First Quarter, 2007

It’s common knowledge now that the single-family housing market across the county is being hit by a confluence of factors which are reducing home values today and perhaps for the next one-to-two years. During this period of time, home values may experience declines on average of approximately 30% from their peak levels in 2005 and early 2006. While this may sound like a wildly pessimistic projection, similar peak to trough declines were experienced in the last three real estate recessions of 1980, 1982 and 1991 (average decline-34%). Furthermore, our research leads us to believe that counter-balancing positive factors such as continued economic growth, low levels of unemployment or modestly declining interest rates (should they occur) won’t have much of an impact on the deflating real estate bubble. Because the ramifications of this unfolding situation are negatively affecting the economy at both a corporate and personal level, we have dedicated most of this letter to a discussion of this issue. Significant portions of the historic information we will be presenting have been developed by Credit Suisse in a detailed research piece published in mid March.

Before you become too alarmed about what this may mean to your portfolio let us reassure you with the following comments. You own no stocks of builders or mortgage companies or REITS that are feeling the heat of this imploding portion of the real-estate market. However, as is typical when crises envelop a particular sector of the economy, the strong get trashed along with the weak creating from time to time extraordinary investment opportunities without significant risk of capital loss. We are seeking to take advantage of such opportunities on your behalf as we perceive them.

It’s not possible to project how far the growing financial damage will ripple through other areas of the economy, either domestically or globally. We do note that there is at present a general belief among economists and many Wall Street types that the damage will be tightly contained and that continued robust global economic growth in 2007 and 2007 will steam-roller over the problems associated with high risk home mortgage loans.

We thought you might find it interesting to learn how the current housing downturn began. Around the end of the stock bear market in late 2002, home prices began a rapid rate of ascent which coincided with dramatic declines in interest rates. At the beginning of the new millennium, prime conventional and jumbo mortgage loans represented the most significant portion of the mortgage market. “Sub-prime” loans had never been a significant factor in overall mortgage originations prior to the early 2000’s due to their paperwork complexity and the general unaffordability of higher-interest rate mortgage debt to this distressed economic class of borrowers. A sub-prime borrower is a person whose credit is impaired for any of a number of reasons and whose FICO credit score is in the mid 600 range or below. In 2002, sub-prime loan originations constituted only 6% of all mortgage originations.

At around the same time, an enterprising computer software designer created a program that allowed lenders to screen sub-prime borrowers in a matter of seconds by retrieving the prospective borrower’s FICO credit score over the internet and then applying an algorithm to gauge the risk of a given borrower’s subsequent default.

This new automated screening software, designed and sold today by many different vendors, reduced the need for mortgage originators to verify information regarding credit worthiness or borrowers’ ability to repay loans. Furthermore, sub-prime mortgage origination became an immensely profitable business as hundreds of new players, armed with their algorithmic software products, began competing for these borrowers on any of three levels: speed of loan approval, creativity in financing and loosening of lending standards. The New York Times has reported, for example, that in 2005 at the height of the housing boom, First Franklin Financial, then one of the country’s larger sub-prime lenders, was able to process 50,000 mortgage applications per month using automated underwriting software.

Most mortgage originators sell blocks of their mortgages to large brokerage firms and banks which pool them for ultimate resale to yield hungry investors. In this fashion, the mortgage originator gets its money back plus a profit allowing the firm to recycle its cash into new originations and additional fee income. Until approximately six-months ago investors were unconcerned about the risks inherent in these investments.

Shockingly loose lending standards introduced in 2005 and 2006 share a large part of the blame for the current real estate market downturn. For example, in one type of widely offered loan program borrowers were not required to verify income or assets. People utilizing this program tended to misrepresent their financial condition and thereafter enjoyed for a short period of time “owning” a home that they were in many cases financially incapable of supporting over the long-term. Other sub-prime borrowers were qualified by lenders only on the basis of low “teaser” interest rates which remained in effect for an initial short period of time. At the end of the teaser rate period, the borrower’s interest rate would move significantly higher for the remainder of the loan term or until the next rate adjustment period. Typically, the borrower could not make monthly debt payments at the higher interest rate.

Traveling on a parallel track during these early years of the new millennium, a new risk classification for mortgage loans became popular and saw its numbers also increase at an extraordinary rate. This new classification, called ALT-A or A- minus loans, served the market segment of borrowers whose FICO credit scores were above the sub-prime cut off, but below the scores of prime borrowers. These borrowers typically have some blemish to their credit history but are broadly perceived to be somewhat better able to carry their debts. Over time, the ALT-A market gradually shifted to consist of primarily low or no down payment loans, frequently on second homes or investment property purchased with the intention of a quick flip. These properties typically remain vacant most of the year.

Sub-prime loans increased from 6% of all mortgages issued in 2002 to 20% by the end of 2006. ALT-A loans increased from 5% to 20% of all mortgages during the same period. It wasn’t until the third quarter of 2005 that delinquency rates began to ratchet higher as home prices peaked around the country and began their downturn. Prior to then, weak borrowers could ride the wave of rapid home price escalation. Speculators could flip homes every year or two to bail themselves out of a rising interest rate cash flow bind. When home prices peaked, this Ponzi scheme began to unravel. As has now become plainly obvious, many exotic loans were structured with the seeds of their own destruction planted firmly within them.

The Exotic Loans

Here are some examples of the problem mortgage products commonly available in the past few years:

A purchaser would arrange for a first mortgage in the 70-80% loan-to-value range to qualify for a more favorable interest rate and avoidance of private mortgage insurance and simultaneously take out a second mortgage for a portion or all of the remainder of the purchase price. Combining loans in this manner limited or even eliminated any out-of-pocket cash investment. It is estimated that for 2006, approximately 46% of all home purchases had a combined loan-to-value (CLTV) ratio greater than 95%. In real estate hot beds such as Fort Myers and Miami, approximately 55% of all loans exceeded a CLTV of 95%.

Loans of these types are designed to minimize monthly payments for some limited period of time after which fully amortized payments are scheduled to begin. IO’s simply require the payment of interest without principal repayment. A Neg-Am loan’s monthly payment is less than the amount needed just to pay the interest. The monthly shortfall gets added to the principal balance resulting in a rising loan balance. If home prices fall, as is now the case, or just don’t increase fast enough to offset the rising debt level, the homeowner is “under water” with a home worth less than its outstanding mortgage balance. The incentive is great in that situation to turn the keys over to the lender and walk away since a sale of the property would cost the homeowner money.

IO and Neg-Am mortgages represented an average of 26% of all mortgage originations in the period 2004-2006. They represented 62% of ALT-A mortgages in 2006.

For those borrowers willing to pay approximately 25 basis points (1/4%) more in interest, mortgage originators offered loans which required little or no verification of borrower income or resources. These loans have come to be called liar’s loans as evidence has mounted showing that borrowers tended to overstate their income by significant percentages. One study in 2006 of 100 such loans revealed that 60 of those borrowers had overstated their income by 50%. Low/no documentation loans have increased from approximately 18% of all purchase originations in 2001 to 49% of all originations in 2006. Such originations constituted 50% of all sub-prime loans and 81% of ALT-A loans in 2006.

This background information brings us to the present situation of steadily rising defaults and ensuing foreclosures across the country. States have differing requirements and procedures for lenders to reacquire homes through the default process, but in general it typically takes up to a year for a home to go through the foreclosure process and end up in somebody’s inventory. Since 2006 represented the year of the most egregious origination practices we can predict that the wave of defaults associated with that year’s loans will begin to abate sometime in 2007. In the meantime news reports discussing the mortgage loan crises are expected to become increasingly grim during the rest of 2007.

Reality Trac is generally recognized as the industry authority in monitoring homes passing through the foreclosure process. On a trailing 6-month basis, Credit Suisse, using Reality Trac data, estimates foreclosures in process total 700,000 at this time, a number equal to approximately 20% of the 3.55 million homes presently listed for sale by the National Association of Realtors. As many as 2 million people may lose their homes over the next two to three years, according to Credit Suisse.

Within the default process homes are put on the auction block as an interim step before the mortgage holder takes possession. If the homes do not sell at auction, the final step in the process is for the property to become REO- real estate owned-with title passing to the lender, or back to the builder, as explained below. When homes become REO the real bargains can be had as the unhappy owners typically want to unload properties quickly. The foreclosed homes enter the MLS inventory system about two months after an unsuccessful auction at which time prices typically are slashed. We are now at the very early stages of REO sales. This type of sales activity should continue to accelerate as the year progresses.

Returning to the ripple effect for a moment, if your expensive neighborhood street or condominium building has empty homes or condo units with auction signs out front, it’s likely that the resale value of your home has just declined by 10% or more – perhaps much more. Delinquency rates, foreclosures, auction sales and REO’s are all expected to continue rising throughout 2007 and into 2007 resulting in increasing pressure on home prices, barring major Federal Reserve easing to forestall a recession.

Fed Chairman Bernanke is beginning to let it be known that the deteriorating housing situation has caught his attention. As we head towards an election year it’s reasonable to assume that concern for the economy may overtake inflation as the primary domestic economic issue.

As you might readily surmise, all homebuilders are taking a financial beating in the current environment. Not only is pressure mounting for reductions in new home sale prices, but prospective buyers are also canceling their purchase contracts due to the increased difficulty of selling their own existing homes. This situation is affecting builders in all price ranges from starter homes at the low-end to very high-end homes at the top. Furthermore, most of the country’s largest residential builders have mortgage subsidiaries which are legally obligated to reacquire, within a predetermined time frame, defaulted mortgages for homes which the builder had previously sold if the mortgages had been sold to investors. Known as Early Payment Default (EPD) provisions, these builder obligations enhanced the investment appeal of sub-prime and ALT-A mortgages when they were eventually packaged into retail investment products. Many of the country’s largest builders have begun to reacquire previously sold homes due to purchaser defaults at the same time that appraisal values are declining.

Financial institutions that purchase mortgages and assemble them into pools for resale to investors have been damaged by rapidly rising default rates. These institutions are now tightening credit standards pursuant to which they will purchase new mortgages in the future. The obvious consequence of credit tightening is that the pool of qualified buyers is shrinking at the same time that supply is growing. Many observers of the housing scene believe that tightening credit standards will precipitate a much broader and deeper real estate recession. The reason is simple. When credit standards are tightened, legions of prospective buyers are precluded from participating in the housing market.

Tightening credit is a sure way to slow or perhaps kill overall economic growth. The consensus view of economists and Federal officials today is that domestic economic growth will slow somewhat for the next one to two quarters and then snap back to more robust levels as the global economy continues on its strong growth trajectory. Perhaps the economists and Fed officials are correct. Over time, as properties move from weak hands to strong hands, housing conditions will improve. For the next one to two years however, the US should experience a steadily deteriorating housing market which will ultimately lead to some extraordinary buying opportunities.

So let us summarize the current domestic housing situation:

All is not gloom and doom however. Economies around the world continue to surge ahead. Global financial stability continues to be underpinned by solid economic prospects in the developing nations and emerging markets. The present global economic picture is, in fact, unprecedented. Large capital inflows continue to seek investment opportunities in developing nations around the world. At the same time capital surpluses continue to build in the developing world. The international monetary fund, in its current semi-annual analysis, believes economic growth in 2007 and 2007 will be only slightly less robust than 2006. Surprisingly, one of the weakest economies in a relative sense is the U.S., but the stock market is choosing to ignore signs of an impending slow down. The U.S. has historically been the engine of growth for the rest of the world, but the times “they are a changing”. Now the rest of the world is pulling the U.S. economy along, particularly to the benefit of large companies with significant international sales.

The huge reallocation of global wealth is causing a mad scramble for investment assets. Prices in virtually all investment areas are high – stocks, bonds, diamonds, rare wine, art, energy, and real estate (except the U.S. housing market for the next 12 to 18 months.) U.S. companies are going private and buying back their own shares on a scale never before imagined. In other words, investment demand is rising while the domestic supply of stocks is shrinking – a recipe for rising prices.

We are witnessing a fascinating disconnect between the U.S. economy and the U.S. stock market as well as between inflation (moving higher since last November) and interest rates (flat since last October). The hackneyed expression “it's different this time” has never been more true. Stay tuned!