by Tanta 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 Tanta 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 Tanta 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 Tanta 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!)

by Calculated Risk on 6/29/2007 05:06:00 PM

The BEA releases Personal Consumption Expenditures monthly (as part of the Personal Income and Outlays report) and quarterly, as part of the GDP report (also released separately quarterly).

You can use the monthly series to exactly calculate the quarterly change in PCE. The quarterly change is not calculated as the change from the last month of one quarter to the last month of the next (several people have asked me about this). Instead, you have to average all three months of a quarter, and then take the change from the average of the three months of the preceding quarter.

So, for Q2, you would average PCE for April, May and June, then divide by the average for January, February and March. Of course you need to take this to the fourth power (for the annual rate) and subtract one.

Of course June isn't released until after the advance Q2 GDP report. But we can use the change from January to April, and the change from February to May (the Two Month Estimate) to approximate PCE growth for Q2.

Click on graph for larger image.

This graph shows the two month estimate versus the actual change in real PCE. The correlation is high (0.92).

Sometimes the growth rate for the third month of a quarter is substantially stronger or weaker than the first two months. As an example, in Q3 2005, PCE growth was strong for the first two months, but slumped in September because of hurricane Katrina. So the two month estimate was too high.

And the following quarter (Q4 2005), the two month estimate was too low. The first two months of Q4 were negatively impacted by the hurricanes, but real PCE growth in December was strong.

You can see a similar pattern in Q3 2001 because of 9/11.

But in general, the two month estimate is pretty accurate. Maybe June was exceptionally strong, or maybe April and May will be revised upwards, but the two month estimate suggests real PCE growth in Q2 will be about 1.5%.

For other reasons - like business investment and inventory changes - Q2 growth will probably be stronger than Q1. But the scratching sound you are hearing is from Wall Street firms revising down estimates for Q2 PCE and GDP growth.

by Calculated Risk on 6/29/2007 04:49:00 PM

Bank of America analysts Daniel Oppenheim, Michael R. Wood, and Michael G. Dahl, released a research note this morning:

BofA Monthly Real Estate Agent Survey
Buyers Take Their Time and Watch Prices Drift Lower

The analysts wrote:

"Another leg down in June as traffic and prices worsen further. Our traffic index fell to 21.9 in June (down 4.5 points from 26.3 in May), the lowest level since we started the survey."
underline emphasis in research note
Excerpted with permission

This fits my view that housing activity is continuing to decline.

by Calculated Risk on 6/29/2007 02:26:00 PM

If you read this AP article - Consumer Spending Up As Incomes Rebound - you might think that the Personal Income and outlays report showed strong real growth in May. You'd be wrong.

From the AP:

Consumers boosted their spending in May as their incomes grew solidly, an encouraging sign that high gasoline prices haven't killed people's appetite to buy. Inflation moderated.

It was the second month in a row that consumer spending went up 0.5 percent, the Commerce Department reported on Friday.

Incomes, the fuel for future spending, rebounded in May, growing 0.4 percent.

Incomes up "solidly". Spending up. Inflation moderated. What's not to like?

From the Census Bureau report on real Disposable Personal Income (DPI):

Real DPI -- DPI adjusted to remove price changes -- decreased 0.1 percent in May.

And spending?

Real PCE -- PCE adjusted to remove price changes -- increased 0.1 percent in May.

So real disposable income declined in May and real spending barely increased. Oh, and that great 0.1% increase in spending is really 0.06% rounded up. Annualize that!

by Calculated Risk on 6/29/2007 10:56:00 AM

From the Fed: Federal Financial Regulatory Agencies Issue Final Statement on Subprime Mortgage Lending

The federal financial regulatory agencies today issued a final Statement on Subprime Mortgage Lending to address issues relating to certain adjustable-rate mortgage (ARM) products that can cause payment shock.

Here is the Statement on Subprime Mortgage Lending.

by Calculated Risk on 6/29/2007 10:36:00 AM

From the Census Bureau: February 2007 Construction Spending at $1,170.8 Billion Annual Rate

The U.S. Census Bureau of the Department of Commerce announced today that construction spending during May 2007 was estimated at a seasonally adjusted annual rate of $1,176.6 billion, 0.9 percent above the revised April estimate of $1,166.0 billion.
...
[Private] Residential construction was at a seasonally adjusted annual rate of $549.0 billion in May, 0.8 percent below the revised April estimate of $553.6 billion.

[Private] Nonresidential construction was at a seasonally adjusted annual rate of $343.1 billion in May, 2.7 percent above the revised April estimate of $334.1 billion.

Click on graph for larger image.

This graph shows private construction spending for residential and non-residential (SAAR in Billions). While private residential spending has declined significantly, spending for private non-residential construction has been strong.

The second graph shows the YoY change for both categories of private construction spending.

The normal historical pattern is for non-residential construction spending to follow residential construction spending. However, because of the large slump in non-residential construction following the stock market "bust", it is possible there is more pent up demand than usual - and that the non-residential boom will continue for a longer period than normal.

This will probably be one of the keys for the economy going forward: Will nonresidential construction spending follow residential "off the cliff" (the normal historical pattern)? Or will nonresidential spending stay strong. I'll have some comments on this question later today.

by Tanta on 6/29/2007 08:50:00 AM

Hat tip to Ministry of Truth for bringing up this startling Bloomberg article, "S&P, Moody's Hide Rising Risk on $200 Billion of Mortgage Bonds." (How much did Fitch pay to get out of the headline?) As our fine commenters have noted, that's an amazingly bearish headline for Bloomberg. It's also a startlingly bald accusation: there's a line between asserting that the rating agencies are not downgrading bonds as fast as some observers think they should, and asserting that they are "hiding rising risk," without the usual "may be" weasel. Bloomberg just stomped right over that line, which suggests to me that tempers have become a bit short:

Standard & Poor's, Moody's Investors Service and Fitch Ratings are masking burgeoning losses in the market for subprime mortgage bonds by failing to cut the credit ratings on about $200 billion of securities backed by home loans.

"Are masking burgeoning losses"? That's even worse than "hiding rising risk." One rather hopes that Bloomberg has its numbers right.

This particular blogger is not sure she understand's Bloomberg's numbers. We get, in order:

1. "$200 billion of securities backed by home loans" should have their ratings cut.
2. "Almost 65 percent of the bonds in indexes that track subprime mortgage debt don't meet the ratings criteria in place when they were sold"
3. "the $800 billion market for securities backed by subprime mortgages"
4. "$1 trillion of collateralized debt obligations, the fastest growing part of the financial markets"
5. "estimates that collateralized debt obligations . . . will lose $125 billion"
6. "25 percent of the face value of CDOs is in jeopardy, or $250 billion"
7. "asset-backed bonds, securities that use consumer, commercial and other loans and receivables as collateral . . . which includes mortgage securities, has doubled to about $10 trillion"
8. "the $6.65 trillion in outstanding mortgage-backed debt"
9. "Investors snapped up $500 million of the securities [CDOs] globally last year"
10. "subprime-related debt made up about 45 percent of the collateral backing the $375 billion of CDOs sold in the U.S. in 2006"
11. "Of the 300 bonds in ABX indexes, the benchmarks for the subprime mortgage debt market, 190 fail to meet the credit support standard . . . Most of those, representing about $200 billion, are rated below AAA"

OK. So we know right off the bat that item 9 has to be off by an order of magnitude if item 10 is true. If the true size of "the market" of subprime-backed mortgage bonds is $800B, that makes it 80% of the size of the CDO market, 12% of the size of the total MBS market, and 8% of the size of the total ABS market.

If $375B of CDOs were sold in 2006 in the U.S. and 45% of that involved "subprime-related debt," and we assume just for fun that "subprime-related debt" means subprime-backed MBS and that CDOs invest mostly in subordinate tranches (because we aren't sure otherwise where they get enough high-yield to make their numbers work), that suggests that there were at least $169B of low-rated tranches of subprime securitizations available to resecuritize into a CDO last year. That would be just over 20% of this "total market" of $800B. That would imply a pretty thick layer of subordination. I'm thinking that either those CDOs are buying higher-rated paper than we've been led to believe, or else, possibly, "subprime-related debt" includes things like credit default swaps on subprime paper, which implies that brains will explode before we'll be able to line up bond balances on one hand and the notional value of CDO holdings on the other.

Whatever. My brain exploded a good 20 minutes ago. Does anyone else want to take a stab at estimating the potential principal losses that exceed the current estimated principal losses on $200B in subprime ABS, so that we have some idea of how many dollars of losses the rating agencies are "hiding"?