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Friday, October 9, 1998

FOOL ON THE HILL
An Investment Opinion
by Dale Wettlaufer

Asset-Backed Carnage, Part 2

On Tuesday, we looked at the bankruptcy of Criimi Mae (NYSE: CMM) and the balance sheet issues that affected the company. The contention that the company was just fine and dandy except for getting shafted by its creditors and trading partners has been put forth, but that misses the point of the business model and the risk to investors. If you build your business model on making a spread on constantly turning lower-quality securities through your balance sheet, you end up down the creek without a paddle if you can't turn your balance sheet any longer.

One money manager sent me a note explaining the difference between now and the days when lots of businesses trading this sort of stuff got rolling. He explained, as a former credit analyst before going elsewhere in the investing world, that he covered "...high-grade financial services and CMBS [collateralized mortgage-backed securities] and asset-backed credits. Back in those days (1992 - 1995) the lower-rated CMBS tranches would trade at rich spreads with prepayment lock-outs and make-whole provisions to entice portfolio managers looking for bullet paper to buy this stuff. A BBB-rated CMBS deal with good property diversification and good geographic dispersion would trade at a spread premium to a liquid BB-rated high-yield deal. Thus you could buy higher credit quality at a larger spread than corporates. All the RTC deals that came to market in 1990 - 1995 were just fire sales and all this paper was stupid cheap. Anyway, I guess those days are gone."

Enter the real estate investment trusts (REITs) in the last couple years that couldn't come to market quickly enough. With the imprimatur of all the popular investment magazines and the image of stodgy investments for older folks, the outperformance and the high yield of these securities drew in momentum players and safety investors alike. However, many of these companies were like having your own personal trading desk. When things are going right, you're the rig. When they're not, you eat the diminishment in capital. In the case of Criimi Mae, the company's leverage didn't increase this year and, in fact, had dropped through the end of the first half of the year.

It wasn't so much leverage per se that killed the company. Leverage is a fine thing when assets are stupid cheap. But when your assets are growing at better than a 100% annualized clip and those assets are being acquired at super premium pricing (and thus a deteriorating margin of safety), all it takes is a downturn in the market for those assets to nuke your balance sheet.

One of the most interesting cases in the mortgage investment trust world this year is Redwood Trust (NYSE: RWT), which has certainly had a rough go of it in 1998 but exercised admirable caution earlier this year when it said it didn't like what it was seeing in mortgage pricing. In the middle of a raging bull market in equities, it is pretty interesting to see a company pull back, sacrifice near-term earnings growth, and exercise some caution when it doesn't like what it sees. Not that Redwood Trust is out of the woods, but its credit quality is much different from Criimi Mae, which is loaded with subordinated credits that are priced in extremely illiquid markets.

But moving on to a different component of the asset-backed world, the last year has seen some spectacular blowups in the mortgage lending world as the result of what one could presume to be a more rational approach to pricing business models. Amazing how a liquidity crisis can force that rationality. Before we get to that kind of business model, we need to establish a framework for looking at lending in the late 1990s.

We already know that lending to plain vanilla mortgage borrowers is a tough game. If it were easy, then we would have never had S&Ls blow up in the 1970s, seek regulatory relief, get that "relief," and then blow up in the late 1980s and early 1990s. Anyway, you can't be a mortgage lender using just equity and expect to build shareholder value, because you'll never get the return on investment that equity investors demand. You have to use generous amounts of leverage to generate a return to equity holders, and there you get into the dangerous waters of interest rate risks, not to mention default risks. If you mismatch maturities and credit terms of your portfolio versus the terms of your liabilities badly enough, you can set a clock to the time expected for your equity to collapse.

So what's the best way to go about mortgage lending? That's right, get the government to insure it. Take the credit risk almost completely out of the picture, and you get Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE). You get a lower nominal interest rate on your mortgage, but you also get a larger federal budget and more taxes. What's the best way to offset the higher tax bill if you are an older person who has already paid off the mortgage? Invest in these government-sponsored entities. Yup, for every dollar of equity these companies have in use, they hold $25 to $30 in assets. No problem if you make $0.008 yearly for every dollar in assets, because with 25x to 30x leverage, that turns into $0.20 to $0.24 in earnings for every dollar of equity. Can't beat that, especially if you were smart enough to acquire these companies at a low multiple to book value.

OK, so you've got this huge force out there that acts as a lender to all the good credits in the U.S. and which can finance its operations through the securitization process. If you want to be a mortgage lender, there are a few options. You can run a plain vanilla business and have an extremely low overhead and generate a middling return on equity. Or you can run a plain vanilla business with low overhead and throw in some fee-generating services, generating a decent return on equity. Or you can build a huge infrastructure to originate the mortgages, earn a little money on the origination, get it off the balance sheet via securitization, and earn money by servicing those loans for the benefit of the investors buying into those securitization trusts. And then repeat ad infinitum.

You can also find some niches where this huge mortgage force doesn't operate. And you can go out on the credit quality spectrum -- anywhere from borrowers with a good credit history needing a high loan-to-value (the amount of the value versus the amount of the asset being acquired) loan all the way out to people with bad credit, bad prospects, and no collateral. But don't forget to charge them a huge interest rate.

We'll look at those scenarios on Tuesday in Asset-Backed Carnage, Part 3.

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