THE seized-up United States mortgage market claimed more victims both here and abroad last week. The American Home Mortgage Investment Corporation, once a big lender, closed its doors, laying off more than 6,000 workers. In Germany, IKB Deutsche Industriebank received a $4.8 billion bailout from a government-owned group that said it would cover potential subprime losses at the bank.
In a report last week, Charles Peabody, an analyst at Portales Partners, an independent research firm in New York, characterized the state of the mortgage market this way: “Investors finally realized that there is such a thing as a bad mortgage loan. As a matter of fact, there is such a thing as a whole bunch of bad mortgage loans.”
As a result, Mr. Peabody noted, investors are no longer interested in most of the risky loans that mortgage bankers have been creating lately. Bankers can sell only the highest-grade pieces of those wonderful securities pools that were so popular among investors until about five minutes ago.
That gives two choices — neither one felicitous — to the bankers who originated the low-grade loans. They can either sell them at a loss, reflecting the market’s view of such debt, or hold them on their own balance sheets and watch them decline in value.
It is never pretty, watching a mania come undone. Unless you are one of the folks who never bought into the madness in the first place.
Michael A. J. Farrell, chief executive of Annaly Capital Management, a high-grade mortgage real estate investment trust, is one such man. And with a perspective on the residential mortgage and credit markets extending back to the 1970s, he is an excellent person to consult on what is likely to happen next.
Annaly is an investment management company that oversees a portfolio of strictly high-grade assets. The company invests solely in mortgages backed by government-sponsored entities like Fannie Mae, Freddie Mac and Ginnie Mae. Investors understand that it has little exposure to the current credit crunch and have bid up its shares almost 8 percent this year. The shares also pay a generous dividend of 6.4 percent at current prices.
For his conservative approach, Mr. Farrell confirms that for about two years beginning in 2003, he took plenty of abuse from more aggressive counterparts in the industry and from potential investors who urged him to buy lower-quality assets for their greater returns. Some of those ridiculing Mr. Farrell were the same people who jeered at investors who did not get the new paradigm, espoused in 1999, that any-Internet-company-is-a-good-Internet-company.
“I definitely took heat not only in my professional life but in my personal life,” Mr. Farrell said. “I had people stop me on the street while I was walking my dog saying, ‘Where is your dividend going?’ ”
During the crazy years, Mr. Farrell and his team decided against increasing the size of Annaly’s balance sheet. Investors willing to throw money into anything mortgage scoffed when the company turned them down. “We decided to withdraw from the market until the end of 2005, when we thought investment risk was being recognized by the market,” he said.
Mortgage real estate investment trusts came public like weeds during the boom, of course. But the strategies they use can vary widely. Some originate mortgages — New Century did, for example — and others buy mortgage loans in the secondary market, whether risky or not.
Most mortgage REITs do a bit of everything, explained Jeremy Diamond, a managing director at Annaly. As a result, investors in these companies must rely on their managers to put the right emphasis on credit risk and interest rate risk at different periods in a business cycle.
But because Annaly shuns credit risk, its investors are trusting its managers to bet appropriately on interest rate risk only. In this they are also conservative, holding assets with a duration of six months to two years. They also have one-third of their portfolio in fixed-rate assets, with the rest in adjustable- and floating-rate assets; this allows the portfolio to work well whether rates decline or rise.
“There is no official Annaly interest rate forecast,” Mr. Diamond said. “We manage the portfolio with no significant directional bias because we could be wrong.”
Annaly’s biggest challenge comes when rates plunge, as they did in 2004, pushing mortgage holders to refinance. But it has reduced its exposure to refinancing risk in recent months by raising about $2.5 billion in capital and reducing the premium-priced mortgages in its portfolio. While the company paid an average of $102.50 per $100 worth of bonds in its portfolio in 2003, its average is now $100.50.
When the mortgage market started to regain some of its sense in 2006, Annaly began raising money from investors. It made two stock offerings in 2006 and two more this year. Each time, the deals carried a higher price tag, reflecting investors’ appreciation of Annaly’s conservative business model. Even those who bought into the company’s most recent offering last month — at $14 a share — are ahead. Annaly’s shares closed Friday at $14.98.
Mr. Farrell and other Annaly executives also align themselves with their investors by not taking performance fees as most REITs do. Instead, the executives’ compensation, just 0.12 percent of assets under management, comes out of the company’s revenues.
So what does Mr. Farrell, who has been through at least three mortgage market seizures in his career, see on the horizon for the credit markets? More of the same turmoil, alas.
“I look at this sort of like 1990 and 1991,” he said, referring to the savings-and-loan crisis. “Against that background you had a $7 trillion economy that gave birth to the $300 billion Resolution Trust Corp. Now we have an $11 trillion economy and we’ve already seen $2 trillion of market capitalization going away” before many loans in the pools have actually defaulted, he said.
WHAT about the people who argue that the impact of the mortgage mess will be muted because risks have been spread well beyond the banks and into many parts of the financial world? Mr. Farrell takes the opposite view. Spreading the risk beyond the banking system will make the task of fixing the mess much harder.
“Even if the Fed eases, it is probably not going to help the housing market,” he said. “This repair cycle is going to take a lot longer because it is not concentrated in the banking system like it was in the 1990s. Back then, they could repair the banking system by dropping interest rates. Now they can’t bail out rich hedge fund guys in Greenwich.”
