Garrett is as Garrett does

An autoblogographic view of things.

'Garrett is as Garrett does'

For those with inquiring minds as to why Wall Street is tanking…

August 17th, 2007
by garrett

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Yes it’s off “teh InterWebs”, but the logic is pretty sound.  It’s a long thread, but if you want to know just whats going on with the sub-prime market and why it’s hitting Wall Street hard, please peruse this condensed / edited thread. Orginal source: Fark from August 2007

NEWS ITEM: Federal Reserve Cuts Discount Rate by 0.5 percentage point to “address liquidity issues”.


Why do I get a feeling this action is a little like rearranging deck chairs on the Titanic?


Because that’s exactly what this is.

The “liquidity crisis” is a result of massive leverage unwinding (15x to 20x in some instances). For those who care: leverage is when you use an existing asset to borrow to buy more assets. This can be done with stocks and securities, it can be done with real estate, it can be done whenever people will lend you money against your assets. The number (15x or 20x) is a multiplier of your existing asset to your new purchases. Ergo, if you have a $500,000.00 stock portfolio, you might have a broker which will let you trade on margin up to, say, 5x or $2.5 million. The big houses have assets which are several orders of magnitude higher, and they get to leverage at a higher rate. More on that in a moment.

Unfortunately, as a condition of all leverage trades, the lender has the right to make a “margin call” if your new purchases go below their break-even value. So, if your $2.5 million in new purchases tank down to $1.8 million, you will get a margin call for the difference, or $700,000.00. This, by the way, exceeds the value of your initial stock portfolio. You then have a choice: you may either cough up $700,000.00 from somewhere, or your initial $500,000.00 portfolio will be liquidated at whatever price can be had for it, then you’ll still owe the difference.

This has been happening across the board, throughout every financial business in the world for a week or two now. They’re discovering, to their horror, that the collateral they’ve been offered isn’t worth anything near what they were told it was worth, and the new investments have been less than stellar, so the lenders make the margin calls. The margin calls have been coming up empty, so collateral has been dumped. This explains why commodities and the conventional “safe” investments of gold, etc. have been falling too. They’re being sold to satisfy margin calls. Unfortunately, dumping collateral in a falling market tends to produce less than was thought for that asset, so there’s still a whole lot of unfunded margin call deficiencies out there. This, more than anything, is why there is a credit crisis: no lender in their right mind (save possibly the Fed) will make more loans to these borrowers when the borrowers haven’t made good on the initial debts and margin calls. If you have someone who can’t pay their bill, do you continue to lend them money? The decision appears to be not just “No” but “Hell no.” Nobody is lending money right now, and this is wreaking havoc far and wide.

Here’s the kicker: No money down loans and no-doc mortgages combined with the CDO and MBS markets have permitted effectively infinite leverage for mortgage lenders. They shovel out a loan, sell it on the secondary market, recapitalize, then relend the same money again. Wash, rinse, repeat.

Me: CDO = Collateralized Debt Obligations = Generic term for a bond issued against a mixed pool of assets. In this context the assets are various loans backed by the value of real propety – ie 1st, 2nd, 3rd morgages, home equity loans, car loans, etc. MBS = Mortgage-Backed Security = Term for a bond issued that is ultimately backed by mortgages only.

The credit contraction can cause damage proportional to the amount of leverage being unwound. Nobody has a really good grip on how much leverage there is, but the sheer size of the mortgage markets should be a major caution to everyone. The Fed is putting a band-aid on a gut-shot. It will look better for a short time, but the fundamental damage has not, and cannot, be addressed by such measures.

God Is My Co-Pirate

what happens next?


Realistically, if anyone can answer that, they have a very lucrative job waiting for them on Wall Street. There are far too many variables to track. Everybody, myself included, can only speculate. If you want my thoughts (insert stuff about newsletter here), I can tell you what I think.

The losses from the liquidation of margin collateral have not yet been disclosed, and will not be disclosed absent a bankruptcy filing, until reqular third-quarter results are announced sometime in mid-October (but note, there is another variable: companies may delay their results in a sort of poker bluff). Even if the markets stage some sort of recovery prior to that time, and companies can stay liquid and solvent until then, the 3q results will (should) be devastating as they begin to show the extent of the damage. This will lead to an “October Surprise,” which should be expected by now, but never really is. The surprise will be another plunge of the stock markets and several rounds of downgrades from rating agencies.

Downgrades are bad, particularly near year-end, as the mutual funds where so much of the retirement and “safe money” is stored cannot hold investments which are below a certain grade. They will need to liquidate their positions in the downgraded stocks, so another cascade will begin.

I think by the time the holiday season is ended in January, 2008, we will be looking at a market which has deflated considerably from its’ peak. Whether it begins to recover in January, 2008 depends on how holiday sales are. Quite frankly, with the number of mortgages being foreclosed, the decreasing home values, and the lack of refinance money, I think the housing ATM has been cut off, credit card defaults are rising, and most folks will be operating on a cash-only basis by Christmas. I’d say it’s about 50-50 as to whether the consumer comes through for business this holiday season. I think a whole lot will depend on what happens between now and then, and whether Joe Sixpack gets scared. We’ll see.


[…] all the ARMs will be resetting over the next 3 years… I mean, the market will have to stay down and interest rates will have to stay high throughout that period, won’t it?


Actually, the biggest part of the ARM wave is already on us and will last 2-3 more months. Prior to the recent unpleasantness, lenders had been working hard to get people refinanced into fixed rate loans, even if they were interest-only, so the situation could stabilize. I think those efforts are over and there will be more pain for ARM borrowers in the future. The next really big problem, however, is the negative amortization borrowers or the “pick-your-pay” people. These folks have obtained jumbo loans (for over $417,000.00) and were told they could “choose” to pay a much lower amount, say, $1,500.00 per month. The fine print says that the difference between a fully amortized payment (which would be much higher) gets added to the loan balance and when that balance reaches a pre-set point, usually 115% to 125% of the original loan, then the whole loan resets and requires payment of the full amortization at the full rate. Frankly, most people didn’t read the fine print, or, if they did or were told about it, they didn’t care because they figured on selling or flipping the house.

Example: Consider a borrower who took a $600,000.00 neg-am loan, and then paid only $1,500.00 a month as opposed to the fully amortized $3,792.41 which would be due. They would accrue negative $2,292.41 per month – for about five and a half years. Suddenly, at that point the loan value hits $750,000.00 (125% of original value) and the lender demands payment of the full amortized amount of $4,750.51. Wow. Those mortgage payments just tripled. Good luck, Mr. and Mrs. Borrower. Hope those five years were good and that the market increased by at least 30% or you’re in deep trouble. If it hasn’t, and the current conditions strongly suggest it won’t, then they cannot refi[nance] or sell because they’re underwater – the house is worth much less than they paid for it.

In terms of timing, the foot of the big wave of neg-am adjusts hits at the end of 2008, with the major part of the wave hitting in 2009-2010 (loans made in 2004-2005 adjusting after 5 years). We’ve thus got about twelve months or so of lead time to get the current problems resolved. I don’t see that happening. In fact, given the increasing scrutiny this field has been receiving, the problems may be recognized and cause reactions relatively soon.

In my opinion, the neg-am adjustments will continue the trend of increased foreclosures and bankruptcies for at least the next two years. This will continue or exacerbate problems in the credit industry, the mortgage industry, the residential markets, and eventually the broader market. I think we will see widespread declines in the prices of residential real estate through the end of 2010, with a possible bottom in late 2011.

[…] The result of a depressed residential housing market is very likely given the number of foreclosures and the volume of inventory on the market. The credit crunch and reluctance of lenders to jump in to what may be a bloodbath will create a high-interest rate environment – they will charge dearly for the risks they are taking to make more loans. High interest rates will further erode the affordability of housing, and prices will be adversely affected again.

The real question is whether a deflationary spiral can be averted – without establishing another inflationary spiral. Either way, strange days are on us.

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