From the October 2007 issue of Research Magazine • Subscribe!

Mortgage Meltdowns

For one of the most comprehensive perspectives on the subprime mortgage crisis, Research turns to Jeffrey E. Gundlach, Morningstar's 2006 Fixed Income Fund Manager of the Year, TCW Group's Chief Investment Officer and portfolio manager of the TCW Total Return Bond Fund (TGLMX)*.

*The fund invests primarily in mortgage-backed securities guaranteed or secured by collateral guaranteed by the U.S. Government, its agencies, its instrumentalities or its sponsored corporations and in privately issued mortgage-backed securities rated Aa or higher by Moody's or AA or higher by S&P.

What caused the current subprime mortgage problems?People bought bonds backed by subprime mortgages based on credit ratings bestowed by the rating agencies. These credit ratings were based upon a na?ve extrapolation of historical default rates. In fact, mortgage lending had undergone a serious deterioration in underwriting standards - to the point that, in an open letter on May 3, I forecast a cascade of downgrades and losses on subprime-backed bonds rated "investment grade" and on collateralized debt obligations (CDOs) backed by these bonds.

By June, two Bear Stearns hedge funds with nearly $22 billion in subprime exposure were in a state of collapse. Then during July 10-13, the rating agencies downgraded or placed on negative watch some 1,300 recently issued subprime-related securities.

Many investors had assumed that the risk profile of these bonds was comparable to that of like-rated bonds of earlier vintage. Instead, they took part in the biggest calamity in the history of rated debt. An unprecedented inventory of securities only recently rated investment grade have been marked down in some cases to less than a third of par value. Today investors in these securities are echoing a lament heard time and again in financial crashes - "I thought I owned this, and now I realize I own that."

More than a wake-up call, the subprime mortgage market has suffered a psychological blow whose effects probably will extend well past 2007. Fortunately, to help us foresee what lies ahead after such a blow we have an historical template: the crash of certain esoteric mortgage securities in 1994.

What do you predict?We should expect to see the liquidation of billions more in subprime-related assets by all manner of investors as further waves of downgrades and defaults roll over the market. Many portfolios with concentrated exposure to subprime will be forced to sell assets. A number of hedge funds and subprime lenders have already succumbed under the pressure of margin calls and repurchase demands. There will be more. Other portfolios will be forced to liquidate downgraded securities to satisfy minimum ratings requirements and other investment constraints. This also will be the case for certain structured-finance vehicles, including CDOs.

I also expect many investment managers with relatively limited subprime allocations to voluntarily sell off these assets at large losses. Their ranks will include asset managers for insurance companies, mutual funds and pension funds. In time, many of them will tire of explaining the deterioration of this part of their portfolio to their boards of directors, investment committees and Wall Street analysts in the face of an ongoing news media barrage.

What are the parallels between the '94 crisis and now? History appears to be repeating itself in subprime. In 2006, the first signs of trouble emerged in the form of heightened delinquency rates due to the deterioration of underwriting characteristics in securitized loan pools. As more fully described in my May 3 letter, the first casualties included subprime lenders, which were overwhelmed by repurchase demands on early-default loans.

The long grind will result in forced sales by and of structured-finance vehicles such as CDOs. I suspect that ultimately there will be capitulation sales coming from certain less-exposed institutional investors once they have soured on the subprime portfolio "sweeteners" they purchased solely on letter rating criteria. I expect some selling will even come from certain supposedly "top-tier" bond investment firms who are known to have waded into the subprime morass ill-equipped for managing the now evident risks.

The whole grinding process now underway is already being accompanied by a rueful refrain which I find uncannily reminiscent of the leitmotif of 1994. Back then, investors cried, "I thought I owned a 2-year, and now I own a 20-year, precisely at the wrong time." Today the song of recrimination and self-recrimination goes: "I thought I owned a single A, and now I own a single C, precisely at the wrong time."

What's the role of quantitative models in the crisis?Na?ve investing in subprime based on letter ratings represents an outstanding exemplar of the foreordained train wreck of regression-based decision making, but by no means is it the most recent. The same faith in a regression-based autopilot methodology derailed Long-Term Capital Management in 1998 and Granite Partners in 1994. The correlation coefficients based on the past interplay of factors proved lethally wrong when the world changed. As I told the Morningstar audience in June, whenever someone tries to sell you an investment strategy based on correlation, run away as fast as you can. It's doomed to fail.

Is there any upside? With regard to the mortgage sector, a lot of subprime merchandise is priced very cheaply. This offers a unique opportunity for investment managers with the ability to analyze credit risk. Crashes by definition never just stop at fair valuation and today's subprime assets in particular may require an extended consolidation before recovering to levels approaching ultimate economic value.

Looking beyond subprime, it strikes me that few are paying attention to the coming problem of adjustable-rate resets in prime mortgage loan. Unlike subprime resets, I don't expect prime resets to result in outsized default activity.

Pressure from resets, however, does imply some increase in the default rate and certainly a reduction in consumer discretionary income for borrowers who do meet debt service requirements. Whatever the split between those two concurrent outcomes, the implication is a drag on the consumer economy.

As for the war at hand, the immediate problem I see is a general risk apprehension that has overtaken Wall Street. The crash in subprime asset prices and the anarchy in credit ratings have left the markets incredibly illiquid at a time when an avalanche of supply - both in terms of leveraged corporate finance assets and distressed mortgage assets - is teetering on the store shelf.

Perilous as this may sound, let's keep matters in perspective. Crashes are inevitable. Oceans of liquidity can evaporate overnight. Models must fail. The unknown is always present. Peril lies not so much in these things as in na?ve assumptions, often compounded by wishful thinking when investors face outcomes far different from their expectations.


*The fund invests primarily in mortgage-backed securities guaranteed or secured by collateral that is guaranteed by the U.S. Government, its agencies, its instrumentalities or its sponsored corporations and in privately issued mortgage-backed securities rated Aa or higher by Moody's or AA or higher by Standard & Poor's.

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