by Calculated Risk on 7/02/2007 01:53:00 PM

Paul Krugman writes in the NY Times: Just Say AAA

(For excerpts, see Economist's View)

What do you get when you cross a Mafia don with a bond salesman? A dealer in collateralized debt obligations (C.D.O.’s) — someone who makes you an offer you don’t understand.

Krugman criticizes the rating agencies and regulators, and notes these failures have been all too common:

... you might have thought that S.& P. and Moody’s, which gave Thailand an investment-grade rating until five months after the start of the Asian financial crisis, and gave Enron an investment-grade rating until days before it went bankrupt, would by now have learned to be a bit suspicious. And you would think that the regulators, in particular the Federal Reserve, would have learned from the stock bubble and the wave of corporate malfeasance that went with it to keep a watchful eye on overheated markets.

But apparently not.

by Anonymous on 7/02/2007 01:19:00 PM

It seems that not everybody is getting the point yet. From Reuters, "U.S. regulators stymie mortgage lenders again":

"I think (regulators) are coming in after the fire," said Peter Paul, president of Paul Financial LLC in San Rafael, California. "I'm a little concerned about legislating credit standards. You could start to limit credit."

Why, yes, Mr. Paul, you certainly could start to limit credit. There's a theory that those heartless regulators actually thought that was a feature, not a bug.

by Calculated Risk on 7/02/2007 11:55:00 AM

From the WSJ: New York Building's Record Price Shows Office Market's Strength

... investors agreed late last week to buy 450 Park Ave., ... for $1,589 a square foot, or about $510 million.

The price -- believed to be the most expensive on a per-square-foot basis for an office building in U.S. history -- demonstrates that trends like strong foreign currencies and the availability of equity are helping the market for commercial office space, at least in premium markets such as New York, despite concerns over tighter lending practices.
....
The 33-story building at 57th Street and Park is being sold by a partnership that includes New York State Common Retirement Fund and Taconic Investment Partners LLC, which paid $158 million, or about $492 per square foot, in 2002.
...
The contract shatters the per-square-foot record set just four weeks previously, when Italy-based Gruppo Zunino agreed to pay $1,476 a square foot for New York's 660 Madison Ave....

It doesn't look like tighter lending standards have slowed the NY commercial real estate market yet.

by Anonymous on 7/02/2007 10:00:00 AM

This may not be the most hysterical article ever to appear on the subject of the subprime mortgage market, but it is certainly the most hysterical one I've yet seen on Bloomberg. Please note that I am using the term "hysterical" here in the clinical sense, not the ha-ha-funny sense. "Bear Stearns Meets Possums in Georgia as Foreclosures Increase." That's the headline.

And how did them city slickers at Bear Stearns become acquainted with southern varmints?

July 2 (Bloomberg) -- Only the possums are enjoying the backyard of 2035 Lilac Lane in Decatur, Georgia, where Wall Street titan Bear Stearns Cos. is just another homeowner by default. . . .

Bear Stearns took possession of the three-bedroom Lilac Lane house for $76,500 on March 6, according to the foreclosure deed. The owner who defaulted had purchased the house in April 2005 for $160,000 using a subprime loan that required no money down. He had been renting it out, according to the neighbor, Ford.

The lender was Meritage Mortgage Corp., one of more than 60 subprime home loan companies that have halted operations, gone bankrupt or sought buyers since the start of 2006, according to data compiled by Bloomberg. Bear Stearns had bought the mortgage from Meritage at a discount.

The firm sold the Lilac Lane house on June 28 for $84,000, said Elisa Marks, a Bear Stearns spokeswoman. That's about half the price paid two years ago. Other homes on the street sold this year for $85,000 to $185,000, according to public records.

The house's condition deteriorated while it was a rental property, Ford said. Being empty for six months only made it worse to the extent that possums had the run of the backyard, she said. . . .

Home values and the $6 trillion U.S. mortgage-backed securities market are locked in a downward spiral. Bear Stearns is bailing out one money-losing hedge fund it controls and leaving another to liquidation by creditors. Both funds invested in securities backed by subprime loans. The loans, for borrowers with bad or limited credit histories, are secured by houses such as the one on Lilac Lane. . . .

Conditions are the worst since the 1990-1991 recession, which was caused by a credit crunch that followed a boom-bust real estate cycle similar to the last seven years, Gumbinger said. Like the 2000 to 2005 boom, the previous surge in sales and prices was sparked by a decline in mortgage rates, and featured ``risky mortgage lending,'' he said.

The whole article is one of the strangest combinations of fact, hype, oversimplification and just weirdness that I've seen in a long time in the "respectable press." Look, I grew up in a part of the country in which having occasional possums--not to mention raccoons, rabbits, squirrels, chipmunks, groundhogs and, if you lived close enough to the river, the odd muskrat--in the backyard was considered, um, neither surprising nor particularly subprime. Am I imagining things, or are we beginning to see this "subprime contaigon" metaphor work itself into something a bit panicky?

by Calculated Risk on 7/02/2007 01:58:00 AM

From the WSJ: Bear Stearns Investors Await Tally on Losses

Investors in two Bear Stearns hedge funds will have to wait until as late as July 16 to learn how much money they have lost.

The Wall Street firm has had difficulty calculating the funds' fair value, apparently because many of the mortgage-related securities they hold are thinly traded and the market for them has been volatile.
...
Investors are watching the process closely because they believe that other hedge funds also are holding thinly traded mortgage-related securities, and they want to see how far Bear thinks their value has fallen.

by Calculated Risk on 7/01/2007 02:49:00 PM

There is barely a mention of the Q2 consumer spending slowdown in the weekend papers. One of the few who noticed was the ever reliable Asha Bangalore at Northern Trust: Core Inflation Is In “Comfort Zone,” Q2 Consumer Spending Should Be Noticeably Slow

The April-May data of consumer spending and a conservative assumption for June point to about a 1.7% annualized increase in consumer outlays during the second quarter. Consumer spending grew at an annual rate of 4.2% in each of the prior two quarters. This bodes poorly for headline GDP in the second quarter, after a 0.7% increase in the first quarter.

Is this just a one quarter slowdown? Or is this the beginning of a housing related slump in consumer spending?

by Anonymous on 6/30/2007 12:00:00 PM

Here are the lyrics, pure and unadulterated. Certainly I don't possess the talent to improve on them:

If you didn't care what happened to me,
And I didn't care for you
We would zig zag our way through the boredom and pain
Occasionally glancing up through the rain
Wondering which of the buggers to blame
And watching for pigs on the wing.

You know that I care what happens to you
And I know that you care for me
So I don't feel alone
Of the weight of the stone
Now that I've found somewhere safe
To bury my bone
And any fool knows a dog needs a home
A shelter from pigs on the wing.

by Anonymous on 6/30/2007 10:46:00 AM

No, no, not the marks to market. The marks to whom Brookstreet sold inverse floaters, according to the OC Register:

"Those investments are pretty involved and sophisticated," said Wayne Willer, a Brookstreet client in Galena, Ill. "And I probably got involved in something I shouldn't have."

"I have no idea what this stuff is," said H.H. Hartmann, a southern Illinois resident who invested $150,000 in Brookstreet CMOs. Nonetheless, when Brookstreet sent him a two-page list of warnings about CMOs this spring, he did what the brokerage asked: He initialed each disclosure and mailed it back.

"(Brokers) kept telling me 'You're going to make money,' " said Gary Stephens, a Brookstreet investor in Missouri. When his monthly statements showed his CMOs declining in value, Stephens said, brokers told him "there was more money there than the (statement) showed."

(risk capital, I'm not sure we can take any more of this today . . . but thanks . . .)

by Anonymous on 6/30/2007 09:55:00 AM

Lord help us. We're beginning to get some detail on just what Brookstreet's clients were buying. From the OC Register:

The securities, called Collateralized Mortgage Obligations, are backed by pools of residential mortgages. Most CMOs are safe, paying investors principal and interest drawn from thousands of mortgages.

But 30 Brookstreet CMOs reviewed by the Register were more complex than most CMOs. Their structures expose investors to losing or gaining money following tiny fluctuations in interest rates. As such, they are difficult to value. Most are "interest-only strips," which pay investors the interest stream but no principal from mortgages.

Brooks said the accounts collapsed because the clearing firm, a subsidiary of Fidelity Investments, used what are called "notional values" to price the CMOs. Those values plummeted as confidence plunged in mortgage-backed securities to subprime home loans.

"We never had a performance issue," Brooks said of the CMOs. "We had a notional pricing disparity."

These jokers were selling IO strips to retail investors?

For those of you playing along at home, here's a quick definition of the IO strip (and the yin to its yang, the PO strip) from SIFMA:

Principal-Only (PO) Securities.

Some mortgage securities are created so that investors receive only principal payments generated by the underlying collateral. These Principal-Only (PO) securities may be created directly from mortgage pass-through securities, or they may be tranches in a CMO. In purchasing a PO security, investors pay a price deeply discounted from the face value and ultimately receive the entire face value through scheduled payments and prepayments.

The market values of POs are extremely sensitive to prepayment rates and therefore interest rates. If interest rates are falling and prepayments accelerate, the value of the PO will increase. On the other hand, if rates rise and prepayments slow, the value of the PO will drop. A companion tranche structured as a PO is called a “Super PO.”

Interest-Only (IO) Securities.

Separating principal payments to create PO mortgage securities necessarily involves the creation of Interest-Only (IO) securities. CMOs that have PO tranches will therefore also have IO tranches. IO securities are sold at a deep discount to their “notional” principal amount, namely the principal balance used to calculate the amount of interest due. They have no face or par value. As the notional principal amortizes and prepays, the IO cash flow declines.

Unlike POs, IOs increase in value when interest rates rise and prepayment rates slow; consequently, they are often used to “hedge” portfolios against interest rate risk. IO investors should be mindful that if prepayment rates are high, they may actually receive less cash back than they initially invested.

Issue number one: all IOs have a "notional value" by definition. This has exactly jack to do with sinister manipulation of pricing by some nefarious model. The "notional value" of an IO strip will change, just as the face value of a PO strip will change, as payments and prepayments of principal are made on the underlying mortgage loans.

The OC Register story does not tell us what the vintage was of these CMOs, but I'm sure readers of this blog can imagine that IO strips of mortgage-backed securities originated in the period from about 2002 to last quarter had pretty darned fast prepayment speeds. Us insiders call that a "refi boom." A "refi boom" is one of those things in which buying IO strips can bite you in the ass. In any case, while there's a lot of rocket science in the CMO business, calculating the notional balance of an IO strip isn't all that hard: original notional balance minus prepayments of principal equals less notional balance for you to earn interest payments on. Your problem in this circumstance is not that the balance is "notional."

That is why these things are known as sophisticated hedge vehicles and are never, ever sold to retail investors on margin. Unless, apparently, you're Brookstreet. After all, it's probably quite true that they "never had a performance issue." You do not lose your shirt on an IO strip because of principal losses. You lose your shirt because enough of those underlying loans are high-quality enough (or enough refi lenders are low-standard enough) that the damned things prepay.

Brooks said clients who paid the full price for their CMOs – and other financial products – still have money in their accounts, which will accompany his former brokers to whatever new jobs they get.

What?

SEC filings said Brookstreet managed $571 million for 3,644 clients.

Although he served as Brookstreet's president, Brooks said Friday he was not responsible for overseeing the company's trades, which relied on a network of 650 independent brokers nationwide.

In March 2005, the National Association of Securities Dealers suspended Brooks' securities license for two years for inadequate supervision of trades. Last week, Brooks' license was suspended again, this time for 60 days, because of failures in record keeping.

That must be why it's all the clearing firm's fault.

(thanks again, risk capital!)

by Anonymous on 6/30/2007 07:39:00 AM

Remember Brookstreet, the brokerage whose overleveraged retail clients discovered the magic of mark to market a while ago? Evidently the SEC is interested in exactly how that went down. Stories are being, well, not exactly stuck to yet. They're in the works:

[Stanley Brooks] said he is still trying to sort out how the firm imploded. "It's so complicated that the smartest guys in the industry got their lunch handed to them," he said. "It was a perfect storm."

It was also, apparently, a dark and stormy night, during which the Ronco Pocket Cliché Generator began to malfunction. I suppose the industry having its lunch handed to it is better than competitors trying to eat each others' . . . models. Ahem.

Brooks, who founded the family-owned firm in 1990, said the markdowns were executed by its clearing firm, the National Financial unit of Fidelity Investments, the biggest U.S. mutual funds company.

Brooks said "the pricing services [employed by National Financial] issued theoretical pricing [on the CMOs] that apparently wasn't accurate." But he said it was unclear if the firm is planning litigation in the wake of the collapse.

"We are not responsible," Fidelity spokesman Adam Banker said. "While we won't comment on an individual client, I can tell you certain contractual provisions apply when investors borrow on margin purchased securities.

"National Financial has clear margin agreements in place with its clients and uses reputable firms to price securities held in brokerage accounts."

One New York lawyer, who asked not to be named, said he may be retained by one Brookstreet client who lost $1.5 million and is considering litigation.

So Mr. Brooks has settled on the "theoretical pricing" story. One wonders: did Mr. Brooks and his merry band of brokers have any idea that this pricing was "theoretical" before they sold this stuff to clients with 90% borrowed money? Was there some observable market price generated by frequent trades in the asset in question in May that suddenly became "theoretical" in June? Are we to understand that National Financial never marked those positions on the way up?

So now we know: it's "mark to market" during the boom, but it's "mark to model" in the bust. I am eager to find out whether Brookstreet's retail investors get treated with the same contempt certain parties have been heaping on hapless first-time homebuyers who took out 100% toxic loans they didn't understand on the mistaken belief that house prices only go up. I mean, if you want fun, just walk into any group of mortgage-market participants and mention "fiduciary requirements." You will be told in no uncertain terms that your average unsophisticated would-be homeowner carries all the responsibility for doing the due diligence, and that the mortgage brokers are just here to take orders.

If you're an "investor" with $1.5 million to blow? The SEC will get right on it.

(hat tip, risk capital!)