Handle With Care

Photo: Vincent Laforet

What are your true feelings about America and its dream of home ownership? Do you believe it will survive the economic meltdown? Do you think most people will keep paying their mortgages and not walk out on their homes?

If so, you might want to join me in buying mortgage-backed securities, commonly lumped into that odious investment category known as “toxic assets.” Years ago, on Wall Street, I helped create these securities with computer software (which I described in “My Manhattan Project”). Now, I farm oysters out in Long Island. But like a lot of people, I’m always on the lookout for a good investment opportunity. And for a few months now, I’ve been thinking that the economic panic has been overblown and that, if you look carefully, bargains can be found in toxic waste.

I’m hardly the only one—with the hand-holding of the Treasury Department, two large companies have recently started buying them as part of the once-ballyhooed Public-Private Investment Program. The difference is, I’m proceeding without a taxpayer safety net, so I have to be extremely cautious.

When I was on Wall Street, the bonds that I worked on were based on a model that had proven infallible over 40 years—it projected that home prices would rise steadily at 5 percent a year and that no more than one percent of homeowners would default on their mortgages. With these assumptions, you could buy almost any slice of a mortgage-backed bond, even a really risky slice that paid you an elevated rate of return, and expect to make your money back and then some.

Well, those days are history, as we all know. Many holders of mortgage-backed bonds have been wiped out. But it is the nature of economies that one person’s distress presents somebody else with an opportunity, and so I am wading into the toxic sludge. My conviction is simple: Betting against America has been a losing proposition. We are, after all, the only country in the world that has always made timely payments on its debt. Considering the oceans of stimuli being poured into the system, is there any way that streak won’t continue? If the country remains solvent, so will the vast majority of its homeowners.

I have no illusions about the risk of what I’m doing. Buying mortgage-backed bonds today is putting your finger to the wind in a storm, like you’re standing on a seawall facing a nor’easter. You know the second wave of defaults is coming. It’s forming out past Montauk, swelling in Gardiners Bay, about to smash into your seawall. Will it knock you down, rip your boat from its cleats, and scatter your oyster cages all along the rock pile?

More Americans are going to lose their homes, but how many? How bad will it end up being? How bad is where the trade is.

I buy my bonds through a former colleague named T. He and I started together in mortgage research at Lehman in 1988. He went into trading in 1990, then into institutional sales. He was one of the few lifers I knew. After twenty years at Lehman, he retired, six months before the firm disintegrated.

T. went through a period of mourning for Lehman. Retired, he tried to buy homes in foreclosure with the goal of fixing them up and renting them. But prices were 60 to 70 cents on the dollar, while he knew that collateralized mortgage obligations, the first lien on real estate, were trading much, much cheaper. He thought he saw “arb,” a price discrepancy that could be exploited for profit. Because house prices hadn’t fallen as much as institutional investors had feared, that meant the bonds were underpriced. T. rejoined many of his ex-Lehman colleagues at a major investment bank and set about buying bonds.

“I gave up on stocks: One goes up, one goes down, who knows why,” T. tells me. “I only invest in real estate, what I know. So if the stock market has rallied by 50 percent, corporates and munis are way up this year, why are CMOs still dropping? I’d rather buy the lien on a house at 15 than pay 65 for the foreclosed home from the bank.” (By 15 and 65, he means cents on the dollar.)

Five trillion dollars of existing CMOs are out there, each one slightly different than the others. Their value depends on the quality of the underlying home mortgages and how they’re structured. Once upon a time, investors relied on the rating agencies to tell them which bonds were safe to buy. Now that the ratings have been discredited, you have to treat every bond like a time bomb, carefully assessing how much time you’ve got before it blows up in your face.

T. is selling me CMO bonds. I’ve bought seven of them in the last three months. Their prices range from 15 to 50 cents on the dollar, meaning that a lot of pain is priced in. And price is everything. There’s an old saying in the bond market that there are no bad bonds, only bad prices.

My CMOs are “whole loan”—that means they come with no guarantee from any federal agency (the bonds with federal backing trade at a premium; no bargains there). Similarly, the deepest discounts are available for structured bonds that are made up of bits and piece of individual loans. The holders of unstructured bonds have an advantage in this climate because they are better able to negotiate with individual homeowners and possibly lower their principal—that enables them to keep the house (their benefit) and it keeps the level of payments to the bondholder higher than if the house went into foreclosure (the bondholder’s benefit). With structured bonds, negotiation is difficult, if not impossible, because the loans are all split up among different bonds. And that drives the price of these bonds down further, into the freefall zone that’s attractive to me.

The first variable I look at in assessing the attractiveness of a bond is the current Loan to Value Ratio (LTV). A good homeowner would start with an LTV of 80 percent—they put 20 percent down, so the bank loan covers 80 percent of the house’s value. All good until the value of the house drops. If it drops in half, a common occurrence of late, that poor guy’s LTV is suddenly over 160. They call that being underwater, and that’s when people start walking away from their homes. So you look for LTVs well below that, say 100 to be safe.

The second variable is credit support. Bonds are typically broken up into different risk segments—for absorbing more risk, you get a higher rate of return. At this point, I am interested only in the least risky portions of the bond, the top shelf of toxic assets, which are known, in descending order, as AAA super senior and AAA mezzanine. Not only do I avoid anything below that grade, but I calibrate what I’m willing to pay for the bond with what percentage of bondholders are absorbing credit risk ahead of me. So if the price is 20 cents on the dollar, I want credit support of at least 20 percent. If the bond is more expensive, say 40 cents, I’ll want 40 percent credit support.

Then there’s the FICOS scores, or credit ratings of the homeowners. If they’re declining—which indicates they’re falling behind on their car payments or credit cards or whatever—I don’t touch the bonds. Finally, there’s loan size, which the simplest of all. I prefer bigger loans because of the many fixed costs associated with foreclosure (everything from lawyers to house painters to Realtors). If the loan is bigger, there’ll be more left over to pay the bondholders in the event that the bank has to seize the house and sell it.

Buying toxic assets is brutal business. You’re trying to calculate the economic effects of other people’s misery. But that’s how the world works. It’s what keeps the economy from tumbling into the abyss. Somebody’s got to be there to buy what other people can no longer afford.

Buying bonds that you know will be devastated by defaults is a race against time: How much cash flow will you receive before the bond washes out with the tide? Price is the ultimate protection. If you pay 15 cents for a bond, you can stand to lose a lot. If there’s 20 percent credit support under you, you’ve bought time. Will you harvest those flows before that second wave carries you and your bonds away? As the wave gets closer to you, it’s harder to gauge its height. All you know for certain is that it will smash you.

There are $120 to $150 billion of option-ARM loans out there that will recast in 2010 and 2011. Those are people who haven’t been paying down any principal, in the hope that they can refinance before their payments balloon. Most of them won’t be able to, not with their house having shed half its value. The option-ARM wave is cresting right now, forming angry whitecaps. You can see its shape in the latest foreclosure and delinquency numbers in the loan-remittance reports. How high will it swell? What if that second wave is smaller than the current fears? What if things only get a little worse?

“I saw Armegeddon,” A. told me yesterday at lunch. We were having lunch at Union Square Cafe, where I had just delivered my oysters. I had not seen A. in years. We had the intimacy of men who had slept in the same bed: On September 11, A. lived in Tribeca two blocks from the WTC. He grabbed his wife and daughter and ran for their lives. I was just starting my oyster farm, so my apartment, five blocks from where he was head of mortgage trading, and later president, was empty. He moved into my place for four months while his new house in Westchester was being renovated.

A’s bank was one of the few banks that took no bailout money. A. did his job for the bank and its shareholders. He was going to retire in fall of 2008, but when reviewing the book of a CDO trader, he found it mismarked by $2 billion. He stayed on until this April and is getting his Ph.D. in math at Columbia, something he’s been telling me about for the last ten years. “That was the worst six months of my life,” he said, referring to the CDO cleanup.

A. is in all cash now, a fact that frightens me. He has a similar look that returning G.I.’s from Vietnam had when they enrolled in college after their stint. “We shorted every market that was trading at $80 or $90 prices. Corporate and muni guys were screaming to get us out of their markets.”

A. agreed that the super-senior tranches had been too cheap. But he winced when I said I had bought some senior mezzanine bonds, a notch below the super seniors.

“Those are some thin slices,” he cautioned. “Once they start to go, they’re done fast.”

“But at 20 cents on the dollar,” I said. Originally, the market offered a 20 to 30 basis-point premium for super seniors. Now they trade 20 points higher than the Senior Mez bonds—a spread adjustment of 100 to 1. “The world has to go to hell for these bonds to lose,” I defended my actions.

“That’s what has surprised me,” A. replied. “The actual lack of pain in the economy as a whole. With the defaults and liquidations we were seeing, I don’t know why there hasn’t been more pain out there.”

For the economy to sink so low as to render my bonds worthless, I would be seeing people poaching my oysters, which has not happened. There was a run on gun-and-ammo purchases last year, but that has peaked. I don’t see the class warfare that these prices imply.

No one is forcing me to buy CMOs. Despite the risks, the knowledge that a certain percentage of my bonds will be pounded by the coming defaults, I believe they are a good investment at current prices. We Americans are a resilient population and seem to be addressing our bad habits: We’re saving, paying off our credit cards, and forsaking needless, idiotic vacations. Yes, homes in Las Vegas may have to be bulldozed. But was there ever a reason for a desert wasteland to be a booming metropolis? Most important, perhaps, the false concept of a home as the average person’s major asset is now disgraced. A house, by definition, is a liability that demands tax payments, repairs, upkeep, and usually a large mortgage payment.

I’m selling more oysters this year than last. When I come into town to make delivers, I see people strolling the Village late at night, laughing and talking, instead of huddled at the bar whispering about who had been fired that day. The entire range of restaurants, from the power-lunch spots to the neighborhood bistros to the chic pizzerias, are enjoying a decent fall. Right now, I can’t envision a scenario where I have to patrol my oyster beds at night, fending off hungry Americans.

See Also
The Beginner’s Guide to Toxic Assets

Handle With Care