Gundlach Says Market is “Too Bearish”
Robert Huebscher
March 24, 2009


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On the broader question of whether government programs, such as the just-announced plan to purchase an additional $1 trillion of Treasury and agency debt, will succeed, Gundlach said that the government cannot “make the problem go away by papering it with more money.  They can change the form of the problem – that is, usher in inflation.”

Bad fundamentals continue to characterize the non-agency mortgage market.  “There is no end in sight for sub-prime delinquencies,” Gundlach said.  Approximately 40% of all securitized sub-prime mortgages are now delinquent, compared to 10-15% two years ago.  Alt-A delinquency rates are approximately half of those in the sub-prime market.

The supply of non-agency mortgages is rapidly diminishing, as forced sellers – mostly foreigners and funds facing redemptions – liquidate their portfolios.  Gundlach likened this to “taking a pitch fork and throwing money into the incinerator,” since prices in this market offer attractive opportunities.

In the prime mortgage market, approximately 4% of securitized loans are delinquent.  This sector is particularly sensitive to unemployment, Gundlach noted. He forecasts that this rate will go to double digits.

Sub-prime loss severities (the recovery rate for homes that are sold out of foreclosure) have risen from approximately 30% in mid-2007 to the current rate of 63%.  “This will continue to rise,” Gundlach said.

Gundlach said the bankruptcy “cramdown” issue, wherein bankruptcy courts may be allowed to restructure the terms of homeowners’ mortgages, will not affect investors.  Only 5% of defaults go through bankruptcy, he said.  Given the slow pace of bankruptcy proceedings, it is highly unlikely that significant portions of investments would be affected.  “It might create an incentive to declare bankruptcy,” he said, but it will not radically change the percentage of defaulters. 

The broader issue with bankruptcy cramdowns, according to Gundlach, is whether they “cross the Rubicon.”  In this case, the Rubicon is the legal framework which protects investors by requiring homeowners to abide by the terms of their loans.

Gundlach is opposed to the proposed $75 billion program to incentivize mortgage servicers to reduce interest rates, extend amortization schedules, or write down principal.  “This would incentivize servicers to abrogate their duty to serve investors,” he said.  Furthermore, he said government plans to give servicers a safe harbor from lawsuits are unacceptable.  His biggest fear is exposure to abuse, such as homeowners purposefully defaulting on mortgages in order to qualify for government programs. 

To solve the foreclosure problem, Gundlach advocated a self-policing system based on the tax code.  The income stated in loan applications would be compared to the income reported by homeowners on their tax returns.  If the amounts do not match, homeowners will either be excluded from loan modifications or would receive a bill from the IRS for taxes on unreported income.  “This would be elegant and self-policing,” he said.

Gundlach said equity investors in the banking sector still face a strong threat of dilution as the government invests additional capital.  Even senior bondholders are not protected.  “No debt is sacrosanct, particularly in an institution that is receiving government money,” he said. 

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