Toomre Capital Markets LLC

Toomre Capital Markets LLC ("TCM") has been quite busy during the past few weeks on client work ahead of the summer vacation period. As a result, there has been limited time to update this blog. Today's news of the Treasury Department's defense of the struggling GSE's known as Fannie Mae and Freddie Mac though deserves some comment.

That both of these GSE's need to be supported in at least an oral sense is more than a ripple in the Capital Markets pond. It is much more like a major wave. Just what the final cost to tax payers will be remains to be seen. TCM suspects that the final bill will not be known until well after residential home prices stabilize and even begin to appreciate again. No doubt, though, the costs will be significant.

Lost in all of the GSE consternation is the lack of discussion about the critical policy decision on the future of mortgage finance in the United States. TCM has highlighted this critical issue before. Until the late 1980s, the S&L's were the primary holders of mortgage debt. Commercial banks also have owned some mortgage debt (with significant capital haircuts). The relatively lower capital requirements and the ability to "turn" the mortgage origination portfolios led to the rapid growth in securitization and the funding of mortgage debt through investors in the capital markets.

CNBC Television personality Jim Cramer penned an article on Thursday, June 5^th 2008 entitled Why Own Lehman? In that article he said that No, he did not think that Lehman Brothers was going under. "It's got a great franchise with a good cash position, reduced leverage, much better management than Bear [Stearns] and a buyback that's kicking in that wouldn't if things were as bad as the bears make it out to be." The questioner then apparently asked if Cramer would buy the Lehman Brothers stock. Cramer said, "Why the heck would I do that? To catch a 2- or 3-point rally? There is no earnings power at Lehman."

Toomre Capital Markets LLC ("TCM") normally approaches such pronouncements from television pundits with a healthy dose of skepticism. However in this case, Jim Cramer is right on. The article continues:

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.