Red Bud

Above you will see my favorite flowering tree--a red bud. These trees sport tight--purple to fuschia like clusters close to the trunk as you see here. These buds have not yet opened. Aren't they beautiful? They bloom just before the dogwoods--my state's state flower. I'll share another picture when it blooms this year.

Circuit City

Circuit City announces to today that they are going to let go of 3400 workers who make more than the market range and will replace them with cheaper workers.

While I understand, too well, the need to have operations that are profitable, moves such as this only impairs quality. So these workers who make more are presumable experienced personnel who will now be canned for new hires.

Circuit City will not be getting any of my business, and I will be writing them to tell them so. There is something more broken with their model if they cannot be profitable otherwise. In my opinion, of course. I recognize that there is room for other opinions and I could argue the opposite side. But firing people to make way for cheaper workers cheapens Circuit City's image. Would I want to go to work for them? I don't think so.
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03.29.08 addendum: Mish has a more detailed post here

Inflection Point

We are at an interesting juncture in the market as it flails about. This is the time where the average investor like myself is perplexed. The market looks fragile, but there are folks that are telling you that we've had the obligatory follow through day after the 28th's mini-crash so we are in a confirmed bull market.

• From Bill Cara who is also quoting Colin Twiggs: "As I say, until the M&A deals are cleared from the HBB decks, and their prop trading gets a chance to off their dogs, I can see continued strength in US equities. Yesterday, the Nasdaq, Dow Utilities and S&P 500 were all up on the day. Equity futures are soft this morning, but Colin Twiggs is also looking for some strength to follow."

• Gary Kaltbaum two nights ago, though expressing some concern over the quickness of the follow through stated that: "We are back into a confirmed bull market."

• Gary K last night: The action today was just horrible. If you are a bull, you cannot be happy with today's market." (A reminder that Gary is almost purely a technician, but he is honest about his observations and I'm very glad to have his radio show).

• Jeffrey Saut at Raymond James is perpetually cautious as is John Hussman--read them for gravitas (see links under Info Mosaic).

• George Dagnino writes: "We are witnessing the unfolding of three major crises. I wrote several times here that the market is going to reflect these uncertainties. It looked like a top and walked like a top. It must be a top. I have been talking about it since December 2006 in my service." [if you are not reading George's blog regularly, then I urge you to put it on your regular reading list--see it to the right. Also, if you've not visited his website @ Peterdag.com and read about the business cycle--go there. Read ALL of the free stuff--better yet, print it out. It's like having a free book for the price of paper. But get his book, too, if you read not one other thing on the market: Profiting in Bull and Bear Markets.

Granted, Kaltbaum, Dagnino, Sauth, Hussman all want to sell you something, so showcasing their talent is one way to do that. Take advantage of that showcasing, for they still take time to educate you. Bill, well he's not trying to sell you a thing, and he's plainly passionate about peeling back the eyelids and fanning the miasmic smoke away so that we can see clearly the pickpockets!

My point, though, is simply this--you can find an opinion to suit your own bias. That is the single worst danger in managing your own money. You could be dead wrong, and you can easily find many well-qualified people who share your opinion. They'll be dead-wrong too, but such good company you will be keeping. You want to be with people that will tell you when THEY are wrong and a track record to show that they are able to realign their views.

One of the most telling things to read during financial storms is the steady press of good news all the way down to the gates of financial hell. You cannot trust the headlines. If you learn anything as your own personal money manager, it needs to be that. And if you are an amateur, like me, you want a stable of opinions so that you can soundly develop your thoughts and theses about the market and your investment strategy.

For my money (your money might be different), I see very little short term fundamentals that will lift this market much higher without great risk to my capital. So, I'm cautious, and I'm listening to the experts I've come to trust, and I'm making decisions that make sense for me. I might be wrong, as might they. But you have to weigh the risks--perhaps construct a probability table of returns based on your underlying investments. Here I've taken a principal balance of $100K and am setting out a 50% probability that the market will go up 10% (meaning I'm wrong) and a 50% probability that the market will correct by 25%. Now, I understand that the probabilities as well as the % earned or lost are subject to the gauntlet of criticism. Nevertheless, if you have worries and you want to quantify them, you could use a very simple model such as this. Naturally, you want the summation tells you important things about your overall decision.



So, for a 50/50 chance of being right/wrong over the above scenarios, my choice would be to protect capital and avoid the weighted probability of an 8% loss. Despite these lovely probabilities, in real life, the outcome is 100% one way or the other. It gives you a quantitative means of measuring your bias and the cost of your being wrong.

Market Close: 03.27.07

MBS--Loan Documentation

A loan is a legal contract between a borrower and a lender. As we will later see, the "lenders" can take on several guises. But let's talk about the borrowers for the moment.

Borrowers are sorted in accordance to credit quality. Most of us have been through extensive credit screening gauntlets where information is gathered over a current period...perhaps the last year or two. So we have to produce most recent tax returns and supporting documentation, most recent paycheck(s) etc. In addition, our property was most likely appraised in order to provide an objective, third party valuation based on current market standards.

How well you are able to service your debt is based on your liquid assets and earnings. How well collateralized the debt is, also known as the loan to value ratio, depends on the appraisal quality and the relative market conditions.

Credit quality of borrower: I'm going to lift this straight out of a Goldman Sachs S-3

From S-48: The credit score tables appearing in Appendix B show the credit scores, if any, that the originators or underwriters of the Mortgage Loans collected for some mortgagors. Third-party credit reporting organizations provide credit (or FICO) scores as an aid to lenders in evaluating the creditworthiness of mortgagors. Although different credit reporting organizations use different methodologies, higher credit scores indicate greater creditworthiness. Credit scores do not necessarily correspond to the probability of default over the life of the related Mortgage Loan, because they reflect past credit history, rather than an assessment of future payment performance. In addition, the credit scores shown were collected from a variety of sources over a period of weeks or months, and the credit scores do not necessarily reflect the credit scores that would be reported as of the date of this prospectus supplement. Credit scores also only indicate general consumer creditworthiness, and credit scores are not intended to specifically apply to mortgage debt. Therefore, credit scores should not be considered as an accurate predictor of the likelihood of repayment of the related Mortgage Loans."

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Think about the above when you hear about how "good" the FICO scores are for borrowers.

To be continued

MBS Fundamentals--Structure

This is from Wikipedia:



You've seen this in another form, but seeing a different view cements the concept(s). I will be covering how certain aspects of this structure are covered in filings. I will post this chart in each entry for ease of use.

MBS Fundamentals--Why?

Wikipedia does a nice job of explaining these issues, so I will borrow liberally (with attribution) from them.

Reasons for issuing mortgage-backed securities

(Link above to Wikipedia from which this is lifted)

There are many reasons for mortgage originators to finance their activities by issuing mortgage-backed securities. Mortgage-backed securities

1. transform relatively illiquid, individual financial assets into liquid and tradeable capital market instruments.
2. allow mortgage originators to replenish their funds, which can then be used for additional origination activities.
3. can be used by Wall Street banks to monetize the credit spread between the origination of an underlying mortgage (private market transaction) and the yield demanded by bond investors through bond issuance (typically, a public market transaction).
4. are frequently a more efficient and lower cost source of financing in comparison with other bank and capital markets financing alternatives.
5. allow issuers to diversify their financing sources, by offering alternatives to more traditional forms of debt and equity financing.
6. allow issuers to remove assets from their balance sheet, which can help to improve various financial ratios, utilize capital more efficiently and achieve compliance with risk-based capital standards.

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It appears, then, that these securities go along way towards providing substance for derivative instruments such as cash flow swaps and interest rate swaps.
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The Woodshed

For those of you who read Bill Cara (that man is a saint!), you will know that frequent contributor MarkM infrequently self-imposes punishment of going to the woodshed.

Here's a wooshed that we can all hang out in for smokin' , drinkin' and cussin'--all of the things that promote civil discourse and social cohesion--

Form 10-D

Form 10-D is an Asset-Backed Issuer Distribution Report Pursuant to .....

Here is one of Accredited Home Lenders (through their REIT) for the 2006-2 Trust
If you are interested in this securitization issue, then I urge you to look at this report. It's fascinating. Your eyes will not glaze over.

Essentially this distribution is a report card for discrete securitizations. It's everything you wanted to know about the loans: State, principal, interest rate, and LTV. Oh, DO look at some of those rates. What you will also find is whether or not they've been naughty or not about required overcollateralization. I'm not sure, but I think that the deficiency in the overcollaterization may result in a margin call.

In no particular order...hey, it's late. Here's the report that you can go to and see where the delinquencies are--you'll not find this on the company's balance sheet...it is in the real estate investment trust (REIT).



Remember my previous post? where there was credit support/enhancement through overcollateralization? Here's the summary that shows that:

I have to believe that overcollateralization deficiency is not a good thing--what I understand (I couldn't find any good information), is that this is part of credit support, and if it is not there, then, those folks at the bottom of the food chain have more risk than they gathered.

I did find something very interesting in a Goldman Sachs shelf filing. I'll add it to my Horizon Issues. I will not shoot my entire wad tonight--and it is late in my neck of the woods...speaking of which....my neck of the woods showed up in the top 100 fastest growing counties in America. Unbelievable (just goes to show you what you can get when the denominator is small to begin with!).

Derivatives

The explosion of derivative instruments represents the monetizing of EVERYTHING. In today's Financial Times, there was the following headline: You may not be able to use the link without a subscription, but I'd be happy to e-mail it to any interested readers. Just e-mail me your e-mail address leisa-va@cox.net and I'll use the e-mail article function. Your e-mail address will be kept private. Here's the headline anyway with the link. I'm just including the first paragraph in honor of the subscription/copyright obligations:

Risks of derivatives 'not fully evaluated'

By Saskia Scholtes andRichard Beales in New York

Published: March 26 2007 03:00 | Last updated: March 26 2007 03:00

Fewer than half of global financial institutions account sufficiently for complex financial and commodity exposures in assessing the riskiness of their holdings, according to a survey by Deloitte.

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These instruments are beyond my abilities, but I'm sufficiently interested in them to pursue a bit of knowledge. I did a little nosing around and I found this article. Given the preponderance of hedging risks through derivatives instruments, and particularly if you invest in the financial sector, I would recommend your cultivating your knowledge regarding hedged risk. I found MOST of this article comprehensible, but my understanding is very limited. I'm in no position to educate you, but I'm in a position to make you aware.

I did note that LEND had $10M in hedging losses. I suspect that even if we do not suffer from some financial cataclysm, some dynamic shifts in the credit markets might provide some nasty surprises for folks hedged for one risk when the obverse materializes (causing the hedge position to be a loser--unless of course, the obverse situation is hedged). I wonder if company CFO's and/or Treasury heads know exactly what is in their banker's black box that calculates hedge settlements? I think that these are the stories that we are going to hear about more and more.

03.26.07 Market Close

Trustee Sales

Everything that you Wanted to Know about ...

Mortgage Backed Securities but were afraid to ask.....No, I'm not really going to give you that. If I did, I'd have to charge you for it, and it would be worthless, for I'm not really qualified to opine. But remember the name of the blog: The Perplexed Investor. I'm just an ordinary person trying to make sense of things.

I do have a few things to share with you. Note that I'm doing this only to raise your awareness about some of the underlying issues--issues that I really do not fully understand. Caveat...I may have this totally wrong.

I found Accredited Home Lender's (LEND) S-3 (Registration statement) for its very first issue of 2007 (2007-1). This is a whopping doc 390 pp.. I'm not able to devote the sort of time needed to review it.. But there are some gleanings that I wanted to share with you...... First, though, I want to make a couple of comments as to why any of this matters. Any there are smarter people reading this blog than the writer, so PLEASE FEEL FREE TO CORRECT MY ERRORS.

• We are hearing that subprime will not spill over. Well, I think it has spilled over in the worst sort of way because these loans have largely been part of a securitization machine led by government entities and the investment banks. So yes, this crap is in lots of porfolios--pension funds, insurance companies, fixed income portfolios.
• Due to the liberal lending policies, these loans can have LTV ratios as high as 100% (for the securitization that I'm commenting upon), but had appraisals been done, those ratios might change--for better or naught. So the quality of the underlying securities (and their commensurate ratings) might be materially different than expected. All manner of bad things can happen because of that as you will see if you read.

May I suggest that before you go further that you get something to drink, and if your eyes begin to glaze over, do some jumping jacks.

Let's look a moment at the structure of these collateralized instruments:


There are two things that are important.

1. Each tranche represents a different risk (quality) level--greater risk = greater interest
2. Each tranche represents a holder that gets lower in the food chain as you move down.

Per theLink: "Rating agencies rate the different ‘slices’ (from AAA to

unrated) in order to provide market participants and investors with an assessment of the risk associated with each. Performance is largely driven by the collateral manager’s ability to avoid defaults and maintain creditworthiness of the investments." [I do not understand yet how the rating process is effectuated, but I imagine that it is due to FICO, LTV, level of loan documentation and other factors that would provide one with greater comfort of ultimate payback--that's another day. ]

Here's another concept to be aware of and that is "credit support" or enhancement. You can read about it in greater detail here. IF you want your offering to be considered attractive, you need to offer some comfort--some cushion. There's a couple of ways to do that: (1) through structuring subordinated tranches (low on totem pole) as you see in the above diagram, and/or (2) through overcollateralization. Think about overcollateralizaton as a LTV ratio for the securitization (structured debt obligation).

The example above shows the tranches--think about it as a food chain or totem pole. It's not going to be a pretty place to be. An example, then, of support/enhance might be your issuing $100M of underlying assets (loans to borrowers) but only issuing $80M in securities. IN this example, the difference of $20M would be the equity portion retained. Now look at the diagram (above) again. The equity portion is unlikely to be the cream. So if you see issuers (such as Accredited) with these loans (equity) on their books, my understanding (I could be wrong) is that these would be drecht loans--and you would likely see higher default rates. Accordingly, loan loss reserves may need to be beefed up. Additionally, one could get an insurer (such as FGIC, Ambac, XL Capital, Radian et al) to take on risk in this area.

Let's follow the money. This is from LEND's S-3 registration Even if you click to make this larger, it will be a bit fuzzy, that is from the original. Do notice that everyone gets their fees first before anything gets disbursed to note holders.

I do not fully understand this diagram with respect to the Overcollateralization Deficit. But there appears to be cross collateralization between A-1 and A-2 notes, and if there is some deficiency, then the note insurer must be increased to maintain the appropriate reserve. I apologize for not having this more fully researched, but I wanted to post some general things first. If I waited until I fully understood all of the ins and outs (which I'm not equipped to do), then this post would never happen. Again, full disclosure of underlying ignorance.

Now what can go wrong? When you buy bonds supported by indebtedness (or if you make loans), you have two types of risk:

• market (interest rate) risk. Rising rates lowers the value of the instrument. This risk is mitigated through interest rate derivatives;
• credit risk: the risk that the borrower will be unable to pay. This is mitigated through the collateral support, enhancement (to include having an underwriter to insure the risk, remember MGIC and Fidelity Guaranty).
  

If the level of defaults are beyond the expected levels--and remember, there is not much "experience" yet regarding the level of default rates because there are not many resets--I see the following types of problems:

• Ratings of tranches may prove misleading--the underlying notes are assigned to each tranche--these are specific notes, not a fungible pool of securities. So what? If ratings have to be changed, and former investment grade securities are now looking like something different (think pig's ear v. silk purse), holders who are required by their charter, etc to hold investment grade, must do some dumping of these securities. That is called a sell-off. and those are not pretty.
  
• Holders in the lower tranches run significant risk of not getting paid their principle--they will start dumping those securities (and calling their lawyers).
  
• The equity portion of these tranches (and I'm sure some hedge funds may be involved in these as well as the issuers) will need to be written down to reflect the net realizable value--these impairments could affect required capitalization of issuers (this happened to LEND) and cause their being in default of credit agency requirements and/or contracts with their underwriters. (Again, this happened to LEND).
  
• The insured portion of these securities may cause greater payouts from the insurers, so their earnings and their capital ratios could be affected. Those insurer's are dependent on their agency ratings, too. So I see Fitch, Moody's and Standard& Poor as being quite busy in their assessment of these exposures and what it means to the people they rate.
  

To my simple mind, there will need to be a re-calibrate risk reward for holding these securities that will be reflected in the discounting of these securities in the market. Now, I'm sure credit default swaps are part of this scenario, and I imagine that these premiums will go up considerably. (I don't pretend to know a thing about these.) So bond holders who wish to protect their underlying assets are going to have to pay more IF they are even allowed to continue to hold these securities.

So...all of the above is how subprime potentially reaches into our financial system. Until these issues are addressed by trusted financial leadership, do not think for a minute that it is a "contained contagion". And I would urge you to look at any fixed income holdings you have to see if YOU have any portfolio exposure. I just do not understand why you have the financial leadership (economists, money managers) speaking about this issue. Maybe I have the whole thing wrong, and I would welcome that criticism.

SEC Regs on Asset-Backed Securities

I'm declaring that I've officially gone over the edge, for I have searched out, found, copied and am beginning to read the SEC regs on Asset Based Securitizations. I'm not really sure why I have latched onto to this subject, and it is probably best that I don't probe deeply there. Nevertheless, I have and I want to drag you through it a bit too! I'm beginning to see that these ABS's with all of their participants is a big ball of string. The regs are 320 pages long, and I've read up to page 50. It is slow going, particularly for someone like me who is pretty far away from any real knowledge of securitized transactions.

I'm not going to even try to post a summary of what I'm reading, but I do plan to post a few tidbits.

These SEC regs are designed to "consolidate and codify existing interpretative positions."

Here's a tidbit: One can issue asset based securities where the underlying pool has as many as 50% delinquencies. To qualify, though, for S-3 registrations, as many as 20% of the underlying assets can be delinquent.

WSJ's Market Close 03.23.07

Don Coxe

I urge you to listen to Don's broadcast. A very lucid outlook. My dad sent me this link. I didn't think that he was still available for free. I used to listen religiously.

Everything hinges on the consumer and the employment picture as well as real inflation.

Lender Disgust--A Rant

I left a form of this rant on Roger Nusbaum's blog may he forgive me.

In posting the loan types for FED, I became overwhelmed with disgust at the types of loans that were being offered to people. The categorization of this "issue" is misleading, and some of the castigations of the borrowers has been unwarranted (in my opinion). I'm going to have to provide some context first.

I'm a reasonably intelligent person. I was 5th in my class in my major (Accounting), and I've had a rich and diverse career which has required my understanding new and complex things. (I don't say any of this to be arrogant, but to provide context). So when I'm having difficulty understanding these loan terms (from a 10-K perspective, I'm sure it's harder in a loan doc), you know a teacher, fireman, geologist (pick your job/profession), is going to have some difficulty.

Part of my responsibilities in my past life (as regular readers now) was to negotiate contracts. So I'm accustomed to reading and arguing about contract language for all sorts of things--both when my organization was providing services and when I was purchasing services. I will tell you a line that I've heard on more than one occasion, from people who are selling to me and sometimes from their counsel when I have expressed concern over a particular clause: "Oh, that is what it says, but we would never do that, or that has never happened before." In negotiating a loan for financing that my company was particularly desperate for I was presented with loan documents that were frightening in many aspects. I expressed concern. "Nobody has ever expressed concern over this. We have NEVER changed our loan documents."

A contract is just that, a contract. My expectation is that if there is something written in it that gives someone the right to do something potentially injurious, that regardless of whether or not that company has ever exercised that right before the clause gives them permission to do it. And that has been my retort. And the documents were changed or--and this is the hard part--you walk away.

I walked away from a home equity closing because the bank had a clause in there for an automatic loan default if one or the other of us were to die. That' s a pretty onerous clause. You might have enough assets to pay the loan for quite a while, but no current income; accordingly, you might not qualify for a loan with the same interest terms. I insisted that it be changed. The loan officer tried everything she could, but their underwriting department would not budge. My husband and I walked out. My advice to each of you is that you always get documents in hand first, read them, consult with your attorney and then sign. That is NOT how it is done in most placed. Later, I got a loan from E-loan because the rate was more competitive than what I could get locally. (No Alt-A loans there....I had to give them tax returns, stubs, W-2's; they had an appraiser come out.) Excellent, professional service. I have not one complaint.

Now, I was under no duress to get the home equity loan. But if I were buying a home, or otherwise had a time frame or circumstances that would make walking out difficult, I may have passed on that concern. I'm going to cast what would be my concerns (and the soothing responses) under these modern day loans:

• Interest rate increase--Oh, don't worry about interest rates; they are the lowest in years and it is unlikely that they will increase.
  
• Payment fluctuation--We've crafted this loan so that your payments are low now, but will increase as your income increases (no discussion on negative amortization). You may be able to qualify for a different loan later because of your income increasing and your home increasing in value. Did you know that last year home values increased more than 20% in your area?
  
• Loan to value--Yes, it is a high loan to value, but you have mortgage insurance and that will take care of your payment in the even that you cannot. (Do you think that some folks might believe that mortgage insurance is like AFLAC--it pays the bills if they are unable to? I bet they do.) And remember what I said about your payments--your home's value is appreciating rapidly which is why we can offer this loan to you now.

I think that people have a tendency to trust American institutions and that there is an innate sense of fairness because these industry's are regulated--and those loan docs just do not make any sense to the average person trying to buy a house.

Market Close: 03.23.07

FED Loan preview

Here's another installment of 10-k peak into mortgage lenders.

This peek is for FED

Interest Rates, Terms and Fees. We originate residential adjustable mortgage loans ("AMLs") with 30 and 40 year terms and interest rates which adjust monthly based upon various indices.. . .

Loans with 40-year terms were 80%, 77%, and 27% of loan originations during 2006, 2005, and 2004, respectively. The increase in loans with 40-year terms is attributable to increased marketing efforts for this product as a response to the decreased "affordability" of houses in our market areas.

Payment Caps. There are varying periods for which our loan payments may be fixed, ranging from one year to five years. If the payment is fixed for one year, after the first year the payment may be increased by no more than 7.5% each year. If the payment is fixed for three years, after the third year the payments for the fourth and fifth years may be increased by no more than 7.5% for each year. If the payment is fixed for five years, after the fifth year, the payment will be adjusted to provide for full amortization, starting with the sixth year. An annual payment cap of 7.5% applies thereafter, subject to the lifetime balance cap described below. Most of our loans, including loans with fixed payment periods of less than or equal to five years, will have payments adjusted ("recast") every five years without regard to the 7.5% limitation to provide for full amortization over the balance of the loan term. The annual payment cap of 7.5% applies thereafter. The portfolio of single family loans with a one-year fixed payment was $4.6 billion at both December 31, 2006 and December 31, 2005 and was $2.9 billion at December 31, 2004. The portfolio of single family loans with three-to-five year fixed payments was $1.8 billion at December 31, 2006, compared to $2.7 billion at December 31, 2005, and $1.6 million at December 31, 2004.

(Click to make larger).

The following table shows the contractual maturities of our loan portfolio at December 31, 2006:

Here are my takeaways--

Interest rate variability: A monthly calculation and application has to be a nightmare.

Payment Caps: This is so special. The payment will cap at no more than 7.5% (so if you have a $1,000 payment it will now go up to $1075--whoop dee do), but the interest that accrues is variable every single month. Further, even though there are payment caps in place, for most loans in the 5th year the entire thing gets reset so that the payment is set so that it will re-amortize over the remaining life of the loan. If you have a 40 year mortgage, I guess that is 35 years, and you are likely to owe more than your home is worth. HOW CAN THE AVERAGE HOMEOWNER UNDERSTAND THIS CRAP?!

Conundrum

Herman Miller is getting hammered, but Steelcase is up today.