Holman W. Jenkins, Jr. wrote this excellent analysis on the opinion page of The Wall Street Journal March 5, 2008 (page A16).
The problems occurring in the nation’s housing markets are caused by many factors, but a leading contributor right now is the liquidity problem on Wall Street. Part of the issue today is banks need to “mark to market” financial instruments that don’t have a market right now. This is required by accounting rules put in place by congress. For additional information about the role “mark to market” is having on the ongoing financial crisis, please read “The Reasoned Sceptic’s” well written column entitled “More on Marking to Market.”
While Wall Street and other banks around the world wright off hundreds of billions of dollars right now, at some point they will likely be “writing up” billions and billions of dollars once the panic subsides and these markets find their legs again. It’s impossible to know if that will be in 6 months or years from now, but it will happen in my opinion. The fact of the matter is the underlying assets are not in as bad a financial shape as the financial instruments would lead you to believe. Part of the problem is because there are some very bad loans mixed in with the good loans in order for the banks to securitize and sell off these bundled portfolios. You remember the saying your mom probably told you, “a few bad apples will spoil the whole barrel,” such is the case with these substandard mortgages mixed in with the good. The reason I say that the underlying assets are not in as bad a shape as the financial instruments is because you have various CDOs and bond portfolios losing 30-90% of their value and yet the houses they are funding have not dropped by that much. Yes, in parts of the country prices are down or likely to be down 30+% when all is said and done, but it’s hard to imagine the houses will be worth 10-50 cents on the dollar like the bonds are of some of these companies. Leveraging up is great in an up market, but when the market turns, all that extreme leverage is devastating when the air comes out.
For example, let’s look at the problem with Thornburg. Thornburg is a company that we used to use quite a bit for clients who were self employed or ran their own business. These folks made lots of money, but because of their tax situation and business write offs, didn’t show that they had a lot of income. This is very common in America. Many of these folks would end up taking on significant mortgages through Thornburg – Jumbo’s over $417,000 conforming loan limits. These were solid loans and solid applicants. Now the company is facing potential bankruptcy given the cash crunch and “mark to market” accounting policies. The winners will be the companies that swoop in and either buy their equity or bonds or buy their assets should they go in to bankruptcy. I don’t have the exact details on their loan portfolio and I am not doing this to give investment advice. It’s merely an example so you can see how this credit crunch is hurting outstanding companies with excellent loan portfolios.
According to The Wall Street Journal article published March 8, 2008 (page B1),”REIT Lender Thornburg See Collateral Seized,” Thornburg’s borrowers have an average credit score of 744! The Journal also reported that, “William Gross, chief investment officer of U.S. bond titan Pacific Investment Management Co., said on CNBC yesterday that the firm bought about $100 million of Thornburg’s debt in the last few days. He expected the return on the investment to be close to double-digits.” (note the article is not available online to the public). I suspect Mr. Gross will earn a very nice double digit return on his investment. Later in the article, Thornburg’s CEO, Larry Goldstone goes on to say, “quite simply, the panic that has gripped the mortgage-financing market is irrational and has no basis in investment reality.”
Wall Street is likely to continue to struggle as these debts get unwound and the margin calls increase.