The Macro Strategist

David P. Goldman

+1 917 915 2985

dgoldman@macrostrategy.com

Subprime bargains will get better

Thursday, November 10, 2011
SUMMARY
The headline report that mortgage foreclosures rose by7% in October to a sevenmonth high may not be bad news: the housing market is beginning to clear, with a
significant uptick in the sale price of foreclosed homes.
Housing markets will stay depressed indefinitely and foreclosures will remain
elevated for several reasons, but any stabilization of sale prices on foreclosure
makes distressed securities look cheap. That is also good news for American banks.
Balance sheet pressure on European banks, which have retained roughly 80% of the
American mortgage debt they purchased before 2008, will keep private label MBS
prices depressed for the foreseeable future. The collapse of subprime securities
prices during the past six months may reflect market participants getting out of the
way of anticipated European de-leveraging. It's time to nibble but not to wade in.

75%

240000

74%

220000

Home Sale Price

Foreclosure sales
are running just
25% below the
average sale price

260000

73%
72%

200000

71%

180000

70%

160000

69%

140000

68%
67%

120000

66%

100000

65%

Source: RealtyTrac

Foreclosed/Average Sale Price

Exhibit 1: Modest Recovery In Foreclosed Sale Prices

Foreclosed
Average
Foreclosed/Average

The Macro Strategist

What's Subprime Worth?

The Markit ABX index for subprime-backed securities issued with a AAA rating in 2006
has fallen by a third during the past six months.
What does that mean?
Exhibit 2: Markit ABX.HE.06-2 Index

Is it really the
case that
subprime
properties are
worth just 27
cents on the
dollar? That's
what the graph
implies

Source: Markit

The 20 securities included in this index have a 35% band of credit protection, which
means that lower-rated tranches absorb the first 35% of losses. The AA-rated
tranches are trading at about 6 cents on the dollar, which implies near certainty that
losses will exceed 35% and wipe out all the lower tranches. But how much will be left?
At a 42 cent dollar price, the index implies that only 42% of the remaining 65% will be
left, or just 27%. Properties backing subprime may be distressed, but there is no
market in the country where home prices have fallen to 27% of their 2006 value.
Nationally, home prices are around 70% of their 2006 level. Even in Phoenix and Las
Vegas, the worst market in the country, prices are at 40% of their peak 2005 level.
Mortgage-backed securities, to be sure, are path dependent, which is to say that the
timing of the cash flows is as important as the ultimate volume of the cash flows.
There's a big difference between a partial recovery of principal today, and five years
from now. That is why the best of all possible worlds is a very high foreclosure rate
(which means that distressed properties will be sold quickly) combined with rising sale

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The Macro Strategist

prices for foreclosed propertieswhich is what appears to be happening at the

moment.
This is a marginal improvement, to be sure. Foreclosure moratoriums in several states
forced HSBC to take higher loss provisions for its subprime debt book during the third
quarter. Still, the delinquency rate on subprime mortgages is stabilizing. The federal
government reported November 7 that delinquent sub-prime mortgages numbered
1.738 million in September, up from 1.725 million in August but down from 1.827
million in September of last year.
European banks
with large
holdings of
subprime
securities are
having a Wile E.
Coyote moment

Take into account all the legal costs and uncertainties associated with foreclosure, and
the securities look stupid cheap. The trouble is that they will remain stupid cheap for a
long time. The natural home for such securities is with hedge funds, but most of the
hedge funds involved in the product are sitting on substantial mark-to-market losses
and have a poor case for raising additional capital. Subprime has performed so
miserably that it is a difficult story to tell to investors.
Add to this the problem of European bank de-leveraging. We continue to believe that
the Italian body politic, like that of Greece, is incapable of distributing sufficient pain
required across different constituencies to sanitize state finances. The likeliest
outcome after the endless series of emerging meetings is a haircut on Italian debt and
a multi-hundred-billion-dollar hole in the capital position of European banks. Unlike
American banks, the Europeans for the most part did not liquidate the subprime debt
they bought prior to 2008. "Regulatory forbearance" in Europe is what Americans
would call "unindicted co-conspirators." Where the American regulators pushed the
banks to take the pain and get the toxic waste off their books, the Europeans have sat
on their positions with crossed fingers, hoping that it would inch closer to par.
Liquidity in the market for structured subprime securities is so poor that it is hard to
know whether European banks have begun to de-lever, but we see no signs that any
such thing has occurred. A huge overhang of distressed debt remains suspended over
a long drop. That will discourage hedge funds from harvesting value in the sector for
some time to come.

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The Macro Strategist

Exhibit 3: Property Tax Receipts vs. Home Prices

Source: Census Bureau, S&P

The residential
property market
is a boiled frog:
rising property
taxes are killing it

Residential property taxes continued to rise all through the housing bust, to the point
that in many parts of the country, homeowners pay more in taxes than in mortgage
interest. No relief is in sight. A dozen states face deficits equal to 15% or more of total
budget outlays, and they cannot cut spending quickly enough. Property taxes now
comprise 35% of total state and local government revenues, up from 29% before the
crisis. They have replaced individual income tax receipts, which fell from $106 billion
in September 2008 to only $91 billion in September 2011. Many other factors weigh
on the housing market including sustained high unemployment and the expiration of
low introductory rates on teasers ARMs. The national mortgage delinquency rate rose
slightly during the third quarter to 5.88 percent after six consecutive quarters of
decline.
As noted, housing prices do not have to rise, but merely stabilize at low levels, to
make the current pricing of subprime securities seem cheap.

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The Macro Strategist

Exhibit 4: Household debt service burden vs. consumer delinquences at all

commercial banks

Fastest recovery
ever of household
balance sheets

Source: FRED Database

The resilience of American households in the face of a massive wealth shock and high
unemployment is remarkable. It seems that the reduction in credit card debt
outstanding is less a function of write-offs by creditors than by actual repayments by
consumers, according to research by the credit agency Transunion. What Transunion
calls the voluntary de-leveraging of American households is reflected in far lower
charge-off rates on household debt other than mortgages.
Market participants who do not have trading expertise in difficult-to-value and illiquid
subprime securities might consider mortgage REITS as a (very rough) substitute.
REITS that take a levered position in non-agency as well as agency MBS have fallen
sharply, in some cases by 25% or more, during the past six months.

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The Macro Strategist

Exhibit 5: MBS REITS That Own Subprime Get Beaten Up (May 10, 2011=100)

The subprime
penalty

Exhibit 6: Agency REITS barely budged

Again, it's too early to dive in, but at some point during the next six months subprime
should provide lavishly excess returns.

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