April 19, 2007
Dow Jones Average: 12,804
S & P 500 Index: 1,472
Sub-Prime Mortgage Debacle
The real estate boom of the past six years priced many prospective
homeowners out of the market. So lenders devised new mortgage
products that allowed people to buy homes that they could not afford
on an income basis. The mortgages were called sub-prime or
alternative-A mortgages. In some instances buyers were not required
to even list an income figure on the mortgage forms. The assumption
was that perpetually rising real estate prices would build equity for
all owners of real estate, including those who bought at inflated
prices and had incomes far too low to cover the monthly mortgage
payments. Lenders theorized that home equity lines could be used in
an emergency to make the monthly mortgage payment. Unfortunately
most buyers had no initial equity in the property and could only
build equity if real estate prices had continued to escalate. The
advent of sub-prime mortgages brought more people into the real
estate market which prolonged the real estate boom. In 2006 real
estate prices started to fall, and the house of cards that was sub-
prime lending quickly collapsed.
The availability of capital seeking a return better than the paltry
one percent bond rates of 2003-2004 gave rise to numerous alternative
investment products, such as sub-prime mortgages. The interest rates
on these mortgages were well above traditional mortgages, and in many
instances could be viewed as predatory lending. The lower income
borrowers who took on these mortgages frequently had to commit to
interest rates of eight to ten percent, with the possibility of rapid
escalation in the rate over time. Certain companies formed that
specialized in promoting the mortgages, and reselling the paper to
investors. The high rates that the borrowers were supposedly going
to pay implied a handsome return for investors and big fees for the
mortgage generating companies.
In retrospect the real estate boom looks like another bubble, built
on the same supply of aggressive capital that gave rise to the tech
bubble of 1999-2000. As is always the case with frothy markets, some
of the bundlers and investors in high risk mortgage paper made
fortunes and got out before the bubble burst. The NY Times had a
recent story on a 36 year old fellow who is worth 250 million, mostly
as a result of sharp dealings in the mortgage market. He was
pictured playing with his kids in the backyard of his Florida estate,
with his colossal 140 foot yacht in the background. For the millions
now going through foreclosure the picture is not so pretty.
Current Strategy
The stock market was roiled in the first quarter of 2007 as the
magnitude of the mortgage mess became apparent. One of the biggest
companies in the sub-prime mortgage business, New Century Financial,
declared bankruptcy during the quarter, only months after commanding
a share price of 65 dollars. Many other mortgage related companies
experienced declines of 50 percent or more in their share prices. A
one day plunge of ten percent in the Shanghai market was another
factor that shook investors’ confidence. Stock market investors, who
had become increasingly complacent after 2006, woke up and took note
of the risks that are always lurking in any fluid financial system.
It is surprising that worldwide equity markets stabilized quickly
after a drop of about six percent and are now moving higher. The
Shanghai market is once again hitting record highs on a daily basis,
and the U.S. markets are back in recovery mode. It seems that the
global economy is able to withstand numerous shocks. Some analysts
have suggested that the sheer size of the global capital markets
makes the world economy more resilient. A fiasco in the U.S.
mortgage market that involves millions of borrowers is less toxic to
the financial system when spread out among investors worldwide. It
is an interesting proposition, but one that could also lead to a
false sense of security as bad economic practices and policies fester.
We have never subscribed to new paradigms, assumptions, or leaps of
faith that might induce complacency. We continue to look for
companies that sell below fair value, because other investors have
turned away from the company for reasons that we find unsubstantial
or most likely temporary. While the kind of opportunities we are
looking for can be found in all market environments, more buys are
found in markets where fear replaces investor enthusiasm for
equities. We made two new buys in the first quarter of 2007, and
hope to make about ten in an average year.
On the fixed income side we have set up a balance of shorter term
treasury notes yielding about five percent, inflation protected
securities that yield somewhat more than five percent after adjusting
for inflation, and treasury bills that yield over five percent while
providing maximum flexibility. Two months ago, bond investors felt
that the Federal Reserve Board might lower interest rates due to the
problems in the real estate market. The Fed has not lowered rates,
because of concerns about current inflation rates and a steady drop
in the value of the U.S. Dollar, which could produce even more
inflation. In this environment we do think that longer term bonds
yielding less than five percent adequately reward investors. We have
decided to stay with the shorter term paper that provides greater
flexibility in strategy, and actually yields more than the long term
bonds.
