GRANTS INTEREST RATE OBSERVER Vou 27,No. 12 “yo Wn Seat, New York, Non Yaa. T0005 ram grentapuncon “JUNE 12, 2008 Horrible? Certainly. Bearish? Not necessarily. No: even rising joblessness, plug, jing Teasury prices and the wieeaing prewsence of megative equiy entiraly ‘exh the list of exons to despair for American residential teal este, [A thin! wave of loses, set vo soak the heretofore high-and-iry prime bor rower is supposedly crashing over the matter, “We're night in the middle of this third: wave,” Marke Zancl, chief eeonamiat st Mcody"s Keononiy.ccm, told Te New York Times la month, “and t's incensi¥ing, That loss of jobs fand loss of overtime hours and being foroed roma fulltime to part-time ob is reeling in defaules, They’ coast Reridential mortgages and house prioes are the aubjecto at hand. In pre View, we ste selectively balish on the first and expectant toward the second, Regrettably, che easily accsssble pu: lic pleys on recovery in “oxic” mort- sgage-backed securities have. moved cout of bargsinchunting range. Mt. Ma eo, selably fickle, may Just desde 1 reve them back again: thoagh we ‘woul not spin om the following essay fon thit hope alone, Rather, we feape rgse the stave of American siden {ial morgage finance because so much seem to depend on i. “Dollis” acmicedly, en's ch first word that springs to the roinds of waders of de everyday mortgage news, For instance, fine quareer de Tingwency cates climbed serose the board, even for prime borrowers. So- quently, vey were up dy 19.39% (o 68% From $.06%) and By 63.3% from the yeanage level (0 6.06% fromm 3.7190). The inventory of foreslored houses financed by prime mortgages climbed by 325% sequentilly (o 2.49% of prime morgeges surveyed sam gd i A 0 level (t0 2.49% of thar mort age universe from 12206, “The alhin cost of foreclosure pro- ceseddings £0 ereditors has alto tcken 1 leap. Aecording to new data compiled by Ritch Rarings, loss seventies anoss the crediteamitsecelerated between June 2007 and April 2009—for sub- rime mortgages, 0 73% fiom 40% for AlcA morgeges, to $5% from 1996 and for prime morgages, «0439 from 14% Tn Suet patlance, houses ase che “underlying” in the residential more sage marker, and they are lying lower all the tine. As of March, the S&P/ Case-Shiller 20-ciey composite index vwas down by 18.7% ia a year and by 32.2% since July 2006. Phosnix, wich 4 peak-to-pieseat destne of 53%, lest the moss; Dallas of by only 11.1%, she least. Not surprisingly, traction vole umes have plunged with hoae prices, while inventories have ticod # course ih the opposite direction. In Apri, ae cording the US Gensis Buea, new homes sold aca seasonally adjust ced annual rate of 352,000, 03% higher Wl thar’ wr ging sp.” chan in Mateh but 485 below the yea tao ceding and 94.7% below the uly 8s patton The invent. :7 of unold,unlved-n bawscs stood 2 lae repor, at 10.1 ante ley i would ee 16.1 months to god of toute a the current ales pace, down So 124 mont in January. if you detected sal shfe of aun- ight inthe previous ventencee wasn rovr imaginadon ksling. pisos ere baring the clouds, Distreaed proper sales aoecunted for Filly 45% of al ‘ed-home cranstetons fn Api, a cording co the National Asocstion of Seaton: “After mostly weeating fom he housing mares afer the bubble ie Dh Wal Sie Sorel pete ae May 2, “nreatow are rlureing droves, hoping to take advantage of ho cine, In many casen, rears ‘ay invents bo ae ourbsddng fn fe home huyersand other woul be douupans becuse they often come Ze nb wah alteah offerings.” Gallesgue ‘Dan Geren, tur fr tice prettenc for che mortage ie ta house es, Raving novaly oveithor to the hprige, now ssam fo bo overdoing iil tedies fon iin the i fal tert developed by render Re Ring Burch: Mukiply the average havse ovce (new and tet bythe mmr of isles and evde by CDP wartive stan iy atratve Dubble-osmeter ‘bracsidental real eae, Since 1970, he Burch Inde, si il henceforth Se known, bas averaged 9.9% with andar devinon of Te peaked st 1.396 in 2005, jot sy ofa care stan Sart devstion fom tnd, Te art ‘ealing 7.5% a the end of the fst ‘Cone’2ownrsnvse .s09 utp id ‘quarer, is © 0,8 standard deviation be 2t-1979 mean. "Ike Burch jermner observes, “indicates that the housing correction has over soc t the downside” Gertner invokos ¢ second test of hhousesprice value, she tentvo-price ratio ronitered by Moris A. Davis ‘af the Univecsity of Wiscontin-Math son School of Business. For donkeys) ‘errs, houses returned an average of 59%. "The yield declined from 5.5% in 1960 to slighly less than $4 in 1999 ‘Then ic plunged to 3.1% in the first ‘quarter of 2006, But row look: Owing to reing ronts and falling house prices, the mio is back to 5.1% "Let us say" snses Gettner, "hat 5% isthe correct Yel for house and that the price-o Fen ratio overshoots by one stand doviation co 5.7%. Assume, too, that tenis stay the same. In that exse, Ue ‘Case-Shiller index would have to re Ister an addtional decline of 9.9%, (or ‘tata drop, peak-co-rouph, of 38 9%. "A third test of house prices.” Gere- ner proceeds, “is che National Astonia tion of Realtors inde of affordability. "The index is a 20 that & roading oF 100 means a family eavning the me dian income would be able to afford « house affred at the median price, An dex of 150 wen athe fam i's inceme is 180% of the minimum amount requized co afford a median pried house Gssuming a 20% down payment and principal and incerest payment no grester than 25% of in come). As of Murch, the index stood at ‘record 17235, mote than thaee ste Not so prime on o 2998 2QW BONE ‘ore Nora Brkos cen ‘rouble prime mortgages av of 2009 fist quarter Creditors’ losses soar 0 Tmorigagelow severior « 021080105 ard devistions above its longe-term average of 125" OF course, things are never so bad thar ehay eae gee worse, end the best tmarkes chat follows try but bly bull market often eucprses the pure catio rallse by how fow ie goes. Soles us pose suggests Gene’, thar honse prices ‘evershoot tothe downside by the same thee standard deviacons a they over shot to the upside (as weasurec’ by the rens-to-ptie ratio). In that case, they ‘would vegiste a futher drop of 26.5% for an overall éeelire of 0.4%, ‘Nabedy nove she furure, Due all can observe how markers discount i Inthe eas of the esidontial mortage: f | fo fete zon 2006200 int i, ata, stn eenientene ina ime per ic feet oe ech RSE ech ce Sas meagre ie Eloi ea stereos see ic is heExcess, now, to the downside ‘calulated transaction value as « percentage of GDP | ro sardad dort enero COP 4 4 1970 1978 1980 1985 19901998 2000 ems 2009 so a 6 ecromic nash enn Dre, Nal A. of Rea ‘whe expect the 10.38—hes modeled alot prime RMBSandjunk-rated At-A thice sets of corltetan outcomes RMS, Sindying rhe most event [0-9 ‘corresponding so chee different seis reports, we Yentute that management fof essumptions. ‘The mosc important is paying 68 cents on the collar fora. of these assumptions are prepayment sets it regards as money-goed. [prot Epeods, defiult ree anciloss soveri- ve enough bet Redwood sommon tes. Our investor's base case Featies is quoted at 16 times book and yields Prepayments decelerating to 4% from 66%. Perhage Mr. Market Would be the 14% actualy registered over the so obliging as co mark it back down ps threo months, default rates 20- to bool of ey, to 1.2 times book at Celerating 10-396 annually from the minimis in onder to afford the value feurtent 1%, and los seventies imme- _mindod invostora margin of sary? ately rising eo 50%, "Then theve is Chimera Investment Even under a furure as bleak es his Cop, (CIM on the Big Boat, + spe- fons,curcranche, worepeat,isexpected city finance company managed by to deliver an annval cezurn of 10.38. a wholly owed subsidiary of Annaly Under iess severe set of essumprions Capital (to dscloso an intrest, Gert (e.g, prepayment speeds doubling 10 ser and your editor are both Annaly 8% dofaute rates at 2% and loss severi- investors}. Chime invests in RMBS, cs of 40%). an investor would ean residencial mortgage leans snd other 12.2% a year. OF some comfor: to us eal estate-related securities. Its men: Js the finding char even under a truly agement is paral 9 AIGA secuttes ‘gruesome set oFassumptions (cx. pre- of 2006 and 2007 vintage, 3 part of the payment speeds falling 29 2% 1 year, matket that KecMtuod as avoided, defunls rising ro8% and loss severities characterise Chimere sttepy is we Climbing to 75%), ap investor would pay 5D 0 85 cents on the collar forse fexin a projected’ 2.8% per annum, _hios AltA borals that, down the rod Incidentally at « 75% loss severky, si enpeet so soll for 70 to 80 conts on '8750,000 house would be hammered dhe. olay, allowing for write-downs ‘down to $195,000 ‘of 20 to 25 coms. Gertner asked Wel: ‘We Know of only wo avenues by lingten Denahan-Nows, chief invest. which @ rotal investor ean paticipate ment offiect of Chimets, if the lat in the residential mamupge-selvage et. mortgage ate.on delinquencies movement. The fistisRecwood Trust had her spooked. “We expocted i to (RVI on che Big Bond, featured in be bad, and it continves to be bad. there pages on February6,Rednoo’s ——.." she replied. "We run some prev managernent seas lately out buying draconian scencrios, end none of thit 2004 ‘and carlice vintages of senior is unexpected, and the bonds chat we AIA RMMBS and 2005 vintages of se- buy can withseand increases of much Conanersqun 2.290 3 greater magnitude than we've experi> reed so ft” ‘ALLA times book value and aith 2 Yield of 9.1%, Chimera, like Redvrood, ades as ithe market were confident of a happy ousome, Wo, tn, expect goed things, bur we would be mare Conforible investing if the market fexpeoted bad things. Twill co, s000- ror later Just wait Life begins at 65 For Perer 1. Bernstein, who died fon Jone 5 in New York at 90, author Ship really began st an ayo when he could have sired on full Social See rity benefits, But nothing wee farener fiom the economists mind than TV land erisbage. Borstsin wes 77 when “Agains: the Gods: The Remarkable Story of Risk” appeared in, 1996, 81 when The Power of Gold: The His- tocyof an Obsession” was published in 2000, and 86 in the year of the Inne of "Wedding of the Waters: The Bric (Canal and the Mating of a Great N tion” in 2005. He seemed slightly fa {in 2007 at the book panty to celebrate the relewse of his “Capital Ideas Bvalv~ ing.” Not knowing his age, one might have supposed he was pushing 70. Bemstcin’s books (though they wore to lest the books of his wife and business purines, Barbara) ‘vere temmatkableachievernents. Bewer stil, to thele reipiens, were the notes of friendship, oncowrage- ment and pruise thee he dashed off whenever his generous spirit moved him. He must have written a milion of them. Barly bird specials ‘The trouble with long-anteipated lisstos is not tha: they never happen. ‘The trouble, rthes, that they zal) unfold according to 2 wellthumbed Serpe. Bearing this traizm in mind, ve return to commercial veal este, 4d in fac: a well a8 in the making, [Not precisely, acoording eo |. Bruce lac, senior menaging parser and CEG of Brooktiold Asset Menage ‘ment (BAM on the New Yore Stee Exchange), manager of $80 billion of