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By Martin Hutchinson
Director of Global Investing Research
The U.S. banking trio of Citigroup Inc. (C), J.P. Morgan Chase & Co. (JPM) and Bank of America Corp. (BAC) yesterday (Monday) announced that they were setting up a new fund - perhaps as large as $100 billion - to buy mortgage debt held in "Securitized Investment Vehicles" (SIVs) controlled by Citigroup.
When you have belly-crawled your way through the muddy and crater-strewn minefield of jargon all these deals seem to generate - keeping your head beneath the whizzing bullets of risk - and through the minefield of jargon all these deals seem to generate, this one has a simple message for the retail investor, a of Gypsy's Warning: Don't Invest in Anything Related to This Area. [For our news report on the formation of this fund, and the negative effect it had on stock prices yesterday, please click here.]
In short, if you want to avoid stinging losses from the still-dangerous subprime-mortgage crisis - and hope to stroll out of this debt jungle with an actual profit to boast about - there are three investments to avoid, and one stock to buy.
We'll get to the stock to buy shortly. But, first, here are the three areas to steer clear of if you want to avoid the stinging pain of losses. The three big "subprime don'ts" are:
- Don't buy securitized mortgage bonds.
- Don't buy asset-backed commercial paper, which this new investment fund will issue in profusion.
- And don't buy shares in any of the banks involved in the deal, or that you know is still a player in the mortgage market.
That may seem a little harsh and sweeping, so let me explain.
The Mortgage Market Ain't No 'Wonderful Life' Anymore
As we all now know, the U.S. mortgage market has changed in the last 25 years. In the old days, like back when the late great actor Jimmy Stewart portrayed character George Bailey in the 1946 movie classic, "It's a Wonderful Life," local institutions like the Bailey Bros. Building & Loan lent money to local borrowers, like Ernie the Cab Driver (played by actor Frank Faylen).
Today, the Building & Loans are gone, and lending is not longer local - its global (just look at how many foreign banks got their tail-feathers singed because of investments in U.S. subprime mortgage debt).
Mortgage brokers arrange the mortgages, which are then packaged by Wall Street and sold to investors all over the world. That appears to have made mortgages rather more expensive than they once were; it has certainly greatly enriched Wall Street and the "mortgage banking" industry (which is really more of a "mortgage brokerage" industry, because few of the firms do any actual lending).
As we've all discovered, this new mortgage system also has a fatal flaw: Nobody was responsible for vetting the credit-decision on the actual mortgage, yet everybody made money from packaging it and then selling it to somebody else.
With easy money being pumped out by the Fed, this had the inevitable result of generating a lot of unsound mortgages - subprime mortgages are around 10% of the total currently, compared with a maximum range of 1% to 2% in the early 1990s.
The Downside of Asset-Backed Debt
In another wrinkle, many of these mortgages weren't even purchased by end investors, at all, but by SIVs similar to the one that Citi and its two compatriot banks unveiled yesterday. The SIVs went on to buy mortgages, and would issue asset-backed commercial paper (ABCP) to pay for them.
Asset-backed commercial paper (ABCP) is a short-term corporate debt - usually due in less than a year - that is backed by such assets as real estate or mortgages. It's perhaps the latest example of financial engineering in an area known as "collateralized debt obligations," or CDOs, which are sold on secondary markets. Financial instruments such as these were created to create additional economic liquidity.
When used correctly, they achieve that objective superbly, enabling companies, banks and other financial institutions to 'monetize,' or sell off, debt, in turn providing capital that can be used to finance other projects. Unfortunately, as has been demonstrated time and again, when Wall Street uses engineered financial instruments - such as derivatives - either as devices for speculation, or outside appropriately prudent investing parameters, the results are disastrous.
With ABCP, a key problem is that the loan originators won't also be the loan collectors, since by definition the asset-backed debt will be sold to other investors. Some experts fear these split roles may make lenders much-less disciplined about lending standards, substantially boosting default rates.
When the subprime mortgage mess "jumped the shark," and became an international problem earlier this summer, it became just this kind of problem. Not only did U.S. banks and mortgage-lending firms not use appropriate credit-qualifying standards.
Had the U.S. commercial paper market remained open, liquid and efficient, all would have been well. The SIVs would profit from the difference between the yields on the mortgages and the cost of the commercial paper (if the mortgages were at a fixed rate, while the commercial paper cost went up and down with short term rates, an interest rate swap employed as a 'hedge' would solve the problem). But the growing global subprime scandal then generated a crisis of confidence in the worldwide commercial paper market, forcing central banks worldwide to intervene. They injected capital into the marketplace, and U.S. Federal Reserve policymakers on Sept. 18 finally slashed short-term interest rates by a bigger-than-expected half a percentage point.
The result is a $12 trillion mess - a morass of mortgage debt of all types and of varying risk levels.
Possible Loss Rates
The bulk of the debt is relatively safe, and much of it is actually covered by one of the so-called "Government Sponsored Entities" (GSEs) that include Fannie Mae (FNM) and Freddie Mac (FRE) (which almost certainly means ultimately by the taxpayer if they get in trouble). Some of the debt is even guaranteed by Ginnie Mae, which is the government directly. And there is still some fixed-rate mortgage debt issued several years ago, when house prices were much lower than they are today. So even in a 15% to 25% home-price decline - which now seems possible - most of the mortgage debt will be okay.
Even so, market-loss estimates are still way too low, meaning the problem is still getting worse. But you can be reasonably confident that, at most, $3 trillion of the $12 trillion in debt is at risk. Of that total only $1 trillion of the $3 trillion will lose more than a modest portion of its principal. The bottom line: We're probably looking, realistically, at mortgage-debt losses in the $500 billion to $1 trillion range.
That's not a big percentage of the total - we're talking about a range of 4% to 8% of all mortgage debt, here. Still, that's a lot of money - about a month's worth of U.S. Gross Domestic Product (GDP).
What's more, the $1.2 trillion asset backed commercial paper (ABCP) market, mostly invested in some of these mortgages, has recently shrunk to about $900 billion. The reason: Investors have refused to take on the risk they perceive they're shouldering when they buy ABCP. That's left the big banks like Citi, who sponsored these things, to find the missing $300 billion somewhere else.
In a free market, this wouldn't matter too much. The mortgage bond market would be tugged to and fro by the forces of willing buyers and willing sellers, and you could be confident that whatever price emerged for a mortgage bond or ABCP, that was the market's real estimate of its true value. You might think the market was being too optimistic or too pessimistic, but on average, if you bought a $1000 mortgage bond for $850, you could expect to get $850 of value.
But this isn't really a free market. Citigroup, J.P. Morgan Chase and Bank of America, with the encouragement of the U.S. Treasury, are going out to borrow $100 billion and invest it in mortgage bonds, mostly those residing in Citibank SIVs. In that way, they can prop up the market and so avoid recognizing the losses that the SIVs and their sponsors should be recognizing from investing in lousy mortgages.
The One Profit Play to Make
If this deal goes forward - and it seems very likely that it will - the market for mortgage bonds will no longer reflect that efficiency-inducing balance between willing buyers and willing sellers. Instead, it will reflect that balance - with a $100 billion thumb on one side of the scale: Anyone buying mortgage bonds will be paying more than their true market value.
It's a distortion of the market. Mortgage bond prices may rise a bit given this $100 billion bailout fund, so if you're holding them, sell into the rise. If you're holding asset backed commercial paper, make the SIV and its sponsoring bank redeem it when it comes due - better for this rubbish to be on Citi's balance sheet than on yours. And avoid the shares of the big U.S. banks that have been active in the mortgage market - thinking up clever tricks to avoid recognizing reality will do their shareholders no good in the long run.
Finally, a recommendation as to what you should buy instead, assuming you still want some of your money in the financial-services business, which is a good idea, if you're to have a truly balanced portfolio.
Our choice: Nomura Holdings Inc. (NMR), the parent company of the largest investment bank in Japan. One big thing that Nomura has going for it is , taking write-downs totaling $1.4 billion to do so. It also announced it will report a loss for the second quarter ended Sept. 30.
Losses aren't great, but uncertainty is far worse. And what this means is that Nomura has put this whole saga firmly behind it, removing the veil of uncertainty that still covers other U.S.-based large banks.
While Nomura has, over the last 25 years, had an appalling tendency to waste its shareholders' money on ill-considered foreign ventures in which it is inevitably a minor player, this write-off will at least for a time lessen the risks of further such forays. Meanwhile, in the Japanese market, which is growing nicely and where real estate prices are far below their 1989 highs and beginning to recover, Nomura remains a truly dominant player. With the stock beaten down, it looks like a good time to buy.
News and Related Story Links:
- Money Morning Investment Analysis:
Four Ways to Beat the Credit Crunch and Profit From Global Growth.
- Money Morning Global Investment Analysis:
Japan's Politics Shouldn't Derail Its Economy: Profiting from the New Prime Minister.
- Money Morning Investment Analysis:
Investments for a Weak Dollar World.
- Money Morning Economic Analysis:
It Was a 'Wonderful Life' Before Wall Street Hijacked the Home Mortgage Market.
U.S. Economy/Asset-Backed Commercial Paper (ABCP).
The Federal Reserve and the 2007 Banking Liquidity Crisis.
It's a Wonderful Life: 19 Mistakes.
Bert and Ernie; "It's a Wonderful Life" Connection.
Jumped the Shark.
- Money Morning Global Investing Analysis:
Europeans Won't Euthanize Corporate Stupidity.
- Money Morning Global Economy Analysis:
Central Banks Engaged in a Constant Battle with Liquidity.
- Money Morning Global Financial News:
Europe, Japan and U.S. Central Banks Inject More Cash Into Markets.
- Money Morning Economic News:
Super-Sized Rate Cut Spurs Super-Steep Rally; Dow Soars Nearly 336 Points.
- CNNMoney.com: .