Monday, October 29, 2007

MetroPCS files $134 million suit against Merrill for CDO losses

Merrill Lynch & Co. is being sued by Metro PCS in Dallas County, Texas, over a $134 million investment made this spring in CDOs that Merrill underwrote between 2003 and 2006. This according to a WSJ artcile written last week in the wake of Merrill's giant write-down of $8.4 Billion of CDOs. Click here for the full artcile. The article profiles Christopher Ricciardi, a former Merrill hand who pioneered the firm’s entrance into the CDO market. It describes how Merrill's sales people "scoured the globe for buyers of CDOs" and
distributed some of its riskiest CDO slices through its global network of wealthy clients. One former Merrill executive recalled attending an event at New York's Harvard Club in 2004 at which salesmen described the merits of CDO investing to doctors, hedge fund managers and businessmen. The WSJ writes that "Mr. Ricardi coached salespeple he worked with to stress that mortgage CDOs offered better interest rates than corporate bonds with similar ratings."

MetroPCS is suing over particluar investments known as auction-rate securities. They were marketed as short-term investments that buyers could resell, if they wanted to, in auctions run by Merrill. But this summer, as nervous investors began to shun almost anything connected to subprime mortgages, MetroPCS found it couldn't sell the CDOs it had bought, and it now expects to incur losses.

For its part Merrill says it believes it acted appropriately with MetroPCS and made all of "the appropriate disclosures..."

Wednesday, October 24, 2007

Subprime Meltdown: The Reckoning

Here's the latest tally from the New York Times:
  1. Sales of existing homes are falling twice as fast as expected;
  2. Merrill Lynch is taking a $3 billion charge on the mortgage backed securities on its books over and above the $5 billion charge that it announed just two weeks ago;
  3. Total losses to investors and financial firms is now estimated at $400 billion;
  4. Total loss in real estate wealth expected to be between $2 and $4 trillion;
  5. The Joint Economic Committee of Congress predicts about two million foreclosures by the end of next year on homes purchased with subprime mortgages;
  6. Housing prices are predicted to decline between 10-20% over the next year and a half;
  7. A 5% drop in prices is expected to result in a $60 billion decline in consumer spending, because of reduced wealth;
  8. Over the next year and a half, interest rates are due to reset higher on two million homes;
  9. Inventories on unsold existing homes has reached the highest level in 20 years;
  10. From 2003 to March 2006, housing-related businesses added 1.3 million jobs, or about 23 percent of all new jobs created in that period. Since March 2006, the housing industry has lost 383,000 jobs and more layoffs are ahead; and
  11. Layoffs in the financial industry are expected to be just as bad.
On the positive side, you can buy one square inch of a Miami condo for only $35.50. So, if you're a mouse with a taste for South Beach, you're in luck.

Housing Bubble or Credit Bubble

The Big Picture notes that what we're seeing here is not the result of a bubble in housing prices, but of a bubble in credit:

We can define a bubble as a “trade in high volumes at prices that are considerably at variance from intrinsic values." By that definition, I'm not so sure Housing was a true bubble -- the run up in prices, a doubling over the course of about 7 years, was actually a rational market response to interest rates being dropped to generational (46 year) lows. Trading volumes moved up, but proportionately so. Compare that with the Nasdaq, which doubled from October 1999 to March 2000 on a dynamic of a new paradigm. Trading volumes skyrocketed. When it was over, the Nazz had plummeted 78%.

House prices normally fluctuate in response to interest rate changes due to how they are financed. An example I used a few years ago: The first house I owned had a $300,000 mortgage. Back when interest rates were over 9%, the monthly payment would equal $2,632.71 (30 year fixed 10% mortgage). When mortgage rates plummeted, a buyer could finance a $500,000 purchase with a 6% fixed mortgage for a monthly payment of $2,997.75.

That easy credit resulted in part because lenders no longer worried about whether the loans would be repayed. Instead, they repackaged and sold off their loans through mortgage backed securities:

This drop in lending standards and absurdly easy credit is where things truly went awry: Despite the incredibly accommodative interest rates, lenders simply stopped being concerned about the borrowers' ability to repay loans. My favorite example: California strawberry picker Alberto Ramirez, who despite earning just $14,000 a year, was able to obtain a mortgage to buy a home for $720,000.

The assumption appeared to be that lenders could simply sell the mortgages to Wall Street to be securitized, without worries about delinquencies, defaults and foreclosures.

At the end of the day, it's the investors who purchased CDOs consisting of mortgages owed by strawberry pickers who are going to feel the bubble pop.

Tuesday, October 23, 2007

If your money market fund didn't give you your money back

. . . because the fund manager invested in a bunch of SIVs that in turn invested in subprime debt through a series of opaque transactions that would be bad, right?

It's like subprime redux: Some money market fund investors are again wondering if their investments are at risk because another complex investment product has fallen out of favor and become difficult to unload.

* * * *

The uncertainty among money market fund investors centers on what would happen if the SIVs couldn't repay their debts because their assets lost value. Some money market fund investors are, in turn, worried about losing money.

But, don't worry, because that's almost totally not going to happen:

But that's unlikely, says Bruce Bent, who invented the money market fund in 1970. His firm, The Reserve, has about $83 billion in assets and doesn't hold investments in SIVs.

"In the history of the money funds, you've had a number of situations where the management companies have bailed out the funds," he said.

He thinks it's unlikely the companies running money market funds would allow them to "break the buck," as it's known in Wall Street parlance even if the funds lost money on SIV-related investments. The draw of money market funds, of course, is that an investor putting in $1 get $1 back plus interest. If a fund were to, say, give back only 90 cents for every dollar, investors would be outraged.

Still, it's important to remember that money market funds, though considered safe investments, aren't FDIC insured.

Gee, ya think? [h/t Atrios]

Proposed Legislation Povides No Relief For CDO Investors. “The Mortgage Reform and Anti-Predatory Lending Act of 2007” H.R. Bill 3915

Yesterday, House Democrats introduced legislation to combat abuses in the mortgage lending market, and to provide basic protections to mortgage consumers and investors. Click here for Press Release. The bill, H.R. 3915, the “The Mortgage Reform and Anti-Predatory Lending Act of 2007” reportedly aims to reform mortgage practices in three areas. First, the bill would establish a federal duty of care, prohibit steering, and call for licensing and registration of mortgage originators, including brokers and bank loan officers. Second, the legislation would set a minimum standard for all mortgages which states that borrowers must have a reasonable ability to repay. Third, the legislation attaches limited liability to secondary market securitizers who package and sell interest in home mortgage loans outside of these standards.

Section 204 of the Bill, “Securitizer Liability” is a lot less than advertised in press releases and news reports. Click here for HR 3915 Summary. The idea is to open another pocket to the injured borrower which could be important as mortgage brokers are increasingly insolvent and unavailable to provide a remedy. However, the securitzer can avoid liability by offering the borrower a loan that meets minimum standards or by maintaining various policies and procedures designed to avoid purchasing unqualified mortgages. It is not enough to deter conduct in a billion dollar business where carefully looking the other way means large profits.

More important, there is no protection for unsuspecting customers who purchase bonds or CDOs made up of loans that violate the proposed Bill’s lending rules. The subprime lending debacle was fueled with innocent investor money, as purchasers of mortgage-backed securities bought billions in bonds and CDO tranches they thought were designed to produce an uninspired but steady and safe return. HR 3915 does nothing to hold the securitizers liable to customers for the mortgage backed securities they sell. As long as that lucrative market is unchanged the lifeboat for mortgage borrowers is going to leak big time.


HR 3915 Summary.

House Finance Committee Press Release:

New Stories:

New York Times, October 23, 2007, p C1.