Kass: Subprime's Siren Call

Doug Kass

This column by Doug Kass was originally published on March 12 at 9:12 a.m. EDT on Street Insight. It's being republished as a bonus for TheStreet.com and RealMoney.com readers. For more information about subscribing to Street Insight, please click here.

Maybe Jim "El Capitan" Cramer is right when he writes, Get Over Subprime's Collapse and in his view that the brokerage companies will be relatively immune from the subprime carnage.

But I doubt it.

It is far too easy and convenient to dismiss the subprime woes based on the notion that because it is on the cover of The New York Times or on the tongue of many market commentators, it is either discounted or not as bad as it seems. Rather than listen to the comments of others on the Street and in the media, I prefer to deal in facts as opposed to simple and glib sound bites.

Here is a tidbit from Page 132 (yes, I do read every page in these filings!) of Goldman Sachs'(GS Quote - Cramer on GS - Stock Picks) 10-K dated Nov. 24, 2006.

Securitization Activities

The firm securitizes commercial and residential mortgages, home equity and auto loans, government and corporate bonds and other types of financial assets. The firm acts as underwriter of the beneficial interests that are sold to investors. The firm derecognizes financial assets transferred in securitizations provided it has relinquished control over such assets. Transferred assets are accounted for at fair value prior to securitization. Net revenues related to these underwriting activities are recognized in connection with the sales of the underlying beneficial interests to investors.

The firm may retain interests in securitized financial assets, primarily in the form of senior or subordinated securities, including residual interests. Retained interests are accounted for at fair value and are included in "Total financial instruments owned, at fair value" in the consolidated statements of financial condition.

During the years ended November 2006 and November 2005, the firm securitized $103.92 billion and $92.00 billion, respectively, of financial assets, including $67.73 billion and $65.18 billion, respectively, of residential mortgage loans and securities. Cash flows received on retained interests were approximately $801 million and $908 million for the years ended November 2006 and November 2005, respectively. As of November 2006 and November 2005, the firm held $7.08 billion and $6.07 billion of retained interests, respectively, including $5.18 billion and $5.62 billion, respectively, held in QSPEs.

Note to Cramer: El Capitan: I am officially ordering a Code Red!

The Subprime Fungus

"I guess we are a bit surprised at how fast this (subprime) has unraveled." -- Tom Zimmerman, head of Asset-Backed Securities research at UBS, in a recent conference call for institutional investors.

The fungus of subprime credits has grown in scope and in economic consequence over the last three months. We are now beginning to experience a full-blown bursting of the latest asset bubble, which could prove even more devastating than the piercing of the Nasdaqstock bubble in 2000. The impact of the subprime collapse on the availability of mortgage credit -- and, in turn, consumer spending -- is the primary reason why I believe the U.S. economy and corporate profits will materially disappoint most observers, and why the equity markets remain vulnerable.

Many, like Cramer, Larry Kudlow and others, readily dismiss the potential spending consequences of substantially less capacity in the subprime mortgage-lending market and the emerging trend by mainstream originators and lenders to reduce lending in the primary mortgage market and for refinancing cashouts.

Indeed, Jim takes the subprime issue one step further, noting that the mortgage house of pain will have a salutary market and economic result, as it will hasten the Federal Reserve's path toward monetary ease. Shockingly (at least to me), many others can't comprehend the link between mortgage availability and consumer spending, claiming that the correlation between the two variables is unclear.

I have not touched on the outlook for considerably higher credit losses at the financial intermediaries that address the housing market, which I will reserve for a future time. However, I will underscore the perfunctory conference calls and the generally disingenuous role of Wall Street rating agencies, which continue to hide the damage for owners of collateralized product paper as it relates to the collapse of the subprime market. It seems that at the end of every cycle's excesses, the investment community rationalizes the indefensible, owing to the enormous profitability of the products that are being peddled. The higher a market surges, the easier the product is to sell, but the less straightforward the pitch becomes.

Time and time again -- whether it be junk bonds, tax shelters, technology stocks, high-priced IPOs, glowing research reports -- Wall Street (despite former New York Attorney General Spitzer's noble initiatives) continues to exist for the purpose of raising capital (i.e., selling stocks and bonds) and not for the purpose of producing objective research and making clients money.

The brokerages' ties (in packaging and trading mortgage products) and earnings exposure to the subprime collapse -- they have 60% of the market share of the mortgage financing market -- were covered in depth in yesterday's New York Times article by Gretchen Morgenson. (Editor's note: A subscription is necessary to access this link.)

Broadly Negative Multiplier Effect

From my perch, the collapse of the subprime markets -- delinquencies now stand at 12.6% for subprime and 4.7% for the overall mortgage market -- within the context of the $6.5 trillion mortgage securities market will have a broad and negative multiplier effect on mortgage activity (housing turnover) and retail spending. It will also serve to further grease the current slide in new residential construction activity and hasten the drop in home prices.

It is important to understand housing's disproportionate role in terms of buoying employment and industrial production from 2000-06 in order to appreciate how violent the reversal's effect might be on aggregate economic growth. As I wrote back in October 2006:

The real estate industry has been responsible for 40% of the job growth since 2001.

The rise in home prices has provided for 70% of the increase in household net worth since 2001.

The increase in consumer spending and real estate construction spending has contributed to 90% of the growth in GDP since 2001.

Not only did new home construction embark on an era of unprecedented growth, but the broad rise in national home prices gave way to the concept of the "Home as an ATM" -- a source of cash, a substitute for savings and an enabler of the consumption binge (which was above and beyond the income means of the average consumer).

During the 1990s, mortgage equity withdrawals averaged between $20 billion to $80 billion per year, or only about 0.50% of GDP. By contrast, average yearly mortgage equity withdrawals climbed to about $230 billion, or 2% of GDP, over the last five years and peaked at nearly 3% of GDP in the second quarter of 2006 -- or at an annualized yearly rate of almost $400 billion!

Several months ago, Freddie Mac(FRE Quote - Cramer on FRE - Stock Picks) forecast that mortgage equity withdrawals will drop by 20% this year and by another 30% in 2008. These projections were done before the subprime fungus spread, and I think its estimates are too high.

In 2006, subprime mortgage loans trebled (to 36%) as a percentage of all mortgages issued. "Liar loans," or non- and low-documented loans that relied on the candor of homebuyers (never an intelligent loan strategy!) doubled (to 40%) over the same time frame. Creative loans, characterized by teaser rates, negative amortization and interest-only, among others, became the New Big Thing in real estate and dominated the mortgages issued in 2006. Refinancing cashouts proliferated, and, according to BankAmerica Securities, the average loan to a subprime borrower rose from 48% of the property's value in 2000 to 82% last year.

While the media have been focused on the D.R. Horton(DHI Quote - Cramer on DHI - Stock Picks) CEO's bleak forecast, every quarterly conference call with leading homebuilders last quarter confirmed the mounting restrictions of credit by mortgage lender. Stated simply, it is growing harder and harder to get mortgages. In the interim interval, the subprime market's health has worsened and so has, on a daily basis, the availability of mortgage credit (the lifeblood of our economy's well being).

In light of the recent adverse loan experience and bad publicity, most originators are avoiding these loans like the plague. Today, no mortgage lending officer at any bank or thrift will dare stretch lending standards to home buyers, as the mandate of tightened loan-to-values and higher FICO scores are, increasingly, the directive from financial companies' management.

Moreover, the fixed income market has a diminished appetite for packaged subprime loans and a diminished appetite for any collateralized product that includes subprime loans. It is unlikely that the institutional investors will hunger for this product for some time to come and originators will be faced with the hard reality that subprime loans will face more limited demand in the primary and secondary markets.

With financial intermediaries turning off the mortgage loan spigot, first-time homebuyers and trade-up buyers -- who already are pressed by the lack of affordability (home prices divided by household incomes) -- will have markedly reduced access to the residential real estate markets. As a result, the cyclical decline in housing will be forced into another down leg, just at a time when inventories of unsold homes remain elevated and the volume of ARM resets peaks (in third-quarter 2007). As a consequence, the gradual decline in home prices seen over the last 12 months runs the risk of becoming a full-fledged waterfall slide.

The mortgage market's new reality will serve to immediately (and adversely) affect housing turnover and reduce the demand for expenditures on many products. Exacerbating the decline in personal consumption expenditures will be the virtual disappearance of mortgage equity withdrawals, which have been the straw that has stirred the drink of consumption since 2000.

Spending on everything from appliances, furniture, flooring, roofing, paint, televisions, telephones and tools will suffer from the lower housing turnover and activity. The cessation of refinancing cashouts could have an even broader effect, constraining discretionary spending on restaurants, apparel, vacations, remodeling projects, automobiles and other durables.

With the demand for a broad array of consumer goods and services moderating, corporate profits are at risk -- and will quickly disappoint relative to expectations. Up until now, the service sector has remained healthy (even while housing and autos weakened), but even the buoyancy in services will be pressured and put to the test in the months to come. In the fullness of time, the rate of job growth will decelerate even more markedly than we have seen over the last several months as construction unemployment accelerates and the contagion permeates the broader job market.

More tepid top-line sales growth will weigh on corporate profit margins (one of the cornerstones to my bearish case for equities and valuations) as operating leverage will be difficult to come by. Unfortunately, all this will occur at the same time cost pressures remain high.

The CRB RIND Index -- an index of spot raw material prices -- just made a multiyear high last week, while unit labor costs have upticked to levels not seen in years.

In summary, the credit contagion that started with the fungus of subprime lending will hit an already weakened housing market and could spread to other securitized markets. Its impact will be felt broadly and should have a pronounced negative effect on personal consumption, corporate profits and stock prices. It will suck.

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