Sub-Prime Mortgage Debacle – April 2007

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.

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