by Anonymous on 6/02/2007 10:26:00 AM

In case you missed it in the comments, there were many discussions of this (excellent) Bloomberg piece yesterday, "Banks Sell 'Toxic Waste' CDOs to Calpers, Texas Teachers Fund." Please read the whole thing if you have not done so already. Some highlights:

June 1 (Bloomberg) -- Bear Stearns Cos., the fifth-largest U.S. securities firm, is hawking the riskiest portions of collateralized debt obligations to public pension funds.

At a sales presentation of the bank's CDOs to 50 public pension fund managers in a Las Vegas hotel ballroom, Jean Fleischhacker, Bear Stearns senior managing director, tells fund managers they can get a 20 percent annual return from the bottom level of a CDO. . . .

The California Public Employees' Retirement System, the nation's largest public pension fund, has invested $140 million in such unrated CDO portions, according to data Calpers provided in response to a public records request. Citigroup Inc., the largest U.S. bank, sold the tranches to Calpers.

``I have trouble understanding public pension funds' delving into equity tranches, unless they know something the market doesn't know,'' says Edward Altman, director of the Fixed Income and Credit Markets program at New York University's Salomon Center for the Study of Financial Institutions.

``That's obviously a very risky play,'' he says. ``If there's a meltdown, which I expect, it will hit those tranches first.''

Calpers spokesman Clark McKinley declined to comment. . . .

Chriss Street, treasurer of Orange County, California, the fifth-most-populous county in the U.S., says no public fund should invest in equity tranches. He says fund managers are ignoring their fiduciary responsibilities by placing even 1 percent of pension assets into the riskiest portion of a CDO.

``It's grossly inappropriate to take this level of risk,'' he says. ``Fund managers wanted the high yield, so Wall Street sold it to them. The beauty of Wall Street is they put lipstick on a pig.'' . . .

The General Retirement System of Detroit holds three equity tranches it bought for $38.8 million. The Teachers Retirement System of Texas owns $62.8 million of them. The Missouri State Employees' Retirement System owns a $25 million equity tranche.

Ronald Zajac, spokesman for the Detroit pension fund, declined to comment on the fund's equity tranche investments.

Kay Chippeaux, fixed-income portfolio manager of the New Mexico council, says it decided to buy equity tranches after listening to pitches from Merrill Lynch & Co., Wachovia Corp. and Bear Stearns.

``We got very interested in them just because a broker brought them to our attention,'' Chippeaux, 50, says. She says the investment is worth the risk because the fund may be able to get higher returns than it can from bonds. The council has purchased equity tranches from Bear Stearns, Citigroup, Merrill Lynch and Morgan Stanley.

The council is relying on advice from bankers who are selling the CDOs, Chippeaux says. ``We manage risk through who we invest with,'' she says. ``I don't have a lot of control over individual pieces of the subprime.'' . . .

Pension fund managers face the same hurdle as all CDO investors: The market has almost no transparency, with both current prices and contents of CDOs almost impossible to find, says Frank Partnoy, a former debt trader who's now a law professor at the University of San Diego.

The murky nature of the CDO market presents danger for the unwary investor, and it's particularly unsuitable for public pension money, Partnoy says.

``I think `smoke and mirrors' in some sense understates the problem,'' he says. ``You can see through smoke. You can see something reflected in a mirror. But when you look at the CDO market, you really can't see enough information to enable you to make a rational investment decision.''

That hasn't stopped pension funds from taking high risks with the retirement plans of teachers, firefighters and police. [boldface added, only because I don't have an html tag for flashing red lights]

Your pension fund managers are buying "high yield" bonds that put you in first loss position on a bunch of junk bonds, and they are doing so on the risk-management "advice" of the people who are making a commission from selling those bonds.

Look, CDOs are complicated, and one of these days I'll manage to do a long UberNerd post on them. Here's the short version, with a nice picture (vandalized by Tanta) courtesy of Pershing Capital Management:

You take a bunch of subprime loans, and make a pool with them. Then you tranche that pool up and create a security (this chart calls it ABS or asset-backed security; it's the same thing as MBS or REMIC for present purposes). Then you take those low-rated subordinate tranches and put them into a pool with a bunch of other stuff (commercial security tranches, corporate debt, junk bonds, heaven knows what), and then you tranche that up into a new thing called a Collateralized Debt Obligation, the "beauty" of which is that it's an actively traded, not static pool, so that while you might know what's in it the day you bought part of it, you may never know what's in it after that. Then you take the lowest possible tranche of the CDO--the "equity" portion or the very first part to take any losses, which is so high-risk it is referred to as "toxic waste," the stuff that is unrated by the rating agencies because it has no "credit support" whatsoever--and you put it in a pension plan managed by some goofball who thinks that it must be a good deal because a party who owns some of the higher rated tranches--the ones you "support" with your equity piece--tells you that if the planets align and the Messiah returns and everybody rolls a lucky seven, you'll make 20%!

I'm still not sure everyone is getting the picture here, so let's try this: the subordinate tranche of a subprime ABS/MBS is a "pig." With or without lipstick. The equity tranche of a CDO made up of subordinate tranches of a subprime ABS/MBS, mixed up with some other junk you do not understand, is a pig of a pig, distilled essence of pig, ur-pig, Total Ultimate X-Treme Mega Pig. Buying a B tranche of a subprime ABS is playing with matches. Buying the equity tranche of a CDO is playing with a blowtorch in the parking lot of the Exxon station while wearing a St. Lucia wreath on your head.

There is, you know, a reason they call these "equity" tranches. "Equity" in this context means "skin in the game." In what we might laughingly refer to as a "normal market," the party who issues the security keeps the "equity" piece, giving it some "skin in the game" and thus some incentive to make sure that underlying pool isn't total stinking piles of sewage. In what we no-longer-laughingly call the market we're in, the investment banks are "selling" their "skin" to your pension fund. Unless that IB has zero interest whatsoever in the rest of the CDO, they just pulled one on you. And the only party who could tell you who owns what--and could "appraise" the thing for you--is the IB, who will make a fee from selling it to you regardless.

Have I mentioned that there is such a thing as a "CDO Squared"? I bet you can guess what that is. Do I know whether there are pension funds buying pieces of a CDO²? No. Do you?

Teachers, firefighters, and police officers: you are not just the sucker at the table here. You are the sucker at the table of the suckers in the big casino of suckers. Your "managers" of your pension money just took the "opportunity" to assume the risk that Wall Street does not want to keep because it doesn't think a "20% return" is worth it.

Go. Call. Your. Benefit. Manager. Now.

by Calculated Risk on 6/01/2007 09:56:00 PM

From the WSJ: Skyscraper Prices Might Start Returning to Earth

... lenders have become worried that prices have gotten so high that buyers wouldn't be able to raise rents high enough to pay off their loans. In response, the interest rates that buyers have to pay have risen, and banks have demanded that buyers put up bigger portions of the purchase price.

The following sounds familiar ...

At the root of the buying frenzy was a change in the way investors viewed real estate. In the past, buying a building was like buying a bond -- you were purchasing a stream of income for years to come. ... More recently, investors started treating buildings like stocks, betting that they could sell them later at significantly higher prices. Loans were being underwritten based on predictions of future cash flow.

"It used to be people bought for the current rents, and the upside was a surprise," said Cedric Philipp Jr., managing director of Commercial Mortgage-Backed Securities Structured Finance Group for Moody's Investors Service. "Now, they are banking on the upside."

by Anonymous on 6/01/2007 04:53:00 PM

Via Reuters:

NEW YORK, May 31 (Reuters) - JPMorgan Chase & Co. is downplaying its role in subprime lending even as spectacular flameouts in that sector have turned the Wall Street bank into one of the biggest originators of risky mortgages.

"We don't do much in the subprime business -- at all," JPMorgan Chief Executive Jamie Dimon told investors earlier this month at the company's annual meeting. "It will be a good business, by the way."

The King Is Dead. Long Live the King!.

In other banking news, via the Boston Globe:

ASHLAND -- In a scene reminiscent of the Cartoon Network bomb scare that paralyzed the Boston area in January, police shut down a strip mall yesterday in this small western suburb after employees at a Bank of America branch mistook a botched fax for a bomb threat.

Frustrated shop owners said the branch overreacted to the strange fax, which turned out to be an in-house marketing document sent by the bank's corporate office.

Frankly, that's the first I've ever heard of anyone actually reading a fax from corporate marketing. Guess it wasn't such a hot idea.

And via the Associated Press:

ATLANTA - On an episode of A&E's popular reality series "Flip This House," Atlanta businessman Sam Leccima sits in front of a run-down house and calls buying and selling real estate his passion.

Now authorities and legal filings claim that Leccima's true passion was a series of scams that included faking the home renovations shown on the cable TV show and claiming to have sold houses he never owned.

You mean this whole flippin' thing was just some kind of made-up teevee ripoff? I wonder if the bondholders are going to sue A&E . . .

Happy Friday afternoon, all.

by Calculated Risk on 6/01/2007 02:42:00 PM

According to Hovanian (via Briefing.com hat tip Brian)

[Land sales have] "just really slowed to a complete trickle with very few buyers of any type out there"

So homebuilders are building spec homes to liquidate land:

"that's part of the reason why you do see many home builders resorting to selling spec homes because there's really a way of liquidating the land portfolio."

Can't sell it? Build on it. With too much inventory already on the market, I wonder how this will work out for the homebuilders ...

by Calculated Risk on 6/01/2007 11:27:00 AM

A press release from Wal-Mart states that Wal-Mart plans to build "190 and 200 new U.S. supercenters during this fiscal year". This is a significant reduction from the announced plans just six months ago:

In October 2006, the Company had announced that its fiscal year 2008 growth plans included between 265 and 270 supercenters in the United States.

This will result in approximately a 10% reduction in capital spending for Wal-Mart:

[The] strategy is expected to reduce capital expenditures for fiscal year 2008 to approximately $15.5 billion, down from the previously projected $17 billion ...

This reduction in spending by Wal-Mart is a sign that the commercial real estate boom might be ending. And, as I keep pointing out, continued strong non-residential investment is one of the keys for keeping the U.S. economy out of recession.

by Calculated Risk on 6/01/2007 09:10:00 AM

The BLS reports: U.S. nonfarm payrolls rose by 157,000 in May, after a downward revised 80,000 gain in April. The unemployment rate was steady at 4.5% in May.

Click on graph for larger image.

Here is the cumulative nonfarm job growth for Bush's 2nd term. The gray area represents the expected job growth (from 6 million to 10 million jobs over the four year term). Job growth has been solid for the last 2 1/4 years and is near the top of the expected range.

The following two graphs are the areas I've been watching closely: residential construction and retail employment.


Residential construction employment decreased by 1,300 jobs in May, and including downward revisions to previous months, is down 137.9 thousand, or about 4.0%, from the peak in March 2006. This is probably just the beginning of the loss of hundreds of thousands of residential construction jobs over the next year or so.

Note the scale doesn't start from zero: this is to better show the change in employment.


Retail employment lost 4,900 jobs in May. As the graph shows, retail employment has turned positive in recent months. YoY retail employment has also turned positive.

The expected reported job losses in residential construction employment still haven't happened, and any spillover to retail isn't apparent yet. With housing starts off over 30%, it's a puzzle why residential construction employment is only off about 4%. It is possible this puzzle has been solved (see: Residential Construction Employment Conundrum Solved?), but we will not know until the yearly revisions are announced.

by Anonymous on 6/01/2007 09:05:00 AM

A number of you good folks have been linking to this presentation by Pershing Square Capital Management in various comment threads. It's an interesting presentation (unless you own shares of a bond insurer, in which case it's fascinating). I for one am interested, if not fascinated, by this particular chart, which shows the dollar volume of subprime purchase-money piggyback loans, by documentation type, over the 2004-2006 period.

This is important data to contemplate, since credible claims have been made that a lot of new home purchase volume over the period in question was running on the fumes of the most marginal borrowers--stated income high-CLTV subprimes--and that any cutback in that kind of lending spells disaster for the home builders. And we have seen some "voluntary" tightening of this exact kind of subprime credit; we have also just heard the OCC hinting loudly at a regulatory "involuntary" tightening here.

So take some white-out to all the red and yellow parts of the bars on this chart, and then do the math. Ick.

Note: "Verbal verification" means "oral" (phone) verification of employment, but not of income. (You call up Calculated Risk and ask, "Does Tanta really work for you? OK, thanks.") It is, in other words, what you all think of as "stated income." The "none" category includes loans that do not even state income. They probably don't even "state" employment; if the borrower does fill out the box on the application for "employer," no one verifies that on the "none" loans. So on the "verbal" loans you know the borrower is employed but you don't know how much they actually make; on the "none" loans you don't know nuthin' 'bout nuthin'.

by Anonymous on 6/01/2007 07:28:00 AM

We've talked a lot about the individual and community misery generated by housing busts, irresponsible lending, and waves of loan failures. We have pondered the potentially devastating effects on employment, residential investment, and consumer spending. We have surely noted the damage to shareholders of bankrupt mortgage originators and investors--true bagholders--in mortgage-backed bonds.

Evidently we have forgotten to spare a tear for those poor hedge funds, whose honest day's work of betting on failure, without having to pony up any real capital, apparently, is under threat. Yes, friends, there's a conspiracy afloat to put the interests of homeowners--the people who supply that cash-flow--and actual capital investors--the people who supply the actual loan funds--ahead of the credit default swap punters. I don't know that I've ever been so moved.

From the Financial Times, "Fears Over Helping Hand for Mortgage Defaulters":

The hedge funds are worried about modifications that mortgage administrators, or servicers, sometimes make to home loans for troubled subprime borrowers – for example, changing the interest rate, or extending the repayment term.

Some investment banks are active in the mortgage servicing business as well as being mortgage lenders, underwriters for mortgage-backed securities and derivatives traders.

The hedge funds claim that the banks’ ability to modify the terms of individual mortgage loans could go beyond helping borrowers and enable them to profit – or avoid losses – on the derivatives contracts sold to the hedge funds.

“Manipulation is a charged term, but there are concerns that the potential for manipulation is there,” said Karen Weaver, global head of securitisation research at Deutsche Bank.

This is because, in contrast to other strategies for managing troubled mortgages, these loan modifications show up in performance reports as no longer in arrears. Loans modified in this way would not trigger writedowns of bonds backed by such mortgages, and in turn, this could mean an investment bank would not have to pay out on derivatives contracts tracking those bonds.

Oh, my. Someone stands to profit from "helping borrowers." And a bunch of hedgies stand to lose some bets if those borrowers get back on their feet. Why, this is predation.

Ms Weaver at Deutsche Bank said: “The bottom line is that when a servicer modifies a loan, they have to represent that they believe they can maximise the value of the loan by doing a modification as opposed to choosing another option. There’s a fiduciary responsibility there.”

Moreover, whatever their motivation for modifying loans, dealers can only make changes if borrowers agree.

“A lot of the most problematic mortgages were taken out in late 2005 and 2006, when many borrowers took on huge loans on the belief that house prices were going up,” said Ms Weaver. “That hasn’t happened and those homes have become albatrosses, so a lot of borrowers may just walk away.”

Part of the problem is a lack of specialist knowledge on the part of some hedge funds, one dealer said. “There are participants in the derivatives market that don’t understand the servicing process and don’t understand the mortgage process. They are great macro players that made a great call on a sector that was going to underperform but they didn’t take into account that servicers have options to modify the loans.”

Ah, yes. Risk always ends up where it is most understood. And who'd have thunk that Mary Ellen in the Servicing Department could be causing all this grief for the big-money punters just by servicing a loan?

Oh, the humanity. I am driven, as I am so often, to take refuge in the consolations of great literature.

"I suggest, Headmaster, that Potter is not being entirely truthful," he said. "It might be a good idea if he were deprived of certain privileges until he is ready to tell us the whole story. I personally feel he should be taken off the Gryffindor Quidditch team until he is ready to be honest."

"Really, Severus," said Professor McGonagall sharply, "I see no reason to stop the boy playing Quidditch. This cat wasn't hit over the head with a broomstick. There is no evidence at all that Potter has done anything wrong."

Dumbledore was giving Harry a searching look. His twinkling light-blue gaze made Harry feel as though he were being X-rayed.

"Innocent until proven guilty, Severus," he said firmly.

Snape looked furious. So did Filch.

"My cat has been Petrified!" he shrieked, his eyes popping. "I want to see some punishment!"

Harry Potter and the Chamber of Secrets

by Calculated Risk on 5/31/2007 06:57:00 PM

There is no question that investment in non-residential structures is still strong. As an example, from the Orange County Register: Commercial real estate still roars

"Orange County is one of the high spots for commercial real estate," said Scott MacIntosh, a senior economist with the National Association of Realtors. "There's low vacancies and high investor interest."
...
"Commercial drivers are stronger than ever, and I have never seen so much money pouring into Orange County,"[ CB Richard Ellis' Barry Katz] said. "There's still billions of dollars chasing Orange County property."

The construction spending report today showed that private non-residential construction investment was still very strong in April. And investment in non-residential structures for Q1 was revised upwards in the GDP release today. Both reports confirmed what we already knew - CRE is booming.

However, the above article goes on to note that the Orange County office market is "facing [a] glut" later this year. That is also true nationwide, in fact vacancy rates have already started to rise, and there is significant more supply scheduled to be delivered later this year. From a personal perspective, when I drive around Orange County (where I live), I see commercial construction projects everywhere, and I also see more and more "For Lease" signs on existing buildings. An interesting combination: more supply coming while vacancies appear to be increasing.

It was just two weeks ago that I asked: Commercial Real Estate: Slump Ahead? I tried to connect the dots: rising vacancies, significant supply coming on line later this year, lower demand reported for CRE loans, many banks over exposed to CRE lending, etc.

Click on graph for larger image.

Here is an update to the second chart in the previous post, including the revision to the GDP report today. This graph shows the YoY change in Residential Investment (shifted 5 quarters into the future) and investment in Non-residential Structures. In the typical cycle, non-residential investment follows residential investment, with a lag of about 5 quarters. Residential investment has fallen significantly for four straight quarters (following two minor declines). So, if this cycle follows the typical pattern, non-residential investment will start declining later this year.

I believe that continued strong non-residential investment (both structures and equipment and software) is one of the keys to avoiding a recession this year.

by Calculated Risk on 5/31/2007 02:19:00 PM

From the FDIC Quarterly Banking Profile

• Industry Reports Year-Over-Year Earnings Decline
• Rising Loan Loss Provisions Reduce Profits at Larger Institutions
• Net Interest Margins Decline at Small Institutions, Rise at Large Banks
• Loan Growth Slows for Fourth Consecutive Quarter
• Mortgage Assets Decline for Second Quarter in a Row

Click on graph for larger image.

This is Chart 7 from the FDIC banking profile for Q1 asking a key question.

From the FDIC report it appears small institutions are struggling. But mid-sized institutions ($1 to $10 Billion) have improved their margins by taking on more risk, mostly associated with commercial real estate.