We’ve all heard that this is a liquidity driven selloff and I think most understand that the sub-prime mortgage industry has provided the catalyst for this lack of liquidity. As banks and hedge funds alike purchase mortgage backed securities, mortgage lenders continue to write new loans and pocket the underwriting fees knowing that they will be able to sell these securitized loans to free up capital to start the process again. The problem for mortgage originators comes in when there is no willing buyer for the loans they have written and suddenly the company does not have the capital to lend out any more money - lately, home buyers have found out at the last minute that the loan they have been promised isn’t available.
So why does this very specific portion of the market have such a drastic effect on the broader indices and potentially on the global economy? The answer lies in the recent history of our globalized markets. As stability characterized the mature markets over the past few years, managers have been willing to take more and more risk to enhance returns. As this trend continued, leverage became more and more accepted and liquidity became king as money poured into all kinds of asset classes. Mortgage backed securities were one of the most popular as it was well known that rising home prices would provide ample collateral, and investors such as hedge funds could borrow seemingly unlimited capital at say 4.5% and invest those funds in MBS’s yielding 6.5%.
Now that housing prices have begun to drop, and foreclosures on houses have picked up, light is being shed on the finance industry in general and the mortgage industry specifically and there are some ugly things being uncovered. Many mortgages have been written without proper documentation to homeowners who should never have qualified for the loans in the first place. Properties pledged as collateral turn out to be worth less than originally thought (and less than the financing balance) so investors in the loans are not as well protected as expected. Issuers of credit are taking it on the chin and now have less appetite for risk and less capital to lend even to high quality borrowers such as stable corporations.
Now the prices on securitized mortgages are dropping and funds who leveraged up borrowing cheap funds to invest in higher yielding MBS and this is kicking off margin calls. The funds may not be able to meet the margin calls because they can’t sell the MBS for enough to pay off their loans. Banks and brokerages who lent the funds margin capital are at risk because they may not get the lent funds back. That is part of the reason you see MER, GS, BSC and LEH dropping.
As the vicious cycle continues, funds are now liquidating whatever they can to meet the margin calls. So if there’s no market for MBS, they have to sell what is available to sell and now we start working on KO, HD, GE, and IBM. Before too long, the entire market is under pressure because of the contagion that is present as liquidity is sucked out of the system.
The bad news is that there are very few places to hide. Volatility makes even short selling difficult because violent swings both down and up stop traders out of positions and wreak havoc on anyone committing serious capital. The good news, however is that the final outcome will be some incredible values for those left standing when the smoke clears. It will not be unusual to see moderately diversified unleveraged accounts increase triple digits the year or two after the carnage is complete. The key is making sure you are around to play when the game gets fun. For now, damage control is key. Make a list of stocks to watch - even dabble by buying or shorting small lots to stay involved. But leave the majority of your capital safe until the risk is lower and the reward is ready to be taken.
FD: Author does not have a position in the stocks mentioned.
Additional Reading:
The Curious Investor offers some alternative asset classes to seek returns non-correlated to equity markets.
The front page of the WSJ has an indepth discussion on how securitized pools of mortgages were rated by Moodys and S&P during the boom and bust of this decade.
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August 14th, 2007 at 11:00 pm
Nicely said.
Thanks.
August 15th, 2007 at 6:54 am
Using leverage can’t increase your long term returns because you can’t continue to leverage forever. It’s the “gambler’s ruin” that without infinite resources, a Martingale like betting system, which is what leverage really is, is destined to an eventual, dramatic collapse. We’re seeing that now in the ripples from these failing loans.
Leverage is a smoke and mirrors game that can’t work forever. You have to look at the fundamentals that drive the market: corporate profitability. In the long term, it will always be the true value of the underlying securities that determine their dollar worth.
August 15th, 2007 at 11:21 am
ZACH- STP is down to $37 again. the dip is $7.
August 15th, 2007 at 12:29 pm
Joel, thanks for the comment. Honestly, I think there is a time and a place for modest leverage only if the investment is relatively stable and constraints are put in place to exit positions if they begin to trade outside historical norms. But the problem is that greed and fear enter the equasion all too often luring even the most seasoned investor into making poor decisions at inoportune times. This is precisely one of the main reasons why our funds do not take leverage (the other main reasons being tax considerations for clients).
Borris - i’m watching it and wondering if it will hold the 50 day. It’s not a great time to be committing much capital on the long side (in my humble opinion). There may be some decent opportunities but the risk is tremendous!
August 15th, 2007 at 7:15 pm
stp - i guess if your cheap you may sqeeze another $1 or $2 out of the $37 low end but its down there. crox- i dip bought today near $49. brcm- i dip bought yesterday lower 34s.
August 17th, 2007 at 8:40 am
the interest rates are down and friday is gonna rock.
the million-billion dollar basket balls have room to bounce.
August 17th, 2007 at 2:49 pm
The question is how far they will bounce. Fed intervention will not be enough to stem the tide long-term (always my humble opinion). I wouldn’t be suprised to see us give up a lot of the ground we gained Friday morning by the end of the day Monday or Tuesday. I’m not a day trader, but this gives me an opportunity to leg into a few stocks I have been wanting to short for some time now.
August 17th, 2007 at 7:09 pm
your are prudent to be cautious. i am gonna go out on a limb and open positions for multiday upticks. main bounce plays for next week are broadcom, california pizza, and intuitive surgical. BRCM- for the supersized news flow factor, CPKI- for the short interest covering + corporate share buyback = 28% of all shares outstanding, and ISRG for the stellar story and expanding popularity to inspire dip buyers to chase the bounce.
August 18th, 2007 at 7:51 pm
hi i enjoyed the read
August 19th, 2007 at 9:34 pm
per Bloomberg almost all asian market indices have opened monday with sharp gains of 3.00%-4.00%.
August 19th, 2007 at 9:37 pm
well at 9:40 Sunday night, the US futures are down about 0.3% so I’m expecting that Asian markets are actually catching up with our strong gains from Friday and not in fact pointing to a strong US opening. But a lot can happen between now and the opening bell!
August 19th, 2007 at 9:46 pm
very slick zach. i guess my Bloomberg Asia indicator favorite places bookmark is obsolete.
August 19th, 2007 at 9:48 pm
haha - i don’t think i’d go that far. you just have to put it in the right context. Have a great evening and hit ‘em well tomorrow!
August 20th, 2007 at 10:20 am
the 50 basis point discount rate cut is something that might be very serious. i would not be in a hurry to assume it doesnt effect the markets. take time and care to reach that conclusion. dont be swayed by the media. and again consider being the fast money CNBC @8pm with TIVO or DVR. i see room for about 10 days of upticks.