Blown Mortgage

If you're new here, you may want to subscribe to my RSS feed. Thanks for visiting!

Understanding Wall Street (Mortgage) Losses

We’ve all been reading about the massive losses at most all the major Wall Street investment banks and commercial banks, but let’s understand how most of these losses are generated.

Merrill Lynch has written off around $22.4 billion in mortgage related losses (so far). Anyone who has dealt with Merrill Lynch’s mortgage division, Merrill Lynch Credit Corporation (“MLCC”) understands that MLCC was one of the most conservative mortgage lenders on Main Street. MLCC was a joint venture between Merrill Lynch and PHH Mortgage, another lender I’ve always respected. The only loans they originated were full doc, high FICO, low LTV, high asset borrowers.

The Merrill mortgage bankers were the something that we could all strive for in our professional lives. I had lunch with Larry Washington, the President of MLCC who told me that one of the reasons MLCC was so conservative was that “you’ll never get hurt originating a quality loan.”

Do you think that the vast majority of investors, mortgage lenders and originators feel that way now?

So how did Merrill Lynch lose $22.4 billion?

If you’ve ever had the privilege of dealing with a Wall Street investment banker you’d remember as you’ve been in the grace of a god-like human. Armed with MBAs from the elite B-Schools, investment bankers and hedge fund managers had egos larger than their wallets.

The former “Masters of the Universe” are no longer masters of their own domain (Seinfeld joke). Investment bankers were not concerned with risk (or potential losses), but rather profit, on which they earned their annual bonuses.

There’s a word on Wall Street called “leverage” that works beautifully when your investment goes up in value. However it becomes a nightmare when the investment turns south.

In simple words “leverage” means borrowing, much like “margin” with stocks, to purchase part of your investment. This is similar to a real estate mortgage, except with leverage the lender must always maintain their initial lending percentage of the current market value.

Say I’m a Wall Street firm and I want to purchase $100 million of mortgage securities such as CDOs (Collateralized Debt Obligations) then yielding 8%. My $100 million of capital earns $8 million for an 8% rate of return.

However if I use leverage I can purchase a whole lot more securities with my same capital. Back then I cold have borrowed collateralized capital at 3% and invested in the same subprime CDOs earning 8%.

So instead I purchase $200 million of mortgage securities CDOs and have the bank lend me $100 million. If my borrowing cost is 3% and I’m making 8% of my investment I’ve just made an easy 5% of free money.

That’s $5 million net profit from the $100 million I’ve borrowed from the bank plus my $8 million from my own $100 million of capital. So I just made a 13% net return on my $100 million capital. That’s a whole lot better than U.S. Treasuries paying only 2-3% at that time. Follow me so far?

I got some choices here — I can pay $100 million cash for my CDO investment OR I can have 50% leverage (AKA: 2x leverage) with my 50% cash equity position and 50% borrowed collateralized capital.

Isn’t this country great!

But why stop there? Why not only put up 10% of my own capital and borrow the 90% from the capital markets? Now my $100 million capital would control $1 billion of CDOs and earn a net profit of $53 million for a – get this – 53% rate of return on bonds.

We should all be hedge fund managers making a $1 billion a year.

Alas leverage is a double-edged sword. That bank I’m borrowing the 50% loan from will always demand that their debt position is never greater than 50% of the current market value of the securities that I’ve purchased.

But what happens if the value of my $200 million mortgage securities portfolio declines, much like what has happened recently in the mortgage securities market?

Let’s say that the value of my $200 million mortgage securities portfolio declines by 10% to $180 million. Now the bank who lent me the initial $100 million loan demands that they are kept in a 50% equity position. 50% of $180 million bond valuation is $90 million. So now I have to come up with $10 million in cash to pay to down the bank margin at the same time my investments declined by 10% (or $20 million).

Ouch!

That’s with only 2x leverage. Many of the Wall Street firms and hedge funds had 5x, 10x, even 13x leverage on their mortgage security portfolios.

That means I only put up $100 million of my own cash to purchase $1 billion of mortgage securities. The other $900 million came from the bank(s) lending me 9x leverage.

Let’s look at the same scenario – my $1 billion mortgage securities portfolio declines by 10% to $900 million. The bank will initiate a margin call to maintain their 90% loan of the current market value. That means the bank will reduce their loan exposure to $810 million (90% of the $900 million current market value).

Now I have to come up with $90 million in additional cash (or liquid marketable securities) to the bank while at the same time my portfolio declined by $100 million in market value.

Even though the mortgage securities portfolio declined by only 10% ($1 billion to $900 million) thanks to leverage, my initial investment has lost 90% ($90 million bank margin call).

To put things in perspective the ABX subprime indexes have declined from a price of 100 to around 65 since July 2007. God forbid any of those investment bankers and hedge fund managers (those same ones so much smarter than you and I) had any leverage to their mortgage portfolios.

This has been rather common around The Street over the past nine months as investment bankers and hedge fund managers have been trying to unwind, or in some cases – “don’t sell, don’t tell” — as many of the CDOs do not have an active market on which to set a daily price.

In other words, if no one sells, then no one has to mark down the value of their mortgage security portfolio. The problem comes when any investor sells a block of CDOs, then the entire market is supposed to “mark” their CDO portfolios to the new market price.

This is how Bear Stearns lost 100% of the value of two of their hedge funds last year.

Nobody is buying or selling any sort of esoteric loans on Wall Street right now. Another reason why the mortgage market has frozen up for jumbo, Alt-A and subprime loans.

Ask Countrywide, IndyMac, First Fed, Downey, etc. etc.

The good news is we’re back to a conforming and FHA/VA mortgage market. Personally I can’t fathom having 1 out of 10 of my clients going into default. Heck, in any one year if I have 1 out of 100 clients going into default then I feel I didn’t do my job in consulting and advising them of their payments, closing costs, options and the risks involved.

Some more good news. The wife and I had some great filet mignons and shared a bottle of 1999 Clos Du Bois Briarcrest Cabernet Sauvignon at dinner tonight.

Share This