Crisis Counsel

Chairman and CEO, WL Ross & Co

I recently overheard two men arguing about who was better off. One boasted about his new car, the other about a plasma TV and so on, until one proclaimed, "I am better off because I owe more than you are worth." The second man conceded defeat. This anecdote summarizes the mortgage bubble. Americans spent more than they earned in 2005 and 2006 and borrowed the difference. The federal government did the same. Everyone secretly feared this was unsound but wanted immediate gratification, so there was applause for talking heads who said global liquidity would make these borrowings safe. Alan Greenspan went so far as to suggest that people take out adjustable-rate mortgages.

Liquidity, however, is not about physical cash; it is mainly a psychological state. Subprime problems have consumed only trivial amounts of global cash but already have burst bubbles by shocking lenders. Clever financial engineering effectively had convinced lenders to ignore risk, and not just in subprime. A major hedge fund participated in a loan to one of our companies, but sent no one to a due diligence meeting. So I called the senior partner to thank him and tell him about the non-attendance. He responded, "I know. For a $10 million commitment, it wasn't worth going to a meeting."

When subprime issues first surfaced this spring, many major institutions said they had none, but recent quarterly write-offs show they did. They weren't lying; they just didn't know what they had. Their embarrassment has brought risk control back into vogue. It was always silly to lend to weak credits at discounted interest rates, and without documenting income and balance sheets and without appraisals. No amount of model building should have enabled Wall Street to take $100 of such paper and alchemize it into securities sold for $103. Models inherently assume a future similar to the past and therefore they fail when multiple standard deviations occur. Subprime models also did not capture ever more lax credit standards nor that real estate might suffer severe and protracted price declines, again proving that the two most dangerous words in Wall Street vocabulary are "financial engineering."

Now that we have identified the cause of the disease, how severe and how contagious is it? The present $200 billion of delinquencies will grow to $400 billion or $500 billion next year because $570 billion more low, teaser-rate mortgages will reset to market and consume more than 50% of the borrowers' income. Therefore most of the loans will be foreclosed or restructured. Probably 1.5 million to two million families will lose their homes. Meanwhile, few lenders will put mortgages on the foreclosed houses, so the prices will plummet. Despite these tragedies, total losses will probably be less than 1% of household wealth and only 2% to 3% of one year's GDP, so this is not Armageddon. However, even prime jumbo mortgages will be more expensive and more difficult to obtain.

Similar excesses occurred in corporate debt markets. Leveraged buyouts were financed with few or no restrictive covenants and with some borrowers able to "toggle," or issue more bonds to pay interest in lieu of cash. The debt-to-cash-flow ratio hit record highs, and more than 60% of junk bonds issued are rated B or lower. Only 13% of high-yield issuance proceeds was for capital expenditures for expansion--87% went for sponsor dividends, stock buybacks, LBOs, or refinancings, none of which inherently advance credit worthiness. And this exotic lending paid only 2.5% to 3.0% more interest than Treasury bonds' 5.5%. Therefore investors received only 8% or 8.5% interest on bonds that had a 25% probability of defaulting, the same ignoring of risk as in subprime.

The cause was also the same. Wall Street made $100 of these credits into tranches of securities that sold for $102 or more. Again we had securitization pseudo-alchemy creating fool's gold. The weakest 5% or so of a $2 trillion universe of leveraged loans and high-yield bonds will crater. This is only 1% of GDP, but lending standards will tighten for a while, just as they did after the telecom bubble burst.

Because of this outlook, WL Ross portfolio companies raised $2 billion this year to eliminate outside financing needs. More recently, we provided a modest $50 million debtor-in-possession financing to American Home Mortgage, the tenth-largest subprime lender, as it entered bankruptcy. Ultimately, we will make a major move into mortgages, because lending to weak borrowers makes sense at premium rates with proper due diligence and appraisals. After Japan's real estate bubble burst, we used a similar strategy to rehabilitate Kansai Sawayake Bank. It was earning 17% a year on equity after one year, almost twice the return typical of a Japanese bank.