GLG News by Maureen Bolton

Implications: This article is important because it announces and describes: a) the US Treasury's support of covered bonds, an on-balance sheet method of funding mortgage originations, as an alternative to off-balance sheet mortgage securitizations or mbs b) Four major US banks announcements of their intentions to bring covered bond issues to market in the near future and and their commitment to provide pricing information in order to facilitate the trading of covered bonds and c) the FDIC's support of a covered bond market and its policy statement describing how it would treat covered bond investors in the event that an issuing bank become insolvent. The government and market participant actions described in the article are remarkable because they appear to contemplate an on-going involvement of the US Treasury and FDIC in the funding of mortgages that is more hands-on than any such actions to date, creating a defacto US govt gtd covered bond market.

Analysis:

I believe that the covered bond market advocated in today's announcement by the US Treasury, coupled with the "Best Practices" posted on its website and the FDIC's policy statement (also on its website) with respect to covered bond investors in the event of a covered bond bank issuer insolvency create, in effect, a US government guaranteed mechanism for funding residential mortgages.

Implications: This article summarises Temasek's recent equity investment in Merrill, including the price paid and future intentions.  Temasek appears to be more than satisfied with its investment and is inclined toward similar investments (financial institutions undervalued due to over-estimates of subprime/CDO related losses) in the near future.

Analysis: Its not surprising that Temasek supports Merrill, despite its subprime problems.  First, it has been less than a month since the investment in Merrill was announced and absent some sort of horror scenario,(e.g. the new CEO is jailed for fraud, actual losses in excess of US $500 billion are revealed and the company declares bankruptcy) Temasek is hardly going to declare its equity purchase was a mistake.  Second, it would be foolish for Temasek (and other sovereign funds) not to invest in Merrill or institutions of its ilk.  To date, the overly-publicised "losses" are not cash shortfalls due to non-receipt of cash due bond portfolios, but declines in market value.  There is a big difference between the two. Investors that can figure it out must act quickly. Opportunities like this arise rarely, if ever, in a lifetime.

Implications: This article is important because it reveals the current efforts of banks to sell off leveraged loans and contrasts such efforts with past sales.  The fact that banks are offering price guarantees and discounts to buyers of loans related to buyouts of recession-proof companies is an indication that getting rid of the enormous, committed leveraged loan pipeline will be much more difficult than anticipated. In addition to detailing the type of terms the banks were offering sellers, the article also contains a terrific illustration of the  current road show environment  -still crowded- and attendees -KKR attended and bought loans related to its very own deal-resulting in the borrower merging with the lender. 

Analysis: It's good to hear that the leveraged loan road show are more crowded -could be that most attendees were curious to see loan packages related to the largest PE deals and the other attendees were future sellers hoping to grab marketing tips, which will be sorely needed.

Most may feel that last week's shows were a harbinger of difficulties to come, which does not bode well for those waiting in the wings to allocate risk related to buy-outs of non-recessionary proof companies.....

Having said that, all  leveraged loan sales exceeded projections and, all kidding aside,  the shows were crowded -both of which mean that liquidity still exists. 

On the other hand -these buyers may not be first, but they sure aren't dumb.  Getting price guarantees and discounts from sellers who aren't used to acknowledging requests or questions about such things in past sales, is definitely a sign.  The old days are over.  The liquidity sponge may have  room to sop up the rest of the leveraged loan pipeline-but only on its own terms.

Implications: This article is important not only because it announces a US$1.3 billion write-down of UBS' fixed income portfolio, but because it parallels the situation with that of Bear Stearns' (huge write-downs followed by the "departure" of a key executive) and questions whether there are more of such "disclosures" in the coming week as Merrill Lynch, Deutsche Bank and others announce their third quarter earnings.

Analysis:  By now we know that Deutsche Bank, along with Citigroup and Morgan Stanley joined UBS in announcing massive write-downs.  Deutsche Bank's chargeoff totaled US$3.11, lowering its profit by 20% from a year earlier.

It seems as though an invisible switch has turned a spotlight on banks' fixed income portfolios and all those worries about "hidden" losses leaking out quarter by quarter can be put to rest.

Even if this is so, I don't believe the street collectively decided to be so conservative with valuing their esoteric securities.  As the WSJ hints in an article today, most of these "confessions" resulted in an immediate increase in the confessors' shares.

Since it is so difficult to objective value many structured securities, it could be that the banks are taking huge losses now, so that they can report profits later.  Think about it.  If this is the case UBS is simply joining the herd.
UBS' "lemmingness" and not the fixed income portfolio losses are the problem.  UBS has a history of buying expensive, experienced teams in order to aggressively enter a hot market and there efforts have never been successful.  Perhaps this loss is just another signal that they should stick to their knitting, regardless of the trends.

Implications: This article announcing Morgan Stanley's plans to invest in Jutian Fund Management is important because it reveals another component of Morgan Stanley's investment strategy.   It also indicates that wealthy Chinese may be a more lucrative target for foreign investors, as opposed to the potential billion retail accounts.

Analysis: Morgan Stanely has had a presence in China since the early 90's, ahead of all of its Wall Street competitors.  They have established contacts, have invested in a large formerly owned government bank, created a joint venture securities firm and a smaller regional bank.

In all of its other acquisitions, the key to profitability is maintaining their local-ness.  The average Chinese consumer and retail bank customer is extremely loyal and has no knowledge or expectations of Morgan Stanley's expertise.

One exception to this key, is the wealth management business.  China has slowly begun to allow its citizens via certain banks to invest their foreign currency income in foreign securities via the QDII regulation and this has proven extremely popular.  Due to the lack of a liquid long term bond market in China and equity markets with artificially high prices, the Chinese have little investment alternatives.  The government has already admitted that the real estate market is out of control and will ultimately have to allow its people, particularly wealthy people, to go outside of the country to invest their money.  When this happens (and if the laws permitting it limit such investments to foreign currencies, similar to QDII -it can happen quite quickly) Morgan Stanely will be perfectly poised to service such investors, who appreciate their reputation and expertise.

Jutian is a perfect choice for this strategy, as it is located in Shenzen, which is a short ferry ride from Hong Kong.  Mainland Chinese currently residing in Hong Kong or even Hong Kong citizens will be attracted to such a close fund manager.

Implications: This article is important because it describes the nearly five-fold rise in call center businesses in Carribean countries such as Jamaica and the Dominican Republic.  The article also details the positive economic impact that opening one call center can have on such small countries.  Finally, an optimistic prediction that such call centers can eventually evolve into more profitable work, such as creating web sites or assisting with IT problems is made along with the consequent mpact on the islands' employment levels and wages.

Analysis: While I heartily agree that Caribbean locals, who are used to providing impeccable customer service from being economically dependent upon tourism for so long, are excellent candidates for out-sourced call centers, they are a far cry from being considered a threat to India.

Answering customer service questions is one thing, building web sites, preparing US tax returns or providing computer programming services is quite another.  While the article cites one company's,Jamaica's e-services, evolution from providing data entry services to creating web sites and processing insurance claims - I doubt many others will be able to make the leap from simple customer service chores to assisting companies with developing IT sources or reviewing complex documentation and making recommendations. 

The reason why India has been so successful in attracting and staffing outsource centers is its educated workforce.  Indians providing complex outsourcing functions typically have postsecondary educations from one of India's hundreds of competitive IT schools. 

Educational Institutions similar to those in India simply do not exist in the Caribbean and creating websites and programs are simply not skills one can easily acquire "on the job".

If the governments of the Caribbean countries are sincerely interested in the long-term growth of their economies, they need to help their citizens develop the skills necessary to compete with India and other countries.  Transitioning to a knowledge-based economy requires the diversion of tourism profits to the creation of appropriate education and training facilities.

Implications: This article is important because it announces the break up of what was to be one of the most synergistic mergers in mortgage-insurance history.  MGIC with its portfolio of traditional mortgage and bond insurance business  coupled with a bit of international exposure and Radian with its new product development skills and ability to rapidly respond to clients and assist them in assessing and pricing risk.  Unfortunately Radian lost MGIC's interest when their in-housen expertise at pricing and profiting from distressed mortgages -C-Bass lost  US$1 billion in market value due to investments in non-investment grade subprime mbs.

Analysis: The most significant impact this merger will have is the imminent downgrading of Radian by all three rating agencies.  Both firms have announced that Radian would lose its AA/A2 rating if the MGIC merger was off.

Radian's value (and consequently that of its insured municipal bonds and of mortgage pools backing mbs issues which are guaranteed by Radian) will collapse without its AA rating.  The AA rating is specifically what makes Radian attractive as a mortgage and bond insurer.  At the very least, a downgrading would impact what Radian could charge for its guarantees, at worst, their business will completely evaporate.

Unfortunately, Radian's primary source of dealing with any distressed loans it ends up taking into portfolio due to borrower defaults is C-Bass.  A victim of marking to market, C-Bass' still has a tremendous platform for pricing, re-underwriting and selling (at a substantial profit) distressed loan portfolios.  That is a business that is growing at a tremendous rate and C-Bass is poised to take advantage of it.

Will Radian end up giving C-Bass capital to grow their business?  Highly doubtful for a variety of obvious reasons?  Selling C-Bass and its US$1 billion market value loss is much more likely.  Would MGIC, who also is a part-owner of C-Bass, be a potential purchaser? Again, doubtful, as the C-Bass loss is the primary cause of MGIC's turning runaway bride.

Implications: This article is important because it introduces the reader to Alan D. Schwartz, the new sole President of Bear Stearns, a dominant player in the mbs markets and raises the question of whether he can assure bankers regarding Bear's ability to retain the same access to the same money at the same rates.  The article also questions whether Bear Stearns can be successfully run by an investment banker and whether an outside investor may be solicited or decide to take advantage of Bear's lower stock price and take a sizeable position.  Current market conditions have caused the collapse of two hedge funds run by Bear and a crisis in confidence among its lenders. 

Analysis:    This article raises key issues relevant to the future of Bear Stearns.  First, can Schwartz assure Bear's continued access to credit at rates low enough for Bear's continued profitability.  I believe the answer to this is yes.  As the article points out, Schwartz is a relationship banker not a "mortgage guy" and Wall Street's major lenders are likely to be more receptive to his approach, which will be more diplomatic and conciliatory as opposed to the "bull in a china shop" style which is Bear's trademark style.

The article also raises the issue as to whether Schwartz is the guy who can lead Bear on to continued growth and profitability. Based upon my experience with Bear and the mbs market, I would say no.  Bear is primarily a mortgage house.  Before former Chairman Ace Greenberg made the strategic decision to focus on the mbs markets in the mid 80's, Bear was an unknown and irrelevant player in the capital markets.  Describing Bear's investment banking business as overshadowed by its bond operations is like describing a toy sailboat as being overshadowed by an aircraft carriers.  Warren Spector and a handful of his close colleagues were the impetus behind the gigantic growth of Bear's ability to price, trade and sell mbs which generated huge proprietary income and sales revenue. 

Given recent events, e.g. the collapse of Bear's hedge funds due to valuation and subsequent funding problems, it is highly doubtful that Schwartz or Cayne have the stomach to jump in and seize the gigantic opportunity that currently exists in the mbs market.  Bear, better than any firm with the exception of Lehman, knows how to price undervalued mbs.  They could quickly turn the hedge funds' collapse into a distant bad memory by taking huge positions in downgraded mbs tranches that are trading at unjustified prices.  These bonds have not experienced losses in cashflow, yet the market is discounting them by as much as 50%.   But Schwartz and Cayne have 1) been burned and forcing Spector to leave the firm clearly sends a message to the market that Bear is going to change the way it manages risk and 2) even if they did decide to go for it, Bear's lenders are not likely to stomach more risky mbs purchases.

The third and most crucial issue of course is whether Bear can survive.  I'm confident Bear can survive.  As S&P made clear yesterday, Bear's capital position is more than adequate and they still have their potent posse of mortgage traders; however, will they thrive under Schwartz/Cayne's management?  I'm not sure.  It depends on whether they can trust one of Spector's Lts. to develop and implement a Spector-like strategy -which does not seem likely, at least not until a sufficient (read more than a year) period of time has passed. One thing that would assist Bear in regaining and surpassing its previous dominance is an investor with a huge balance sheet and high risk tolerance  -which means Schwartz/Cayne may no longer be managing Bear.

Finally, a potentially huge factor affecting Bear's ability to thrive: Spector could be dialing up his team at this very moment, convincing them to jump ship and join him in starting a new investment vehicle, designed to take advantage of current market opportunities which he actually helped to create.  I think the only thing stopping this scenario from actually is occurring is ..... funding.  Think that could be a problem for Warren ......at least for awhile.

Implications: Recent discoveries regarding Chinese distribution of poisonous toothpaste, dog food and candy should cause us to reassess China's position as an Economic powerhouse. Sure, the Japanese and Koreans once made dodgy products, but their mistakes were due to their learning curve, as opposed to a deliberate deception in order to save money by swapping poisonous materials for more expensive ones. In this article, Nicholas Vardy cogently compares the mirage of China created by the media with the cold reality of its shaky economic state.

Analysis:  

The discovery of China’s recent attempt to lower manufacturing costs by substituting dodgy and in some cases, poisonous, ingredients, in order to save money, will no doubt impact any company thinking of outsourcing work to China –but how long will investors remember this?

Clearly, China is the go-to place for growth. Sustaining impressive GDP growth rates year after year means they must be doing something right. China is well on its way to surpassing Germany as the world’s third largest economy by the end of this year. China’s 1.2 trillion in foreign currency reserves gives them a weighty position in the global debt and equity markets. China Development Bank’s recent commitment to purchase Blackstone stock before its IPO no doubt sparked the interest of other investors and contributed to the success of the IPO. Goldman Sachs, HSBC, Morgan Stanley and a seemingly infinite list of the largest and most profitable institutions have all, or are in the process of, purchasing equity in a Chinese partner, usually a formerly government owned bank. Who wouldn’t want to rush-in?

Not me, at least not yet. As Mr. Vardy’s article points out, for several reasons, including the dodgy toothpaste, that China’s current management of its economy cannot be sustained.

This should be of no surprise, as Mr. Vardy states in the article “Communist political systems and economies tend to consistently overestimate their economic achievements and underestimate the costs that the culture of corruption has on future development." Russia, which defaulted on its government bonds, shocking investors worldwide, is the most recent large-scale example of how one can get burned by cooking the books.

Take China’s enviable 1.2 trillion dollars in foreign currency reserves –it is equal to the amount of bad debts on its banks’ balance sheets, which is equal to 50% of China’s GDP. These banks with bulging non-performing loan portfolios are the same financial institutions that completed successful overseas IPOs over the past three years. As BusinessWeek pointed out a few weeks ago, while it may seem that maintaining such large reserves and rising export surpluses are a sign of economic strength. in a real economy, they are signs of an over-reliance on exports, weak domestic consumption and a primitive financial system.

I’m not sure if I believe, as some do, that China can only achieve a sustainable economy by changing its politics.. I believe that China’s slipshod management of its economy can actually create opportunities . The recent bad press may make it more difficult for China Focused Hedge Funds to attract more investors, if they even need to. The insolvency of Chinese Banks may make it difficult to mark-to market fund investments –if you think Bear Stearns had a hard time ….

Implications: This article summarizes Fed Chief Ben Bernanke's recent testimony last week before the Senate Banking Committee and the House of Representatives. the Subprime Mortgage/housing market and the expansion of the Federal Regulators' role in monitoring mortgage lenders. Mr. Bernanke's remarks regarding both of these subjects are extremely significant, as hundreds of billions of subprime mbs and CDOs invested in such securities will be impacted by how the Fed views the damage caused by improper lending/underwriting and describes its impact on the overall potential for continued economic growth.  

Analysis:  

The global fixed income markets have virtually come to a standstill regarding potential subprime losses, and lack of liquidity due to lack of trading has already caused billions of “-on-paper” losses. If Mr. Bernanke had accurate information regarding the extent of such losses, or at least had narrowed his estimates a bit (a range of 50-100 billion is bit too wide to be considered credible) we would all take some comfort in the Mr. Bernanke’s remarks.

Unfortunately, no one, not even Mr. Bernanke can know, with any type of accuracy or precision, the extent of subprime losses. If Mr. Bernanke wished to provide some clarity regarding this unknown that has been stultifying the market, he would have asked his staff to distinguish actual “hard-money” losses, i.e. the amount of money that investors in subprime mbs have not received due to subprime borrowers’ failure, for whatever reason, to make their monthly payments; from “market” losses” i.e. value write-downs due to mark-to-market requirements required by accountants and lenders.

This difference is crucial, since the primary reason behind the tremendous valuation write-downs are not hard-money losses, but an increase in delinquencies causing market panic and subsequent illiquidity. One could argue that the Fed’s primary role here should be to provide clarity to the situation, as opposed to adding fuel to the fire by irresponsible throwing out meaningless, unsubstantiated numbers.

As far as the Fed’s requiring broker licensing –this will be meaningless, unless it is implemented at the federal level. The inconsistency of various state regulations has clearly contributed to the subprime mess. This is the time for the Federal regulators to take control.

Regarding China –I support Mr. Bernanke’s earlier remarks that the Yuan’s value does not fit the legal definition of “export subsidy”. Mr. Bernanke could have taken this address as an opportunity to explain the global economic consequences of China rapidly devaluing the Yuan and note that if China would take such an action, our local industries would wish they hadn’t. Mr. Bernanke is an economist, after all, who better to educate congress and through them, the American people, on fundamental issues regarding international finance.

Implications: Thanks to the recent increase in subprime mortgage delinquencies and defaults, the media has finally divulged three of the lesser known US mortgage industry practices. 1) Credit scores are not (or should not be) the sole factor in categorizing borrowers as “prime” or subprime”. 2)Brokers are compensated almost twice as much for bringing lenders subprime vs. subprime loans. This provides more than enough reason to put a borrower in the “subprime” camp, regardless of the qualification process. 3) Despite the deluge of information regarding mortgage products and interest rates that is made available to all of us via television, radio and newspaper ads-not to mention the internet, homebuyers most frequently rely solely on their realtor to assist them in obtaining a mortgage..

Analysis:  

When FannieMae, one of the most vital contributors to the US mortgage industry, admits that up to 50% of subprime borrowers could qualify for prime loans, the message is clear: mortgage lenders need to re-examine their underwriting and broker compensation practices, before the regulators do it for them.

Since February of 2007, Capital Hill has been flooded with lender lobbyists, consumer advocates and politicians promising to help the subprime borrower. Despite the sins of the brokers and lenders, the most responsible party for this injustice is the borrower him or herself. A few additional phone calls can make the difference between a 6% loan and a 12% loan. The information necessary to find the most economical loan for all of we borrowers exists, we just need to open our eyes and read it.

I fervently believe that borrowers lacking the financial literacy to compare interest rates and loan terms should be entitled to some sort of guidance and protection. This exists in the form of RESPA and state and local consumer lending laws. Such laws require that lenders inform borrowers that they have a choice of lenders and that they may be able to obtain a lower rate. The laws also require that brokers disclose their compensation. It is difficult to believe such laws exist if 50% of subprime borrowers could qualify for mortgages with much lower rates. Politicians and regulators would be more effective if they ensured the enforcement of these laws instead of discussing modifications and bailouts.

Implications: This FT article brings up an issue that most of those interested in the subprime mortgage sector have been discussing –modifications for borrowers who are willing but not able to pay their mortgages. Most of the discussion has focused on legal and tax issues –Can you modify a loan within a REMIC? Will doing so destroy true-sale status? But this article describes a new issue: CDS investors, (i.e. those taking a short position in specific subprime mbs deals) claiming that loan modifications will minimize losses in subprime rmbs and therefore negatively impact the value of their CDS. To make matters worse, the broker that sold them the CDS is the same broker that structured and sold the subprime rmbs. Do we have a conflict here?

Analysis:  

There is no conflict for several reasons:

-the broker that structured and sold the rmbs is not the party that makes the decision to modify a securitized loan. That responsibility is the Servicer, whose primary obligation is to maximize the value of the securitized mortgage pool.

-I realize broker/dealers own servicers; however, any evidence of interference with the Servicer’s obligations would jeopardize the true-sale status of the rmbs transaction. Which is a risk no one wants to take, even if modifying the loans upsets the CDS holders …

The industry should have expected this. If the CDS investors had read their deal docs, they'd realize they have nothing to fear -but successful subprime loan modifications. And why worry when there is nothing they can do about it?

Implications: This article, published last week's Economist, is the first article purporting to explain the global credit derivative market that I have read which isn't full of algebraic formulas.

It is a cogent and clear primer on derivatives and would be helpful to investors, clients and portfolio managers who are not yet familiar with derivatives. 

In addition to explaining how derivatives are structured, their purpose in the fixed income markets and their past and probable impact on risk management, the article offers significant food for thought on whether derivatives will do their job (i.e. mitigate the impact of credit defaults) when the bond market tanks.

Analysis:
This article is important for anyone working in the finance industry that uses derivatives as a credit hedge or to short certain corporate credits because the authors raise fresh issues that will certainly impact the demand for such instruments and the "approach" taken by most regulators /auditors in assessing or valuing derivatives as part of a portfolio review.

While derivatives clearly dissipate risk by dispersing it among many more parties other than the bond issuer and original investors, this may not be such a good thing.  As more "ring-fenced" special purpose vehicles are created providing investors with even more assets to purchase, the possibility that somewhere along the line, responsibilities are diffused and when massive defaults eventually happen, all parties involved simply point fingers at each other, either literally or via litigation, instead of accepting their "medicine" and moving on.

In essence, the global credit derivative market creates a huge pool of liquidity (see the article's chart illustrating the tremedous growth of this market over the decade) that is outside the purview of any central bank.  Is this a good thing or a bad thing?  I'll leave it to you to decide.

Implications: This Standard & Poor's report, released March 14, 2007 provides both crucial information and comfort to investors in subprime mbs or subprime mortgage originators. 

In light of the recent media blitz about increased defaults in subprime mortgages, S&P contacted each major Servicer and "Special Servicer"  to gauge their preparedness for the deluge of defaults subprime mortgages are expected to experience.

A cogent summary, it provides an introduction and succinct explanation of loss mitigation, how it is implemented by the Servicer/Special Servicer and gives one an idea of how a few of the largest players plan to approach this anticipated problem. 

It is no surprise that Foreclosure is not at the top of any of the servicers' plans.  In addition to defining "Loss Mitigation," the report describes the economic and operational aspects of the various alternatives to foreclosures.

Analysis:

The market, or at least those new to the market, has been crying out for such an article.  Despite all the media attention aimed at what has come to be know as "the subprime crisis" , I Have yet to come across one article, besides this S&P report, which states that there are alternatives to foreclosures. 

This article  not only explains loss mitigation, but also provides the reader with specifics on how the major players intend to cope with subprime mortgages.  Surprisingly,  throwing poor families that have been tricked into subprime mortgages out on the street isn't in any of the servicers' strategies.  One would never guess from what we're reading in the newspapers! 

One other note -S&P does not completely explain their servicer rating/review process, however, they do emphasize how crucial the Servicer's operational processes are.  Financial Strength is considered if there is a sudden change in a company's capital and the change is drastic enough to cause the servicing management and staff to begin resigning.  

Implications: This article is important because it announces the willingness of US mortgage lenders, most of which are banks, to supplement their typical funding mechanism (i.e. mbs) to covered bonds. 

The article also provides a brief explanation of the covered bond structure and its authors indicate that several US banks are poised to follow WAMU and Bank of America and start their own covered bond programs.

Understanding the Covered Bond structure is crucial; If investors continue to avoid the US mortgage market;this funding mechanism will be adopted by more and more lenders.

Analysis:

Covered Bonds have been used by European Issuers for centuries, to fund a variety of assets, including residential and commercial mortgages.  However, this structure was not widely used tby European lenders to fund residential mortgages until late 2005,

  Covered Bonds are an on-balance sheet bond secured by the lender's portfolio, the size of which must be 20-40% larger than the amount of Covered Bonds that can be issued. This contrasts with an mbs issue, which provides off-balance sheet-treatment and does not require substantial, if any, overcollateralization.

This structure has not been widely used by US lenders because it is is inefficient.  The substantial overcollateralization unnecessarily ties up a large portion of the lender's portfolio, since the mortgages representing the overcollateralization cannot be repo-ed, sold, securitized. 

The reason why European Lenders switched their funding structure from securitization to Covered Bonds is that European investors had no information that could assist them in evaluating prepayment risk related to US mortgages, which has a direct impact on an mbs yield.  Because the Covered Bond issues are substantially overcollateralized, they enable the lender to issue "bullet bonds"  or bonds with a definite maturity.    If the underlying mortgages prepay, there is extra cash flow from the Covered Bond portfolio to continue paying the bonds.  No need to worry about borrower behavior.

US investors and lenders were never too interested in the Covered Bond structure, since data regarding US mortgage payments is widely available.   The inefficiency/negative carry  of the Covered Bond structure simply was not necessary.  Why have the lenders changed their minds?  Could it be because European investors, tired of reviewing prepayment models in order to price a US mbs, are now demanding the bullet structure?  It's entirely possible -another reason -Covered Bonds  may be the only way to leverage/fund US mortgages in the near future if the media blitz on the US mortgage meltdown continues..  If this is, indeed the case, it significantly limits US mortgage lenders' access to the global capital markets.   Only a few large lenders have the portfolios necessary to support a Covered Bond program. 

Implications: This article is important because it contains a detailed and substantiated explanation of why the current problems with subprime lenders are an opportunity and why, despite the predicitions of just about every newspaper in the country, subprime loans are here to stay.

Analysis: This article is long on facts and short on opinion.  For example:

It is a fact that Wall Street firms, not greedy lenders or foolish borrowers have been the force behind the tremendous growth in subprime lending.

Wall Street is not going to turn away from this cash cow.  As evidenced by the recent purchases of Wall Street firms by Merrill Lynch, Morgan Stanley, Deutsche Bank, UBS and the recent cash infusions made to firms near bankruptcy by Citigroup and Morgan Stanley.  These firms know that the demand for subprime credit will continue and they want to be in a position to take advantage of it.

The article also correctly mentions that Wall Street will most likely surpass its domination of this market, as depository institutions will most likely exit this market due to growing federal regulatory concern and talk of guidelines that would be impossible for even the most prudent lender to file without exposure to litigation.

Bottom Line:  Subprime will survive.  Now that Wall Street owns their own pipelines, they will have better control over the quality of the underwriting, which will lead to significant lowering of fraud and delinquencies. 

The impact on the consumer? One thing the article doesn't mention is the de-fanging of Freddie and Fannie has contributed to the development of this market, since their failure or inability to participate early on enabled the Street to dominate the market before the GSEs had time to do their own credit analysis.  Bad or good, the GSEs participation in this market would or arguably should, be the primary protection for borrowers.  If GSEs set the standards for underwriting for the subprime market, as they have for the prime market, their lower cost of funds would make them a powerful force and the Street would have to follow the GSE  lead (just as they have for the past twenty years in the Prime market).

Will this happen?  Not unless the GSEs present a plan for their prudent participation in the subprime markets -and do it soon.

Implications: This WSJ article is a cogent summary of recent efforts by State legislatures to protect borrowers against subprime lenders.

If implemented, any one of these proposed laws will immediately cut-off a vital source of funding for subprime borrowers.

In addition, the statutes would generate a significant amount of business for class action lawyers.

Analysis: This article mentions that Iowa's Attorney General is proposing legislation that would require mortgage brokers to limit their loan origination to mortgages that are in the best interest of the borrower and not the Lender.  The inevitable consequences of such legislation would require lenders to offer their customers loans with rates lower than their costs of funds (since to do otherwise would be advantageous to the mortgage lender).  Profits would be eliminated and therefore mortgage lenders would stop making mortgage loans.  Where will the state's citizens obtain funding for a home purchase?  I'm assuming the State Government.

The current Truth in Lending Act is sufficient to protect any literate borrower.  It requires the lender to provide the borrower with a clear explanation of the terms of the loans, including the maximum monthly p&i payment, APR interest and the entire amount the borrower would have paid if he never refinanced (i.e. the amount over the entire 30 year duration of the loan).

Having said that, subprime lenders need to bear some responsibility for such a strong reaction.  Underwriting a hybrid ARM to the teaser rate (instead of the fully indexed rate) is creating a time bomb.  Essentially, such lenders were gambling that interest rates would fall and if they were wrong, the borrower would end up paying the price.

The issue of originating new loan products for subprime borrowers is an emotional one, which is why it is attracting so much attention from politicians. 

In order to accommodate the politicians, borrowers and markets concerns, all mortgage lenders which originated hybrid ARMs or Option ARMs without using a fully indexed rate to determine the borrower's ability to pay, should approach such borrowers and offer to put them into a new fixed rate product (provided the borrowers have been current).  Implementing such a proactive response will clearly take a lot of time and money -but not as much as having to exit an extremely profitable business - A guaranteed result if the proposed legislation is enacted.

Implications: Mr. Jubak's article is definitely worth reading, if only to hear his explanation of the current risks being taking by bond investors: insurance.  In his explanation, Mr. Jubak does a terrific job of dissecting credit default swaps and proceeds to inform us that the increase in their availability is causing bond buyers to disregard risks.

Analysis: Mr. Jubak does have a point--to an extent.  The fact that bond insurance exists and can be structured in ways that make it much easier to sell is having an impact on credit spreads is true.  However, it is also true that our markets are efficient and if defaults do start occurring, bond insurance will be more expensive and may not be available in certain markets (just as hazard insurers are raising rates or exiting the business in New Orleans). 

I have to disagree with Mr. Jubak that the market has created a moral hazard by structuring and selling credit risk. Bond buyers and rating agencies all know the buck has to stop somewhere and each are placing their bets. Are we better off now, when if risk can be quantified and allocated a number of entities? Or were we better off when a bad mortgage portfolio could bring down an entire company (Think Westinghouse in early 90's)?  I wonder what my hazard insurance provider thinks.........

Implications: This article represents the sole rational and credible (by virtue of the speaker's managing the world's largest bond funds) description of the current mbs market conditions and the impact on mbs investors.

Analysis:
Rather than predicting a blood bath of borrower defaults, failure of lenders and consequent losses suffered by mbs investors, Mr. Scott Simon, manager of PIMCO's abs/mbs fund, seemingly brings us all back down to reality.  In an interview with Bloomberg, Mr. Simon states that 80% of the mbs market will remain unaffected by the predicted defaults and that, should the defaults actually occur, the primary losers will be CDOs and hedge funds,primary purchasers of the lower or unrated mbs tranches.

Key Implications:

The largest mbs investor may have a position to protect -nonetheless; however, when his commentary is credible.  This article makes a persuasive argument that mbs BBB spreads should not widen by 300 basis points because HSBC is having problems with its on-balance sheet portfolio (which is not even securitized and hence mbs investors have no exposure to it) and because New Century is increasing its reserves.

Implications: The article describes Wall Street's increased intent to "put-back" subprime loans to the lenders who sold them and the consequent impact such requests have on subprime lenders without access to funds.

Analysis: I believe this article is more important for what it doesn't say, then for what it does.

There is no mention that there is an alternative remedy for EPD loans -substitution.  The standard MPA (mortgage purchase agreements) enable a seller to substitute a similar mortgage loan as another remedy.  

Seller/Lenders are also given 30 days to execute either action -but the fact that so many lenders are suddenly being inundated with EPDs, coupled with the fact that many have downsized their staff due to the decline in originations, leaves them little time to search through their inventory for an acceptable substitute loan, much less dispute the Purchaser's EPD claims.

There is no mention that Merrill Lynch, a firm that has publicly denounced the subprime industry, has recently purchased a subprime originator.  A focused strategy of identifying technical loan breaches and EPDs in order to increase put-backs to Seller/Lenders would certainly hasten the Lender's demise, enabling Merrill and any other firm to purchase their portfolios at a conveniently low price.  For those lenders that do survive EPD avalanches, the decline in their stock price will make it much easier to purchase them at fire-sale prices.

One final thing, Clayton, the due diligence firm that is mentioned as being hired by street firms to search for technical breaches and other reasons for putting back loans -is the same due diligence firm hired by street firms to perform the original due diligence.   Therefore, one can conclude Clayton is being paid again for a job they were paid to do properly in the first place. 
Nice work if you can get it.