Cozy Relationships & Improprieties

Following are a few snips from The New York Times article Crisis Looms in Market for Mortgages.

On March 1, a Wall Street analyst at Bear Stearns wrote an upbeat report on a company that specializes in making mortgages to cash-poor homebuyers. The company, New Century Financial, had already disclosed that a growing number of borrowers were defaulting, and its stock, at around $15, had lost half its value in three weeks.

What happened next seems all too familiar to investors who bought technology stocks in 2000 at the breathless urging of Wall Street analysts. Last week, New Century said it would stop making loans and needed emergency financing to survive. The stock collapsed to $3.21.

Thomas A. Lawler, founder of Lawler Economic and Housing Consulting, said: “It’s not that the mortgage industry is collapsing, it’s just that the mortgage industry went wild and there are consequences of going wild.

“I think there is no doubt that home sales are going to be weaker than most anybody who was forecasting the market just two months ago thought. For those areas where the housing market was already not too great, where inventories were at historically high levels and it finally looked like things were stabilizing, this is going to be unpleasant.”

Like worms that surface after a torrential rain, revelations that emerge when an asset bubble bursts are often unattractive, involving dubious industry practices and even fraud. In the coming weeks, some mortgage market participants predict, investors will learn not only how lax real estate lending standards became, but also how hard to value these opaque securities are and how easy their values are to prop up.

Wall Street, of course, was happy to help refashion mortgages from arcane and illiquid securities into ubiquitous and frequently traded ones. Its reward is that it now dominates the market. While commercial banks and savings banks had long been the biggest lenders to home buyers, by 2006, Wall Street had a commanding share — 60 percent — of the mortgage financing market, Federal Reserve data show.

The big firms in the business are Lehman Brothers, Bear Stearns, Merrill Lynch, Morgan Stanley, Deutsche Bank and UBS. They buy mortgages from issuers, put thousands of them into pools to spread out the risks and then divide them into slices, known as tranches, based on quality. Then they sell them.

The profits from packaging these securities and trading them for customers and their own accounts have been phenomenal.

Mortgage securities participants say increasingly lax lending standards in these loans became almost an invitation to commit mortgage fraud. It is too early to tell how significant a role mortgage fraud played in the rocketing delinquency rates — 12.6 percent among subprime borrowers.

Still, the rating agencies have yet to downgrade large numbers of mortgage securities to reflect the market turmoil. A spokesman for S.& P. said the firm made its ratings requirements more stringent for subprime issuers last summer and that they shored up the loans as a result.

Nevertheless, some investors wonder whether the rating agencies have the stomach to downgrade these securities because of the selling stampede that would follow. Many mortgage buyers cannot hold securities that are rated below investment grade — insurance companies are an example. So if the securities were downgraded, forced selling would ensue, further pressuring an already beleaguered market.

New Century Upgrade

Let's stop right there and take a look at the rationale behind Bear Stearns Upgrade of Century Financial.

New Century Financial Corp. was upgraded Thursday by analysts at Bear Stearns, saying the risk of the subprime lender's shares falling further is limited by the potential for an acquisition of the struggling business. Shares of New Century were lifted to peer perform from underperform by Scott Coren and Michael Nannizzi at Bear Stearns.

If management comes up with a sound strategy to stabilize the business and improve liquidity, or the upcoming earnings restatement is less onerous than expected, New Century shares could rally into the "high teens," they said.

"The potential downside in the stock if the company is forced to sell or liquidate is roughly balanced with the potential upside," the analysts wrote in a note.
Still, they also estimated that New Century could burn through its available cash before the year is up.

"This is significant because the company will likely need to seek additional capital by further cutting production (substantially), raising money externally, selling a portion of its investment portfolio or perhaps some combination of the three," Coren and Nannizzi wrote.

Upgrade Rationale

"If management comes up with a sound strategy to stabilize the business and improve liquidity .... shares could rally into the high teens".

So the upside was the high teens from 15 and the downside was obviously zero (shares are now sitting at $3.21) plunging almost immediately after the upgrade. What is interesting is the rationale began with a big "If". Given that New Century management was under investigation for criminal fraud, exactly how likely was it that "management would come up with a sound strategy to stabilize the business and improve liquidity"? I think we just found out.

Was that a good risk/reward setup knowing as Coren and Nannizzi did, that New Century could "burn through its available cash in less than a year" knowing that New Century was under criminal investigations and that the subprime market was in severe stress. So why the upgrade?

The big firms in the business are Lehman Brothers, Bear Stearns, Merrill Lynch, Morgan Stanley, Deutsche Bank and UBS. They buy mortgages from issuers, put thousands of them into pools to spread out the risks and then divide them into slices, known as tranches, based on quality. Then they sell them. The profits from packaging these securities and trading them for customers and their own accounts have been phenomenal.

Did a cozy relationship between Bear Stearns and subprime lenders influence Coren and Nannizzi, or did Coren and Nannizzi simply make a horrible call? Unless there is a smoking gun memo the truth on this may never be known. What we do know, however, is that relationships between rating companies and analysts offer fertile ground for all kinds of improprieties. The same goes for Moody's , Fitch, Merrill Lynch, Morgan Stanley, and the like. As long as companies are allowed to have business relationships with companies they rate, and/or take positions in the stocks and bonds of companies that they upgrade and downgrade, allegations of improprieties are simply not going to go away.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/