For me, Merrill Ross (Wunderlich Securities) is one of my Monday essentials. She puts out an overview of all things mREIT called Real Estate, Weekly Crossroads.
Today it struck me that her initial editorial (before going into the numbers, charts, etc.) was right on the money.
While professional opinionators like Mauldin certainly get wider distribution with their New Apocalypse views, Merrill has seen the current round of problems in mortgage land much as I had:
- That the real winners will be lawyers;
- That delinquent borrowers will get to stay even longer without paying;
- That the system needs to get away from being 90% Agency guaranteed; and
- Risk-based pricing is likely to increase the cost of borrowing, but that risk (and associated additional profit) will have to be retained by the banks or the mortgage aggregators, not the end investors.
After the jump, I’ll include her initial comments that came with today’s report, and her cool relative value scatter chart of the mREITs she covers. I’m willing to bet that you can also get on her mailing list with a simple e-mail to her at email@example.com
Please be aware that there are disclosure statements that are part and parcel of her analysis. They are in the full pdf document and recommended reading before anyone takes action on their investments in this space.
From Merrill Ross this AM:
Over the course of 2010, the GSE purchased about $200 billion of delinquent mortgage loans from MBS collateral pools. In the course of trying to resolve these loans that did not perform according to original expectations, the GSEs questioned the representations of originators, and uncovered all manner of technical faults that make the originators liable, in their opinion, to perform under warrantees offered at the time the loans were securitized under the GSE guarantee.
It comes as no surprise to us that many originators skipped a few steps in creating loan files and validating title, for example, and documenting the lien at the courthouse. Loan origination volumes were key drivers of profits, and the risk of default was considered remote because home prices just kept rising. Under the circumstances, the strategy of originators was to speed to closing to gain market share and profits, and in that process, the risk of performance on a warrantee on an event of default was mis-priced. Profit today, don’t worry about what might never happen.
The unthinkable happened, and the tail is wagging the dog. Calling for performance under warrantees is a method of sharing the clean-up cost for providing excessive credit, and large institutions, such as Citigroup (C: $4.11, not rated) and BankAmerica (BAC: $11.44, not rated) have disclosed rep and warrantee reserves. Are they adequate? We doubt it, and would estimate roughly that the issuer’s share of losses on the $200 billion of late-stage delinquencies could be on the order of $40 to $70 billion. And, that doesn’t begin to tap the exposure to private-label securitizations, where investors in non-agency MBS have demanded that BAC buy back delinquent loans collateralizing Countrywide’s MBS. Talk about a contingent liability! That’s a whopper.
We believe the put-back issue is rather similar to a full-employment act for lawyers, and the courts will be sorting out issue for some time to come. This buys time for the issuers, and time could offer the opportunity for home prices to stabilize. However, tail risk has taken root, and will continue to wag the dog and influence housing finance reform. We think the robo-signing issue is a symptom of the problem, but only the tip of the iceberg. This does suggest to us, however, that if securitizations create contingent and long-lived liabilities, they don’t belong buried off balance sheet with nominal capital requirements.
If banks are forced to keep mortgage pools on balance sheet, capital will be relatively constrained. However, private-label issuance by Wall Street intermediaries could resume, though we would expect that higher regulatory burdens and investor risk appetite would demand high pricing of mortgages. We’ve said it before, feels like déjà vu all over again, but risk-based pricing is required to attract capital to be the long term holders of residential mortgage cash flows. There’s got to be a rational expectation of value creation, or all bets are off.
And now for that chart:
I should note that Merrill puts both CMO and ANH at the lowest expected valuation combination of Return on Common Equity and ratio to book value. This reflects what I’ve been saying about them holding the least risk to their capital.
Her recommended stocks are all up in the higher ROCE range, suggesting that risk pricing has to be higher for these. So far, she’s been right in her recommendation that investors take on more risk — the market price has rewarded holders of the higher risk mREITs.
I freely admit this situation could continue for another year or three. I’ll continue to swing trade in the high-risk crew whenever they hit air pockets or issue secondaries, and hold the lower-risk stocks as core income holdings.