Toomre Capital Markets LLC ("TCM") wrote yesterday in the post 'Moment of Truth' for Wachovia about Wachovia's surprise first quarter earnings loss and how much of the loss was due to their approximately $130 billion portfolio in pay option ARMs. On Tuesday April 15^th 2008, Slate has followed up with the sobering article entitled Here Comes the Next Mortgage Crisis. The subtitle to the article is Subprime was just the beginning. Wait until California's prime borrowers start handing their keys to the bank. For those who are more optimistic that the Capital Markets are nearing the end of the mortgage crisis, they would do well to read this very sobering article written by Mark Gimein.

The main thesis behind this article is that with the California residential real estate prices in a free fall, the phenomena of walking away from a home will sharply increase, even for those with strong credit ratings in the so-called "prime" mortgage category. TCM refers to this walk-away phenomena as "jingle mail" and sadly thinks that this phrase will become part of the national lexicon in the coming two years. The article states "Unfortunately, the crisis in California is going to get much worse, and there is no bailout that will solve it. Why? Because if the first stage of the foreclosure crisis was about people who could not afford their mortgages, the next stage will be about people who have every reason not even to try to pay their mortgages." [TCM emphasis added]

Later the article continues. "… for all the California homeowners who in the next year or two are going to find themselves with the choice of whether, faced with a huge new wave of interest resets and a historic decline in the value of their homes, they will simply walk away. First, those home prices: For a weird few months of the mortgage crisis, statisticians came up with peculiar numbers about home values, rolling out comforting stats showing single-digit declines. Well, that's over. Last month, the California Realtors' association (folks who in October managed to "project" that prices would fall 4 percent in 2008) reported that, actually, California house prices in February fell 26 percent from a year ago. In the places where the foreclosure boom has hit hardest, it's worse."

This sharp decline in California real estate prices is causing many of the mortgage products originated in the 2005-2007 to have current LTV's near or in excess of 100 percent. The article then continues to explain how the decline in real estate prices when coupled with coming "prime" option ARM resets is likely to leave many homeowners with the economic quandary of whether they should remain in "homedebtor" hell servcing more debt than the home is worth or in a nonrecourse state like California simply walk away. The article explains:

The just concluded week of April 11^th 2008 ended on a down note. The earnings announcement (and considerable disappointment therein) by General Electric caught many by surprise and resulted in the largest one day decline in the GE common share price since the 1987 market crash. Perhaps one of the most widely held common stocks, General Electric was thought to be relatively immune to the on-going credit crunch due to its strong balance sheet (and "true" AAA/Aaa ratings), its diversified portfolio of short and long-cycle businesses and its truly global market exposure where more than half of its earnings resulted from activities outside of the United States. Yet even GE disappointed. The chief culprit was attributed to the global credit crisis and weaker American economy. According to The Wall Street Journal, CEO Jeffrey Immelt said, "We assume the economy is going to be very tough and remain very tough." Accordingly, he lowered GE's earnings growth rate to at most 5% for the year. That was a far cry from his pronouncement on December 12^th 2007 that "10% earnings growth next year is 'in the bag'", which also partly explains the sharp share price sell off.

As readers of this Insights section many recall, Toomre Capital Markets LLC ("TCM") has been warning that this credit crunch triggered by the American subprime mortgage default crisis will take far longer to work out than many in this near-instantaneous world of communication might fully appreciate. Many in the financial markets are buffeted by the 24x7 news cycle and feel compelled to react to the latest change(s) in this or that stock, credit, commodity or foreign-exchange price. Is it any wonder then that volatility as a whole as sharply increased from early 2007 levels, many are now decrying "complexity" and most are extremely fatigued? This credit crunch will take yet further time to work out. The key question is, though, Are we at the beginning of the end or just at the end of the beginning of the credit crisis?

Back during the last significant mortgage crisis (S&L liquidations by Resolution Trust Corporation) in the 1989-1991 period, Lars Toomre followed Lew Glucksman and Larry Fell from Lehman Brothers to Primerica where he headed what then was known as Smith Barney's mortgage-securities trading department. As Lars has described since, it was much akin to moving from a battleship to a small destroyer in the midst of perhaps a once in a century cyclone.

At that point, the Capital Markets division of Smith Barney was not prepared to take on tens of millions in positions, let alone the hundreds and even billions positioned by its larger broker/dealer brethren. As a result, there was a significant effort undertaken to upgrade the mortgage areas procedures, systems and people. Aldon Hynes, for instance, quickly joined Lars where he single-handedly assured that the first LAN was installed on the trading floor and each trading professional had a connected computer on his desk. With the demise of Drexel Lambert in the early months of 1990, several mortgage researchers joined Smith Barney, including Chris Schorin and Linda Lowell. Although we subsequently went in different directions, their research then was and has continued to be quite good.

On April 9^th 2008, Linda Lowell published a piece entitled Viewpoint: Those Who Bury History Are Doomed to Repeat It. Her "perspective – that's one with over 20 years in MBS/ABS research — is the fact that, by abandoning the Great Depression as the worst-case benchmark and shifting to models based on contemporary mortgage performance, the ratings companies helped create the current house price crash and credit squeezes that are routinely compared to the Great Depression." This article is a great review of how the rating agencies came to create mortgage credit rating scenarios and is well worth reading.

Some readers may recall that Toomre Capital Markets LLC ("TCM") addressed the issue of the rating agencies in the post Bond Rating Agencies Get Subpoenas. The reader might want to reference both articles as they reflect on the UBS structured product research report Linda Lowell references at the end of her article to answer the question "Which rating company's ratings are most reliable?" According to UBS, the rankings are Fitch, S&P and pulling up the rear Moody's. Somehow TCM is not at all surprised that Moody's – which always has seemed to put commercial interests at the forefront of accuracy – still lags the other rating agencies.