Late on Thursday April 3^rd 2008, news emerged that c/a>, a former president of troubled Swiss bank UBS AG, is pushing for a potential break-up of the bank, according to a letter Mr. Arnold and his London investment firm Olivant Advisers Ltd. in London have sent to UBS's board late on this date. Mr. Arnold served as president of UBS in 2001 before departing the bank after a dispute with current Chairman Marcel Ospel. This is a surprise move and is likely to accelerate changes at UBS, particularly regarding its investment banking division.

Luqman Arnold is quite a credible individual. After leaving UBS, Mr. Arnold joined U.K. lender Abbey National PLC as executive before overseeing the sale of Abbey to Spain's Banco Santander SA. As The Wall Street Journal details, today Mr. Arnold's firm Olivant Advisers Ltd. specializes in financial services.

The Financial Times Alphaville blog is a worthy read. On Wednesday, January 16th 2007, it is particularly so. Toomre Capital Markets LLC ("TCM") thanks that site for the significant news that S&P again is in the process of readjusting its structured finance risk models. S&P last adjusted its risk models back at the end of October 2007.

Alphaville relays "In a late press release, S&P announced it was adjusting its cumulative loss measure on 2006 subprime collateral to 19 per cent - up from 14 per cent:

We revised our expected losses for the 2006 vintage subprime collateral to 19% from 14%, as delinquencies continue to rise, and we will recalculate lifetime loss expectations for all vintages of U.S. RMBS. Additional losses are projected to result directly for the additional delinquencies and defaults.

The implications of this small change are significant. Many RMBS are structured on something akin to 70% Senior / 20% Mezzanine / 10% Junk/Equity. As a result, S&P is effectively saying that all of the subordinated debt/equity and close to half of the typical mezzanine will be wiped out. The ratings of the senior classes are also more suspect although they are likely to remain investment grade.

Toomre Capital Markets LLC ("TCM") is simply amazed. How the heck does an institution like the combined Citicorp/Salomon Brothers lose $17.4 billion dollars on its CDO and subprime mortgage positions? In just one quarter!!!! Maybe it is just TCM, but does not anyone really care about how abysmally, shitty, horrible, horrendous this bank's risk management controls have been?

Toomre Capital Markets LLC ("TCM") has previously written about the other ticking credit bombs that will affect the Capital Markets in the coming months. TCM posts to review include Estimated Investment Bank Fourth Quarter Earnings??, Where is Value in Structured Mortgage Products? – Early December 2007 edition and Incestuous Mix: Structured Credit, Financial Guarantors and Rating Agencies.

On Monday January 14th 2008, The Los Angeles Times published yet another excellent article written by E. Scott Reckard. This one is entitled Adjustable loans spur new worries and has more details on the most toxic mortgage credit "bomb" of all: the Pay Option ARMs. Typcially, these Pay Option ARMs present the mortgage borrowers with a choice every month during the first five years of the loan: pay the interest due and some of the principal; pay interest only, leaving the loan balance untouched; or pay less than the interest due, making the loan balance rise. Then, at the end of the five year option period, the loan is reset to fully pay-off with a fully indexed adjustable interest rate.

Since many of the mortgage borrowers elect to pay less than the amount that will fully amortize the mortgage and the effect of fully indexing the interest rate from the typical more "teaser" initial rate, when Pay Option ARMs are reset, they almost always require a higher principal and interest ("P&I") payment than initially was required. Sometimes these reset P&I payments are as much as two or even three times what the borrower was originally paying on the mortgage each month. If the borrower elects only to pay interest only during the initial months and the balance rises above a set percentage of the original loan amount, the reset process can occur earlier as soon as three years.

This LA Times article suggests that the second tide of the mortgage defaults are about to start. After reviewing data from mortgage industry data trackers, the author concludes that Pay Option ARM borrowers -- "most of whom boast respectable and often top-tier credit scores and appear to have substantial incomes and home equity" – are having severe delinquency problems that are tied to the loose lending practices that inundated the sub-prime business. Pay Option ARM loans often were granted on the basis of stated income, not proof of a borrower's income, giving rise to their nickname, "liar's loans."

"This is not a sub-prime crisis. This is a stated income crisis," said Robert Simpson, chief executive of Investors Mortgage Asset Recovery Co. in Irvine, which works with lenders, insurers and investors to recover losses related to mortgage fraud. "Simpson said loan officers routinely inflated earnings of workers with regular paychecks. On some written requests to confirm a borrower's employment, officers would specify that an employer should not provide a salary figure, he said." As a result, borrowers often overstated either their income or their assets.

The article references Mortgage Asset Research Institute in Reston, Virginia, which investigates lending fraud. Apparently one of that firm's customers checked one hundred stated-income loans against tax documents and found that nine in 10 of them overstated income by at least 5%. "More disturbingly, almost 60% of the stated amounts were exaggerated by more than 50%," the institute reported, saying the Pay Option ARM mortgages clearly deserve their "liar's loan" handle.

Oh no… Why is it a surprise to hear that Wall Street has been selling to CMO securities to retail investors in these times of sharply reduced liquidity? And now Wall Street's regulators need to investigate?

As this Wall Street Journal article suggests, "Securities regulators, broadening their review of Wall Street's role in the mortgage industry, have asked several brokerage firms for information about the marketing and sale of mortgage-related products, specifically those sold to individual investors." Apparently, The Financial Industry Regulatory Authority ("FINRA"), Wall Street's self-regulatory body, last month sent letters to firms asking for documents, including marketing materials, a list of supervisory policies and procedures, and descriptions of how collateralized mortgage obligations were valued. These letters, part of an on-going "sweep" operation directed at more than a dozen Wall Street firms, asks for PowerPoint presentations, sales scripts and detailed customer-account information from June 30, 2006, through July 31, 2007.

The WSJ article discloses that FNRA "specifically asks for offering documents on products sold, created or distributed during the months of March and June 2007." Toomre Capital Markets LLC ("TCM") notes with interest that those months just happen to coincide with the quarter ends for three of the largest Wall Street entities with both large retail brokerage personnel and the biggest CDO losses from aggressive underwriting – UBS, Merrill Lynch and Citigroup. Could these firms and others possibly have tried to cram as much CMO (and CDO) product down less sophisticated retail channels ahead of their earnings reports? No, Wall Street never would do such a thing…

Toomre Capital Markets LLC ("TCM") has long been concerned about the opaqueness of the Credit Default Swap market. As this market sector has exploded in size in the past decade, TCM has feared that some losses from these credit derivative instruments may be hidden from investors, regulators and counterparties. Hence, the soundness of the global financial system might well be less sound than what international regulators, rating agencies and large financial institutions might think.

Others have been concerned too. The Australian has started off the 2008 New Year with a rather ominously entitled article Forget CDOs, Is is Time for CDSs. The article starts with "If 2007 was the year of the CDO, the latest acronym to loom dark and large on the financial markets' horizon for 2008 is the CDS. And the CDS (credit default swap) is shaping up to be far more noxious than its little derivative brother, the CDO - a spliced and diced bundle of mortgages known as a collateralized debt obligation that sent Wall Street into a tailspin last August when the market for low-grade US mortgages froze over. At least Warren Buffett seems to think so. After the world's top two bond insurers were scolded with [the threat of] a ratings downgrade last month and told to go and raise some capital, the visionary Buffett revealed last Friday that he was to set up a bond insurance business." [emphasis added]

The key point of this article is that "the murmur among the cognoscenti is that an implosion in the CDS market could do serious damage to the international banking system." They have slightly misquoted Warren Buffett who did say "We felt that, in many cases, the prices that people were charging were inappropriate." What Mr. Buffett was referring to was the cost of credit enhancement insurance to ensure that a municipality's debt was paid on a timely and ultimate basis that is part and parcel of a AAA/Aaa rating. He was not referring to the prices of CDS transactions. However, the article authors were correct that the crux of the problem is that there is not only price transparency but there also are problems about reserving and regulation.

Back on March 1st 2007, Toomre Capital Markets LLC ("TCM") created a post entitled Where is Value in Sub-Prime Mortgage Market? In recent days, UBS has announced a further write-down of $10 billion in sub-prime mortgages and CDO securities; London-based HSBC, Paris-based Societe Generale and Germany's WestLB have all rescued their sponsored SIVs either by taking them on to the balance sheet or providing credit lines that ensure that all of the outstanding senior commercial paper will be repaid; and MBIA has announced a $1 billion investment by Warburg Pincus LLC that for at least for a few weeks will help ensured that MBIA maintains its AAA credit enhancement rating. Late on Monday December 10th 2007, Washington Mutual, the United States' largest savings and loan by market value, declared that it was exiting the subprime mortgage business, eliminating another 3,150 jobs and raising some $2.5 billion dollars in additional capital through the issuance of convertible shares.

Based on the recent TCM posts about the perils of reaching for yield and some the enormous losses various financial institutions are taking from their subprime and CDO security activities, a couple of investors have asked Lars Toomre to go back and update his thoughts on that Where is Value in Sub-Prime Mortgage Market? post. Hence, a few hours ahead of the release of Lehman Brothers 4th quarter 2007 earnings release, here goes:

Clearly, Lehman Brothers was wrong back in late February arguing that the sell-off in the ABX index was way overdone. From their historically very tight levels around the start of 2007, the risk premiums for all types of credit investments have dramatically increased. For all practical purposes, the mortgage sector has virtually stopped trading and those risk premiums are now more of a "pick 'em" variety.

So where is value from here? As Lars has preached in many different conversations and written comments, the trade-off from going from a liquid to an illiquid position requires a very significant yield pick-up and recognition that one must be able to live with the illiquid investment for five years or more. Given that criteria, most, if not all, mortgage investments are still not trading cheaply enough to justify going illiquid. Hence, Lars Toomre would recommend that interested institutions remain more in a seller mode than an acquisition mode when considering structured mortgage investments.

As The Wall Street Journal reminded investors, home prices will need to fall about 30 percent to restore their historic relationship to inflation, rents and incomes. Hence, Toomre Capital Markets LLC would urge that investors avoid the mortgage sector for at least another six months as housing prices continue to decline. Whether the popping of the housing bubble will take five or six years as Jim Rogers has argued remains to be seen.

However, clearly the full effects of cheap and easy mortgage credit are not fully reflected in mortgage security valuations. Make a point of following just how badly home equity loans, Pay Option ARMs, other intermediate and hybrid ARMs and the Alt-A security sector will decline in the coming months. While there no doubt will be periodic spikes as people perceive the housing market is bottoming, remember that a 30% price decline is going to turn almost all of these mortgage types into "upside down" positions with borrowers having negative equity in their homes.

An interesting question is just how prevalent the "jingle mail" phenomena will become. Also, remember that the housing price bubble is beginning to deflate during a period of relatively healthy employment. Just imagine how bad the delinquency and default statistics would be if the United States economy were to enter a "normal" recession.

As before, thoughts and comments are most welcome.

Deanne Landress is another individual who was very instrumental in the development of the Lehman Brothers mortgage trading business and who strongly praised the relative value of investing in structured mortgage products. Deanne also was Lars Toomre's predecessor as the head of the Lehman CMO Trading Desk and taught Lars tremendous amounts about relative value, risk/reward and that funny relationship between price and yield on mortgage-backed securities, especially as general market rates plunged from more than 14% in 1984 to less than 7% some two years later. Some people call this latter phenomena "negative convexity"; others who have lived through a market experience where an illiquid market turns "all sellers" refer to this phenomena as "Oh, shit!!"

Deanne left the securities business some years ago and now runs an Internet café business in suburban New Jersey where so to speak "she now sits at the point where the rubber meets the road." In the past week, she wrote Lars Toomre to comment about how bad this mortgage crisis truly is and to voice her frustration at the current state of the mortgage securities market, especially "having spent so many years and so many hours convincing investors of the veracity" of the structured mortgage market. She relates that the local economy is not particularly strong and has not been for a while. Apparently, local pizza parlors are howling since both of their two main ingredients, flour and cheese, have DOUBLED from where prices were about six months ago. People are paying at her internet café in coin as a regular occurrence. The local restaurants apparently are terrified because the number of customers is so low. Her argument is that much of the weakness in current economic activity was masked by cheap easy credit.

Deanne suggests that after its substantial run-up since the start of the decade, the residential real estate market is now looking at drops between 30 and 50 percent. She suggests that "we're moving towards the point where homeowners don't feel particularly obligated to pay off their mortgages if they are 'upside down'." She asks quite seriously what happens when the broad market figures out that the entire mortgage market for the last few years was one big strategy to keep everyone refinancing every couple of years and raking in the associated refinance fees. The FICO disaster, the home equity nightmare and the droves of stories about fraud might just lead a very scary state affairs. What happens if the regular guy who CAN make his first, second and/or home equity loan payments just decides not to – and in droves?

Apparently there already is another new word in the ether: "jingle mail". It is not defined in wikipedia yet, but mortgage brokers are already using it to describe the case when the borrower just mails in the keys and walks away. How frequent this might occur is anyone's guess at this point. However, Toomre Capital Markets LLC ("TCM") would suggest that interested parties keep an keen eye out for on-going developments in the home equity loan, "Pay-Option ARMs", 2/28 and 3/27 hybrid mortgage and Alt-A mortgage security sectors.

With the relative relaxation in mortgage underwriting standards starting in 2002, lesser equity was required to purchase a residential property and little, if any, documentation was required to demonstrate the borrower's capability to service that debt throughout an economic cycle. TCM is unsure whether the residential mortgage markets will decline by the more than 30 percent that Deanne Landress suggests. However, clearly they have declined already and will decline yet further. Many recently originated loans, whether for the purchase of a home or for a cash-out refinancing, will be "upside down". A key question will be how prevalent will "jingle mail" become? Reader comments and thoughs are most welcome.