We Have Gone Full Retard

There’s not much else I can say.  We have gone full retard:

Why?  Well, let’s start with this:

Are the credit markets flipping the switch again on risky deals?

Consider gun maker Freedom Group’s $225 million bond with a “payment-in-kind toggle,” more commonly known as a PIK toggle. The deal closed Tuesday and is the first of its kind this year, according the Standard & Poor’s Leveraged Commentary & Data.

via The Return – WSJ.com.

And this:

Credit markets have staged a comeback. Now, too, it seems some of the exotic securities that were hallmarks of the credit bubble are having a small renaissance of their own.

The rally in the corporate-bond market and a steady supply of easy money courtesy of the Federal Reserve are encouraging investors to take more risks. And Wall Street bankers and companies are taking advantage where they can.

via Bond Buyers Start to Accept More Risk – WSJ.com.

Yes folks, PIKs are back.  You know, those bonds that allow the issuer to make interest payments with, well, more bonds?  I heard someone call them “the corporate sector’s Option ARMs” and that’s about right in my mind.

But then I saw this:

A prime jumbo residential mortgage-backed security (RMBS) deal being structured in the private-label market appears ready to thaw the long freeze of credit in securitization, according to sources.

The deal, Sequoia Mortgage Trust 2010-H1, will consists of 255 first lien mortgages secured by single-family residential properties –110 in California alone — according to a preliminary term sheet filed today with the Securities and Exchange Commission (SEC).

The loans bear approximately $222.38m of principal balance, with an average $932,700 principal balance per loan. The loans bear a weighted average seasoning of eight months, and a weighted average original loan-to-value ratio of 56.57%. The weighted average original credit score for the borrowers is 768.

110 jumbos in California?  Guess it’s not that difficult to do, but wait, this gets better:

There is no loan level data available in the filing, though the deal is set to be publicly-placed and closed by April 28, and more information may be available then, sources tell HousingWire.

Are you effing kidding me??  One of the biggest problems rating these things had in the first place was incomplete data.  They say there’s no loan-level data so how am I supposed to know where these properties are?  I don’t have zipcodes to reference.  I don’t have data on the property itself (square footage, number of rooms, etc.) so I have no idea how marketable it is in this economy.  More specifically, in California in this economy. If I can’t make any determinations of these factors, I don’t know if that LTV ratio is worth a damn.  So if you’re pitching me this thing, you’re expecting me to fly blind and buy into this thing.

So here we are, after God only knows how many of these securities and their SPEs blew up (I’m complaining about the blow-ups.  We need them from time to time to enforce discipline that rules & regulations either do not address or can be easily skirted.), making the same stupid mistakes that we just made five years ago when underwriting was complete garbage.

But don’t take my word for it.  Fitch said this about CMBS vintages.  While it’s commentary about a commercial mortgages, instead of residential, it still applies (emphasis mine):

The loans in the 2006, 2007 and 2008 vintages were subject to aggressive underwriting and, thus, higher leverage, which is resulting in higher default rates relative to other vintages. In fact, Fitch predicts that the 10-year cumulative default rate for the 2007 vintage could reach 27%, significantly above any pre-2004 vintages when underwriting standards were more sound.

via Fitch: U.S. CMBS 2009 Default Study: Cumulative Defaults Doubled in 2009

So there you go.  We’ve forgotten how to properly underwrite and structure a loan – much less a portfolio of loans.  I take that back, some people obviously never learned how to structure and price a deal reasonably in the first place.

The point I’m trying to make is this: typically, in a normal credit cycle, there is a period of time where loan standards are tightened quite dramatically after witnessing a deterioration in credit, followed by losses/charge-offs.  It’s often said you make your best loans in the worst of times and your worst loans in the best of times.

Why?  Call it a race to the bottom, if you will.  Tightness in loan structures eventually give way to a relaxation of standards as economic growth occurs.  By the time you reach peak economic conditions, the loans you make are probably not your best deals.  These tend to blow up rather early on in a downturn.  We went from virtually no deals being done over the past 2 years to doing deals like it’s late ’06-’07 again.  We didn’t start with ’03 – ’04 lending standards.  We started at the bottom.  There’s no bottom to race to.

To me, this is an abysmal failure of Fed monetary policy.  Keeping rates low has conditioned investors to go further and further out in terms of risk, but the returns they’ll get are getting squeezed.

But in the meantime, be careful out there…

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3 Comments

Filed under finance, macro, Markets, risk management, Way Forward, You're kidding

3 responses to “We Have Gone Full Retard

  1. Dave121670

    I believe you are exagerrating a bit. Home lending standards are nowhere near as loose as they were a few years back. No doc loans are gone, 125% LTV is gone for example. You can either do FHA or have 20% down. Period. Don’t get me wrong, I agree with your general points on the matter, but 2006/2007 style loans are NOT being done. That is a fact.

    • Agreed, but that wasn’t my point. My point was this: the securities that were created from mortgages never had sufficient detail (borrower, loan level) to make an effective decision on whether or not the deals were any good. For instance: those CA jumbos could’ve been underwritten on homes in the Inland Empire or someplace like Malibu. That affects whether or not I might want to buy into the deal. But, like ’06/’07, I don’t know that information. The market hasn’t learned a damn thing. That’s what bothers me. It was one of the biggest errors made in the credit/securitization boom over the last decade, and all it did was involve millions of borrowers & trillions of dollars in mortgage debt.

      Oh and LTVs > 100% are being accepted… by the FHA…

  2. Pingback: Want to Be Bullish? Try Credit Spreads « Deep Thoughts by Professor Pinch

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