Short the DeMarco Trade

Or Wall Street Doesn’t understand Washington 

HousingWire and the Wall Street Journal both recently carried articles about the DeMarco Trade. The DeMarco trade is the idea where market participants believe Government Sponsored Enterprise (GSEs) guaranteed mortgage backed securities (MBS) will have a significant increase in prepayments as DeMarco is replaced in the first or second quarter of 2013 and the new Director of Federal Housing Finance Agency will allow immediate principal forgiveness for GSE MBS. The GSEs will cover the losses to investors in the form of immediate principal prepayment. If true then investors should be flocking to Principal Only (PO) or heavily discounted 06-08 vintage GSE MBS.

However, anyone who buys into this trade should 1) have their head examined and 2) learn how the government actually works. The DeMarco trade makes several assumptions which history and facts have proven false over time.

Assumption: The Obama administration anger over DeMarco’s refusal to agree to principal forgiveness makes him an early target for removal.

The Administration, like the GOP, didn’t trust Nat Silver’s statistics and worried how they were doing in the polls. Principal forgiveness seemed like a great idea to help out many struggling homeowners and an economic stimulus without adding to the federal debt thereby generating votes. Based on press at the time, Geithner was especially upset by DeMarco’s resistance to the idea. When DeMarco finally said no after months of delay (or “study as he called it), Treasury retaliated by changing the preferred stock agreement to sweep all of the GSE’s so that they will never leave conservatorship leaving only a path at some time in the future for receivership.

And unlike High School, politicians don’t stay angry when political bigger game is available to hunt.

Moreover, with the election over, President Obama has bigger appointments he needs to worry about including Secretaries of Defense, Treasury, State, Energy, and Commerce and a permanent chair of the SEC.  The fiscal cliff negotiations will determine how many chips he has earned or lost to set up who he nominates for positions. For instance, the GOP helped to kill the Rice nomination for Secretary of State to, hopefully for them, to force Obama to nominate Kerry and thereby allow soon-to-be former GOP senator Scott Brown to reclaim his job.

DeMarco isn’t on his immediate todo list.

Assumption: GOP will roll over on FHFA Director nomination.

Senate GOP are licking their wounds after losing three of their colleagues in the election and are willing to fight to keep DeMarco in office because he helps their agenda (which could change and then they would scream for his removal). As I said Obama has bigger issues to fight than housing. Senator Shelby will very likely repeat his winning performance by blocking any Obama nominated candidate. Senator Shelby enjoys and earns political points at home being the thorn in the side of the Administration especially in his roll as Ranking Member of the Banking, Housing and Urban Affairs Committee.

For those with a sort memory, Obama nominated Joseph Smith, the head of North Carolina’s banking regulator who is widely respected by the industry. Senator Shelby (of Alabama) screamed Mr. Smith was too weak on banks and therefore held up his nomination. Mr. Smith withdrew his name for consideration in frustration. (As an interesting side note,  “the weak” Mr. Smith was chosen by state Attorney Generals to administrate the five bank robo-signing settlement including the one from Alabama in February 2012)

Expect a bruising confirmation should a candidate be nominated.

Assumption: Obama will use a recess appointment to remove DeMarco

Recess appoints are temporary appoints that last only a year or so creating a bruising battle when the next nomination comes up.  Recess appointments are also shut out from getting the position on a permanent basis. Recess political appointees also tend to have a tough time in front of the senate, which has far reaching subpoena powers. If they senate appointments were so easy, more appointees would be in place.

Secondly, GOP has figured out a procedural trick to keep congress open so the President can’t perform a recess appointment without extreme difficulty. The appointment of the Consumer Finance Protection Board director recess appoint was done with significant issues including a lawsuit questioning its legality.  Don’t expect a FHFA recess appointment anytime soon.

Assumption: Obama will appoint him in the first quarter 2013

Not true! With the Mayan Apocalypse occurring 12/21/12, Obama won’t have time to appoint anyone.

Good luck with your trades.

How I legally caused $BAC to lose $4k on my mortgage.

Legally Hurting your Servicer in Three Easy Steps

I knowingly caused Bank of America ($BAC) to lose a little over $4,000 on my home mortgage originated last year and, best of all, I did it legally. It is my duty to provide this public service announcement to the world at large since $BAC is a bank hated by everyone including the 99 percent, anyone holding a Countrywide mortgage backed securities, and Rating Agencies. The trick to causing more pain to $BAC (or any other servicer) is to:

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Next on the Blame Game: Student Loans.

In an email to its clients, Dominion Bond Rating Service (DBRS) proclaims “STUDENT LOAN DEBT WEIGHS ON U.S. ECONOMIC RECOVERY”. Student Loans will prevent a generation of potential home borrowers from every qualifying for a loan. According to the CFPB and the Federal Reserve Board, Americans have over $1trillion worth of student loan debt and this figure keeps increasing while other debts (credit card and autos) have decreased dramatically. The only debt greater than student loans is mortgage loans. Well, as we used to say on the floor, “Duh!”

This very severe and extended recession kept students in school longer and caused unskilled workers to go to school to improve their earning potential. In both cases, these students took out sizable student loans. As they finished their degrees, the recession hadn’t abated and they were left without jobs or prospect of jobs. Yes many looking took non-economically viable degrees like art history or islamic architecture but the job market hasn’t recovered like in past recessions. Even students from prestigious institutions are looking for good jobs or have been forced to take lower paying jobs (Do you want fries with your burger?).

A student loan is one of the very few debts that aren’t written off by bankruptcy. In 2005, President Bush signed into law the bankruptcy reform act which allowed private student loan originators to have a higher priority in bankruptcy than almost any other debt, with the possible exception of federal tax liens. Only in death does student loans have a priority of unsecured debt. While other debt is charged off or forgiven, student loans can live on forever. Many Democratic politicians have introduced legislation to place student loans at the same level as other unsecured debt like credit cards or forgiveness due to hardship. The GOP on the other hand want students to take responsibility for their debts no matter what and therefore won’t agree to a change in the law. Don’t expect this law to change any time soon.

Student loans are not a drag on the economy at the moment but will have a minor but noticeable effect as consumers de-lever all other forms of debt as this is a problem of the young and/or the unskilled. Many of these people will never truly be able to get rid of this debt and therefore never be able to get the level of credit available to those gainfully employed with degrees prior to the recession. Cheery scenario, no?

DBRS is out proclaiming the death of the US housing recovery due to student loans. They write:

“Some of the items precluding them from being approved for a mortgage may include larger down payments, the potential lack of an established credit history, and the disinclination by lender’s to consider a limited employment history which has resulted in many student borrowers renting or moving back home. Furthermore, certain graduates may also opt to continue with graduate level studies which may add more student loan debt and push buying a new home much further into the future.”

While many of these students maybe locked out of prime credit for years, DBRS makes the implicit assumption that subprime lending is dead forever. I disagree. Subprime mortgage lending will come back as the regulatory framework and risk pricing stabilizes. My crystal ball says four years from now. The other assumption DBRS makes is the lack of household formation from immigrants which has been increasing and they are used to a cash economy.

The housing market has many fundamental problems which are much bigger than student loan debt which will keep it depressed for the near future.

American Securitization Forum 2012: Groundhog Day Year 3

Happy New Year and may 2012 not suck as much as 2011!

I’ve been on forced hiatus due to issues relating to a trip to Cuba, a woman named Carla and a small golden statue of significant religious value. I won’t bore you with the details.

Now that I’ve been released …err… returned to work, I just got back from the preeminent fixed income structured finance (FISF) conference; the American Securitization Forum (ASF). For those outside of the business, the FISF brought you such fine investment products as Collateralized Debt Obligations (CDOs), Subprime mortgage backed securities, Liar Loan mortgage securities, Commercial Mortgage Backed Securities (CMBS) and synthetic version of all the above.


Participants of ASF demonstrated cautious optimism of a prisoner believing the governor would free him at any moment. While CMBS, Autos and Credit Cards have come back in a stunted form, non-government residential mortgage backed securities (RMBS) still lack the appropriate economics to get deals done. Many participants complained about the lack of final Dodd-Frank Act rules but CMBS, Auto and Credit Cards are functioning while waiting for the same regulations. RMBS has too much supply overhang to have spreads tight enough to get a deal done. According to Laurie Goodman, Amherst Securities, the US has a 33 month shadow inventory of defaulted & foreclosed upon houses to process before a supply/demand equilibrium can be hit to make deals economic. To make the situation more painful, most bullish participants believe the home prices will decline another 3-5% before stabilizing. (And yes I said bullish!)

BTW, the private residential mortgage backed securities continues to be stalled with two small deals in 2010 and the first deal of 2012 announced just before the convention.

For those having gone to the previous two ASF conferences will seem like Bill Murray’s Groundhog day all over again. I’m thinking of the scene where the main character drops a toaster into his bath.

Dems who?

Members of the ASF have given up on the democrats and had two very pro-business GOP congressmen speak at the conference. In fact both congressman were so pro-business that they willfully forgot about the abuses caused by the industry. While I agree the Dodd-Frank Act has many issues it also has several really good features. Take what works and ditch the rest.

Perfect Irony

After the colossal market meltdown which lead to the bursting of the credit bubble and implosion of several small countries, the ASF held its 2010 conference in Washington DC as a sign of contrition and to let congress know we’ve learned our lesson and don’t need pesky laws regarding risk retention. In 2011, ASF ventured to Orlando because the business is family friendly and gave Rep. Garrett the forum to espouse his hatred for all things government especially the President, Fannie Mae, and Freddie Mac though he seemed to forget about FHA/VA loans. The time for slinking around is over and the ASF is back in its favorite city, Las Vegas!!

In a bit of delicious irony, the ASF chose to hold the convention in the opulent Aria Hotel. The Aria is located in the new City Center in Las Vegas. The construction of City Center was financed by a loan originated by a large investment bank with extremely loose underwriting standards (pro-forma underwritten and had interest only payments due). This large investment shop placed the loan into its own CMBS and made themselves a good deal of money.

The City Center loan failed as the construction project ran out of money. The equity owner was highly levered and had no interest in putting his own money into the work. The project stalled for over a year until a new partner came with a cash infusion for a significant ownership of the project. Moreover, one of the towers has just been condemned without ever being occupied by the local county. The ASF, having not learned its lesson, holds its conference in the very hotel which represented a shining example of how messed up the originate to securitize model had become.

Naked Bond Bear

FEMA – Internet Outage Warning

As Hurricane Irene batters the East Coast, federal disaster officials have warned that internet outages could force people to interact with other people for the first time in years. Residents are bracing themselves for the horror of awkward silences & unwanted eye contact. FEMA has advised: “Be prepared. Write down possible topics to talk about in advance. Sports, the weather, etc. Remember, a conversation is basically a series of Facebook updates strung together.”

P.S. Don’t ever lose your sense of humor no matter how stressful the situation

A rare Mea Culpa: Rating downgrades and MBS

I, being honest and forthright, have to issue a correction. I was wrong. Agency MBS pring was not affected by Standard and Poors Rating Agency downgrade of the United States sovereign debt from AAA to AA+. A few days later, Fannie Mae and Freddie Mac, wards of the state and responsible for financing (but not originating) over 95% the mortgages in the US, got downgraded and the market continued on as usual.

Well usual for incredible volatility and a bear flatner. More on that later.

I had made the erroneous assumption that with the downgrade many funds would be forced to dump Agency debt & MBS as it would no longer count as capital. I believed ERISA & Pension funds would be forced to dump the non-AAA securities. Regulators, when properly motivated, can make changes very very quickly (especially when the law is on their side.). Shortly after the announcement, all US financial regulators sent out immediate “guidance” that US and US backed debt and securities can be counted for capital purposes no matter what the rating.

So with no forced dumping of bonds and S&P losing any chance of investor acceptance of their credibilities or models, TBA traded as it normally does in a Treasury market with high volatility, it widened on a OAS basis to Treasuries. IOs cheapened as lower rates raise the likelihood of mortgage refinancing.

So lesson learned kiddies, the government (and non-government agencies like SIFMA & FASB) will bend over backward to make sure the US economic cradle isn’t rocked too much. What’s that sound I hear coming to port? Oh yes the newest Federal Reserve Oceanliner the QE3!

Soveriegn CDS Close for 8/8/11

Some prospective on the US downgrade.

S&P AAA Rated

  • Finland – 61.89 bps (-2.67)
  • Netherlands – 68.16 bps (+2.63)
  • Australia - 71.27 bps (+2.92) (After a 12 bps rise yesterday)
  • Germany – 79.51 bps (+7.09)
  • United Kingdom – 79.65 bps (+3.38) And they have riots
  • Denmark - 91.10 bps (+1.76)
  • Austria – 107.69 bps (+6.84)
  • France – 159.14 bps (+10.66)

S&P AA+ Rated

  • United States – 56.33 bps (+1.70)
  • New Zealand – 87.83 bps (+0.74)
  • Belgium – 243.35 bps (-1.15)

Clearly the CDS Market has a different view of US credit worthiness than S&P does.

A Case of Regulatory Capture: OTS deconstructed

The Office of Thrift Supervision: A case of Regulatory Capture

Created with fan fare and removed with disdain, the Office of Thrift Supervision ceased to exist after 22 years of existence. President George Bush Sr. signed the law which created the OTS  in the wake of the Savings and Loan disaster of the 80s and the failure of their previous regulator, the Federal Home Loan Bank Board (FHLB).  In typical congressional action, the OTS staff have been absorbed into the FDIC, OCC, Federal Reserve Board and FHFA.  Like OTS, FHLB didn’t actually go away until it was merged with the Office of Federal Housing Enterprise Oversight (OFHEO) to create Federal Housing Finance Agency (FHFA). The OTS represents how legislative good intentions and economic incentives led a regulator to become a slave to the industry.

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Rolling Stones Hyperbole vs. Goldman Sachs Reality

The May 26th Rolling Stone article “The People vs. Goldman Sachs” claims, in clever and entertaining prose, that Goldman execs should go to jail because they: 1) participated in “the most destructive crime spree in our history…”, 2) sold crappy CDOs to unwary clients, and 3) lied to congress.  I’d like to take this opportunity to add a little bit of what I like to call “reason” to each of these “claims.”

Lying to Congress 

Let’s start with simplest charge: Of course Goldman execs lied to Congress. Everyone lies to Congress. Congress lies to Congress. Who outside of Charlie Sheen wants to air dirty laundry in front of the whole world? Yes I believe Goldman lied but not in they way RS thinks they did. Yes, GS knew these bonds were crappy. Yes, they could have done a better job disclosing all the risks. But as a former CDO manager and investor, I know to review, research, and analyze CDOs independently of Rating Agencies.

Selling Crappy CDOs to Unwary clients

Goldman sold CDOs they knew to be crappy to investors who took the opposite side of the bet. Rating Agencies blessed these structures with AAAs. And why is this a crime? Isn’t the motto on the street “Buyer Beware”? The deals would perform or underperform based on the underlying bonds making up the CDOs. Is anyone claiming GS hid which bonds were included? No. Despite RS’s assertion GS knew these bonds were crap, this does not constitute a crime or a failure of disclosure. These bonds were not sold with a guarantee nor did Goldman ever say these bonds had no risk. Heck, even the rating agencies blessed these structures by allowing 75% of the cash flow to be rated AAA.

To further the car analogy favored by RS, imagine you want to buy a fleet of 100 cars from GS Rental Company. You also have at your disposal the repair (i.e performance) history of each and every car from a variety of third party vendors named Intex, Core Logic and Lewtan. However, you rely on Moody’s Auto Rating service to tell you that only 15 cars are likely to go bad in the worst case scenario. You decided to buy 75 cars with GS Rental company keeping the first two cars that go bad. Crime or out-and-out stupidity?

Further, doesn’t anyone remember all the other products investment banks have sold which blew up shortly after origination? I do. Ask me someday about 125% Mortgages, Manufactured Housing, Airplane Lease ABS, Tech Stocks, and so on. Investment banks only sell what investors are willing to buy. Same with the CDOs. Good salesmen know how to sell. GS has very, very good salesmen. Frankly, any investor who trusts a Wall Street salesman and doesn’t ask the tough questions should go work for a feel-good non-profit. Buying investment products you don’t understand should be a crime.

Crime Spree and Key Stone Cop Regulators

Lastly, cutting through RS’s massive hyperbole, I’m trying to figure out what constituted the biggest crime spree of all time. Fraudulent subprime mortgage backed securities issuers? CDO managers? Fraudulent mortgage originators? Fraudulent borrowers? Fraudulent Rating Agencies? Incompetent and toothless regulators? Lazy investors?

Every part of the business created the housing meltdown. Borrowers who over levered or lied to get access to housing  they couldn’t afford. Real estate agents over sold housing to drive up commissions. Home appraisers inflated valuations at the behest of mortgage brokers. Mortgage brokers, paid on commission, forged or instructed borrowers to lie to get access to as much money as possible. Loan officers, paid based on production, ignored problems in loan origination files. MBS issuers ignored prudent underwriting standards and due diligence with no regulatory oversight. Regulators didn’t have the authority to stop this train wreck nor the poltical backbone to do so. Rating Agencies relied on outdated models and Wall Street pressure. Investors didn’t do the work necessary to understand the risks.

This “crime spree” wasn’t a drive by a Moriarty-esque criminal mastermind but a Confederacy of Dunces.

RS says the “banks were closely monitored by a host of federal regulators, including the Office of the Comptroller of the Currency, the FDIC, and the Office of Thrift Supervision.” I call bullshit. The OTS actively sought more regulatees by stating to them “we are the kinder gentler regulator”. The biggest blow-ups were OTS governed (Washington Mutual, Bear Stearns, Lehman Brothers, Indy Mac, and Countrywide). The OCC wasn’t much better and the FDIC was busy laying off personnel because the world was going well. The Fed’s chief drug lord (Greenspan) was pushing housing as the great engine of the US economy.


I’m sick of Rolling Stone’s hyperbole. If GS had a $6B bet on the housing market then they were a little more than 1/2 a percent of the total investors in the market. They were small potatoes, and because they were small they survived the meltdown like cockroaches in a nuclear winter.

Treasury selling of MBS: Round 1 to the Obama Administration

Buy into Weakness, Sell into Strength

There is an old adage, which says “Those with the Gold Rules”. The US Gov’t has all the gold. After buying $1.5T of agency mortgage backed securities to keep mortgage rates low, the Treasury announced the orderly sales of MBS. The idea as listed in their press release is to unwind their position for a profit without upsetting the markets.  Keep in mind the independent Federal Reserve Bank isn’t selling,

What does the Treasury own:

February 2011    
Current Face of the Portfolio at the End of Month

Fannie Mae Freddie Mac  
4.0% 1,376,966,849 6,495,785,739  
4.5% 17,160,393,201 27,946,089,858  
5.0% 22,436,589,516 21,143,129,062  
5.5% 19,103,475,065 9,018,824,625  
6.0% 8,723,088,415 2,161,991,362  
6.5% 47,223,820 0  


Fannie Mae Freddie Mac  
4.0% 0 318,146,273  
4.5% 60,412,369 0  
5.0% 61,850,726 65,124,834  
5.5% 49,831,614 126,373,957  
6.0% 0 0  
6.5% 0 0  
Numbers represent the current face of the portfolio at the end of the month


The US Gov’t purchased (actually over purchased) the current coupon TBA to bring down mortgage rates in a feeble attempt to bring back the US housing market. This tactic didn’t help stop the bleeding though it did slow it down some. As they overbought production (TBA is a futures market and therefore originators can oversell causing trade fails) in the current coupon, the US Gov’t purchased premium coupons to help with the mortgage rates. Again the US Gov’t overbought real production, so then they bought some discount bonds and then stopped.

With all the unrest n the Middle East and nuclear catastrophe in Japan, Agency MBS bonds like Treasuries are rallying due to the flight to quality trade. The US Gov’t thinks they can have their cake (i.e. profits) and eat it too (i.e. political brownie points by lowering debt).  Additionally, they think they can sell $10B/week without dramatically driving up rates. Are they right? Are they crazy? Will Megan ever see her long lost brother who recently had the sex change operation in Sweden?

In the short term, MBS spreads will widen out with increased supply but not sharply.  The US Government isn’t crazy or stupid (though I do wonder about the strategy of telegraphing your moves). The MBS market is short supply partially due to the previous government overbuying and due to decreased availability of prime credit borrowers who haven’t refinanced in the last few years. The planned selling of $10B per month will be in the higher coupons. Selling in the higher coupons will produce the most profits.

The real question is will the US government sell 4.5% and 5% bonds at a loss or modest gain? The Administration will claim a political victory by 1) spending money to help the housing market when they needed it, 2) make a profit for the US taxpayer better than any private company, 3) demonstrate the need for a government presence in the mortgage market and 4) reduce US debt by $10B/month.

All of this is just the prelude to the main event: The soon to be released Dodd-Frank Act qualified residential mortgage and risk retention rules versus every political self-interest group in the mortgage business.