Another mortgage company casualty after the bell today announced by Capital One (COF) during their earnings report.  In addition to cutting its earnings forecast from $7.15 to $5/share, COF announced that they would eliminate their Greenpoint mortgage unit (the 7th largest Alt A lender) and eliminate 1900 jobs.   According to the WSJ,   Capital One bought Greenpoint, which specialized in jumbo and Alt A loans less than a year ago in a 13.2 billion dollar deal.  With other large layoff announcements from Countrywide (CFC) and SunTrust  (STI) today alone and thousands more to come as other mortgage companies fold, you have to wonder just how much impact this will have on the economy from an employment perspective which has been largely ignored up to this point.  The housing boom was able to cushion the blow of many jobs being shipped overseas so the impact could be great.

Below is a reprint of an excellent article by Daily Wealth detailing the unraveling of the housing market.

What Caused the Housing Bust
By Porter Stansberry
August 18, 2007

Reprinted with permission by DailyWealth

Today, we take a break from our normal format to answer in detail a question regarding the current housing problem that must be on the minds of nearly all of our readers, as expressed by paid-up subscriber David Walker:

What is so unusual about the current times that so many smart people could be so catastrophically wrong?

Porter comment: What happened (and what is still happening) is simply leverage in reverse, or what people used to call a "run on the bank."

For nearly 10 years, as interest rates fell from 1995 to 2005, the mortgage and housing business boomed as more and more capital found its way into housing. With lower rates, more people could afford to buy houses. That was good. Unfortunately, it didn’t take long for some people to figure out that with rates so low, they could buy more than one. Or even nine or 10. As more money made its way into housing, prices for real estate went up – 20% a year for several years in some places. The higher prices created more equity… that could then be used as collateral for still more debt. This is what leads to a bubble.

Banks, hedge funds, and insurance companies were happy to fund the madness because they believed new "financial engineering" could take lower-quality home loans (like the kind with zero down payment) and transform these very risky loans, made at the top of the market, into AAA-rated securities. Let me go into some detail about how this worked.

Wall Street’s biggest banks (Goldman Sachs, Lehman Bros., Bear Stearns) would buy, say, $500 million worth of low-quality mortgages, underwritten by a mortgage broker, like NovaStar Financial. The individual mortgages – thousands of them at a time – were organized by type and geographic location into a new security, called a residential mortgage-backed security (RMBS).

Unlike a regular bond, whose coupon is paid by a single corporation and organized by maturity date, RMBS securities were organized into risk levels, or "tranches." Thousands of homeowners paid the interest and principal for each tranche. Rating agencies (like Moody’s) and other financial analysts, believed these large bundles of mortgages would be safer to own because the obligation was spread among thousands of separate borrowers and organized into different risk categories that, in theory, would protect the buyers. For example, the broker (like NovaStar) that originated the mortgages would be on the hook for any early defaults, which typically only occurred in fraudulently written mortgages. After that risk padding, the next 3%-5% of the defaults would be taken out of the "equity slice" of the RMBS.

The "equity slice" was the riskiest part of the RMBS. It was typically sold at a wide discount to the total value of the loans in this category, meaning that if defaults were less than expected, the buyer of this part of the package could make a capital gain in addition to a very high yield. Even if defaults were average, the buyer would still earn a nice yield.

Hedge funds loved this kind of security because the yield on it would cover the interest on the money the fund would borrow to buy it. Hedge funds could make double-digit capital gains annually, cost-free and risk-free… or so they thought. As long as home prices kept rising and interest rates kept falling, almost every RMBS was safe. Even if a buyer got into trouble, he could still sell his home for more than he paid or find a way to restructure the debt. On the way up, from 1995-2005, there were very few defaults. Everyone made money, which attracted still more money into the market.

After the equity tranche, typically one or two more risk levels offered higher yields at a lower-than-AAA rating. After those few, thin slices, the vast majority of the RMBS – usually 92% of the loan package – would be rated AAA. With an AAA rating, banks, brokerage firms, and insurance companies could own these mortgages – even the exotic mortgages with changing interest rates or no down payments. With the magic of financial engineering and by ordering the perceived risk, financial firms from all over the world could fill their balance sheets with higher-yielding mortgage debt that would pass muster with the regulators charged with making sure they held only the safest assets in reserve.

For a long time, this arrangement worked well for everyone. Wall Street’s banks made a fortune packaging these securities. They even added more layers of packaging – creating CDOs (collateralized debt obligation) and ABSs (asset-backed security) – which are like mutual funds that hold RMBS.

Buyers of these securities did well, too. Hedge funds made what looked like risk-free profits in the equity tranche for years and years.

Insurance companies, banks, and brokers were able to earn higher returns on assets by buying RMBS, CDOs, or ABSs instead of Treasury bonds or AAA-rated corporate debt. And because the collateral was considered AAA, financial institutions of all stripes were able to increase the size of their balance sheets by continuing to borrow against their RMBS inventory. This, in turn, supplied still more money to the mortgage market, which kept the mortgage brokers busy. Remember all the TV ads to refinance your mortgage and the teaser rate loans?

The cycle kept going – more mortgage securities, more leverage, more loans, more housing – until one day the marginal borrower blinked. We’ll never know whom or why… but somewhere out there, the "greater fool" failed to close on that next home or condo. Beginning in about the summer of 2005, the momentum began to slow… and then slowly… imperceptibly… it began to shift.

All the things the cycle had going for it from 1995 to 2005 began to turn the other way. Leverage, in reverse, is devastating.

The first sign of trouble was an unexpectedly high default rate in subprime mortgages. Beginning in early 2007, studies of 20-month-old subprime mortgages showed a default rate greater than 5%, much higher than expected. According to Countrywide Mortgage, the default rates on the riskiest loans made in 2005 and 2006 are expected to grow to as high as 20% – a new all-time record. The big jump in subprime defaults led to the first hedge-fund blowups, such as the May 2007 shutdown of Dillon Reed Capital Management, which lost $150 million in subprime investments in the first quarter of 2007.

Since Dillon Reed Capital, dozens of more funds have blown up as the "equity slice" in mortgage securities collapsed. Remember, these equity tranches were supposed to be the "speed bumps" that protected the rest of the buyers. With the safety net of the equity tranche removed, these huge securities will have to be downgraded by the rating agencies. For example, on July 10, Moody’s and Standard and Poor’s downgraded $12 billion of subprime-backed securities. On August 7, the same agencies warned that another $1 billion of "Alt-A" mortgage securities would also likely be downgraded.

Now… these downgrades and hedge-fund liquidations have hugely important consequences. Why? Because as hedge funds have to liquidate, they must sell their RMBSs, CDOs, and ABSs. This pushes prices for these securities down, which results in margin calls on other hedge funds that own the same troubled instruments. That, in turn, pushes them to sell, too.

Very quickly the "liquidity" – the amount of willing buyers for these types of mortgage-backed securities – disappeared. There are literally no bids for much of this paper. That’s why the subprime mortgage brokers – the Novastars and Fremonts – went out of business so quickly. Not only did they take a huge hit paying off the early defaults of their 2005 and 2006 mortgages, but the loans they held on their books were marked down, with no buyers available and their creditors demanding greater margin cover on their lines of credit… poof… The assets they owned were marked down, they couldn’t be readily sold, and they had no access to additional capital.

The failure of the subprime-mortgage structure – which started with higher-than-expected defaults, led to hedge fund wipeouts, and then to mortgage broker bankruptcies – might have been contained to only the subprime segment of the market. But… the risk spread because of the financial engineering.

With Wall Street wrapping together thousands of mortgages from different underwriters, it’s likely that hundreds of financial institutions around the world have traces of bad subprime and Alt-A mortgage debt on their books. Parts of these CDOs were rated AAA. Almost any financial institution could own them – especially hedge funds. Hedge fund investors quickly figured this out – and asked for their money back.

And so, in July, liquidity fears began to creep through the entire mortgage complex. Not because the mortgages themselves were all bad or even because the mortgage securities were all bad – but because all the market players knew a wave of selling, led by hedge funds, was on the way. Nobody wants to be the first buyer when they know thousands of sellers are lined up behind them.

The market "locked up." Nobody would buy mortgage bonds. And everyone needed to sell. Suddenly even Wall Street’s biggest banks – the very firms that created these mortgage securities – were suffering huge losses, as the bonds kept getting marked down as hedge funds and other leveraged speculators had to sell into a panicked market.

It’s a classic "run on the bank," except today the function of the traditional bank has been spread out among several institutions: mortgage brokers, Wall Street security firms, hedge-fund investors, and banks. The real problem is that the long-dated liabilities (a 30-year mortgage) were matched not by reliable depositors, but by fly-by-night hedge funds, which were themselves highly leveraged and subject to redemptions.

That’s why even as the top executives in these firms believed their mortgages were safe and sound, they can’t get the funding they need to hold onto them through the crisis. As Keynes predicted, the lives of every higher-leveraged financial institution is precarious: " The market can be irrational longer than you can remain solvent."

The hedge funds have no solution. Redemptions will force them to sell. They’ll continue to pressure the market, resulting in huge losses. Hundreds of funds will likely be liquidated.

Wall Street’s investment firms, if they can find additional capital to meet margin calls, might weather the storm… depending on how far it spreads. We saw a move in this direction this week when Goldman announced $3 billion in additional funding for its big hedge funds.

For most mortgage brokers, the party is over – goodnight. Something like 90% of them will be out of business by the end of the year.

——————————————————————-

UPDATE:

I received these comments from the CFO of a local homebuilder (pacific northwest) regarding the above article: