Dear clients and friends, Approximately every ten years or so, the US financial system is perceived to be at risk of collapse. This perception is the result of humans’ acting foolishly greedy in the preceding couple of years’ run-up to the panic.
In the late 1980’s, we had the S&L crisis, the result of exceedingly sloppy real estate lending, itself the result of a voracious non-economic desire to shelter income from taxes. In the late 1990’s, we had the Asian financial crisis, the Russian debt default, and the collapse of Long Term Capital Management. Asia and Russia stemmed from fraudulently rosy economic growth projections begetting overinvestment, while LTCM was felled by the hubris in its statistical models interpreting these very same projections (not to mention insane amounts of leverage). Roundabout late July of last year, our latest financial meltdown fright began in earnest. Before proceeding, it is imperative to note that in both of the above cited crises, dislocation, loss, and pain were the initial but not ultimate consequence. The country rebounded, while responsible enterprises endured, seized opportunity, and emerged stronger.
The US Residential Mortgage Crisis of 2007
One of the long-term forces at work in the financial services industry has been the offloading of risk from banks, its traditional holders, to the capital markets or Wall Street. Now, Wall Street does not like risk at all; the bankers simply like to get paid for selling it to someone else (e.g. foreign governments, pension funds, insurance companies). And, as the adage goes, if Wall Street can sell it – regardless of what the “it” really is, they will. US residential real estate experienced a boom, in terms of both prices and volumes, starting with the collapse of the technology bubble in 2000 up through 2005 or 2006. I would argue that the years 2000-2004 were, for the most part, justifiable as low interest rates supported legitimate homeowners’ capability to buy and/or trade-up to the home of their desires. However, as is common with human beings, what starts out as economically justifiable ends in frothy mania. And it was no different this time. Wall Street’s chief partners-in-crime starting sometime in 2005 (and these are all rough dates as, of course, there are bad loans made every year; there has simply been a preponderance of them made in this froth stage) were the mortgage originators, the most infamous of them being Countrywide Financial. The machine worked as follows – the originators would find the borrowers, package the borrowings, sell them to Wall Street, who would then offload them to the world’s fixed income investors. Everyone got a clip along the way, with the ultimate holders - the world’s fixed income investors - getting slightly (by my standards, at least) higher yields on highly rated paper. As previously stated, what made sense, for all those involved, for the 2000-2004 vintages stopped making sense at some point in 2005. Yet, the players kept playing, which translates as there were a lot of bad loans made in 2005 up through the first quarter of 2007, with the 2006 vintage generally being agreed upon as the most egregious period.
We, in Las Vegas, could see all of this happening right before our very eyes. Home prices increased at 20% annual clips for several years; not unexpectedly, it became fashionable to be a housing “investor” or, more apt, a house flipper. Little money down, low up-front interest rates, and the near surety of selling quickly to someone else for more money became the road to big fortune. My favorite story remains the drink-cart girl all of about 25 years old, with whom my brother and I chatted with on the golf course one day in about 2004 or 2005, bragging to us that she had six “properties.” Now maybe I am out of touch with golf-course wages, but something tells me her intentions were not to support the mortgages of her six cash-flow negative (an assumption, but a fairly safe one for the last decade) properties for very long on a considerably less than six figure annual income. Flipping houses is no different than flipping internet stocks is no different than flipping tulips – it was apparent where this would end. The question for us now is – what next?
Many, many “investors” are and will continue to walk away. Unfortunately, many legitimate subprime (read: people without a lot of money) owner-occupying borrowers, as well as some prime borrowers, who bit off more than they could chew will have to as well (believe it or not, the subprime cohort is actually stabilizing presently). The defaulters will turn over the keys to, not the bank, but the loan servicer who will then inform the bond trustee who will then be left to figure out what to do with the property and how to distribute proceeds from the default to (and the loop is closed!) the world’s fixed income investors. The riskiest tranches of mortgage-backed-securities (again, see Michael Lewis’s book for a detailed explanation) will/are being hit first and they will/are being hit hard.
But, in this gloom, there is something I believe. The vast majority (myself included) of homeowners will stay in our homes and pay what we agreed to pay. There are two basic reasons why I believe this. First, we need shelter and we basically like where we are at and, second, we take our borrowing commitments seriously. I choose to believe that, again, the vast majority of us are inherently honest and upstanding. We will do what is in our best interest (like refinance when money is cheap) but we also care about fulfilling our obligations, maintaining our credit scores, and preserving our reputations. Systemically, we have 1.5-2 years of bad underwriting to work off, and we will.
It will be painful to see the house you bought in 2004 for $500,000, that was quoted in 2006 for $625,000, drop down to $525,000 in 2008, and I would be remiss if I did not say that it may get worse. I am prepared to say, nonetheless, that most are prepared to stick it out and will be rewarded with a $625,000 valuation come 2012, 2013.
As investors in publicly traded companies, the question is obviously begged – what are we doing about this? Herein lies one final belief for this letter. We are buying and looking to buy those good lenders and related companies that have built their organizations to endure crisis and grow through it. We are looking to be owners in these businesses by buying shares on the secondary market (i.e. the stock market) and being the strong hands in these companies when others are skittish. At the conclusion of this letter, I will highlight two such companies that I believe have been built this way and are going to produce very satisfying returns for our portfolios over the next 2-5 years.
(actual results omitted)
While I am disappointed in the underperformance for the year, I contend that at no point in our operation have I ever seen the margin of safety or discount to fair value so large in such a large number of very good companies as I see at the present moment. As you all know, but I feel it bears repeating, 100% of my liquid and accessible (read: monies that I have full control over) net worth is invested right alongside your portfolios in the very same securities; I would not have it any other way.
One of the findings of my year was the works of Khalil Gibran, and it is with one of his more famous quotes that I would like to conclude: “March on. To go forward is to move toward perfection. March on, and fear not the thorns, or the sharp stones on life’s path.”
Wishing you all a prosperous, peaceful, and flourishing march in 2008!
Eric Houssels, Managing Member
Two Companies Built to Endure and Prosper in Financial Crisis
Redwood Trust: a mortgage Real Estate Investment Trust (REIT) founded by George Bull and Doug Hansen in 1994 that went public in August of 1995 at an IPO price of $15.50. In the subsequent 12 years of operations, they have returned $42.68 in dividends and have a current (depressed) stock price in the $30-35 range. Normally, I consider such basic facts as mostly irrelevant; however, in Redwood’s case, the impressive dividend record (as well as the growth in dividend paying capacity as evidenced by the stock price) is actually a crucial part of the story. It is the dividend track record that attests to their ability to endure in the bad times (and the late 90’s was a bad time for their industry). Redwood’s whole operation is based upon returning profits to shareholders in the form of dividends. Their investment philosophy is built around making sound, fundamental investments in the mortgage market. While the market was foolishly ballooning in 2005-07, they were severely criticized by the analyst community for not participating, choosing instead to shrink their balance sheet. As a consequence, they are now very well prepared to take advantage of the severe pricing dislocations occurring in the mortgage markets (e.g. one of the bandied-about euphemisms of the current era is the 20/90 bond; meaning the buyer is willing to pay 20 cents on the dollar, while the seller is willing to accept 90 cents on the dollar, such a spread is only-a-couple-of-times-in-your-lifetime extreme) The company is, in fact, setting up an opportunity fund for institutional investors to invest in the currently frozen markets for mortgage securities. Their ability to raise money for such a purpose in this, probably the single most frightened market for mortgage securities in history, is further testament to Redwood’s strong hands. But back to the dividends; at a time when their competitors are suspending dividends with some even going bankrupt, Redwood is continuing to make its regular 75 cent quarterly one and had the wherewithal (i.e. profitability) to pay out a special 2 dollar dividend in December. Redwood’s fundamental book value is around $30 per share, and I expect this to increase, along with the dividends, as they take advantage of the current dislocation for which they have been preparing.
OldRepublic: I first learned about Old Republic from a client some 3 years ago or so. I took a look, loved what I saw, but thought that the price was just so-so. They were, nonetheless, well worthy of being put into the database because you never know what will happen. Well, it happened. As a title and mortgage insurer, there are times when claims increase and volumes drop. Such will be the case for Old Republic and their industry for the next couple of years. However, for Old Republic, as a true strong handed player, it is exactly these times of distress when the business that they are, and will be writing, prices favorably and, even more importantly, it is these times when they are, and will be, taking share from their weaker counterparts. Mr. Buffett just entered the bond insurance business last week; take note that he is doing this at a time of dire straits and ramping losses, not when all is well with losses unforeseen. In November of 2007, Old Republic demonstrated their strength when they went on the open market and purchased 15% and 11% stakes in their two major mortgage insurance competitors, PMI and MGIC, respectively. Similar to Mr. Buffett, it was the strength of their balance sheet that allowed them to buy assets that they know something about at steep discounts. The mortgage and title insurance business will darken for a while longer. During these darkening days, with its lines of other general insurance, Old Republic, trading at less than 75% of book value, is expected to remain profitable and will continue paying shareholders a 4.2% dividend yield. Ultimately, the mortgage and title insurance industries will heal, and it is my firm belief that Old Republic will emerge stronger and more profitable than it ever has been.
I do not wish to go into the derivations of the ratings for mortgage-backed securities. For those interested, I recommend Michael Lewis’s Liar’s Poker, an excellent history on the astounding growth of the MBS market.
Delinquencies are currently between 5 and 6% of all mortgages, while foreclosures are near 1%; it is perfectly reasonable to assume that foreclosures will reach 2-3% at some point.