More Blood Coming?

John Authers of the Financial Times, in “Market vultures await more blood,” tells us that bottom fishers have been taking a wait-and-see attitude towards the recent market turmoil. While they’ve been able to make handsome profits on certain trades based on the (until a couple of months ago) underpricing of risk, the distressed merchandise pros are waiting for things to get even worse.

One example deserves comment. Authers notes that even though the financial press has almost universally hailed Bank of America’s investment in Countrywide as a bold and savvy stroke, the market has remained singularly unimpressed.

I will confess I haven’t studied the details of the deal for a simple reason: I’m appalled that B of A would even consider it. The two banks had reportedly been talking for six years. That means B of A knew, or ought to have known, Countrywide very well. An article by Gretchen Morgenson in Sunday’s New York Times paints Countrywide is, at least in spirit if not the letter of the law, a criminal enterprise, aggressively targeting misrepresenting its products and pushing customers into unnecessarily costly mortgages.

Here is a typical paragraph from her piece:

Countrywide’s entire operation, from its computer system to its incentive pay structure and financing arrangements, is intended to wring maximum profits out of the mortgage lending boom no matter what it costs borrowers, according to interviews with former employees and brokers who worked in different units of the company and internal documents they provided. One document, for instance, shows that until last September the computer system in the company’s subprime unit excluded borrowers’ cash reserves, which had the effect of steering them away from lower-cost loans to those that were more expensive to homeowners and more profitable to Countrywide.

Morgenson may well have gone overboard; some readers at Calculated Risk are of that view. But I know lawyers who have Countrywide in their crosshairs, and I am certain they have plenty of company.

To put it another way: there’s enough fraudulent selling in the the subprime market in general, and smoke around Countrywide in particular, to deter anyone investor who takes litigation or reputation risk seriously.

In my day, no respectable institution would make a high-profile equity investment or otherwise closely link its name with an organization that had the whiff of serious liability about it (except in liquidation or some other scenario which got rid of the incumbent management team).

Look what happened to Ameriquest. Although the $295 million in fines it paid for deceptive practices weren’t enough to constitute much of a recovery for defrauded borrowers, the scandal and settlement were enough to put the company on a terminal decline. Citigroup today exercised an option to acquire Ameriquest’s wholesale operations (now called ACC Capital Holdings) which includes its lucrative mortgage servicing business. Purists can dispute the ethics of Citi’s purchase, but it’s vastly cleaner and shrewder than B of A’s.

Observers nevertheless claim B of A made a good deal, with a below-book-value conversion price for its investment, with vague language saying the price can be adjusted. As Authers points out, the reason vultures aren’t all over financial services firms right now is no one believes their book values. And having worked on a few securities and M&A deals, I doubt the enforceability of such a non-specific repricing mechanism. Possession is 90% of the law, and Countrywide has the cash.

From the Financial Times:

World markets have been in crisis for weeks. That should mean rich pickings for someone. One of the oldest, but truest, aphorisms in investment is that you should “buy when there’s blood in the streets”.

There is speculation that the legendary investor Warren Buffett, who is sitting on a huge cash pile, is about to start spending it. And hedge funds started buying up stricken subprime lenders earlier this year, to a flurry of publicity. But the history of those deals is problematic.

For example Lone Star, a private equity group, on Friday offered to buy Accredited Home Lenders, troubled by bad subprime debts for months, for about $225m. But this was only after it pulled out of a planned $400m purchase announced earlier this year. The message for other circling vultures is that there may not yet be enough blood in the streets.

Another deal hailed as a masterstroke, Bank of America’s purchase of a $2bn stake in Countrywide, the biggest US mortgage lender, also needs to be proven. Countrywide’s stock has drifted down since the deal was announced. The market is still unconvinced either that Countrywide is a bargain, or that the BofA investment will be enough to propel the company back to safety.

Value investors, such as Mr Buffett, are not gamblers. Part of their creed is that by buying cheap they buy a “margin of safety”. Even if a company goes bust, for example, they want to know that its break-up value is bigger than the price at which they buy.

At first glance, it looks as though financial stocks represent a good value opportunity. They are usually valued by their multiple of book value (the total value of the assets on their books, minus their liabilities). On this basis, they are their cheapest in more than a decade.

But there is no margin of safety in financial stocks. The low multiple to book value is not – as would usually be the case – because of pessimism about future earnings prospects.

Rather, it is because nobody quite believes the current stated book values. With subprime defaults running high, and with financial services groups around the world discovering they cannot put a value on assets they had thought were safe, many may have to mark down the assets on their balance sheets. That generates uncertainty and it does not offer much margin of safety.

But if the bargain-hunters are not yet finding opportunities to make money, others are. Sadly, they are betting on things to get worse.

They can do this with great comfort, because the market’s previous ridiculously low estimate of risk allowed them to place their bets at what now seem to be insanely cheap prices. Bargains were to be found when the credit market was at its peak – but it is now too late to get in and profit to the same extent.

One of the most successful investors to bet on a credit crunch was Jim Melcher, who has run Balestra Capital, a small New York hedge fund, for almost a decade. It has doubled so far this year. He did this by exploiting the complex new debt instruments that are now exploding in the faces of their inventors.

For example, he bought credit default swaps (CDSs) against a range of 30 collateralised debt obligations (CDOs) that were rated AA. Translated into English, he bought insurance against default by packages of loans that were not the highest quality, but were not junk either.

The cost to him, the effective premium, was 0.6 per cent per year. This was the most he could possibly lose from the strategy. The potential profit, if all the bonds issued by the CDOs were to default, was 100 per cent. He now expects to make this on about 20 of the CDOs for which he bought protection. “I’ve never seen a cheaper play to make where you could take less risk with more return than I was offered in this market,” he says. That was a classic value investor’s investment – tiny risks to the downside, with potentially huge profits. He is not waiting for the CDOs to go to zero and has taken profits on a third of these bets. In one case this involved taking $7m for an investment that had cost about $50,000 some months earlier.

Other bets also took advantage of new esoteric instruments and paid off handsomely. He sold short the ABX index of subprime mortgage bonds, a manoeuvre that made money when the price of these bonds shot down.

He also sold short high-yield, or “junk” bonds while buying Treasury bonds. That paid off when there was a sharp increase in the extra yield that junk companies had to pay. And he bought the Japanese yen, which has risen during the market mayhem.

The risk was that someone on the other side of the transactions had to pay up. These counterparties are usually investment banks and Mr Melcher thought some might go under. As insurance he bought “put” options – giving the right to sell stock for a given price – in investment banks. These were cheap because they were “out of the money” – meaning that they conferred the right to sell for a price far below the price at which the companies were trading.

That trade also proved lucrative, as the fall in investment banks’ share prices has pushed up the price of the options. Even his insurance policy is making money.

The true bargains, then, were when the credit market was at its peak. There will be chances to pick up undervalued securities when this crisis has played itself out. But for now, the discouraging news is that value investors remain on the sidelines – while Mr Melcher is still betting on things to get worse.

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  1. Lab Rat

    Just as an aside, the general consensus at Calculated Risk (including Tanta) was that the NY Times article on Countrywide was at best ignorant, and probably qualified as a vicious smear piece.

  2. Yves Smith

    Lab Rat,

    Thanks for the head’s up. I did look at the comments at CR and what Tanta said (along with many other things) was this:

    As usual, there’s a whole lot in Gretchen’s article that doesn’t add up.

    (Disclaimer: I’m prepared to believe all kinds of horrible things about CFC. Not on GM’s word for it, though.)

    If I knew how to do a scratch through correction, I would, but I’ve toned down the reference to her stuff instead.

    But an attorney I know is already gunning for Countrywide (can’t expose the theory, but not the typical class action fraud angle), so there is meat behind the “Countrywide is probably a bad actor” view beyond what Morgenson says.

    The problem is she doesn’t know what she doesn’t know. She is good on matters where she can read filings. But she is flatfooted here. She clearly has sources that got all wound up, but she was unable to sort the wheat out from the chaff in what they were telling her.

  3. Anonymous

    Yves, I certainly have no trouble with what you wrote.

    In fact, I see Morgenson as in danger of doing CFC a favor it doesn’t deserve.

    Publish enough false or muddled accusations, and your target starts to earn some sympathy. Who benefits from that?

    Some of that article was just outright stupid, like the part about ripping people off with a $60 tax service fee. Either she was talking to an idiot or she was talking to someone who fed her a bunch of nonsense to see how much of it she’d print.

    One reason I left our discussion of that in the comments rather than promoting it to front page, however, was that I didn’t think I needed particularly to spend a great deal of time defending one megacorporation from another megacorporation’s reporter. I like to see fair and accurate journalism, but CFC can take care of itself in any dust-up, no?


  4. Anonymous

    This articel is such unmitigated bullshit, it is laughable. For one, what idiot would ever contend that a car dealer has some obligation to sell a car for as little as possible? So why would a mortgage lender have an obligation to sell it’s wares for the lowest possible price.
    If consumers are so stupid that they don’t shop around for the best price they deserve what they get.
    This stupid, liberal, victim-society mindset is absurd.
    Smarten up, assholes!

  5. Yves Smith

    Anon of 1:48 PM,

    There is evidence coming from news sources one would hardly call liberal, like the Wall Street Journal, that customers were mis-sold. The broker told them they’d be getting one set of terms, when the contract said something completely different. There are also cases of contracts mortgages being in such fine print as to be unreadable without a magnifying glass. Those both indicate intent to defraud, not mere consumer failure to shop.

    Mortgages are sufficiently complicated that many consumers and business go to mortgage brokers to shop for mortgages on their behalf. So what happens to the poor chump, um, customer when his agent steers him into a bad deal to line his pockets?

    In addition, I’d be careful about comparisons to car dealers. George Akerof shared a Nobel Prize in economics in 2001 for writing about, specifically, used car dealers and how bad dealers drive out good supply. He called it the lemon problem. I suggest you get familiar with it before you use analogies to the car market to defend subprime mortgage brokers.

  6. Lab Rat

    I realized later, lying in bed, that I should have qualified my comment with “not that this is an attempt to defend Countrywide.” Oh well.

    Akerof’s lemon problem has been mentioned in connection with the CDO market seize-up. Possibly here? I read too many blogs right now, can’t keep track of where the ideas come from. Whee!

  7. Anonymous

    CFC is getting hit with many lawsuits. I’m starting one for breaking commitments and cleint stealing. Just this week they denined a FULL DOC deal the day we where funding, (after signed doc’s returned)! What kind of crap is that? They said guildline changes were the reason, but it was ready to fund with all conditions met. Not to mention a LOCK to “secure” it.

    Last week they strung me along for 2 weeks past closing then denied my file, the borrowers contacted the retail side to find out why, they called me and got my 1003, 1008, credit, ect. and got docs in 6 hours making me look like crap to my agents! Under the exact same program they denied me on!!!

    If this has been happening to you call Amy at (310) 536-1049 to get in on the class action suit. Or email me @

  8. Anonymous

    Bank of America’s purchase was largely about confidence during a very shaky period. A tiny $2 billion investment in Countrywide created gains of several multiples in Bank of America’s stock price and much more value to the overall capital markets. I still believe that Countrywide is at serious risk of going under if the secondary markets don’t sort themselves out quickly. This is the most critical aspect in my mind in saving more mortgage lenders and financial institutions dealing in asset backed securities – redefine credit ratings that actually mean something.

  9. Yves Smith

    Anon of 6:27 PM

    Very good observations. The Countrywide investment could well have been a confidence move (message to markets: we’re in this business and we think even someone like Countrywide is a buy), and the press stories about how long B of A had been courting them and what a good deal it was may all have been cover.

    But I’m not optimistic about the market sorting itself out. I see too many signs of investors of all sorts not trusting ratings on a lot of asset backed paper. And the fact that S&P downgraded some issues from AAA to CCC in the absence of fraud on the part of the issuer is tantamount to S&P repudiating its own ratings.

  10. Anonymous

    Fortunately for you, here is an insiders analysis of the NY TIMES article. I was laid off last week. One observer is correct in stating that the author printed information she knew nothing about. Indeed, CW, along with a multitude of mortgage lenders, engages in deceptive practices. One need only to view the public marketing materials, such as the totally bogus “no cost–no fee” refinance. It literally does not exist. My guess is that there has never, and I mean NEVER, been one no-cost refinance provided to a CW customer due to the national advertising campaign. In house, we were all instructed to tell the customer that the no cost option was for a relatively arcane Payment Advantage product that had the interest rate adjusted upward to cover the cost. The increase to the interest rate would negate any benefit the customer could obtain from the refi, and the sales pitch would continue on the full cost refi. Bait and switch.

    But my favorite sales tactic, and this is evidenced in the mass mailings CW constantly sends to its portfolio, is the “your ARM is set to adjust” letter. This bogus letter is knowingly sent to the customer, who in a panic will call in to the sales line to see what can be done to solve the situation. Often, and i’ve sat next to these sleazeballs, the salesperson will knowingly lie and tell the customer that, indeed, their ARM is adjusting within the next 6 months, and a refi is in order immediately. However, often, the ARM isn’t ready to reset for another 2 to 4 years.
    Right now, CW is on a refi only campaign. So if you call in and need only 20K, you are going to get a refi, cash out sold to you, instead of the cheaper HELOC option. And the refi will have the $1,000 lender fee included, which is pure profit to CW. Among other costs. I would say that in the portfolio servicing division where I worked, half the refinances were unnecessary or not in the customers best interest. A cheaper home equity or fixed rate second would have been the better option for the customer, but that wasn’t sold so CW could charge the higher fees for the refi.

    Anyway, I could go on all day, but the NY Times piece was true to a point, but the author didn’t get the full picture. I’ve seen it, and it ain’t pretty.

  11. Yves Smith

    Anon of 6:29 AM

    Thanks for the detailed and insightful comment. As I indicted, I know some attorneys who are in the process of developing litigation against Countrywide. Information of the sort you have could be very useful in perfecting their claims.

    You could be helpful without risking any exposure. Lawyers can waste a lot of time and money in the discovery/deposition phase if they don’t know what they are looking for. Having seemingly trivial details like product names and sales force management protocols can speed up the process considerably. Feel free to e-mail me directly.

    Or if you don’t want to go that route (and I can understand why you might feel that way) providing specific detail such as you did in your comment (product names and timeframes are good, as are names of organizational units and sales campaigns, to give a clear picture of who did what to whom) here and on other blogs that have Countrywide stories is another way to get the information into the hands of people who could make use of it.

    And no, I’m not an attorney, nor would I profit from a suit going forward. I’m just an old financial services type who is disturbed and deeply saddened at how corrupt much of the industry has become.

  12. Anonymous

    I would be happy to provide a detailed account of the deceptive practices of CW, but honestly, what is in it for me? How would I benefit?

    The misdeeds I can divulge would take far too long to write out, the earlier to examples but a molehill to the mountain of evidence to which I have access.

    Mr. 6:29 AM

  13. Yves Smith

    Mr. 6:29 AM,

    I agree that narrowly speaking, there isn’t anything in this for you. The only way people get any money in litigation is either by being a plaintiff or being an expert witness.

    And to be honest, I am not certain where this planned lawsuit stands. I just happen to know the attorney, who was gung ho a few weeks ago, and if I understand the theory correctly, some of the things you mentioned would be of interest. But they may be either too far along or not far enough along to benefit from your insights.

    So this all boils down to a matter of personal philosophy. You may want to put CW entirely behind you and focus entirely on what to do next. But you were bothered enough by what you saw to put a comment on my blog. That says to me you would like to see the record on them put straight if it doesn’t take too much energy on your part.

    Being a whistle-blower is a thankless task, and I’d tell someone to think long and hard about going down that path. But that isn’t what we are talking about here. Assuming the attorney has some interest, we are talking about spending maybe a few hours, max, making them a bit smarter about what went on. And I would assume you’d want to understand their theory (ie, what they are trying to get CW on) and making sure you agree with it before you went ahead.

    So I see this as a marginal expenditure of your time for some marginal benefit. Honestly, you will never know if your contribution made a difference.

    But (and I am probably an idealistic dope), I put a lot of time into this blog for uncertain benefit. Yes, many readers are kind enough to tell me they appreciate my work, so I can at least take pride in doing a job that some people think is well done.

    But really, my main goal is to encourage people to think more critically , sharpen the debate around certain issues, and get people to focus on the right questions. Am I making much difference? Probably only a wee bit at the margin.

    Now I could regard this as futile. Or I could take the view that if more people decided to do what they could to make things better, even if it’s only at the margin, we’d all be a lot better off in aggregate.

  14. Anonymous

    This may be the week for significant changes at CFC!!! Staff reduction into the thousands – multiple Retail and Wholesale office closures, along with significant reductions of their Correspondent Division. Will this be the beginning of the new CFC/BofA??

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