Behind the Curtain of the Credit Crunch

So, the bulls were cautious as they bid the Dow up 101 points today, the second straight day that investors sought to regain some of the multi-hundred point drop earlier this week. It’s been an up and down ride lately. Uncertainty rules.

Yahoo Finance today exclaims:

Bulls Tread Cautiously on Earnings Data: “Stocks advanced Thursday after Wall Street received some solid readings on corporate earnings and the job market, but remained nervous that a tighter credit market could impede U.S. growth.”

Yes, after the free-for-all of several years of making home loans to whomever could fog a mirror, the pendulum is swinging back, and investors just don’t know how far it will adjust and who will be knocked down.

Delinquencies are up. Countrywide, one of the biggest subprime lenders has a delinquency rate of about 24%, which is actually better than some. In the past, most delinquencies would “cure” (property sale or refinancing), but today’s spike in foreclosures suggests the obvious – borrowers are having a problem selling or refinancing.

That makes sense. After all, many of the subprime borrowers never had any equity to begin with in their home and could only afford the first few years of their mortgage payments – before they “adjusted” upward. Now, facing unaffordable mortgages on homes that, in areas of devaluation, are no longer worth the outstanding balance of the mortgages, borrowers are placing the keys on the door mats and heading for greener pastures.

The impact to financial institutions and the stock market can happen well before foreclosures spike. Consider all the slicing and dicing that our brilliant financial engineers do to eek out another product to sell. Many billions of dollars of Credit Enhanced Securities (“CES”) and Collateralized Debt Obligations (“CDO”) have been produced and sold world-wide. Often, institutions that have purchased and now hold these securities can demand more collateral from the originator which doesn’t exist, particularly if the collateral pool is subject to a write-down. This is what just happened to American Home Mortgage, now heading for bankruptcy.

But for those originators who hold the loans in a portfolio rather than warehousing them and then selling them as whole loans (subject to performance covenants that if not met can trigger repurchases – the originator get back non-performing loans), or for those S&Ls that are dependent on deposits to fund loans rather than institutions, things aren’t so bad, or perhaps not bad at all.

Capital Alliance (my company) is an example of the originator who underwrites the loans and keeps them in a portfolio – they are not sold. In this case, no outside entity can create instability, because there is no investor with rights to demand more collateral or a repurchase. In effect, the herd instinct can not impact the portfolio that Capital Alliance manages. Thus, the potential problems that could beset such a portfolio of mortgages (trust deeds) stem from the actual quality of portfolio, not its perceived quality. If loans were consistently made to borrowers with the verifiable ability to pay debt service in conjunction with enough equity in the collateral to keep the keys in their pockets, exogenous market conditions would have less impact.

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