Cramer’s take on the credit crunch

By Jim Cramer
RealMoney.com Columnist
8/13/2007 6:02 AM EDT
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It’s time to look at what will happen now that the Fed has staked out a position that bails out neither the hedge funds, nor the mortgage companies, nor the 7 million homeowners I believe borrowed money between 2005 and 2006 that they can’t repay to take down houses that are worth less than they paid for them.

In other words, what’s Ben Bernanke’s plan? And why could it actually work and leave us, a year from now, a much stronger, better country? Or to put it succinctly, what happens if Bernanke’s right, and what could go awry if he is wrong?

Just for the record, I’m betting that the cost of Bernanke’s plan and the possible effects of it on the real economy and on real people are too great, and I have staked out the position that he’s going to hurt the country with it. But I have to admit that after the hurt we could end up being in a decent place.

In this multiple-part series, though, I am going to take Bernanke’s side and show you how his smart but conceivably heartless plan makes sense — might even be brilliant — if it works according to plan.

First, let’s set the stage of what Bernanke’s aiming at destroying even if the Federal Reserve, under Alan Greenspan, actively aided the speculative process.

Ever since Alan Greenspan lowered rates dramatically to get the economy moving again after 9/11, it made sense to buy a home with limited financing. Home prices had moved up steadily pretty much since the 1930s in this country and they have been a terrific way for Americans to build equity.

Both the Bush administration and the Federal Reserve actively promoted home ownership, but, for the sake of this series, let’s take their actions off the table. They simply did what had always worked: making homes more affordable. Unfortunately, they made home too affordable, so affordable that it made sense to buy more than one, or, in many cases, nine or 10. The homebuilders cooperated by buying as much land as they could and building homes for a couple of hundred thousand dollars and selling them for more and more each year, a truly great scenario for their gross margins. It’s why homes became growth stocks instead of cyclical stocks.

The homeowners did great, with the ones that put down the least doing the best. In a typical 2 and 28 loan, a teaser loan, homeowners could put down next to nothing for two years and then, if they wanted to, flip the house or refinance at the low short-term rates the Fed set.

Banks had always loaned to homebuyers and either kept the loans on their books, particularly the high loan-to-value ratio covenants made to people with good credit and a lot of money down. The ones that weren’t as good credit were put together into big baskets and sold as mortgage-backed bonds to institutions that wanted to get a better rate than Treasuries for what looked like it wouldn’t be a lot of risk at all.

The business was so good and there were so many loans to make that mortgage brokers sprung up all over the place. Unlike banks, these institutions had no deposits to loan against. Instead, they used loans from major banks to originate the mortgages and put them in baskets, too.

The boom was so great that, after awhile, the mortgage brokers and the banks grew sloppy, many times giving loans to people who should not have gotten them and asking them to put almost nothing down. Remember, the economy had gotten strong, employment was strong and houses still appreciated. Things hummed along. The mortgage bankers accessed low-cost money as the investment banks moved in aggressively to package their loans and make a ton of money selling them to everyone from insurance companies, such as AIG (AIG - commentary - Cramer’s Take - Rating), to banks, like the German and French banks we learned about this week, to hedge funds.

The latter had a particular appetite for these bonds, because they could take capital, borrow 10 times against it, buy these mortgage-backs and make the difference between the mortgage bonds and Treasuries. It was a simple, consistent trade that investors loved, particularly funds of funds, which supply the capital to most of the big hedge funds these days.

In fact, things got so out of hand that beginning in late 2004 mortgage brokers lent homeowners not only mortgages but home-equity loans on top of the mortgages. It made sense, with homes appreciating between 10% and 20% per year!

Even homebuilders got into the act in the end, seeing a quick way to sell homes and make extra money.

While new home sales grew to more than 1.5 million a year, another roughly 5.5 million buyers purchased homes from 2005 to the end of 2006. Of these, probably 50% elected to take teaser rates, and many then took home equity loans on top of that. We don’t know how many did that double-shot, but from the looks of things, it could be as high as 20%.

Some of these loans were covered by mortgage insurance. Some were small enough to be sent to Fannie Mae (FNM - commentary - Cramer’s Take - Rating) for packaging, but Fannie Mae had gotten in a lot of trouble for a few years back based on mismanagement so it wasn’t able to buy as many as it used to. Its regulator, OFHEO, had cracked down and limited its ability to borrow — the caps you hear about. Same with Freddie (FRE - commentary - Cramer’s Take - Rating). They pretty much became irrelevant to the scene.

Throughout this period the Fed sensed, correctly, that the economy was overheating — and took interest rates up 17 times to slow things down.

But the rate increases didn’t slow things down and the economy boomed, employment remained high and houses continued to sell well.

Until the fall of 2006.

Yes, everything was humming along, until the fall of 2006.

At that point, rates had finally started impacting the homebuilders and we began to see cracks. Defaults entered the system as speculators who had bought homes were no longer able to flip their homes. Thus began the period where homes stopped appreciating.

The homebuilders, who have a longer-term time horizon, had bought up billions of dollars in land, through options or outright, and had committed to increasing the new home supply to closer to 2 million homes a year.

The buyers of homes still got 2 and 28 mortgages, but the out years, when the 2 wore off, were much higher than Treasuries, making the mortgages very expensive for those holders who did not refinance or who just held on because they couldn’t sell any longer.

The hedge funds and the European banks and insurance companies kept buying the paper to generate better returns than Treasuries. Some bought paper of just the mortgages that were given to poorer people or undocumented buyers or even to people who had put barely any (or no) money down and had taken immediate home equity loans to pay for the 2 of the 20.

That’s the subprime paper, although given the propensity of people to take home equity loans on top of the mortgages, you had a lot of mortgage pools that looked like they were prime or this category of Alt A that really weren’t, given the second lien on the underlying properties.

Now, come 2007, rates are high and the people who bought in 2005 are beginning to be unable to pay their home equity loans. Given that many of these loans are repackaged and sold, the homeowners couldn’t go to the originators to try to negotiate. Many simply defaulted. But if you owned the bonds, even the low-rated bonds, you didn’t know this was happening. That was in part because the ratings agencies, Standard & Poor’s and Moody’s, kept their ratings on these bonds high and in part because banks and hedge funds figured that mortgage insurance and the diversification of lending regions limited the risk.

Of course, any institution that bought the low-rated bonds — BBBs, say, typically of packaged home-equity loans — knew what it was getting into. But the record was pretty good for that paper, too.

In 2007, some of the lowest-rated paper began to get downgraded as the defaults reached levels that hadn’t been seen before, sometimes as much as 20% of the streams backing the pools.

Still, the buyers of the paper stayed bullish and kept levering, the mortgage brokers kept pumping and the homebuilders kept building. But the stream of homebuyers started tapering off as homes failed to appreciate in 2006.

Then, a couple of months ago two hedge funds at Bear Stearns (BSC - commentary - Cramer’s Take - Rating) that had borrowed billions off a low amount of equity began to feel the pain. (I wrote another series explaining that long unraveling; click here to read it.) It started simply, with the credit departments of those that Bear had borrowed from recognizing that the bonds it had sold to these funds had declined in value. They asked for more collateral; simple request.

But the Bear funds were run with so much leverage that they couldn’t pay. The highest-risk fund — I have called it the Dumber fund (a.k.a. the High-Grade Structured Credit Strategies Enhanced Leverage Fund) — was buying really low credit bonds and borrowing against them. It went under very quickly because it didn’t have any collateral at all.

The higher one, the Dumb fund (or the High-Grade Structured Credit Strategies Fund) looked like it could be worth something because it owned mostly AAA paper. But again, there was little collateral so it had to sell the bonds. When these Bear managers went to sell the bonds, they could find no buyers. Given how little you actually made versus Treasuries and how the paper suddenly had some default risk, it was impossible to find buyers that would pay anything more than about 70 cents on the dollar. Who needed the risk? Warren Spector, co-president of Bear at the time, took one look at what the better hedge fund owned and decided that it would put the firm’s own capital to work to save the fund. It didn’t matter; there were still no buyers and the firm’s capital was wiped out — something that few institutions on the buy or sell side thought would happen.

The rating agencies took note and began to downgrade these baskets.

The funds of funds that provided the capital took note and began to grow concerned that the performances of the hedge funds were overstated, as they were with Bear.

At the end of June it all hit home.

Yes, literally that recently. As I explained in a post earlier this month, the “marks” — what hedge funds thought was the worth of what they owned — were based on not selling their portfolios. The funds of funds and institutional investors that had money in these hedge funds got upsetting reports of the real value being down anywhere from 5% to 10% from these hedge funds.

The hedge funds were huge. Many had a mixture of trades that included everything from owning mortgage bonds and shorting Treasuries in order to capture that differential to arbitrage of stocks and bonds — and even, in many cases, sales of puts against common stock. That was all stuff that was hard to understand and potentially much more risky than the clients had thought.

Some clients asked for their money back. For some reason we don’t know, Sowood got hit by a lot of hot money redemptions. I don’t want to pick on Sowood but somehow it had the most wary of clients. When Sowood went to raise money for these clients, there were no bids. Lots of the paper had been downgraded, the desks who traded with Sowood couldn’t find buyers and it returned 50 cents on the dollar.

The news was widely circulated and clients sent redemption letters worldwide as only the most brain-dead and least literate — they must not have read the papers — were unaware of the sudden decline of assets off of marks that were wrong, at least when it came to selling the bonds.

Trillions of these bonds were issued, including many from the housing/lending boom of 2005 and 2006.

Nobody wanted those at all, even the good ones — at least at not prices that didn’t take into account the potential defaults. Meanwhile, the news on the home front got more grim. The appreciation of housing prices in many areas actually turned into depreciation. Given that many of the mortgages people got were priced at 100% of a home’s value, and given that the home-equity loans taken on top of those loans made the loans cumulatively worth 125% of the value of the purchase, even the slightest decline in value made those loans worthless. Or at least, the home-equity loans.

If you default on a home-equity loan, even if you were a prime buyer, you’re probably going to default on the big loan, too.

Those who made the crummiest loans, the New Century Financials, were the first to go. They made the worst loans, the BBB loans, and banks cut off their loans to these mortgage brokers. Without new loans there’s no business, so many shut their doors.

Understand that unlike deposit institutions that have a cushion, these had nothing. They couldn’t own the loans very long. As hundreds of institutions, including many public ones, had this same business model, most disappeared rather quickly.

Of the public ones, New Century was the first to get hit, but loans began to be cut off to Fremont General (FMT - commentary - Cramer’s Take - Rating) and NovaStar (NFI - commentary - Cramer’s Take - Rating). Some of the equity investors stuck by them, but they were rapidly on the ropes.

Others that had a real estate investment trust entity that paid out whatever came in had no cushion at all when their loans were cut off. That’s the destruction we’re seeing now with the big dividend players being unable to pay those dividends.

As the rating agencies quickly started downgrading the credit of these institutions, their funding disappeared.

I believe that in a few more weeks there will be no mortgage brokers left except Countrywide (CFC - commentary - Cramer’s Take - Rating), that’s how thinly capitalized all these players were and how reliant they were on both the loans from banks like Wells Fargo (WFC - commentary - Cramer’s Take - Rating) and the need to get their mortgages off the books as fast as possible to the Bears (BSC - commentary - Cramer’s Take - Rating) and Lehmans (LEH - commentary - Cramer’s Take - Rating) and Goldmans (GS - commentary - Cramer’s Take - Rating), who sold them to the hedge funds, insurance companies and unsuspecting banks.

So not one but two train wrecks have converged at the same time:

The homeowners who bought in 2005 and 2006 have begun to default, with the weakest borrowers now defaulting at a 20% pace (that’s Countrywide’s (CFC - commentary - Cramer’s Take - Rating) number, and it is a good lender — and it represents 20% of the origination market).
The banks have cut off lending to these mortgage brokers. That’s what Countrywide’s filing made clear this week.
The investment banks have pretty much ceased packaging mortgages as the mortgage business has dried up.
The mortgage-backs that they sold before are for sale all over the place, particularly by the hedge funds with the jittery client base.
And there are no buyers.
Now everything’s frozen. Many of the 14 million homeowners who bought in 2005 to 2007 are underwater on their homes. That doesn’t matter to anyone who can pay the new rates as they reset. It doesn’t matter to those who don’t need to move and are solvent.

But it does matter to anyone who had bad credit or took the home-equity loans out and can’t pay.

We don’t know how many people are in that situation. Maybe it is only a million households. However, given the propensity of the people during those two years to take teaser rates, it might be as many as half of the people who bought.

Many of these loans reset each month, and a higher percentage of holders than ever before has been defaulting. The people who default are basically squatting in their homes or walking away from their homes and renting.

The banks that kept the loans or the institutions that bought the securities made up by the loans are frantic. There’s no market for these loans, and the banks that still own the mortgages are under-reserved. That’s why you see big hits to their earnings.

The investment banks have lost that stream of packaging income. The clients who bought the mortgages are also the clients who tend to buy private-equity high-yield bonds, doing the same “short Treasury, long high-yield” that they did with mortgages. So the investment banks are “hung” on those loans.

The hedge funds and banks are being hit with massive redemptions.

Which brings us back to Ben Bernanke and the Fed, as I discussed in Part 1.

I know from my contacts that the Fed sees all of this. It isn’t brainless. The Fed wants the whole chain of cheap credit to dry up. It wants homes to become affordable, and they are becoming more so by the day, and it wants every speculator in the process to go out of business. So right now, each day, hedge funds are going out of business, the mortgage brokers are about to go out of business, the banks that made these loans against deposits are having to charge off these loans, the homebuilders who can’t sell new homes are having their credit shut down and many, many homeowners are losing their homes.

The Fed is happy with all that.

I don’t blame the Fed, except I wish something had been set up to help the 7 million homeowners who are at risk. When on this site I talk about the casualties being caused here, I am not speaking of anyone in the chain other than those 7 million forgotten households.

Now, here’s the bet that Ben Bernanke made this week when he kept the bias toward inflation. He bet not that the housing contagion would spread from subprime to prime. That’s already happened, so get over that possibility; it’s already a reality.

What he is betting is that the American economy can absorb every bit of this pain and not go into recession, or that it will go into a recession and that he can then cut rates to make things better.

He is betting that it will not matter if even Countrywide and Washington Mutual (WM - commentary - Cramer’s Take - Rating), the two biggest institutions exposed to the contagion, go out of business. It may not be a bad bet; pretty much every savings and loan besides Golden West and Washington Mutual went out of business 17 years ago and it was just a blip on the charts. As was the great hit to most money center banks in 1990. Everything recovered pretty quickly.

My question is, at what point will actual business be hurt by all of this?

Maybe it won’t. Or maybe it will be hurt for a quarter or two and then Bernanke can cut rates.

Either way, the Wall Street firms that abetted this process will be hurt extremely. I figure one of them will go, maybe two, and they merge. The hedge funds that did these trades will all be wiped out. All of them.

The homebuilding industry, all $35 billion of it, should be wiped out.

But the rest of the economy, including 28 of the 30 companies in the Dow Jones Industrial Average, should not feel a thing if Bernanke is right. Which is why I have been saying that if we are in a 1990 scenario, we only have about 500 to 1,000 points more to go down on the Dow, and I think it will be closer to the former.

I am concerned that things won’t be that rosy, that the real economy will be more impacted than that. Bernanke could be right, though.

In fact, I believe that there will be parts of the economy that could be crushed by the collateral damage, particularly retail, which must be avoided until the rate cuts, and autos, which, despite the valiant attempts of American car companies to stem losses, simply won’t be able to pull off their turnarounds in an investable way during this period. In short, they will go down. Airline traffic and tourism will take a hit.

Without a global business that’s immune to the U.S., you will get hit, even if it is only short-term owing to the Fed’s eventually letting go of the jugular when the speculators are crushed, the marginal banks fail and 7 million homeowners have been turned into home squatters. So there are two casualties with a lot of collateral damage.

The first cohort is the hedge funds and their clients, the homebuilders and banks and brokers that played in this world. The cost to these is at best a gigantic hit to earnings, at worst massive closings and bankruptcies. But nothing the system can’t handle. They are meaningless to me and should be to you unless you work at one.

The second cost is more difficult to handle: the 7 million homeowners whom I now see as squatters or renters.

I am sure that Bernanke feels, and I know that William Poole believes, that these people just went to Vegas and lost. I think that if we can do something that helps the honest homeowners who made mistakes or were defrauded, perhaps through Fannie Mae (FNM - commentary - Cramer’s Take - Rating), Freddie Mac (FRE - commentary - Cramer’s Take - Rating) or the Federal Home Loan Banks, then justice wont be as blind as it is appearing to be. But I don’t hold out much hope this will happen.

I think Bernanke is betting that this whole cleansing will occur within six months. If he is at all political, that would mean that he could start cutting interest rates and the GOP wouldn’t get killed in November. If he isn’t political, he doesn’t need to cut until he can be sure inflation is stopped, a la Paul Volcker in the 1980s after Jimmy Carter’s mess.

If he cuts rates, the psychology of the whole system will be changed and buyers will come in off the sidelines to buy these mortgage-backs and hold them. I am pretty sure they’d make a lot of money if they did so, too. If he cuts rates, I believe that will relieve the logjam of homes that is putting pressure on those who need appreciation to keep their homes. If he doesn’t, so be it.

From Bernanke’s perch, it’s worth taking the bet.

But if you are in the line of fire, you are dead. And if you are outside the line of fire and you need a strong economy or a loan, you could be dead, too.

Which is why, throughout all of this, if you can buy shares of companies that are immune to this cycle and that don’t need capital, you should get a good return, and if the Fed blinks you’ll get a great one. Which is why it is so darned hard to be bearish on anything but the financials.

Either way, like in 1990, the problem should be cleared up in about six months, the weak ones are that thinly capitalized and the strong ones are that able to do a lot of business and not even know it.

The bottom line: If you care about the soon-to-be dispossessed, you should be appalled by what he is doing. If you care about the Wall Street casualties, then you are just being greedy.

And if you buy good stocks into the downturn that are unaffected by the chain, I think you’ll make a lot of money, regardless of how you might feel about the consequences of a tough Fed.