Lewis’s “Liar’s Poker”

It feels good to be reading for recreation again.  Although, I’ve had trouble finding time to review the books I’ve read.  I completed Michael Lewis’s classic “Liar’s Poker” earlier this summer and am just getting around to posting this.

If you liked the movie “Wall Street” or like reading about the greedy scum on Wall Street then you’ll definitely enjoy this read.  Michael Lewis writes about his personal experience working for Salomon Brothers as a mortgage-backed bond salesman during the 1980’s.  I think the book is even more interesting following the subprime mortgage crash that we recently all got to watch.  Here are some excerpts & thoughts I want to remember:

*Volker’s Fed policy of the late ’70s & early ’80s led to an explosion of bond trading volumes which set the stage for Lehman Brothers to come to prominence.

*“One of the most remarkable things that happened in the 1980s was [the] sharp explosion of debt, way beyond any historical benchmark….is came about, I think, as a result of freeing the financial system, putting into being financial entrepreneurship and not putting into being adequate disciplines and safeguards.  So that’s where we are.”

*”Wall Street brings together borrowers of money with lenders.  Until the spring of 1978, when Salomon formed Wall Street’s first mortgage security department, the term borrower referred to large corporations and to….governments.  It did not include homeowners….From the early 1930s legislators had created a portfolio of incentives for Americans to borrow money to buy their homes…Nudged by a friendly policy…loans grew, and the volume of outstanding mortgages swelled from $55 billion in 1950 to $700 billion in 1976.  In January 1980 that figure became $1.2 trillion.

*Describing the reason securitization of mortgages came to be: “Mortgages were not tradable pieces of paper; they were not bonds…A single home mortgage was a messy investment for Wall Street, which was used to dealing in bigger numbers.  For the home mortgage to become a bond, it had to be depersonalized.  At the very least, a mortgage had to be pooled with other mortgages of other homeowners.

*The traders who profit from the sale of mortgage-backed securities were involved with the creation of Fannie  & Freddie: [Salomon Brothers] “intended to transform [mortgages] into bonds as soon as possible by taking them for stamping to the US Government.  Then they could sell the bonds…as, in effect, US Government bonds.  For that purpose, partly as the result of [Salomon’s] persistent lobbying, two new facilities had sprung up in the federal government alongside Ginnie Mae (Fannie Mae & Freddie Mac).  They guaranteed the mortgages that did not qualify for the Ginnie Mae stamp.  (As a result) Defaulting homeowners became the government’s problem.

*Creation of a CMO: “To create a CMO, one gathered hundreds of millions of dollars of ordinary mortgage bonds Ginnie Maes, Fannie Maes, and Freddie Macs.  These bonds were placed in a trust.  The trust paid a rate of interest to its owners… The (owners), however, were not all the same.  Take a typical three-hundred-million-dollar CMO.  It would be divided into three tranches, or slices of a hundred million dollars each.  Investors in each tranch received interest payments.  But the owners of the first tranch received all principal repayments from all the three-hundred-million dollars of mortgage bonds held in trust.  Not until the first tranche holders were entirely paid off did second tranche investors receive any payments…

*The creation of new mortgage-backed products (i.e. CMO’s, tranches, splitting principal and interest payments) was partly driven by the Savings & Loan Industry’s desire to acquire assets that they could stick “off-balance sheet” because regulators had yet to regulate the new product.

*Leverage: “…it is a wonder that more attention is not paid to the daily leveraging that occurs within investors’ portfolios.  Say I wanted my customer to buy thirty million dollars’ worth of AT&T bonds.  Even if he had no cash at his disposal, he could pledge that AT&T bonds as collateral and borrow the money from Salomon Brothers to buy the bonds.  We were genuinely a full-service casino…

*No one knows: “I spent much of my working life inventing logical lies…Most of the time when markets move, no one has any idea why.  A man who can tell a good story can make a good living as a broker.  It was the job of people like me to makeup reasons…..Heavy selling out of the Middle East was an old standby.

*Rating agencies: “…the rating services, like most commercial banks, relied almost exclusively on the past… in rendering their opinions.  The outcome of the analysis was determined by the procedure rather than by the analyst.

*Page 218 does a pretty good job of summarizing the causes of the S&L crisis.  Basically, S&L’s were in trouble and Congress gave them access to cheap money and loosened regulations so they could invest in junk bonds.  We all know how that ended.

*A little wisdom to end the book: “He said that every decision he has forced himself to make because it was unexpected has been a good one.  It was refreshing to hear a case for unpredictability in this age of careful planning.

Mortgage rates should benefit from Bernanke’s comments

On Friday Fed Chairman Ben Bernanke announced that he endorses the concept of the federal government guarantying mortgage-backed securities (MBS’s) issued by Fannie Mae and Freddie Mac.  These comments should help mortgage rates move lower.

The reason that a government guarantee helps mortgage rates move lower is because it reduces the risk of default on MBS’s for investors and therefore they are willing to accept a lower yield.

To learn more click these links-

Washington Post article

Wall Street Journal article

Blog posting on the role that Fannie & Freddie play in mortgage market

What the heck are ‘technical trading patterns’?

If you’ve been an avid reader of ‘rate update‘ then you know that I often refer to ‘technical trading patterns’ (TTPs) as a factor that can have a major influence mortgage rates.  Typically TTPs have the most impact when the markets lack new economic data and/ or significant stock market momentum.

However, very few people are familiar with the concept of TTPs and how they impact mortgage rates.  In this post I will attempt to explain what TTPs are and how they impact our advice to “lock” or “float” interest rates.

To preface this explanation it’s first critical that you know that mortgage rates are 100% determined by the price of mortgage-backed bonds (MBS’s)When the price of MBS’s increase, mortgage rates decline.  When the price of MBS’s decrease, mortgage rates increase.

TTPs are essentially derived from the discipline of technical analysis.  Believers in technical analysis claim that previous price data for a specific financial security can be used to predict the future movements of that price.

In this case, TTPs offer a way for us to assess patterns in the price history of MBS’s and determine how future prices will react.

Specifically, in evaluating TTPs we look for where the current price level for MBS’s are relative to the average price levels over a 10, 25, 40, 50, 100, and 200 day time frame.  These averages are called “moving averages” and are calculated by averaging the price level of MBS’s over a specified time frame.

For example, the “10-day moving average” is calculated simply by averaging the price of MBS’s over the previous 10 days.  Likewise, the “200-day moving average” is calculated by averaging the price level of the previous 200 days.

What makes identifying TTPs possible is that MBS prices often react in a consistent manner when they approach these “moving averages”.  Therefore, we often see very predictable patterns of price changes when MBS’s approach these levels.  Because mortgage rates react inversely to the price of movements of MBS’s once we can accurately predict price movements we can also predict mortgage rate movements.

For example, in the chart below look at the first circle near the top left hand corner.  At this point MBS prices are falling and approaching the 200-day moving average (blue line).  We know that when MBS prices approach this level they tend to react in one of two ways.

One reaction is for them to “bounce” higher off the 200-day moving average which causes MBS prices to rise and rates to drop.  However, in this instance MBS prices reacted in the opposite manner.  They dip below the 200-day moving average and rates rise as a result.

At times like this we would advise or clients to float as long as MBS prices remain at or above the 200-day moving average.  As soon as they close below the 200-day moving average we know rates will get worse before they get better.  Therefore, we advise a “locking” position as soon as MBS prices dip below the 200-day moving average.

The second circle near the bottom of the chart shows MBS prices getting support at the “S2 line” (green line) which is not a moving average but likely a low-point in recent trading history.  At this level MBS prices are able to find a bottom and begin rallying.  At this time mortgage rates are likely .25%-.375% higher compared to only a few days earlier (when MBS prices were up near the 200-day moving average). Because MBS prices appear to have bottomed we would recommend a “floating” position at this point as mortgage rates show signs of improvement.

Indeed, off this floor MBS prices rally for 5 days and rates drop back down by .25%-.375%.  Once they approach the 200-day moving average the rally loses steam and  in the third circle show signs of weakness.

Much like our approach at the first circle we would recommend a “floating” position so long as MBS prices remain at or above the 200-day moving average.  As soon as prices dip below this level we know that prices are likely to decline pushing rates higher by .25%-.375% once again.

This is just one example of how we would use technical analysis to identify TTPs that will impact mortgage rates.  This concept is somewhat complicated and takes time to learn.  If you have questions about TTPs or would like to make a comment please do so below.

Explanation: Mortgage-backed securities (AKA MBS’s)

I came across this blog yesterday and started sifting through the postings.  This site does an excellent job of providing educational postings covering various topics in the mortgage industry.

Specifically, I really liked this posting which explains the factors that contributed to the development of the mortgage-backed bond market.  I also blogged about this topic around the time when speculation over the insolvency of Fannie Mae and Freddie Mac was hitting the news.

Essentially, mortgage-backed bonds were originally developed to “spread risk” among many financial institutions back when the banking industry was made up of many regional banks.  The need to spread risk was needed because regional banks were too leveraged to the local economy they did business in.

However, over the years the development of the mortgage-backed bond market (AKA “securitization”) has encouraged bankers to place emphasis on loan volume instead of loan quality.  Thus, we find ourselves in the mess we’re in today.

Main points of government intervention

Treasury Secretary Henry Paulson made it public this morning (this news had leaked yesterday afternoon causing stocks to rally in late trading) that the government would intervene in the financial markets to shore up confidence in the financial system.

According the Wall Street Journal the government’s intervention could become “the largest intervention in the financial markets since the 1930s.”  This is great news as the health of the financial system was being called into question over the past couple days.

In fact, over the past two days $180 billion has been taken out of traditionally safe money market funds because of fear that the assets backing the fund would fall below the value of the deposits.  This led to investors buying short-term treasury securities with a NEGATIVE RETURN (meaning these investors were willing to accept less money than the money they were investing for the safety of the US government).

Among the measures that the Treasury Secretary announced this morning were-

*Increase the government’s purchases of mortgage backed securities.

*Acquire “bad assets” (risky mortgage-backed bonds) from financial institutions so they can remove them form their balance sheet.

*Ban investors from “short-selling” the stocks of 799 vulnerable financial institutions.

It is unclear what this new intervention will look like in terms of the organizational structure but more details should become available early next week.

Rate Update September 10, 2008

Mortgage rates are essentially unchanged from yesterday although pricing on 30 year fixed loans are modestly worse.

We still believe that over the next few weeks mortgage rates will improve. Now that the federal government has assumed the guarantees of Fannie Mae & Freddie Mac’s mortgage-backed bonds investors will view these securities on par with US treasuries.

30-year treasury bonds are currently yielding 4.19% while 30-year mortgage backed bonds yield between 4.85%-5.15%. We would expect the spread between these yields to converge over the next few weeks. Although, it’s not likely that rates will move in a straight line so we still need to be careful on timing.

Watch today’s you tube video for information on two new blog postings featuring important information that real estate professionals should be aware of.

Post #1- What the bailout means for you

Post #2- Mortgage guidelines continue to be tightened

Current Outlook: neutral short-term, floating long-term

Mortgage-backed bonds still attract investors

I often reference “mortgage-backed bonds” (AKA MBS’s) in my daily rate updates.  If you follow rate update consistently then you know that when MBS prices fall interest rates rise and vice versa. 

The WSJ published a story today regarding investor confidence in high-quality MBS’s and how they remain attractive for bond investor guru Bill Gross & PIMCO. 

Here are a few good takeaways and what it may mean for interest rates in the near term:

* “Freddie’s mortgage bonds were trading at a risk premium of around 2.64 percentage points over the 10-year Treasury note’s yield, which was quoted late Thursday at 3.837%.” -A ‘risk premium’ is the spread that an investment earns above and beyond the 10-year US Treasury note (considered to be an extremely safe investment).  The idea is that the larger the spread the more risky the market perceives that investment.  The current spread between MBS’s & 10-year Treasury notes is relatively high compared to historical standards.  The good news is that in all likelihood we will see the spreads shrink in the future which means mortgage rates will have to come down or Treasury yields will have to move higher (or some combination of the two). 

* “Even though Congress passed legislation last month allowing the Treasury Department to provide liquidity to Fannie and Freddie, the Treasury has stopped short of announcing any immediate bailout plans. The uncertainty about the government’s plans have fueled sharp price swings in the companies’ stocks, bonds and mortgage bonds” -This helps to explain why mortgage rates have been as volatile as they have been over the past couple weeks.  This will likely persist for a few months.

* “Fannie and Freddie guarantee or own nearly half of the total $12 trillion U.S. mortgages outstanding. They have long been the mortgage-bond market’s backstop, stepping in to buy when other investors have failed to materialize. With their finances under pressure, however — both companies have reported losses as the housing market has weakened sharply — they have been curtailing their mortgage purchases.” -This is not terribly encouraging.  The housing market needs the two GSE’s to stabilize the secondary market for mortgages.