GLG News by Brian Hershkowitz

Implications: This is an important article because it is detailing the possible exit from the mortgage business of another player that only dealt minorly in the subprime world, if at all.  One of the considerations not discussed in the article is the effect of the potential Economic Stimulus Plan specifically on conduits such as ResCap RFC.

Analysis: The Economic Stimulus Bill, if approved and implemented, will result in a great many positive measures.  While mostly geared towards dealing with recession and the related erosion of consumer confidence, a key part of the bill helps to put the mortgage lending business on more stable footing.  It seeks to do this by increasing the loan amount purchasable by Fannie Mae & Freddie Mac (a.k.a. the Government Sponsored Enterprises or "GSE's"), or insurable by FHA.

By increasing the loan amount from the 4's to the low 7's, much more product can be considered "conforming" and thus be securitized with similar, high quality product.  The GSE's can then carry out their role in providing a stable and available flow of funds for the purposes of mortgage lending.  There are few players that are affected negatively by this change, but one of those is RFC, who is the GMAC mortgage conduit referenced in the article.

A conduit is a similar entity to a GSE in that they buy product in, and securitize it for the secondary market.  They use a variety of means - including wholesale and correspondent lending. to purchase a wide variety of loans that fit into their certain lending programs, and thus create a marketplace for them.  RFC's niche was the high quality "jumbo loan."  The jumbo loan had all the inherent credit and collateral quality characteristics as a loan originated for one of the GSE's, but had a higher loan amount.  By Congress proposing the increase in the allowable loan amount, they are in fact eroding much of the niche that RFC served, as these loans will likely see both lower pricing and more streamlined execution at the GSE's.

It will be a touch decision for the GMAC sub to make, but it is clear that a key consideration has to be the evaporation of their marketplace and the possibility for them to encounter adverse conditions in loan sales if the more stratified and conforming product is going elsewhere.

Implications: This article is illustrating finger pointing looking for a villain, instead of "post-mortem" to find a hero.  What the industry needs is a clear plan for rebuilding the subprime securitization market.  In my opinion, a great part of that will be tied to the outsourced due diligence function, and the value those in that area add to the process.  One of the leading players in the space is now looking to be at odds with their client base. 

Analysis: Disclosure:  I hold a long (albeit small) position in Clayton Holdings, one of the firms mentioned in the article.. 

And let's also get an assumption for this analysis out on the table.  Markets in the US and around the globe are all responsible for the subprime situation.  Most every investor wants more yield, and wants plenty of product and liquidity available with an ever increasing return.  No one player is more greedy than all the others, and all the hunt for wrongdoers will do is show how large a problem this is.  It is simple theory that if increasing yield needs to be delivered on debt instruments, with available product at higher rates than the general market, then credit standards have to drop.

This is a tough one to analyze, but the message is clear to me that there is an avenue of inquiry being looked at here that will not result in positive change for the industry.  The type of finger pointing going on is seeking to find a bad guy in one or more of the participants in the mortgage industry. 

You can be confident that the major "Wall Street" securitizers named in the article didn't start cutting back on outsourced due diligence review to hide problems with underlying credit quality.  They may have, however, done so, to keep the deal flow at unprecedented levels.  It is clear to me, that they chose to use other diligence alternatives to make sure the book of business was what they expected it to be.  More than one of the firms captioned in the article actually built or bought a mortgage banking firm so they could better manage risk.  All utilized automated systems to return information about the collateral underlying the loans.  No one turned a blind eye to quality, rather they were driven to produce "yield rated" originations in very high volumes to satisfy the market.

All the securitizers were buying their loans from the same conduits, and selling them to the same marketplace.  I doubt anyone of them spent less on due diligence in 2007 then previous years, as compared to their peers.

NY is putting CLAY in a bad position with its clients.  Timing couldn't be worse.  If Clayton reinvented their business they could achieve outstanding organic growth by providing more services instead of less.  If they and the small group of niche players (including First American's Bohan, and FIS' Watterson Prime) would actually serve a role where they sat between the originators and the securitizers on every deal, and if typification of sub prime risk could be standardized, this would be a far better market to invest in.  Beyond understanding the level of risk, outsourcing a good deal of the pre-funding decisioning to qualified third parties makes sense.  Given the elimination of no/alternative documentation loans, and with enforcing reasonable (market based) loan to value ratios, it is possible to get back on the right track.

Implications: The Economic Stimulus Act, approved today, will go along way towards its name, and stimulate the economy.  Questions of how much money, too whom, and what may have been sacrified in the cross-party negotiation will remain unanswered, but one thing is clear.  Congress has delivered a very potent set of stimulus to the mortgage markets.  By increasing the loan insuring (FHA) or purchasing (GSE's) authority to more than $700k, Congress answered a prayer and request of many of those in the industry.  The business people know that this gives them a very streamlined and efficient way to originate, fund, and deliver loans to the secondary market and service a large percentage of the population of "A" mortgagors.

Analysis:  We should all be excited.  The mortgage space had become quite cloudy with the liquidity crisis involving subprime mortgages and the related disappearance of available funds for most Alt-A borrowers.  Excellent risk customers, with top notch credit and good downpayments were finding great challenges in getting decent loans.  With the expansion of the lending limits, "A" customers should have no trouble finding cheap and available credit.  This will be true whether they are pursuing a new home purchase (thus giving a nice shot in the arm to real estate values in most MSA's nationwide), lowering their rate (which has become a very worthwhile endeavor after the Fed's action earlier this week), or even taking cash out to retire debt (which always seems to bring with it more spending).

Whichever side drafted in the legistlation deserves a big round of thanks, because this will make a large difference in aiding a recovery that is more at the cause (than the effect) side of the recession.

I'd write more, but I think I will celebrate myself!  At a $725,000 loan limit, this is one benefit that we can say will have more immediate effect than the checks in the mail that most taxpayers will start seeing in June.

Implications: This article is a very good brief about the RiskMetrics IPO, but doesn't attempt to broadly touch the many areas that are set to shine from recent events in the subprime mortgage market.

Analysis: In any major market phenomenon, good or bad, varying firms across the globe stand to benefit or decline from the event.  The current issues involving the subprime mortgage market will be no different.  This commentary is about just a few of the winners and losers in the space.

Advantaged

Appraisal Vendor Management Companies
Due Diligence/Outsourced Underwriting Firms
Default and Foreclosure Service Providers

Handicapped

Offshore/Outsource Providers
Title Insurers
Retail Credit Providers & Retailers Themselves

The types of firms that will see a positive light shine on them are those that either will have enhanced demand as more workable subprime and alt-a lending gains a foothold, as well as those seeing enhanced revenues because of default and foreclosure activities.  Putting the latter, more obvious scenario of enhanced revenue from additional business aside, the thesis is that any firm that will provide product that enhances the overall quality of the loan's in securities going forward will do well.  Far better if those firms are firmly entrenched in the industry already.  Two good examples are appraisal vendor management firms, and due diligence organizations.

An appraisal vendor managment firm is a middleman between the originator of the loan and the appraiser who performs the valuation and provides the data.  Handled properly, the vendor manager can greatly enhance credit quality by:  a) making the selection of the appraiser independent of the requestor; b) providing detailed quality control review of the product (including AVM comparison) prior to submission to the underwriter; and c) maintaining a database of qualified, licensed or certified, and insured appraisers from which to choose.

Due diligence organizations like Clayton (NASDAQ: CLAY), Bohan (a subsidiary of First American, NYSE:  FAF), and Watterson Prime (a subsidiary of Fidelity Information Services, NYSE: FIS) already are firmly entrenched in the quality control component of mortgage lending.  Their biggest customers are the Wall Street firms that make a market in buying and securitizing loans.  With a few changes in the product line, they will be able to stratify mortgages and better classify risk.

On the flip side, those to be most hurt by the subprime marketplace are those that have high levels of "brick and mortar" expense while operating at far diminished levels (such as title insurers), those who provided services to the industry from a far (offshore/outsource), and firms that are affected by borrowers carrying fully charged up credit cards without room to spend.

Title insurers are uniquely challenged in that for the most part they must maintain presence in every local community they wish to serve.  Beyond the need for office space, they also must maintain those that handle the relationship end of the business, the salespeople.  In an environment of diminished volume, this group of companies will be the hardest hit.

A current issue in subprime liquidity and reduced market value from homes is that borrowers cannot easily attain cash out refinance transactions which would allow them to pay off their cards and start spending again.  Retail credit providers (the banks behind the store cards, for example) will begin to feel the pinch as late payments will no longer be cured so easily, and more accounts will go to chargeoff.  Retailers themselves, in addition to dealing with diminshed consumer confidence, will not so easily be able to extend new credit as FICO scores will not support the lending.

Finally, those firms in the Phillipines and India who have so much supported the mortgage lending industry will see diminished transaction volume, and hence less seats needing filling.  While much of this is tied to the reduction in mortgage originations, there are several other factors affecting the sector.  One of these is that troubled loans require more "high touch" interaction, which generally is not outsourced.  Another, and perhaps the most significant is that in times of diminished credit quality, it is not uncommon to take more work in house and not less - keeping layoff at the lowest possible rate, while keeping a sense of higher overall quality to the work.

Implications: It is terrific that one day gains reclaimed much of the territory lost over the various Asian exchanges on Tuesday.  The significance of the instant reaction to the price cut at the Fed's lending window was one of timing.  The question is whether this particular means for economic stimulus will have a long lasting effect.

Analysis: A cut by the Fed of 75 points is extremely significant.  It shows a serious intent to disassemble the mechanisms of recession, and encourage spending and growth.  This happens for two reasons - first that banks have more "inexpensive" raw materials to make loans with, which should lighten the tightening of credit we have seen that.  The second reason is that the economists hold forth that this increase in lending will naturally result in an increase in either investment or spending.

The questions of how this helps in the longer term are more complex.  Tightness of credit and lack of spending are symptoms of a recession not causation.  While the Fed did a very apt job of throwing a wrench in the works and alleviating some of the symptoms (particularly those of a credit crunch brought on in part by concerns about diminshed credit quality), we have to wonder about how long it will be before spending begins to diminish again.  You can't make 75 basis points cuts continuously, and the underlying problems of lack of both consumer and corporate confidence need to be addressed as soon as possible.

I believe this measure bought the Fed, the US, and the Asian markets more time to deal with matters that are the core of the issue.  There are basic reparations that need to be made in the mortgage lending system that will help restore confidence at all levels, both by assuring available credit for investment more naturally, but moreover by helping to stabilize real estate values in the US.  A lot can be gained by studying consumer confidence and its relationship to recession and trying to work on the former to resolve the latter.

One parenthetical comment, is that we should all hope, and frankly it should be the utmost wish for investors on the Indian subcontinent, that the statement by India's Finance Minister Chidambaram, "There is no reason at all to allow the worries of the Western world to overwhelm us," will be ignored or refuted or whatever it takes to make it go away.  Like it or not, the emerging economies are extremely affected by conditions everywhere else.  India in particular must deal in lower growth rates in the event of a Western recession, but moreover the reduction in offshore outsourcing dollars that are building their economy at light speed.  The minister's statement harkens back to a day when an isolationist economic policy was believed to be the only way to control the organization.  It is clear from the currency and investment policies of the country that to some extent they still want to stay independent of the world in terms of monetary policy, but the economy is most certainly a global one, and India needs the worries of the West to be all settled.  As do we all.

Implications: The reduction in US consumer spending is hopelessly enmeshed in the availability of mortgage credit, housing prices, and generalized consumer confidence.  The slowdown in the US economy, tied to these three macro forces, will greatly affect both established and emerging markets across the globe.  No where will this be more felt than in Asia.

Analysis: Goldman's forecast relates to three general conditions.  Recession (both standalone in the US as well as in concert with Japan); emerging markets; and currency weakness.  The general result of these conditions is clearly diminshed growth rates in Asia.

Where are these recessionary economics coming from, and why are matters getting worse?

While the clearest effect of the subprime debacle is its effect on housing prices in markets across the US, one cannot underestimate the effect of lessened refinance activity on spending.  Correlated is the generalized consumer mindset.  The trend is affecting both the affuent and the average individual in the US.  This too is not due to simple macroeconomic principle, but rather to the availability of mortgage credit.

What is at the very heart of the subprime meltdown is the overextension of credit beyond reasonable loan to value limitations.  Seeing the opportunity to earn fee income by continuing to refinance existing mortgage debt, subprime lenders catered (perhaps even solicited) troubled borrowers whose focus was on spending.  Individuals were driven to reduce their monthly debt obligations, but rather than retire their revolving lines of credit, they would pay them down using the proceeds of the refinance activity, and then immediately continue the pattern of spending that would build balances quickly.

The largest effect on consumption rates is being driven by some borrowers (primarily the subprime credit risk) who cannot obtain additional funds or recast their current loans with additional cash out, as well as the "prime" or "Alt-A" customer who cannot refinance because their loan to value ratio is not acceptable given that their property has depreciated.  These individuals and households were dependent on revolving credit to pay for their spending.  With out the possibility to eliminate monthly obligations through cash out refinance, a much greater portion of their net pay must go to debt service.  Consumers are "cash poor" and thus confidence is lacking, and they are afraid to make both large and small purchases at the consistent growth rate for spending evidenced over the past few years.

Clearly the effects on Asia are significant.  The articles comments about India and China also address that outsourcing is becoming more costly in emerging markets, in part because of currency appreciation.  A vicious circle where the lack of consumer confidence and spending in the US further increases difficulty with imports and related growth.   All the worst though for India, as many of the firms closest to the mortgage lending industry are the biggest utilizers of outsourced programming, IT enabled services, and call center services.  As these firms consolidate, there is a smaller pool of potential customers, while diminished volumes have a very large effect on per transaction services or even hourly rates for offshore operations.

Implications: While many eyes are on the transaction as a proposed bailout for Countrywide, Bank of America will be solving a good many problems for themselves, while purchasing the fuel for tremendous growth.  The advantages for Bank of America are many but the largest are the resolution of their August 2007 investment of 2 billion in Countrywide for a 16% stake now devalued by the market, the availability of a full functioning nationwide sales and fulfillment channel for mortgage loans, the acquisition of a large and highly profitable servicing portfolio, advanced technology, and a top notch executive and management team.

Analysis:

Bank of America has made an exceptionally shrewd, well timed, and well priced stock offer for the shares of Countrywide.  In the process of offering up a lifeline to a competitor in a good degree of difficulty, they've delivered a large group of benefits to their shareholders.

The single largest benefit of the transaction will be immediate growth.  Bank of America, even with the large footprint it has in the US, has surprisingly not been a leader in loan origination.  They've had to silently sit back while many of their customers (large and small) chose to obtain mortgages elsewhere.  The idea of applying and getting approved for a mortgage in the time it takes to drink a cup of coffee with the branch manager never really materialized.  Countrywide has both the centralized and the distributed sales force, along with the best origination and underwriting technology in the business to deliver a tremendous cross sell of the bank's existing customers to their mortgage products.  While needing to keep a tremendous "brick and mortar" presence in every town and neighborhood in the US was one of the thorns that pricked Countrywide as volumes dropped, the opportunity, over time, to combine locations will allow for tremendous efficiencies.  While B of A and Countrywide both had sizeable presences in the non-retail (broker and correspondent) origination market, Countrywide has been in the number 1 or 2 position for years, and once again will bring incredible market presence, technology, and management to their new parent that will spur growth.

The next area for discussion is the mortgage loan servicing portfolio.  Estimated in this article at 9 million loans, representing over 1.5 trillion dollars in loans, this asset has tremendous income generation capability.  Though the article mentioned that the portfolio is "troubled," don't think this reduces the over all value of the servicing rights, nor the annual fees retained for servicing the loans.  In the current environment, with subprime and "alt-a" loans being harder to fund, and property values not rising - which affects "A" mortgages as well, loans are staying on the books longer and longer.  As servicers get paid for whatever term the note is being serviced, an increase in duration implies an increase in revenue.  Troubled loans do cause additional expenses (due to more interaction with borrowers), but many of the more costly and complicated steps and costs of servicing a defaulted loan are borne by the investor.  Countrywide is (in general) not an investor - they are a servicer.  For years and years and years, Countrywide has been telling us about their servicing portfolio being a macro hedge against diminshed origination volume.  That scenario is here, and while the high flying income statements in record orgination months are not being seen now, the macro hedge is of great relief to both the balance sheet and the P&L.  It would be naieve to think that a company as large as this would be able to survive forever on their servicing rights (which will extinguish over time), given the costs of operating such a large organization.  But combine the valuation and cash flow with a renewed opportunity to originate in collaboration with their parent (think synergies and large growth), and there is a clear path to improvements in earnings.

Related to this point is that Bank of America is getting a world class servicing system.   Over the course of several acquisitions, B of A has ended up with a variety of systems from different firms, used in different ways.  If they choose, they could easily unite their servicing technology under Countrywide's very capable systems.  Countrywide has always been a "builder" and not a "buyer" of best in class technology and the systems have been specified, designed, and built by people who really understood servicing, and that while modern, have already had the test of time applied.  Beyond technology, Countrywide does not outsource many of the sub-processes involved in servicing (thus keeping additional fee income for their own coffers).  B of A could greatly benefit by adopting a stable "in-sourcing" solution to many of their post funding loan administration needs.

B of A is also getting a top notch management team.  Much in the spotlight over the snowball effect of the subprime liquidity crisis, the group of leaders the company has are very well versed and have extremely long terms in both the mortgage business and at Countrywide.  There is little that is not measured, reported on, discussed, and acted on - this is an environment that gets things done in good times and bad.  B of A would be very smart to ensure these individuals are happy to stick around, as they are a very knowledgeable and decisive group that has braved many storms over many years, and kept the company in the spotlight of origination.  Not the least of the most valuable assets acquired will be the attention, focus, and advocacy of Angelo Mozilo.  When Lewis talks to Mozilo next week, let's hope he offers a compelling vision for the future, as in many regards, Mozilo has been the leader of the industry, and is a very active and involved Chairman and CEO.  Mozilo always kept the company equally focused on its roots and its future, and will help drive the combined companies to unprecedented growth in the space.

There are many more advantages and some things that will need to work out over time, but overall B of A bought itself what will prove to be a great winner.  Leverage the technology, adopt the nationwide origination, underwriting and closing capabilities for both retail and wholesale, and retaining the people is all it will take.