• Home
  • About
  • Team
  • Contacts
  • Blog

High-Risk Mortgages

  1. Home
  2. Blog
  3. High-Risk Mortgages

Portfolio manager’s Letter September 2005

Mortgage Securitization = High-Risk Mortgages

High-Risk Mortgages

It has been said that the main force pushing the speculation in housing today is the lax lending standards. One reason for these loose standards has to do with high-risk mortgages securitization. Several private companies (not just Fanny or Freddy) have now entered the mortgage securitization business. The loan officer can directly sell any kind of mortgage that he can dream up. Which generates a lot of high-risk mortgages.

The securitization of these loans means the people writing the mortgage bear none of the risk generated by the loan. He gets to keep his fees and transfers most of the risk to the investors buying the derivative instruments. Whether the buyers of these securities (hedge funds, foreign investors, etc.) understand these high-risk mortgages they buy is an open question.

It is an example of what Charlie Munger calls the lollapalooza effect (the over-influence of social proof). If everyone says that real estate prices never go down, “They may flatten out, but they never go down”. Then if this opinion is repeated often enough by a large enough number of different investors and the media, then eventually most people accept it as the truth, and investors buy mortgage-backed securities with the belief that they carry little risk.

High-Risk Mortgages – Option ARMs

An option ARM high-risk mortgages are adjustable-rate mortgages that allow the homeowner to pick his monthly payment. If nothing else, this delightful concept proves that equity investors are not the only class of investors with their eyes firmly affixed to the rearview mirror. With mortgage foreclosures at historic lows and home values increasing rapidly, bond investors have no problem projecting present trends endlessly into the future.

The altogether illogical result of all this is that the further we get into bubble pricing, the faster the lending institutions credit requirements decrease. The option ARM high-risk mortgages allow the borrowers to make minimum payments that may result in negative amortization (the balance owed on loan keeps getting bigger). Interestingly, not all option ARMs are securitized.

Last week, the Wall Street Journal reported that one lender from Newport Beach, California (Downey Financial), had a blowout second quarter, beating estimates of $1.54 per share earnings by reporting actual results of $2.29. Never mind, the 20% of this $2.29 was negative amortization — interest that was due on the high-risk mortgages outstanding that borrowers had decided they would rather pay later.

Downey also reported that as of June 30, 87% of the ARMs hold in their portfolio were option ARMs (high-risk mortgages that are a time bomb waiting to explode). So the easy money is again coming from lending institutions obsessed with reporting ever-increasing quarterly earnings. This creative finance instrument’s happy result is the bank gets to report earnings even though they have not received the cash.

The stockholders are happy because the stock price is going up, the borrower is happy because he is making low payments. So what if his loan balance is going the wrong way? He will make up the difference when he flips the house for a profit. After all, everyone knows that house prices always go up.

Speculators and Rents

With more and more people buying homes and condominiums as an investment, renting the property, and then flipping it later for a profit, the supply of rental properties increases while low-interest rates have allowed more people to buy their own home; in the Phoenix area, the collection of rental homes in the number of the outlying areas has doubled since last year. Rents have fallen by 5% to 10%, because of high-risk mortgages with very easy terms and low interest rates.

In a story in the WSJ on August 10, it was reported that there is a surplus of investor properties in some areas such as Las Vegas, South Florida, and Kansas City. The vacancy rate for one unit rentals in the second quarter was 9.7%, up from 8.7% in the same period last year. The Journal story sites an example of All Florida Realty in Palm Coast Florida which has had to lower rents on its three bedroom units from $1100 per month to $850. It also quotes a Las Vegas landlord who bought three condo units for $190,000 in one project:

“It took two months to find a tenant,” says Mr. Hadzicki, who cut his asking rent twice, to $795 a month from $875.

“It was a little difficult because there was a lot of property that came on at the same time”, he says. Mr. Hadzicki figures he’s losing about $135 a month on each property, but will more than make up for the losses when it’s time to sell.”

After all as everyone knows in real estate prices always go up. The article does not say if Mr. Hadzicki has an option ARM high-risk mortgages, but since real estate never goes down, why not?

High-Risk Mortgages – No Documentation

Last week while walking the neighborhood, I met to a neighbor who is a mortgage broker. It was an interesting conversation. He said that he had just changed jobs and is now working for a loan company that is a wholly-owned subsidiary of a large national home builder. He liked this company because they are very aggressive. (they made it easy to get loans approved.) His compensation at this company is based solely on his production.

If I were looking for a mortgage company to short, I guess one of my top criteria would be that they pay their people based on volume of production.

He has worked for several other lenders in the last few years and left because they paid a salary. He explained that that was no good because he could only earn $50,000 to $70,000 per year. He had, for instance, worked for Wells Fargo but left there because the office was dead. I asked if it was because the company was too conservative, and he agreed. They were not interested in high-risk mortgages.

He is a happy camper with his present company because if a customer comes in with a FICO score of 700 or better, he can get a no documentation high-risk mortgages for 100% of the appraisal. (He said that he knew some excellent appraisers.) I asked what was a stupid question. “What kind of debt-to-income ratio did the borrower have to show to get approved?” He gave me a look clearly reserved for the hopelessly naive and pointed out that no application was ever submitted that did not show enough income since there was no documentation required. For this high-risk mortgages.

As Charlie says, “All human systems are gamed”. Now as far as human misjudgment is concerned, in addition to the lollapalooza effect mentioned earlier, we have a big nasty lump of incentive-caused bias added.

But in real estate prices never go down, right? Except of course for Japan where real estate prices have been going down for 14 years, and I am not going to mention an anecdote I heard when I first moved to Florida some 35 years ago. It was from an old cracker who bought a house for $40,000 when he moved to Miami on 1926. Ten years later 1936 he had had enough of Florida, so he put the house on the market. It took a year to sell and he eventually took the only offer he had received — it was for $4,000.

The Trading Range from Hell

The market has basically done nothing since December of 2003, with the S&P 500 trading in a range between 1060 and 1130. This 70-point range represents a total difference of about 6% between the highs and the lows. Losch Management Company’s results have pretty well tracked the market as a whole, underperforming a bit when Berkshire Hathaway is weak and over performing in those periods when Berkshire Hathaway is rallying.

While it is frustrating to watch stocks going nowhere, it is one way of correcting the overvaluation that plagues the equity markets. If corporate earnings are going up and the stocks are moving sideways the value of stocks relative their price is increasing. This is all to the good, but it is a slow process that will take several more years to get equities to reasonable valuation at the rate we are going now. A much better alternative would be a good bear market that would present the opportunity to invest cash at attractive prices.

But trading ranges do not last forever. Sooner or later, something happens that drives the market in one direction or the other. One event that would likely trigger a market correction and bust the market out of its trading range would be the housing bubble pop and a collapse of high-risk mortgages. It is hard to predict when that event will occur but, the longer that current trends continue, the bigger the bubble will get, and the bigger the bubble gets, the bigger the mess it will make when it pops.

During the week of September 5 to September 9, Bill Gates purchased 260 shares of Berkshire Hathaway Class A stock. This brings his total holdings to 3,540 shares, with a total value of $296 Million.

09/01/2005



Leave a Reply Cancel Reply

Your email address will not be published.


Comment


Name

Email

Url


Blog Archive

2020

  • The Stock Market

2019

  • Behavioral Investing

2018

  • Trumped
  • Warren Buffett vs Wall Street
  • Globalism, 1982-2000 Bull Market

2017

  • Volatility Underlying Calm Market
  • What’s new with CB&I?
  • Passive Investing
  • Economic Cycles
  • Current Stock Market 2017 Comment

2016

  • Global Plastics Summit Highlights
  • Value Investing vs Index Investing
  • How to Play an Index Bubble
  • Successful Investors
  • Is the Market Overvalued?
  • Operating Earnings
  • Article by investment manager in Bay Hill Living
  • Building Foundation

2015

  • 3G Culture – Dream Big
  • Myopic Loss Aversion
  • CBI Nuclear Energy
  • St Joe Company
  • What’s in a Word? Plastics.
  • Are Bonds Safer Than Stocks?

2014

  • Chicago Bridge and Iron
  • CAMEX 2014
  • Global Economy October 2014
  • Fluor Corporation
  • Interesting Quotes from Daily Journal Annual Meeting
  • The Daily Journal Annual Meeting
  • Albemarle Corporation
  • Triumph Group
  • The American Energy Revolution
  • Singapore

2013

  • St Joe Company Update
  • Hedge Fund Managers
  • Triumph Group Inc.
  • Bitter Brew
  • An Antifragile Portfolio

2012

  • Leucadia National Corporation
  • This Time it is Different
  • Successful traders psychology
  • St Joe Company
  • Learning from Pain

2011

  • Long Cycles – Part II
  • Long Cycle
  • Nasty Month for Market
  • Make a Buck with Fortescue Metals Group
  • Berkshire Hathaway Look Through Earnings
  • St Joe Company Inc
  • Successful Investment Management
  • A Look Into Latin American Market
  • The Mother of all Quarters
  • 2010 Investment year results

2010

  • Fault Lines
  • US Market 2010
  • Berkshire Hathaway Third Quarter 2010
  • The Stock Market 2010
  • Berkshire Hathaway Second Quarter 2010
  • Berkshire Hathaway Performance
  • Long Term Greedy
  • Goldman Sachs
  • Berkadia and Leucadia
  • USG corporation
  • Berkshire Hathaway 2009 2010
  • Why Capitalism Works

2009

  • The Lords of Finance
  • The $44 Billion Dollar Train Set
  • Berkshire Hathaway 3rd Quarter 2009
  • Career Risk for Investment Manager
  • Berkshire Hathaway financial statements
  • Berkshire Hathaway Preferred Stock
  • Moral Hazard
  • Credit Default Swap
  • The Shadow Banking System
  • Learning Things the Hard Way
  • Our C-System
  • 2008 Investment results

2008

  • Investment Risk
  • Bear Markets
  • Generational Events
  • Orange sheets – Money is doing better
  • Inflation Not The Problem
  • Tipping Point
  • Long Term Capital Management
  • Financial Insurance
  • Western Refining Inc
  • Berkshire Hathaway Year To Date
  • Berkshire Hathaway Cash Flow
  • 2007 investment results

2007

  • Investment results 4th Quarter 2007
  • Greenspan on Inflation
  • Berkshire Hathaway Third Quarter 2007
  • Berkshire Hathaway Operating income 2007
  • Berkshire Hathaway Hedge Fund
  • Leveraged Buyouts
  • Stability Unstable
  • Weak Dollar
  • Berkshire Hathaway Chairman’s Letter
  • Steel Dynamics
  • Breakwater Resources
  • 2006 Investment year results

2006

  • New Investment Stocks
  • Equitas
  • Berkshire Hathaway Third Quarter 2006
  • Hurricane Synergy
  • Berkshire Hathaway Second Quarter 2006
  • Fat Pitch
  • Perfectly Obvious
  • Berkshire Hathaway Growth Rate
  • Berkshire Hathaway First Quarter 2006
  • Berkshire Hathaway Annual Report 2006
  • Inflation Is
  • 2005 Investment year results

2005

  • Exogenous Events
  • The Easy Money
  • Look-Through Earnings
  • High-Risk Mortgages
  • Unintended Consequences
  • Rydex Ursa Fund
  • Warren Buffett Premium
  • Private Equity
  • Latticework Mental Models
  • Buffett’s Lackluster Performance
  • 2004 Investment year results
  • Professor Smith’s Second Bubble

2004

  • Hedging Currency Disaster
  • Risk Assessment
  • Too Many Bears
  • The Chinese Century?
  • Patterned Irrationality
  • Timber
  • Costco’s Cash
  • Physics Envy by Charlie Munger
  • Asset Allocation Berkshire Hathaway
  • The Balance of Payments
  • 2003 Investment year results

2003

  • Hedge Funds
  • The trade deficit is not debt
  • Secular Bear Market
  • Which Index Funds?
  • A Different Drummer
  • Costco’s Float
  • The Power of Float
  • Berkshire Hathaway Annual Meeting 2003
  • Psychology of Human Misjudgment
  • Sitting on the Sidelines
  • Berkshire Hathaway intrinsic value
  • 2002 Investment year results

2002

  • Insurance company Moats
  • Bond Bubble
  • Berkshire Hathaway Cash Flow 2002
  • Behavioral Economics
  • The Bear Market 2002
  • Greenspan Put
  • Second Quarter Cash Flow at Berkshire Hathaway
  • Berkshire Hathaway Annual Meeting 2002
  • Red Wire – Green Wire
  • Stupid FED Tricks
  • The Bottom Line
  • 2001 Investment year results

2001

  • Don’t Fight the FED
  • Buy and Hold? – It all Depends
  • Ben Laden and Berkshire Hathaway
  • The Dinosaurs Dance
  • Costco Moat
  • Bubble Watching
  • Sit on your Ass investing
  • Berkshire Hathaway Annual Meeting 2001
  • Carnival Cruise Lines
  • 450000 Square Ft Furniture Store
  • Lunch Money Indicators – Annual report
  • Other People’s Money

2000

  • Bear Tracks
  • Build It and Money Will Come
  • Efficient Stock Market
  • Style Drift
  • Lunch Money Indicators – Options
  • Identifying Problems
  • Small Retail Stocks
  • Charlie Munger comments
  • Big Al and the Bubble Machine
  • Berkshire Hathaway Cheap
  • Index Funds
  • 16 rules for investment success
Make an appointment or contact us by phone: +1 (689) 246 49 49
© 1999 - 2022 Losch Management Company
Support by Global AGM