen. At this point, foreign creditors like the Chinese play a far more important role than the Fed does when it comes to housing finance.

Bernanke is stuck between a rock and a hard place. On the one hand, he’s worried about rampaging inflation expectations, and on the other, he’s worried that a plummeting housing market could threaten the entire banking system.

I expect that he’ll promote as much creation of money and credit as he can get away with and hope that the public’s fear of inflation doesn’t return to the extremes it reached in the 1970s.

The world is safe today, but for how long?

Best regards,
Dan Amoss, CFA

October 18, 2007

Bernanke’s Choice was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

This human desire to approach the fray is not exactly a new concept. I have read that the ancient Trojans would march off to battle with people encouraging them to "come back with your shields, or on them." So when Greg Grillot asked me to investigate the subprime lending meltdown, I had in mind one particular event here in Irvine, Calif.: ground zero. Almost instantly, I was in my car and driving down Interstate 405 (also known as "the 405"). My destination? Easy, really. Just look for the mushroom cloud and ride to the sound of the guns.

New Century, New Bankruptcy

On Monday, April 2, 2007, New Century Financial Corp. became among the latest of the subprime mortgage lending companies to file for bankruptcy protection. We knew that this was probably in the cards, if not inevitable. I discussed the prospect of New Century filing for bankruptcy in a previous article in Outstanding Investments. The New Century people have spent the last month or so preparing for the bankruptcy filing, and as we shall discuss below, it shows.

What was of immediate interest, at least to this Peak Oil correspondent, was that New Century, based in Irvine, filed for bankruptcy protection in distant Delaware. It is not as if there are no federal courts and federal bankruptcy jurisdiction in the Southern District of California. And there are certainly many capable bankruptcy judges, trustees and lawyers in Southern California who could handle the process. But the New Century filing is reflective of a legal phenomenon called "forum shopping," in which large-scale cases, particularly cases with national economic implications, tend to wind up in either the Delaware bankruptcy jurisdiction or the Southern District of New York (i.e., Manhattan). It is true. You can look this up.

Just as cities and regions compete with each other to host major sporting events like the Super Bowl, so do federal court jurisdictions develop reputations as the "go-to places" for certain kinds of high-profile litigation. Thus, the Delaware and Manhattan jurisdictions are well known for their institutional friendliness to what are called "prepackaged" bankruptcies ("prepacks" for short), meaning bankruptcies in which much of the outcome is already predestined, if not known to a legal certainty by the corporate insiders, their key lenders and their counsel. These sorts of bankruptcies are kind of like professional wrestling, except that, by comparison, wrestling is not fake.

So when it comes to the prepacks, bankruptcy court is often just a brief and convenient whistle-stop on the railroad. That is, the bankruptcy process offers a sheltered watering hole, safe from the creditors and complete with a healthy measure of "automatic stay" euphoria. This is where the common shareholder suckers are put off the train, the unsecured debts are discharged like yesterday’s coal ash, and the title to the high-value freight changes to friendly hands, if it is not so situated already. Accordingly, there is often great interest, both personal and legal, for the key managers and stakeholders of the debtor company to hold the right ticket and to steer their corporate bankruptcy to the safest locales, which are the switching yards with the most accommodating station masters. Presently, these comfortable venues are the southern and northern terminuses along what we might call the "Delaware & Hudson Valley" line.

Yes, I know. The New Century bankruptcy is not technically a prepack, but then again, the New Century bankruptcy has been over a month in preparation. There are no accidents in this world, comrades, and there are a lot of eventual financial and legal outcomes that are already designed into the New Century bankruptcy in (ahem) that "certain way." And on Tuesday, April 4, 2007, in the course of the "first-day motions," the Delaware bankruptcy judge pretty much granted everything that New Century and its lawyers requested. The "debtor," as they say, is "in possession." There is new money on the table, with all of the necessary "super-priority creditor" protections. The paychecks will come on time for most of the New Century senior management. And the best of the assets will get sold and transferred to the right people (or at least to the right kind of people). So clearly, in this world it pays to be the right kind of person. And don’t you forget it.

Somehow, I doubt that many of New Century’s subprime loan customers, who will eventually find their ways into the bankruptcy courts of this fair land, will encounter similar legal deference, if not this particular shade of red carpet. But I digress.

Back to Irvine

Let us return to Irvine, where New Century filed other another kind of legal paperwork last week. While its attorneys were busy in the federal bankruptcy district for Delaware, New Century handed out about 3,200 pink slips to its employees in California. Later in the week, I witnessed some of the scene as I gingerly drove past the New Century headquarters building, like a tank driver of the glorious Red Army warily approaching the rubble of the Reichstag in 1945. A small cadre of shellshocked staff was carrying boxes of whatever it could salvage from the smoldering ruins.

It was not as if the graffiti were not spray-painted, figuratively, at least, all over the walls of the Irvine campus of New Century. Many New Century employees knew far in advance that the ax would fall. But still, as anyone who has ever read and absorbed the meaning of A Tale of Two Cities could tell you, the sharp blade always makes that repugnant physiological thud when it lands. Then, during the French Revolution, as now, on the cusp of economic calamity and Peak Oil disaster, we live in what are both "the best of times" and "the worst of times." Can you tell the difference?

"We were a go-go company, and I was a go-go New Century company man," stated one former employee to a roving Peak Oil correspondent, in all likelihood not realizing the rhetorical parallels with the self-promotional propaganda that characterized life and progress in the former Soviet Union. "Up until February, I was making mid-six figures. I bought a house and two cars and my kids were in private schools. Now I am a subprime borrower myself. I am going to lose everything." Everything? That is a lot to lose. Not to revel in another man’s misfortune, but what was this guy doing in a job the business model of which was premised on issuing mortgage loans to people without the money or income to pay them back?

Another former New Century man told the Los Angeles Times, "I don’t know what to do now. Maybe I can sell cars. People might not be able to afford houses, but they can always buy a car." Always? Don’t count on it. Nearly 40% of automobile purchases in California have some sort of home equity loan tied up with them, according to the New York Times. And alas, this poor soul probably has not heard of Peak Oil. The automobile business may not be the best place to work in the not-so-distant future. And if he goes from working the beats of the housing lots to pounding the pavements of the parking lots, over the long term, he will only be hurling himself from the employment frying pan into the Peak Oil fire. Perhaps he should consider a career of installing solar water heaters.

And still another former foot soldier of the depleted ranks of the New Century army had this to say: "I’m getting out of this business. I am going to get a job selling liquor. No matter how bad things get, people will always drink." Yes, that is probably true. People will drink, but even getting drunk will cost more in the future. The world is already embarked on a crash program to turn its food supplies into ethanol with which to run a ubiquitous and obsolescent personal transportation system, much of which enables people to commute to their subprime bungalows in the distant suburbs and exurbs. And the price of food is skyrocketing, as we at Agora Financial have noted for quite some time, and as the Wall Street Journal highlighted in a front-page article on April 10.

So going forward, there will simply be less corn available to distill into whiskey, and much of that corn will be of the genetically modified type, which I swear makes the hooch taste different. Genetically modified plants may also be responsible for the recent mass die-off of agriculturally necessary bees, according to a recent report in the German magazine Der Spiegel. This is another topic for another time.

A Leaking Sector of the Economy

Nationwide, the mortgage lending industry has laid off well over 21,000 employees since Jan. 1 of this year, according to figures published by the U.S. Department of Labor. This is up over 345% from the same time frame last year. "A whole sector of the economy is leaking," states John Challenger of the outplacement firm Challenger, Gray & Christmas.

3,679 of those lost jobs were in California in the first quarter of 2007 (thus not including the 3,200 New Century layoffs that occurred on April 3). Other well-known names in the subprime lending industry whose ranks are thinner due to recent layoffs include Ameriquest Mortgage Co., Fremont General Corp., and WMC, a unit of General Electric Co. And this thinning of the ranks is just in the "LA Weight Loss" arena of the California Southland. There are comparable stories from other formerly white-hot subprime mortgage markets, such as Florida, Northern Virginia, and Boston.

In the separate category of construction employment, the early handicapping is that over 70,000 of such jobs will vanish in the about-to-be not-so-golden state of California within the next two years, according to Ryan Ratcliff of the UCLA Anderson School of Business. "Each…finance job is worth at least two construction jobs," due to the higher pay scales of the white-collar position, according to Mr. Ratcliff. So the economic ripple effects will spread and, like many waves, lap upon distant shores.

In Part 2 of this article, we will follow some of these waves to some of those distant shores.

Best wishes from California.

Until we meet again…
Byron W. King

April 11, 2007

Subprime Ground Zero, Part I was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“A wave of home mortgage foreclosures is sweeping across Brevard County — signaling a disastrous end to the local housing boom for those who could lose their homes…

“Many of the cases stem from homebuyers — both residents and investors — getting sucked into risky loans, with limited options to refinance or sell because of the recent decline in local property values…

“The trend is part of a rise in foreclosures nationwide, and especially in Florida, which ranked second in the nation in 2006 in foreclosures, behind California.

“In Brevard County, there were 982 foreclosures from November through February, more than double the 377 foreclosures during the same four-month period a year earlier, according to data provided by Brevard County Clerk of Courts Scott Ellis. The figures include some commercial foreclosures, but the vast majority are residential.

“In addition, there are more than 5,600 local properties where the owners are at least two months behind in mortgage payments, according to RealtyTrac.com, a Web site that tracks such data…

“If there is a marked downturn in the economy, ‘this could be seen as the tip of the iceberg,’ said David Brown, Bank of America professor at the University of Florida’s Department of Finance, Insurance, and Real Estate…

“‘There are a variety of factors here,’ said Steve Srein, founder of People’s First Financial Services of Melbourne. ‘The first thing is people are not changing their lifestyles to pay for the loans they took on their homes. We’ve adapted to what I call “The Easy Society,” in that we made it easy for people to get into houses with submarginal credit. Since they had submarginal credit, that puts them in the subprime category, ripe for a product like the exotic mortgage or the junk loan, or optional adjustable-rate mortgage.’

“‘The problem today is that the people were pushed into loans they really couldn’t afford,’ Srein said. ‘The real estate people and the mortgage brokers are saying the borrowers knew what they were doing. But, really, it’s the optional (adjustable-rate mortgages) that are the big culprit behind the whole problem’…

“‘These people weren’t prepared for what they were getting into,’ Srein said. ‘They weren’t ready for phenomenal real estate tax increases and phenomenal homeowners’ (insurance) increases. So if you take that element, and combine it with a person that isn’t willing to make changes in their finances, you have defaults. If your habit is spending on lavish trips or spending on clothes, you need to cap the spending to keep your house. It’s the wants versus the needs.’

“The other factor is that, in recent years, housing prices have soared in Florida overall, Srein said, ‘and the salaries have not.’”

Tsunami of Defaults

A tsunami of subprime defaults is about ready to sweep The Easy Society right out of their houses. Fed Governor Susan Bies says, “Subprime Defaults Are ‘Beginning of Wave’”:

“The nation’s banks are just beginning to feel the pain of defaults on risky mortgages they made at low introductory rates when housing prices were soaring, U.S. Federal Reserve Governor Susan Bies said.

“Bies, who has been the Fed’s top banking policy official in her tenure at the U.S. central bank, said today banks are likely to see more missed payments and foreclosures as consumers with weak credit histories begin to face higher monthly mortgage payments.

“‘What’s happening is the front end of this wave of teaser-rate loans that are coming into full pricing,’ Bies said at a risk-management forum in Charlotte, N.C. ‘So what we’re seeing in this narrow segment is the beginning of the wave. This is not the end, this is the beginning’…
 
“The Fed and four other bank regulators released proposed guidelines last week instructing banks to strengthen their underwriting standards and offer clear disclosures on loan terms to subprime borrowers.

“The central bank also said last week that the delinquency rate on banks’ residential real estate loans reached a four-year high last quarter.

“Bies said the problems in the mortgage market are well contained.

“‘We’re seeing this in a very narrow segment,’ Bies said. ‘We’re watching for contagion, we haven’t seen it.’

“Outside of the housing and auto industries, ‘the economy is strong,’ Bies said.”

Given that housing alone accounted for over 40% of the jobs this recovery, that last statement by Bies seems pretty feeble. The Fed is also four years and trillions of dollars too late on those lending guidelines. I talked about that in “Malinvestments, Predatory Lending, and Demagogues,” and it is likely that I will be writing on that theme again soon.

Contagion Watch

So the Fed is “watching for contagion.” Exactly what can the Fed do about it when it hits? That will not be Bies’ problem, as she is cleverly leaving her post at the end of March, as Forbes reported back in February in “Fed Gov. Bies Quits”:

“Two days after a group of major U.S. banks asked regulators to reconsider proposals for regulating bank risk, the Federal Reserve governor heading their implementation resigned.

“Fed Governor Susan Bies submitted her resignation on Friday that will become effective March 30. Bies leaves five years into an appointment that was not slated to end until 2012. In a resignation letter address to President Bush, Bies called her experience on the board ‘very rewarding’ but offered no reason as to her departure.”

That seems like a good move. I would not want to stick around for this tsunami, either. Most of those in The Easy Society won’t even know what hit them. They will be blaming predatory lenders, hurricanes, insurance companies, and anyone and everyone but the primary culprit (the Greenspan/Bernanke Fed). I suspect that is the real reason (at least one of them) for Bies’ resignation.

To be fair, Forbes also reported:

“In her last position, she was spearheading efforts to revise and implement the international capital standards for banks developed in 1988. Although banks and regulators agreed the old standards were outdated and overly simplistic, updating them has been a contentious issue for years.

“Bies had recently voiced frustration at the slow progress. After a speech at the National Credit Union Administration’s Risk Mitigation Summit in January, Bies told reporters that ‘I’m an impatient person. I clearly wish that things were going faster, but I’m very happy that we’ve got everything out for comment now.’

“On Wednesday, four major U.S. banks submitted a letter to the Federal Reserve and urged it to move away from certain Basel II proposals. JPMorgan Chase, Washington Mutual, Wachovia, and Citigroup complained that the new rules would require U.S. banks to hold more minimum capital and would give foreign banks an advantage.”

If Bies is resigning because she refuses to go along with tightening minimum capital requirements, then perhaps she should be applauded. For now, she isn’t saying. Once she is gone, I hope she will disclose her reasons. It will also be interesting to see if she stops chirping the economy is strong with Paulson, and starts singing the recession blues with Greenspan.

Regardless of what tune she will be singing, The Easy Society is in for very harsh times.

Regards,
Mike Shedlock ~ “Mish”

March 13, 2007

The Easy Society was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

The Mortgage Lender Implode-O-Meter Web site has gained a wide following as an online obituary for the most aggressive, irresponsible lenders. This site, maintained by concerned citizen Aaron Krowne, has only been up shortly. Yet the site’s headline flashes the statement “21 lenders have now gone kaput” since about December 2006. Krowne really cuts to the chase in his description of the unfolding disaster:

“It appears what had to give is now finally giving: the latest subprime loans are going delinquent the quickest, and it seems likely that their prior kin will soon follow (and many of these will likely end up in foreclosure). Further, I expect a large swathe of prime loans to go bad (the prime/subprime distinction is quite fuzzy anyway). Originators cannot handle the buybacks, and so when challenged by them are immediately folding [emphasis added]. The phenomenon is just getting started. What will the banking industry — often all or part owners in these enterprises — do? Stay tuned.”

Lending in the NEW Century

Most of these companies concentrate on the “origination” side of the lending business, because it’s considered the sweet spot. You simply approve your customer’s credit application, perhaps buy some sort of “credit enhancement,” and sell the mortgage to Wall Street, where it will be bundled together with similar mortgages and sold to some poor sap managing a bond portfolio at an insurance company.

One subprime lender in particular, New Century Financial, has been caught with its pants down and now faces financial restatements, shareholder lawsuits, and an uncertain future.

New Century is a “canary in the coal mine” for the entire mortgage industry. Its recent struggles should not be ignored as company-specific. NEW stock is a good gauge of the credit market’s willingness to fund high-risk mortgages:

The availability of subprime credit is drying up as fast as this stock is falling. So what does Implode-O-Meter Web master Aaron Krowne mean when he says, “Originators cannot handle the buybacks?” New Century provides an example. The latest (300-page) 10-K explains:

“We sell whole loans on a nonrecourse basis pursuant to a purchase agreement in which we give customary representations and warranties regarding the loan characteristics and the origination process. We may be required to repurchase or substitute loans in the event of a breach of these representations and warranties. In addition, we generally commit to repurchase or substitute a loan if a payment default occurs within the first month or two following the date the loan is funded, unless we make other arrangements with the purchaser. The majority of our whole loan sales are sold on a servicing-released basis.”

Last week, New Century announced that it hasn’t been accounting properly for what it calls “early payment defaults.” Scores of borrowers are defaulting before the ink on their mortgages even dries. So now New Century is responsible for repurchasing untold numbers of loans backed by homes that are not only illiquid, but probably worth less than the mortgage’s face value.

To make matters worse, New Century is facing a liquidity crisis by violating several covenants on its own lines of credit. Creditworthiness is a rather important characteristic for lenders to maintain. The laundry list of Wall Street firms providing these lines probably agrees (we’d hope) and are likely to balk at extending credit at the time New Century needs it the most.

In a final toss of cold water on the widely anticipated housing recovery, New Century management says that these “early payment defaults” had not bottomed, and had in fact reaccelerated in the fourth quarter of 2006.

Many aggressive mortgages are turning sour so fast that, hopefully, regulators and accounting authorities will crack down on the aggressive accounting tactics that have inflated New Century’s earnings figures.

Other suspected earnings inflators are Countrywide Financial, Downey Financial, and FirstFed Financial. Negative amortization mortgages have been popular among these institutions’ customers because they feature advertisements like “Get a $500,000 mortgage for $250 per month.” But the fine print describes how the difference between this payment and a realistic payment is added to principal — hence “negative” amortization. The principal grows over its life, rather than contracting like a conventional mortgage.

These three players have been booking their customers’ payment procrastination as real earnings. Since this behavior is a good indicator of future default, how should such loans be recorded on their balance sheets? They may be “performing” now, but a big chunk of them will stop performing in the near future. The housing market is fresh out of greater fools to bail out overleveraged speculators. At such time, most of the earnings that have been booked from these toxic mortgages will be erased.

Nobody seems to have a clue what the real earnings are in this business, since executives have plenty of leeway to play around with “lost reserves” accounting, making earnings what they want.

HSBC: Oops! Our Accounting Doesn’t Reflect Reality

On the same day as New Century’s announcement, mortgage giant HSBC Holdings announced a major increase in loan loss reserves, which will directly hit earnings. HSBC’s press release explains:

“The impact of slowing house price growth is being reflected in accelerated delinquency trends across the U.S. subprime mortgage market, particularly in the more recent loans, as the absence of equity appreciation is reducing refinancing options. Slower prepayment speeds are also highlighting the likely impact on delinquency of higher contractual payment obligations as adjustable-rate mortgages reset over the next few years from their original lower rates.

“We have reviewed critically the impact of these factors in determining the appropriate level of provisioning at Dec. 31, 2006, against the Mortgage Services loan book. We have taken account of the most recent trends in delinquency and loss severity and projected the probable effects of resetting interest rates on adjustable-rate mortgages, in particular in respect of second-lien mortgages. It is clear that the level of loan impairment provisions to be accounted for as at the end of 2006 in respect of Mortgage Services operations will be higher than is reflected in current market estimates.

“We now expect that the impact of increased provisioning in this area will be the major factor in bringing the aggregate of loan impairment charges and other credit risk provisions to be reflected in the accounts of the Group for the year ended Dec. 31, 2006, above consensus estimates by some 20%.” [Emphasis added.]

HSBC and New Century executives are sending very clear messages about future mortgage default risk, so why are two key purchasers of default risk choosing to merge? And why doesn’t their accounting reflect worsening real-world conditions?

MGIC and Radian Increasing Exposure to Defaults

On Tuesday of last week, mortgage insurer MGIC Investment Corp. (MTG) announced that it will be merging with rival Radian Group Inc.. Radian shareholders will receive 0.9658 shares of MGIC in the formation of the new “MGIC Radian.” MGIC was the subject of my last Whiskey & Gunpowder article, “Holding the Housing Market Bag, Part II.” Wall Street seems to love the deal, sending the stock up sharply:

But the market is “missing the forest for the trees” by celebrating the cost savings of this deal. The “forest” is the risk in the existing book of business and the “trees” are the operational cost savings (i.e., redundant worker layoffs).

On the conference call the day of the announcement, both management teams extolled these cost savings and that popular M&A buzzword “synergies.” But I expect that they will regret being distracted by a complex integration when they should have battened down the hatches in preparation for this year’s mortgage defaults. So I found it interesting that Radian CEO S.A. Ibrahim, who will become MGIC Radian’s CEO in a few years, can’t wait to lead the charge into even more exotic credit insurance markets:  

“We have an opportunity in the traditional MI [mortgage insurance] area, as well as in offering new kinds of credit enhancement solutions, because the market can no longer really be defined as traditional MI alone. Really, the market for credit enhancement should be viewed as much broader than MI. it’s somewhere between the traditional MI which is a $600 billion [market] and the $9 trillion in mortgage debt outstanding, and it is going to be defined by the companies that can define that frontier.” [Emphasis added.]

Neither management team mentioned risk on the call — only opportunities. Would the analysts on the call bring it up? A grand total of two questions out of about a dozen focused on reserve accounting and risk in the existing books of MGIC and Radian. The first came from Goldman Sachs analyst Andrew Brill:

Q: “Do both companies use similar claims factors in their reserves? What have you factored in terms of reserve changes that might be needed as the books get combined?”

A: “We have very similar approaches, but we go about it differently. But ultimately, we get to a reserve base based upon experience on the claims side and severity, and as we looked at the actuarial reports that [MGIC] prepared and [Radian] prepared, [we determined that] the range of the reserve, in theory, is very close. We have different approaches for it, but ‘net-net,’ the average case basis is very similar when you look at the detail [so we do not believe that there will be any reserve adjustments].”

Management basically reiterated their reserve accounting policy of looking through the rearview mirror at the wonderful boom times in the housing market. This is likely to come back and bite them. Another analyst, probably from the buy side, asked the only other difficult question:

Q: “What is the strategic rationale for this merger outside of the cost reductions, considering the likely management distraction at a time of worsening losses?

A: “We have the issue of running the business. Relative to the business itself, I’m encouraged by what’s going on in the business with the return of insurance in force growth as persistency increases with higher rates and the increasing penetration of MI… The loss side of the business is there. I think both [MGIC's and Radian's] portfolios are well managed. We both thought, looking at our books, that [paid losses] would be up about 10%. But we think that’s well controlled.”

By the end of this conference call, you can tell which analysts are helping management sell MGIC stock to the public with softball questions and which analysts are really trying to properly balance risks and opportunities.

In a presentation a week earlier at Citigroup’s 2007 Financial Services Conference, MGIC CEO Curt Culver addressed the issue of default risk. He stated confidently that the trend in future defaults will be highly correlated with the job market. He expects MGIC to emerge from the subprime disaster unscathed because the company did not overly expose shareholder capital to the riskiest mortgages.

But this housing cycle went far beyond any past cycle. Near the peak of the housing bubble, a huge proportion of buyers were investors with no intention of ever moving into the homes they were buying. This inflated purchase prices and lowered the margin of safety for buyers actually intending to move in. Clearly, the higher the mortgage payment required to get into a house, the lower the household’s ability to consistently make that mortgage payment.

Merger Accounting Muddies the Water

A great example of how merger accounting can misrepresent reality is the experience of Tyco Intl. investors. Wall Street loved former CEO Dennis Kozlowski’s voracious appetite for acquisitions, hailing the company as the “next GE.”    

That is, until early 2002. Then, the seams fell apart as the Enron scandal and a recession combined to shed light on the real value of the hundreds of businesses Kozlowski had rolled up.

This rollup strategy included an accounting tactic called “bootstrapping earnings.” Here’s how it worked: Tyco used secondary issuances of its high P/E stock to acquire low P/E companies in stodgy, “old economy” industries. After the books closed on these acquisitions, Tyco would automatically show higher earnings per share. Throughout the 1990s, this conglomerate consistently produced investor-pleasing earnings growth: 

How was this wave of acquisitions treated on Tyco’s balance sheet? Whenever an acquiring company pays a premium above the target company’s book value, the difference usually ends up as “goodwill,” an intangible asset on the acquirer’s balance sheet. Goodwill and other intangibles cannot fund dividends quite as consistently as capital assets, like plants. Tyco’s intangible assets swelled from $6.4 billion in 1998 to $35.3 billion in 2001.

This was a big red flag. How could investors possibly asses the intrinsic value of the underlying businesses? Tyco is not a software company, in which nearly all assets are contained in minds of programmers and lines of code. As such, the explosion of intangible assets was not justified.

It turns out that a good chunk of Tyco’s performance in the 1990s was function of a virtuous feedback loop: high investor expectations led right back to even higher expectations as follows:

The past few years have been a period of discovery about the real value of Tyco’s conglomeration of businesses. As of early 2007, Tyco management is seeking to speed up the process by splitting up into separate operating units. Apparently, the magic of “synergies” no longer applies.

Tyco is an extreme example of the shenanigans that can occur behind the smoke screen of complex acquisition accounting. While Tyco is a portfolio of manufacturing businesses, New Century is a portfolio of subprime mortgages, and the new MGIC Radian will be a portfolio of insurance policies on $290 billion worth of home mortgages, they all share the common trait of being difficult to value. Now, MGIC Radian’s merger accounting will make it even more difficult to value.

MGIC and Radian both trade for 9-10 times earnings, so Tyco-style “bootstrapping” will not be a factor. Changes to loss reserves are the factor that really moves the needle on EPS in the mortgage insurance business

I wouldn’t be surprised to see MGIC management slip in an impairment charge or increase loss reserves as the MGIC and Radian financial statements join in holy matrimony. Merger accounting would provide a convenient diversion. I’ll be watching closely for management to update their accounting to match reality in the housing market.

Good investing,
Dan Amoss, CFA

February 15, 2007

Accounting Reflects Housing Market Reality was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.