Friday, December 15, 2006

Tanta: Let Slip the Dogs of Hell

by Bill McBride on 12/15/2006 10:26:00 AM

I still haven’t gotten over the fact that there’s a “capital management” group out there having named itself “Cerberus”. Those of you who were not asleep in Miss Buttkicker’s Intro to Western Civ will recognize Cerberus; the rest of you may have picked up the mythological fix from its reprise as “Fluffy” in the first Harry Potter novel. Wherever you get your culture, Cerberus is the three-headed dog who guards the gates of Hell. It takes three heads to do that, of course, because it’s never clear, in theology or finance, whether the idea is to keep the righteous from falling into the pit or the demons from escaping out of it (the third head is busy meeting with the regulators). Cerberus is relevant not just because it supplies me with today’s metaphor, but because it was the Biggest Dog of three (including Citigroup and Aozora, a Japanese bank) who in April bought a 51% stake in GMAC’s mega-mortgage operation, GM having, of course, once been renowned as one of the Big Three Automakers until it became one of the Big Three Financing Outfits With A Sideline In Cars. I tried to find a link for you to Aozora Bank’s announcement of the purchase, but the only press release I could find for that day involved the loss of customer data. They must have been so busy letting GMAC into the underworld that the dog head keeping the deposit tickets from getting out got distracted.

The third Big Dog with a new stake in GMAC is Citigroup, who sent out a cute “Industry Note” on 12/13/06 on the subject of the coming consolidation in the mortgage biz. It so happens that I was doing some heavy drugs on the 13th, but apparently I wasn’t the only one (I, on the other hand, am getting over it). The thing I really like about the Citi note is that everything comes in threes:

Meanwhile, the [mortgage] industry is facing several ‘hot–button’ issues, including:
• increased regulatory scrutiny of exotic mortgages and option adjustable rate mortgages (option ARMs),
• resetting rates on hybrids,
• deteriorating credit on subprime and Alt A mortgages.

Key questions for investors relate to how these issues influence volume, margins and credit going forward:
• Will the recent declines in originations continue, especially given higher long-term rates and relatively lower purchase mortgages?
• Will margins continue to contract, as competition for shrinking volumes is intense, and several players make apparently desperate efforts to keep activity in-line with recently beefed-up capacity?
• Will credit become more of an issue as ARM rates reset higher and consumers feel the pressure of higher credit card payments and energy costs?
I hate to make you wait, so here’s the punchline:
We think the answers to these questions are, for the most part, “No.” . . .
OK, so there was slightly more detail to that answer. As in, there are three reasons why Citi thinks the mortgage origination side will “rationalize” in 2007:
1. First, we expect a continued market share shift away from the industry’s weaker players, toward those with dominant scale and diverse and flexible production channels (i.e., retail, wholesale, and correspondent).

2. Second, we look for further industry consolidation, likely driven by the pressures of market forces (lower volumes and margins) on second- and third-tier players. The market share currently held by top-tier players (47% held by the top five originators) should expand toward two-thirds and beyond over the foreseeable future.

3. Third, we think the ultimate failure and/or closure of certain weaker market participants is a distinct possibility - given the changing economics of mortgage production and securitization sales during the current post-refinancing cycle. While the timing of such potentially market-disruptive failures/closures is difficult to predict, we believe the most likely casualties will be those players that lack the necessary scale efficiencies and flexibility to adjust to an increasingly competitive environment.
Now, I’m just a Little Mortgage Weenie, not a Big Finance Dog, but bear with me while I ask some stupid questions. Like: how do the Big Dogs maintain “diverse and flexible production channels” (i.e., little mortgage banker Puppies to sell you correspondent business and little broker Puppies to sell you wholesale business) when “market share currently held by top-tier players” expands to two-thirds (meaning less diverse off-load strategies for the Little Puppies in the “production channels,” putting them at further pipeline/counterparty risk unless they become Bigger Puppies, which makes them competitors instead of “channels,”), while at the same time watching some of the Little Puppies (in whom the Big Dogs have a major equity stake) crawl under the porch to die? I know Citi doesn’t seem to have noticed that the “increased regulatory scrutiny” is not just of “products” but of “wholesale operational/management controls,” but I did. Anyway,
In fact, several mortgage industry deals have recently emerged, as a few Wall Street firms have shown their increased interest. Notable transactions include Morgan Stanley’s agreement to acquire Saxon (for $706 million), Merrill Lynch’s agreement to buy NCC’s First Franklin (for $1.3 billion), and Bear Stearns’ agreement to buy the mortgage unit of ECC Capital Corp (for $26 million). In addition, a few large monoline mortgage players have either announced plans to sell or are pursuing strategic options, including ACC Capital Holdings’ search for a possible buyer for Ameriquest, H&R Block’s announced exploration of strategic options for its Option One mortgage unit, and ABN AMRO’s recently disclosed decision to put its mortgage business on the block. Finally, the recent unceremonious closure of Ownit Mortgage, which was apparently unable to find a prospective merger partner, seems likely to be the first of potentially many large mortgage operations that may be shuttered due to the industry’s current excess capacity.
Ownit’s “unceremonious” problem was it couldn’t find a merger partner? According to Marketwatch, “Ownit was formed in 2003 when Merrill Lynch, Interthinx, Mindbox, C-BASS, Litton Loan Services and other ‘key industry vendors’ formed a strategic alliance with [Bill] Dallas to buy a wholesale mortgage company called Oakmont Mortgage.” Bill Dallas used to run Little Subprime Dog First Franklin until it found a home with a Medium Respectable Bank Dog National City, who just offered to unload it on Big Wall Street Dog Merrill Lynch, who is rumored to be a 20% stakeholder in Ownit (Dead Puppy). As far as I can tell, the “unceremonious closure” of Ownit came about when Merrill, and possibly some other bankers, shut off Ownit’s warehouse line of credit without prior notice, preventing them from funding any more worthless loans. Well, you could call that an “excess capacity” problem. You could say they just needed a “merger partner.” You could smoke dope with all three of your heads.

(Sidetrack: Citi notes that PHH is a possible Medium Dog merger/acquisition target. I am old enough to have spent years trying to teach myself to stop calling PHH PHH after it became Cendant. I have only just barely gotten used to calling it PHH again after Cendant’s exciting descent into the Underworld. Now this old dog has to learn a new trick? I have no idea why I would bother; I’m beginning to doubt that any of these dogs will come when called anyway.)

I bring all this up not just to stick it to Citicorp, but because we’ve all been asking the question lately of who will be the bagholder when the exotic/subprime mortgage problem finds a home. We have noted in our discussions that credit risk can move in two directions: the wholesaler takes it off the originator and the bond investor takes it off the wholesaler/issuer with the helpful assistance of protection sellers in the hedge fund credit-swap market, but when the “DETOUR” signs pop up, the bond investor can work really hard on forcing it back to the wholesaler/issuer, who can try to put it back to the originator, who gets to try to recover something in a foreclosure sale. If the originator has any financial strength left to buy loans back with, that is; see the sad stories of Ownit, Option One, Fremont, New Century, etc. The “disintermediation” of the mortgage origination side keeps the Big Dogs “flexible,” meaning able to withstand cyclical downturns in the business, but the burning desire on the Street for “vertical integration” seems to mean an endless appetite for erasing that flexibility by buying up the originators of junk, so that they will have paid what one assumes is real money for the privilege of buying back their own loans right at the time they get the “flexibility” of not buying any more of them from the “intermediaries.” If you thought the only thing that would stop the circle jerk of risk was putting some credit and pricing discipline into the game, I guess you’re just a weenie like me. Anyone who can make sense of this is free to set me straight. And if the answer has “sorting socks” in it, don’t bother. I’ve tried that.

There’s some more interesting stuff in the Citi note that I’ll try to share with you later. Let me just leave you with this last bit:
Over the near-to intermediate-term (next 12-18 months), we believe mortgage industry rationalization will be driven by cyclical market forces – including lower originations, weaker margins, and deteriorating credit. We also expect recent secular shifts to influence consolidation next year, including new stricter regulatory oversight of “nontraditional” products, expanding advantages of diversification and economies of scale, and increased demand by Wall Street firms for the “raw materials” (manufacturing and servicing) necessary to vertically integrate the mortgage business.
Am I too old to understand what the term “secular” means these days, or do I just not have enough heads? Or maybe this is all about theology, not finance, and “secular” just means whatever is in Hell next year. Thank Heaven someone’s guarding the gates thereof: a hedge fund.