Decision Quality Blog

These are my notes on comment by Tom Brown at the BAI Mavericks in Banking Conference.

Five interesting aspects to this debt crisis. Why we believe a new financial stocks boom has begun that will be powerful and long lasting. To understand this, you have to realize that the future of the stocks is different than the business.

I don’t use the word crisis lightly. This is a crisis.

The problem is a fundamental asset value deterioration that led to a liquidity crisis because of a loss of confidence. The root cause is that subprime delinquencies became a big problem. The base case with subprime loans is that over the life of the loans, you would lose 5% of the principal. In 2003 they were 3%. You also prepare to be wrong and they might be 10%. The real stress case is 15% and some people are really hurting. We’re way beyond that. For loans originated in 2007, we may see cumulative loses of 20% of or higher.

The good news is that there were $600 bn originated in 2006. There were only $200bn in 2007. So it’s the 2006 vintage you need to focus on.

It was poor underwriting, borrower fraud, declining home value, and rising rates in 2005 and 2006 that lead to a credit problem. What turned us into a crisis was when the Bear Stearns hedge funds failed. People became worried about the counter party. Not just sub prime loads, Any kind of loan. That lead to tighter credit conditions. That let to de-leveraging. And round and round.

The second part is the role of speculators. We know if there was poor underwriting and fraud, you’re going to get some real repercussion. The originators have reps and warranties and the paper is going to move back through the pipeline. The fact is that borrowers misrepresented income and residency.

In 2004 6% of borrowers indicated the loan was for an investor property. In 2006 it was 13%. We think it’s double that. We own Ocwen Financial that does servicing only. In 2006 when a notice of foreclosure went out, they could rescue the borrower 79% of the time. In 2007, that went down to 77%. How much came from owner occupied vs. investor owned? 16% of loans accounting for 50% of foreclosures in 2007 were for non-owner occupied. This isn’t what they said on their applications; this is what they found out afterwards. The government is trying to help these people, but you can’t help the people who lied. They don’t even want you to work with them.

This part of the problem went through the system last year. This is why I think we’ll see a big fall in concern about loses in sub prime.

The third thing about this is that it created a lot of fear. In August when we locked up the credit markets, asset backed commercial paper went up at the point that the T-Bill went through the floor. It was a huge gap and reflected the panic in the markets.

Let’s look at credit default swaps. Take IBM. Let’s say I own their debt. I want to make sure they don’t default, so I by a swap and I buy a premium. It only pays off if they fall from Triple A and don’t pay. So total default. Last year, you were paying 40 bp annually. Today you’re paying 150 bp. There just isn’t that kind of risk here.

GE is a AAA credit. You would have paid 12.1 bp on 12/31/06 to insure that they wouldn’t go from AAA to default. In April 2008 it’s now 104 bp, a 760% increase. The 2006 numbers might have been too low, but there’s no way there is that kind of risk here. The credit default swaps peaked in August.

Underwriting will ultimately matter for investors. Right now there is no distinction between who underwrote loans. Moodys has taken a look at credit performance. They split the underwriters of sub prime into three categories. Almost none of the Tier 3 are still around. The order of magnitude of the difference is this: If you look at the loans that were originated 9 months ago, what’s 60 days delinquent. 4.5% tier 1, 11% tier 3.

Last problem, the one we see growing every month. We have a problem with home equity lending (all types) that are increasingly isolated in areas that are depressed and where there was a lot of speculation. The biggest change in foreclosures is CA, FL, TX OH, MI, GA, and IL. One of the stores you’ll see played out in 2008 is that home price depreciation has slowed in 42 states. It’s still going south in the others.

Why am I optimistic? Unprecedented action by Fed and Congress. The Fed knows it’s bad and they have more arrows to shoot if they have to.

The second reason is they’re doing all this and the fear has driven down company valuations to the point that it looks like companies won’t survive. If they show normal levels of earnings, the valuations will return to rational levels.

When you see headlines on Business Week like “Meltdown” and “Credit on the Edge” in Feb of 2008, you know you’re near the bottom.

When you’re in a bull market you can’t say enough bull things. The same is true in a bear market. You’re always trying to out bull and bear your competitors.

The other thing to be careful with is to think that with your company the worst is not behind us and I’m not going to buy my own stock. In 1990 the last bull market began months before the estimates turned up.

Looking at credit crisis in other markets around the world: The lag between financial market stabilization and the real estate price bottom. In the US S&L crisis, it was 8 quarters of lag.

The maverick in me says that you shouldn’t wait until estimates or home values bottom. Fears over sub prime loses is too high.

When you make a mortgage loan, it’s not like any other kind of loan we make. If there is problem, you have to go 30 days delinquent, then 60, then 90, then you have to go into foreclosure, then take the asset, then sell it. So it’s 15 months before you’re done. There are early signs that the beginning part that’s entering the python is being reduced. It will take a lot of time, but you have to start by slowing the inflow. It’s slowing because of speculation being flushed out.

What percentage of 2006 originations have resulted in loses? Well, 2% in actual loses. We know another 20% has defaulted. We can make estimates in how those things roll down through the buckets (30, 60, 90). There are varying forecasts we can do. We think the bad stuff moved through in 2007, we think this stuff will perform like the 2002 vintage and the curve will be at a lower angle than what others are projecting.

60 + 90 + foreclosure + REO. The delinquency rate is still growing. But the dollars in delinquent loans in 30 day is down 30%. 60 day is coming down. 90 day has flattened. Next comes foreclosure etc. Same is true with second half 2006, first half 2007, and second half of 2007.

Part of that is seasonal. Consumer credit is better in Jan and Feb. But 33% is more than seasonal. It wouldn’t surprise me if the dollars don’t bump up again, but the big pig is moving through the pipe.

There is an index called ABX. They take 20 loan pools of about 1.5 billion. Every month we go through and estimate loan loses. A true analysis of what’s going on is that people got scared and the loss estimates are way too high.

Upside volatility could be similar to downside. On January 23, 2008 BKX rose 8% vs. 2.1% rise in the S&P 500. That has hardly ever happened. When it does, the bull runs.

The average bank was down 44% prior to the last bull run. 1 year after the bull, the worst was still down 6%, the average was up over 83%.

In 2008. Most financial companies will under earn. Stabilization of some financial institutions and narrower spreads. Panic and uncertainty rose so high in 08 that a number of companies are trading below their liquidation value. My conclusion is that we’re in the nasty part of the credit cycle. The markets take all that into account. Next year it will be all better.

Tags: TomBrown, Second Curve Capital, BankStocks, bull market, Ocwen Financial