“The most common cause of low prices is pessimism-sometimes pervasive, sometimes
specific to a company or industry. We want to do business in such an environment, not
because we like pessimism but because we like the prices it produces. It’s optimism that is
the enemy of the rational buyer.”
- Warren Buffett, 1990 Chairman’s Letter to Shareholders
Berkshire Hathaway
We are pleased to provide you with our report of the second quarter of 2007. US Equities in the quarter as measured by the Russell 3000 index returned 5.76%, despite a difficult June in which the index lost 1.9%. Concerns over the weakness in the housing sector and subprime mortgages put a damper on an otherwise strong quarter. It is this crosscurrent and its ramifications that have roiled the equity markets the past month and the subject of this quarter’s report.
Dissertations on bonds are frequently regarded as a sure fire cure for insomniacs. Be forewarned…yes folks, we will be talking about bonds which have become a rather exciting topic in our view. For roughly the last 25 years capital markets have thrived on a benign fixed income environment, that is, interest rates that tended to go down. This backdrop has been a sustaining tailwind to improving valuations of all assets. Typically, when we as analysts assess investments, we set high quality government bonds where there is no risk of default as our benchmark return. We then have to determine what additional compensation is needed to accept additional risk in other types of investments, in hopes of higher returns. After a quarter century of performing as a support to other investments, are bonds now becoming a threat? Is subprime contagion affecting the price of risk?
Low rates have enabled consumers to finance their mortgages and large purchases with relative ease. The spillover effect of healthy US consumer demand has allowed the emerging economies of China and India to develop as manufacturing centers, and in turn, their demand for raw materials have benefited commodity producing countries such as Australia and Canada. The virtuous circle continues as large trade surpluses in Asia are recycled into safe investments such as US Treasuries reducing yields even further. Unfortunately good news can turn into bad news because the good news was too good. The atonement for a night on the town is a hangover…the remorse for a debt binge is a retrenchment and an insistence on higher quality standards.
When borrowing gets too easy, we often see mortgage providers or bond underwriters set low quality standards. Subprime mortgage and their cousin, the alt-A mortgage issues that are currently stressing markets are a function of poor underwriting standards and weak housing prices. As for subprime borrowers who face upward resets of their interest rates over the next 18 months, the impact is yet to be felt. They essentially have three choices:
There is a saying in banking that “a rolling loan gathers no loss.” Lenders frequently will accept loan modifications in order to keep payments flowing rather than accept default. But further declines in housing prices exacerbate the problem by making it more difficult for borrowers to qualify for modifications and by reducing the incentive to continue making payments on homes that are worth less than the amount owed on the mortgage.
These real estate and mortgage related issues have already had a profound effect on mortgage backed securities and an investment product called a CDO, or collateralized debt obligation. The hedge fund problems of the brokerage firm Bear Stearns stem directly from these issues when combined with the high leverage employed by hedge funds. In short, leveraging an already overleveraged product is dangerous to your financial health.
How do these CDO’s work? A CDO is nothing more than a security designed to redistribute credit risk. Let’s construct a typical CDO structure:
We start with a $1000 portfolio of mortgage backed bonds which yield 7%. This is called the collateral portfolio. The collateral portfolio has an average quality rating of BBB. In order to fund the purchase of this portfolio, 5 different subsets of securities are sold having differing quality ratings and yields. The amount, credit rating and interest rate of the first four in our model are as follows.
$750 Class A, rated AAA, yields 5.51%
$100 Class B, rated AA, yields 5.80%
$50 Class C, rated A, yields 7.20%
$50 Class D, rated BBB, yields 9.00%
These are called the debt tranches. Notice that the yields for Class C and D are far in excess of what typical bonds with similar ratings yield. That’s the catch in this type of instrument…stretching for higher yield often comes at a steep price despite what appears to be decent quality. Let me go on:
The fifth security sold is the equity tranche, or the residual interest. That is another $50. We'll get to the equity in a minute.
The tranches receive different credit quality ratings because of the order in which each gets paid. Interest and principal are paid sequentially, starting with Class A and ending with the equity tranche. Only once Class A has been paid what its due does Class B get paid, and so on.
So our portfolio of bonds pays $70 per year in interest (7% of $1000). The CDO then owes interest on the debt it sold:
Class A: $41.33 (5.51% of $750)
Class B: $5.80
Class C: $3.60
Class D: $4.50
That totals $55.23 leaving $14.77 as the residual to be distributed of the $70 interest. Typically, fees of about 25 basis points (or $2.50) apply, so $12.27 is paid to the CDO’s equity holder, a rather handsome return of 24.5%! So far, we have not mentioned anything about any defaults within the CDO collateral portfolio.
Let’s assume that defaults amount to just 1% a year over ten years, not a horrific or hard to imagine scenario. Interest costs get covered all along, even with only $900 of mortgages of the original $1000 performing after ten years. ..$55.23 in interest is covered by the $63.00 in income (7% of $900) leaving a residual of $5.52 for the equity holder. But what about the principal? The nine hundred bucks gets distributed to classes A, B, and C but the unfortunate D class receives nothing in principal repayment…and this is an investment grade BBB tranche with only 1% defaults! This is an over-simplification of a fairly complicated story but I hope you see the point…the margin for error in a securitized deal can be very small, even when default percentages are low.
Fixed income investors are now demanding higher returns to compensate for what is now seen as increasing risks. The ripple effects of this are influencing sectors beyond the mortgage scene. Many private equity deals rely on the availability of credit at cheap rates. In today’s uncertain environment, more equity and less leverage are demanded by the financiers and required interest rates are ratcheting up.
At Value Architects, our strategy is quite clear…in a balanced portfolio, our fixed income representation is predominantly government or government agency bonds…we minimize the use of corporate credits and never use collateralized debt or collateralized loan obligations. We prefer to control risks by using a “dependable” fixed income allocation and a diversified equity portfolio. How are these credit issues affecting our equity selections?
In our opening quote (as is often the case, from Buffett,) as value investors we thrive on pessimism because it creates attractive prices. In our view, few sectors provide as much pessimism as financial services at the moment. Let’s look at a few recent news items:
…National City ... the 16th-largest home lender last year ... said it won't buy loans that can't be resold to Fannie Mae or Freddie Mac, the two largest mortgage buyers, unless the borrowers' income and assets are fully documented.
... Wells Fargo & Co., the second-biggest lender, said last week that it would no longer make subprime home loans through brokers, while continuing to make them in a retail channel.
... SunTrust Banks Inc., the 14th largest home lender, has ``pretty much gotten out of Alt A'' for now, said Sterling Edmunds, who heads its mortgage unit.
Obviously, banks are practicing newly found religion and discipline which was clearly not evident in their zeal for these loans last year when subprime and alt-A accounted for 40% of all originations.
As of the first quarter of 2007, $1.9 trillion in mortgage assets represented about 20% of all bank assets. We estimate that subprime and alt-A mortgages remaining on banks’ books represent somewhere between 5 and 7% of total bank assets, not an excessive exposure by any definition.
Mortgage loans have much lower defaults (or what banks call net charge-offs when they write these down) than other loans because generally they are well collateralized and borrowers tend to do everything possible to maintain their home. Mortgage loan charge-offs generally range between 1/6th to 1/3rd the size of overall charge-offs. Indeed, in the worst charge-off years for banks in the last fifteen, banks wrote-off merely 0.23% of mortgage loans. Based on our estimate, if charge-offs were to treble to 0.75% of all mortgage loans in a horrific credit scenario, overall bank earnings would decline by no more than about 5 to 6%.
The focus on the subprime loan problem has spilled over into the equity markets, lowering stock values in most financial stocks. These valuations are becoming quite attractive and in some cases, yields are well above norms and almost three times that of the general market. We hope to take advantage of the pervasive fear that is affecting these stocks. There are still a lot of craters to avoid in this sector. Naturally, the amount of risk exposure varies widely among banks and we believe that careful analysis should garner some high quality names both in North America and globally. Rather than dismiss the sector entirely, we believe the panic does not represent a long term crisis, but an opportunity.
What about other sectors in the market? We continue to see significant buyback activity.
Clearly, a tighter credit environment will make it more difficult for private equity firms to takeover public targets. But it is our feeling that private equity firms will not be stymied in deploying their capital. Some contemplated deals may well fall by the wayside based on their original terms. But restructured deals requiring a greater injection of equity capital and a lesser injection of debt will likely ensue. Beyond the takeover possibilities, this will be an environment in which well-financed businesses should continue to thrive. We do not anticipate that interest rate pressure will have much influence on most of our companies. Additionally, companies with strong balance sheets looking to improve or expand their businesses, will be more apt to make strategic acquisitions as valuation levels become more reasonable.
We do expect considerable volatility ahead. The logic is wonderfully circular. We know that as the excesses of the past get wrung out of the system all that was bad will become good again. However, it takes time and our strategy is to hold high quality investments while the debt storm plays itself out.
As always, we appreciate your confidence and your trust.
Richard H Konrad, CFA, CFP®
