BLOG VIEW: A Land Mine Or A Gold Mine?


(Today's Blog View column is guest authored by Frank Pallotta, CEO of Steel Curtain Capital Group LLC in Mahwah, N.J. Phil Hall's regular column will be back next Monday.)

Now that we find ourselves in the depths of the worst housing crisis the county has seen in more than four generations, how should an investor determine when or how to jump back in the pool? To get to the answers, you need ask yourself two important questions. First, what is your time horizon? And second, how much of your stomach lining can you afford to lose in the interim?

These are the facts: The U.S. residential capital markets are broken. However, at some point, liquidity, risk based pricing and predictable cashflows for this asset class will return. And home prices will find a floor, if they haven't already.

If you believe these three simple notions, then it's not merely a question of "if," but "when" investors will step back in – and with a lot of cash. Finally, if you believe in the laws of supply and demand (and machinations of Wall Street), you will come to understand that you probably don't want to be on the sidelines for too long when things begin to come around.

Most successful investors rely heavily on past and present trends before betting on future performance. While that may sound obvious, you'd be surprised how many investors are currently "in a trade" because they copied someone's homework, instead of doing it themselves. The carry trades and the currency arb are two of the more common trades (as well as with the popular short credit trade) that you might attribute to "Gee, everyone's in it. They can't all be wrong." The smarter players, though, were in those trades when no one else was looking and likely liquidated those positions while the others were still stepping on.

The current mortgage dislocation is not much different from past dislocations in the capital markets, where investor groups are lumped into three categories. Some have had their heads handed to them as a result of being either too na·ve, too quick to act, too slow to react, or to too blind to see. Still other investors spent their time by the water cooler talking about how they dodged a bullet by keeping their head buried in the sand throughout the "boom and bust" periods.

Finally, a small group of financial revolutionaries decided to go against the grain – not because they merely wanted to be on the other side of the trade, but because something really didn't make sense. It was the time to listen to your instincts – the time to lead instead of follow.

Over these last two years, there have been three separate and distinct mortgage-related investor "camps." The first is the "Long and Wrong" camp. Most of this group entered the market at the peak in housing market. They lost the most money, the greatest number of jobs and annihilated their market capitalization.

Then there was the "On the Sidelines" camp. This crowd saw something they didn't like and decided to let that train leave the station without boarding. These investors lost little or no money over the past two years – except for maybe a dramatic increase in borrowing costs or elimination of warehouse lines. It's important to note however, that while they didn't lose money, they didn't make it either.

Then there was the "Contrarian" camp. They smelled the rotting fruit of the U.S. housing market and put their money to work. They rode the current dislocation all the way to the bank. They sold the positions they had (and some they didn't) and started getting short while the rest of the world was acting like the market might never go down again.

I'm not suggesting that the contrarian mindset is the answer. I am, however suggesting that using all your senses is probably the way to go. Too many young Wall Street traders and money managers never saw a market like this one. In fact, more than a handful of those traders were still in school (some were in high school) during the last significant market dislocation in 1998. Even those that lived through the last crisis got burned when they thought "It can't get that bad again" and jumped in long before the bottom hit.

It is my opinion that the current mortgage environment presents the same – or better – opportunities to make more money than only two short two years ago. We'll likely hear stories of those who jumped in at the bottom to ride the market lower and got their own "shorts" handed to them – much like the investors and dealers who jumped in to buy or build near the peak.

It's also likely you'll hear many more stories two years from now about the investors who stayed on the sidelines and watched spreads tighten as a sense of normalcy returned to the markets. This group will again lose little or no money while forgoing the opportunity to cash in.

Finally, as certain as Cy Young's record of 511 career wins will stand for eternity, you will hear two years from now about the small handful of contrarians who saw in 2008 and 2009 the same opportunities they saw in 2006 and again put their money where their brains were. I don't think it will be all that difficult to find those opportunities. Home equity lines of credit (HELOC), closed-end seconds, Alt-A and super-jumbo all present a compelling story to buy today.

In this market, I believe the greatest upside is in HELOCs. However, not all HELOCs are created equal. There are HELOCs marked at $40 that are going to zero, while others will be at $90 within 16 months – and you will be paid handsomely while you wait.

The Alt-A market (real Alt-A, that is) also presents great upside potential with very limited downside risk. But you first need to understand the difference between an Alt-A loan and an Alt-A borrower.

Historically, Alt-A documentation loans carried a much higher rate than Jumbo A loans instead of the "insignificant" 25 to 50 basis points that we got to in early 2007. Those loans also carried more equity in the home and verifiable assets in the bank. The Alt-A borrower, on the other hand, had a different name prior to 2003. They were called subprime borrowers.

I believe another opportunity for upside in today's mortgage market exists in new production flows. Most will agree that current guidelines and underwriting requirements are as strong as they've ever been. Now is the time to take advantage of that.

However, much like the list of demands the investor needs before buying retained, distressed notes, there is another list of "do's and don'ts" the buyer of new production needs to have when delving into the flow game. For starters, both the buyer and seller should explore exclusivity and anonymity.

This is more the case for the seller, but the buyer can also benefit from keeping things quiet. This shouldn't be like dating the prom queen or the captain of the football team, when you want everyone to know about it.

Keeping things quiet gives the originator the competitive pricing edge over his competitors and the buyer the opportunity to be paid for providing scarce liquidity. The investor should also be intimately familiar with guidelines, credit, underwriting and recourse/repurchase language.

I've been involved in mortgage banking for almost 18 years, and there are only a handful of mortgage companies that have not strayed from basic underwriting and origination principles. I would suggest not only buying from them, but investing in them, learning from them and relying on them to lead the mortgage market into the next decade.

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