Credit Market Meltdown - Part 2

As this new era of easy money and massive leverage emerged, the thought that risk is limited and easily manageable permeated investors’ mindsets. Hedge fund managers, mortgage bankers, and Wall Street leaders were earning unprecedented amounts of money. Arrogance, and the feeling that an investor could do no wrong, as it was with Tech stocks in the 90’s, was once again a dominant trait of many an investor. Investors, in markets such as real estate, stock/bond markets, private equity and LBO’s, thought they found the holy grail of investing. The chalice in this case is superior returns with little risk.

Arrogance and invincibility are traits that have proven deadly in the past and once again are currently a death wish. As I write this I am hearing rumors that Goldman Sach’s, aka the smartest and most arrogant guys in the market, may be looking at an $11 billion dollar write down. That’s funny; I thought the guys at Long Term Capital were also the smartest?

Like other bubbles preceding this one, everyone from main street to Wall Street got roped in to the phenomena. For example, Joe Blow on main street was buying and selling condo’s in Miami Beach raking in one hundred thousand per deal, private equity firms were bidding ridiculous sums of borrowed money for entities with average returns and financiers like Goldman Sachs and other big players in these markets saw their stocks triple over the last 3-4 years.

As goes all previous bubbles, this one too, must POP. As discussed in part one: Credit markets meltdown, I recognize the bubble as the easy availability of cheap credit. This air in this bubble was easy to borrow, cheap money, be it mortgages, hedge fund leverage, or many instances of institutions or individuals overextending themselves.

The headline grabber of this bubble has been the mortgage market. As you will also read below, the mortgage industry was driven by greed and investors to create mortgage products that made real estate more affordable. Many of these products involved loans with teaser rates, little to no down payments, and shoddy even fraudulent underwriting. People with poor credit could “state” their income without proof and borrow close to 100% of the value of the house with little more than a handshake and signature. The sub prime market and alt-A markets are monikers to describe this new class of weak borrowers. These descriptions are not worth diving into but important to understand that many real estate investors that emerged over the past five years would not have qualified for a mortgage in years past. In other words, they are NOT highly credit rated (high FICO)/ prime borrowers with 20% down. This housing market was a great gig for all involved as long as buyers kept buying and lenders kept lending. Despite the homeowners going over their heads to afford homes, consistently rising real estate values quickly put them in a profitable position. Leverage is an important concept here. When a borrower puts 5% ($5,000) down on a $100,000 house and the house rises to $200,000, the borrower in effect has made $100,000 on a $5,000 dollar investment. Not too shabby. The bank or lending institution is also happy. Mortgage fees for loans, as previously discussed, were high. Despite the bad underwriting, defaults were non-existent. If a homeowner cannot make a payment on a house whose value is more than the loan amount they can always sell the house, pay off the loan and walk away with money. The cherry on this pyramid is that banks and other lenders, such as Countrywide, could easily package the loans and sell them at a profit, as investor demand was rampant.

This is where the insatiable investor demand for higher yields and returns enters the equation. Central bankers, hedge funds, money managers and many others loved these securities. Returns were adequate and defaults were minimal and forecasted to be small as many pundits claimed house prices might slow but never drop. Reminiscent of the booming 90’s tech run up. Wall Street quickly seized on this great opportunity and made billions by pooling these securities and then slicing them in to more complex products. For example, Merrill Lynch could assemble a Collateralized Default Obligation (CDO). Essentially this is nothing more than a bunch of BB rated mortgages that are packaged, sliced and diced to create a security that is largely triple A rated. The rating agencies (Moody’s, S&P, and Fitch) enabled this and put their golden stamp of approval on this process. Without house price depreciation in their risk models, these securities looked unbreakable. They assigned low probabilities of default and thus allowed large percentages of these pools to be considered investment grade.

Investors rely heavily on rating agencies to quantify risk. When investors, especially those previously mentioned with large investment needs, realized they could get superior returns with AAA, AA or A rated mortgage securities they jumped at the opportunity. Investment grade securities (BBB- or better) typically have very low rates of default. More demand than supply for these “high”-rated securities drove yields down, which in turn drove borrowing costs for the homeowner down. This relentless circle pushed mortgage costs lower, made qualifying for a loan easier and ultimately drove house prices upwards. Mortgage lenders were rolling in money and determined to increase their market share and profitability by simply supplying the market with mortgages. Poor underwriting of mortgages, fraud and a host of ills that will plague the mortgage market for years to come was is the result of this greed. This dangerous circle of supply and demand was growing in size and could only be stopped by the decline of real estate values and the ultimate defaults of mortgages.

In 2006 and throughout 2007 home prices stopped rising and actually declined. Defaults and delinquencies increased. Despite the warning signs, investors kept buying these securities, lenders kept producing them and Wall Street kept securitizing them. The involved players could not break themselves from this harmful addiction.

The picture is now a lot clearer then it was. Hedge fund defaults, mortgage lender shut downs and massive credit write downs for Wall Street are the result of these once pristine mortgages defaulting. Making this bubble somewhat unique is the significant concentration of risk due to leverage. I previously gave an example of leverage from the homeowner’s perspective. To once again help you understand the leverage concept I will also explain it from the Hedge Funds viewpoint. On day one the hedge fund will raise $10 million of capital from willing investors and then turn around, call Morgan Stanley or other prime brokers and borrow $90 million using the original $10 million of securities or cash as collateral. The fund now has $100 million to purchase assets ($10 million of their own money and the borrowed $90 million). The day of reckoning comes and the $100 million of securities that were purchased at par (100%) are now worth 80 cents on the dollar. The hedge fund is now out of business because they are unable to pay back their $90 million loan. They have lost $20 million, $10mm more than their initial investment. The hedge fund investors walk away with nothing, as was the case with two Bear Stearns funds along with many others. The securities are then taken over by the bank which is also under water as it has $90 million loans that have been defaulted upon and only $80 million in securities to show for it. That my friend is a $10 million dollar write down.

Over the past few months, investors of all types are recognizing massive losses and being forced to liquidate these securities at significant losses. The de-leveraging process has begun and banks and brokers, who were also large mortgage investors, are unable to absorb the extra supply. We are now faced with massive supply of quickly deteriorating securities coupled with limited demand. It’s quite the opposite situation of just a few years ago.

This is the mortgage bubble in a nutshell. As you now are seeing play out massive amounts of cash chasing limited investment opportunities created a viscous circle that is now coming to fruition. I purposely ended the chapter without my thoughts on how this credit and mortgage crisis plays out. I prefer to save this for the conclusion as it is important to discuss the other credit bubbles that exist and what they mean collectively for the markets and economy.