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“One of the least understood aspects of the sub-prime crisis is that it is a crisis of lending standards in general,” says Gertner.  “Sub-prime is the first domino to fall – these borrowers were the most exposed.”

Gertner and Youngblood see more pain ahead in markets affected by imperfect lending practices and insufficient collateral.  Henry Macklowe is being forced to cede control of properties he could not refinance to Deutsche Bank, evidence of trouble in the commercial lending markets.  Leveraged loans – financing provided to already debt-ridden companies – “Sub-prime is the first domino to fall – these borrowers were the most exposed.”

-- Gertner now represent approximately $200 billion of capital on the balance sheets of investment banks, according to Gertner.  With these bonds now trading in the high 80s and low 90s, Gertner sees a 10% write-off as likely.

The key determinant for recovery is in the housing market, which Gertner says will “take a number of years to recover, due to excess inventory and evolving lending practices.”  Excess inventory must be absorbed and lending practices stabilized for a recovery to take hold. 

Gertner’s data shows housing starts are at an annualized rate of 1 million.  Over the last 25 years, population growth and shrinking households have absorbed approximately 1.3 million units, implying the housing industry is now creating 300,000 units less than the market demands.  It will take five years for the 1.5 million units of excess inventory (noted above) to absorb the 300,000 units of underproduction.

Gertner expects to see a recovery in less than five years.  “Housing starts will continue to decline and the inventory will shrink,” he says, adding “the best news would be if builders stopped building houses.”

Youngblood has a similar outlook, and expects the housing market to recover in the 2010 timeframe.  His data shows the average peak-to-trough cycle in housing has been 4.5 years and, with the last peak in Q3 of 2007, the trough should be in early 2012.  “But there is a one year standard deviation on these numbers and, since many markets peaked before Q3 of last year, we will see recovery well in advance of 2012,” says Youngblood.

Youngblood predicts liquidity in the prime securitization mortgage market in mid-2008.  “Leading lenders, such as Wells Fargo, Bank of America, Citicorp, J.P. Morgan, and WAMU will generate enough prime and near-prime loans that can’t be held on their balance sheets, and they will force the reopening of the markets, but in lower volumes similar to what we saw in 2000 and 2001.” 

The Lasting Impact of the Sub-Prime Crisis

“Re-securitization [packaging securitized debt into other pieces of securitized debt] will go away and will have a hard time coming back,” says Gertner.  Both he and Youngblood agree conventional securitization will reemerge, and consumers will realize the benefits of lower interest rates achieved through debt repackaging.  “But the rating agencies cannot assign risks to re-securitized debt, and that is where the trouble is occurring,” notes Gertner.

Ratings agencies will see their business impaired.  “AAA is the brand name of the agencies, just like Coke is a brand name” Gertner says, adding, “Rating agencies cannot sell their services if people don’t believe in the AAA brand.”

Gertner and Youngblood agree the ratings agencies had good information, but perhaps not as extensive or perfect as what is available to some of the bigger market participants.  Their failure was in their models, which among other things did not foresee a decline in housing prices.  Nor did the agencies forecast the degree to which borrowers would lie on loan applications when presented with the opportunity for easy money.  Youngblood also faults the agencies for incorrectly modeling factors such as the correlation between different sectors in the economy and the housing market.  “It is shameful,” Youngblood says.  “There is significant academic research and they had ample guidance on how to model these effects.”

The ratings agencies have limited their liability by claiming protection through free speech under the First Amendment.  But Gertner asks “why are they in business if investors cannot rely on their data?”  “We will see a better framework that inspires investor confidence.”
-- YoungbloodThe ratings agencies’ models are evolving on an almost daily basis, and Gertner is confident that “in two or three years it will not look as it has in the past.”

Youngblood does not anticipate structural changes in the ratings industry, but expects dramatic improvements, including stricter rating criteria for every form of consumer and mortgage security, and more extensive and accurate disclosure of risk factors.  “We will see a better framework that inspires investor confidence,” says Youngblood.

Credit cards, automobile loans, student loans, and other forms of consumer credit will be permanently changed.  “Lenders will be less willing to extend credit and will charge more,” says Youngblood.  “They will be quick to curtail revolving lines of credit and to recover amounts in default,” he added.  So far, these effects have been cushioned by weakening in consumer confidence and spending.

Final Thoughts

Youngblood laments the effect the crisis has had on credit-worthy borrowers.  FHLMC and FNMA rates (relative to 10-year Treasuries) are at their highest levels since 1983 and jumbo loan spreads have not been this high since 1986.  “In just a few months we have rolled back the gains to homeowners of a generation of mortgage finance,” notes Youngblood.

“It remains to be seen how fast confidence will be restored and the cost of credit reduced,” says Youngblood.

“Delinquencies will go up; we are just starting to see the beginning,” says Gertner.  With the economy still growing, albeit at a slow .6% pace, and unemployment still low, Gertner remains optimistic, but cautions that the “bogeyman is a recession.”  “A lot has been tried to jumpstart the economy, but so far nothing has worked,” adds Gertner.

Our belief is the credit markets will stabilize as the housing market reaches equilibrium and lenders regain the confidence to revive the securitization industry.  Until the extent of the at-risk debt is identified, a timetable cannot be estimated.  Specifically, the markets will need to quantify the amount of Alt-A, commercial, and leveraged loans, and other forms of consumer debt facing the combined problems of insufficient collateral and lax lending standards. 

For advisors, we subscribe to the conventional wisdom that this crisis will be no worse than events of seemingly similar magnitude – e.g., the LTCM collapse of 1998.  The markets have weathered these storms, rewarding investors with long term horizons who bought opportunistically when values were depressed and the markets in disarray. 

The danger, as some economists suggest, is this time will be different.  They point to failures such as the “lost decade” in Japan, where a collapse in the housing market led to a ten-year malaise in their markets.  Similar events have happened in other developed economies, a topic we will examine in a future article.

In the short term, as Gertner says, “until the market understands risk, the markets will be frozen.”

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