As the mortgage/credit crisis unfolds daily – many people have asked me are you freaking-out yet? My answer goes something like this: I’m way past freaking-out, now I’m just intrigued…reading the WSJ and watching CNBC  on mute in my office is like watching episodes of LOST!

Since I bored some of you with the history last post, I’ll try to catch us up to current with good old fashioned bullets (hopefully you won’t fire too many back… but I find this community not only to be intelligent in their shooting… but very generous in the use of sarcasm… my FAVORITE form of humor).

So here’s how the whole mess started:
• Foreclosures increased in the Subprime world
• Rating agencies begin lower ratings on Subprime portfolios
• Wall Street buyers of portfolios of loans, ironically called mortgage backed SECURITIES, stop buying this grade of paper
• Subprime lenders begin to tighten underwriting guidelines

At this point (advanced readers, please be patient), I want to clarify there are 2 major types of mortgage banks; those whose liquidity is primarily traced to checking/savings deposits (Wells, B of A, CITI, WAMU, etc.) and those whose liquidity is traced to HUGE warehouse lines of credit based on multipliers on their cash positions. (C-Wide – although they do own depository bank, ALS – backed by Lehman Bros., the artist formally known as Greenpoint Mortgage, etc.)

So as the above began to unfold, the Subprime mortgage banks that operate off these huge warehouse lines usually have to move loans off their lines within 60-90 days of funding. If not, they are hit with large fees and penalties. In addition, they lose the multiplying lending capacity of that portion of their line. (i.e. – if they can’t sell $50M worth of loans and they have a 10x’s multiplier… they lose the ability to lend out $500M!)

• New Century was the first house to fall – they were having the above liquidity issues compounded by the fact that they were now sitting on loan portfolios they would have to service, which is not a core business function for them. The rating firms buried them by declaring the paper basically worthless. Their warehouse lenders gave them a margin call, requiring them to write a huge check that they didn’t have. The rest is history – their stock goes down about 66% in one trading day – and they are done a week later.
• Most call this a contained fire – New Century was only the 2nd largest lender in the sector that only represented approx 15% of the market.
• Moody’s then comes out and rates HELOC’s the same as credit card debt and the lower end of ALT-A Mortgages the same as Subprime paper.

The flames jump the fire line and what happens next is historically epic:

• ALL THE BUYERS OF ANY MORTGAGE-BACKED SECURITY (non-Fannie/Freddie loans) WENT HOME!! – THERE IS INSTANTLY NO MARKET FOR MBS’S…THE GAME BEGINS – HIDE AND GO SEEK

THE LOST EPISODES UNFOLD

Walt gets taken by THE OTHERS, Jack throws the football around the yard with the enemy, Charlie (or CountryWide) avoids death because Edmond is having premonitions!

• American Home Mortgage pulls a New Century…their stock price goes down 33% in one Tuesday, their employees have pink slips by Friday and they are chapter 11 by Monday.
• A few Thursday’s ago, CountryWide (the big gorilla of the industry) slides in a statement (after trading hours… of course) that uses terms like liquidity issues and unprecedented disruption (in lending operations)… THIS IS THE BIG ONE!… Jesus is coming back, N. Korea is dropping a nuke and CountryWide is going down!
• In the next few trading days – the FED infused $40 BILLION into the system, C-Wide cuts a deal with a whole slew of banks to borrow $11 BILLION and finally B of A invests $2 BILLION into C-Wide – disaster averted! (at least till 12/08)
• Capital One decides we don’t need this and lops off its acquired mortgage arm Greenpoint in a day and 1,900 workers have too much free time on their hands. (The question is will Lehman Bros. do the same with Aurora Loan Services?)

My personal theory is that C-Wide has the fed in their pockets because if they went down… they would take a few sectors with them and could throw the country into recession/depression. They will exist in the future… but in a different fragmented form.

So, NOW WHAT? Well, for about the last month, every one is counting… one Mississippi, two Mississippi and Uncle Ben hasn’t yelled Ollie Ollie Oxen Free!

Uncle Ben is moving very methodically: infuse liquidity, then open the discount window (running a .500% blue light special) – which did a lot for the psychological landscape. But now, everyone… especially JIM CRAMER is screaming for a 3 x .250% rate cut in the overnight rate starting in mid-September.

In the mean time – Jumbo rates jump from the 6.75% ish to the high 7’s/low 8’s. Interest-Only and state income loans come at high premiums, option arms have outrageous margins/costs and all the big banks will have to decide which niche they want to fill. (The days of a single bank doing all types of loans are OVER.) What’s left is Fannie Mae/Freddie Mac and whoever has the staying power to hold and service the rest.

Now the good news is this: if you can prove your income, have a conforming loan ($417,000 or less) and have a loan-to-value of 90% or less…the rates are still really good! Also, 100% financing still actually exists. I’ve actually seen signs of the Wall Street buyers peeking out from behind the bushes with Jumbo loans… still, as of today Alt-A loans are very limited in their LTV’s (most at 75%).

This not the end of the lending/real estate world… but the REM song just keeps playing in my head: It’s the end of the world as we know it… Lending will go back to how it was seven or so years ago but until them the pendulum will swing and the only borrowers that will get good loans (for a while) are the ones who don’t really NEED it. The interesting short term dynamics is that more short-term fixed ARMS adjust will adjust between 11/2007 and 3/2008 than did in all of 2007 combined. But even if Uncle Ben lowers the overnight rate by 1% over the next year… if you don’t have equity, a 4.75% 30 year fixed will mean nothing to you.

I’ll end this post with my conspiracy theory and let you guys run with it:

Is it possible that the same hedge funds that bought all this Subprime paper (and sold a ton of it oversees hidden in large collateralized vehicles) will be the ones to fund private equity companies that will go in and buy all this non-performing portfolios from their current illiquid owners at pennies on the dollar?? Then… rewrite these loans back to the current homeowners at a rate they can actually afford. (Remember the price they stole them at). Let these loans perform for 6 months – maybe the FED even tattoos these loans to make them more sale-able. Finally the hedge funds can them sell all these loans back to the secondary market (once they return) at still discounted rates! A bit Pollyanna?… maybe, but at least this way someone other that the consumer foots the bill to create liquidity the system so desperately needs. The homeowner actually gets to retain the asset – (vs. ripping out every upgrade along with the light bulbs before he/she is foreclosed on). The only kicker is this: the hedge funds make billions and the theme of the rich get richer is played out once again. The cool by-product of this theory is that the FED can create liquidity (part of their function) without spending ONE DIME!

Otherwise, episodes of LOST will transition to the season premier of SURVIVOR.

Until next time,

- Jeff