Graham and Dodd on guaranteed real-estate mortgages and mortgage bonds

I recently re-read–with pleasure–chapter XVII of the 1934 Edition of Security Analysis by Benjamin Graham and David Dodd. The chapter addresses guaranteed real-estate mortgages and mortgage bonds.

I re-read the section because I think it highlights the problems of mortgage insurance companies and other insurance companies that enter the business of guaranteeing the payment of mortgages and mortgage securities (such as surety businesses like bond insurers).

You see, the real estate boom of the 1920’s led to a terrible real estate crash in the 1930’s. It basically wiped out the mortgage insurance industry and many of the surety companies that ended up guaranteeing mortgage bonds. The history is illustrative for what can happen and what may be happening today.

I quote liberally from the text below (starting on page 184).

“The idea of underlying real-estate mortgage guarantees is evidently that of insurance.”

“It is within the province of sound insurance practice to afford this protection in return for an adequate premium, provided of course, that all phases of the business are prudently handled. Such an arrangement will have the best chance of success if:
1. The mortgage loans are conservatively made in the first instance.
2. The guaranty or surety company is large, well managed, independent of the agency selling the mortgages, and has a diversification of business in fields other than real estate.
3. Economic conditions are not undergoing fluctuations of abnormal intensity.
The collapse in real-estate values after 1929 was so extreme as to contravene the third of these conditions.”

“In the first place a striking contrast may be drawn between the way in which the business of guaranteeing mortgages had been conducted prior to about 1924 and the lax methods which developed there-after, during the very time that this part of the financial field was attaining its greatest importance.”

“The amount of each mortgage was limited to not more than 60% of the value, carefully determined; large mortgages were avoided; and a fair diversification of risk…was attained.” [loan to value ratios run very high today: 80%, 90% and even 95%]

“It is true also that the general practice of guaranteeing mortgages due only three to five years after their issuance contained the possibility, later realized, of a flood of maturing obligations at a most inconvenient time.”

“The building boom which developed during the new era was marked by an enormous growth of the real-estate-mortgage business and of the practice of guaranteeing obligations of this kind.”

“Great emphasis was laid upon the long record of success in the past, and the public was duly impressed….”

“The weakness of the mortgages themselves applied equally to the guarantees which were frequently attached thereto for an extra consideration.”

“The rise of the newer and more aggressive real-estate-bond organizations had a most unfortunate effect upon the policies of the older concerns. By force of competition they were led to relax their standards of making loans.”

“…the face amount of the mortgages guaranteed rose to so high a multiple of the capital of the guarantor companies that it should have been obvious that the guaranty would afford only the flimsiest of protection in the event of a general decline in values.”

“When the real-estate market broke in 1931, the first consequence was the utter collapse of virtually every one of the newer real-estate-bond companies and their subsidiary guarantor concerns. As the depression continued, the older institutions gave way also.”

“During the 1924-1930 period several of the independent surety and fidelity companies extended their operations to include the guaranteeing of real-estate mortgages for a fee or premium.”

“…surety companies began the practice of guaranteeing real-estate-mortgage bonds only a short time prior to their debacle….”

“In most cases the resultant losses to the suretor were greater than it could stand; several companies were forced into receivership, and holders of bonds with such guarantees failed to obtain full protection.”

Perhaps the real estate boom of the early 2000’s was similar to that of the 1920’s. If that is the case, and I believe it is to some degree, then Graham and Dodd’s historical lesson served as a potent warning for investors in mortgage and bond insurance companies. Maybe that is why they have sold at such seemingly cheap prices over the years….

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Clampdown on risky mortgages

The Wall Street Journal had an interesting article today by James Hagerty and Ruth Simon titled “Lenders Broaden Clampdown on Risky Mortgages.”

In it, they highlighted that “Jittery home-mortgage lenders are cutting off credit or raising interest rates for a growing portion of Americans.”

As they say, “This worsening credit crunch threatens to put further pressure on the housing market.”

The mortgages being effected aren’t just subprime, but also included so-called Alt-A loans, a category in between prime and subprime. This illustrates how the credit crunch impacting the subprime market is spreading to other markets.

The articles quotes Thomas Lawler, a housing economist in Vienna, Va, who said the credit squeeze “will further crimp the effective demand for housing, and will make the late summer home-sales season even worse than the dismal spring season.”

Also, American Home Mortgage Investment stopped making loans earlier this week and said late yesterday it would cease most operations and lay off over 6,000 employees. Accredited Home Lenders Holding is almost in as much trouble after auditors said its “financial and operational viability” is uncertain.

In other words, the so-called “contained” credit market squeeze continues to impact more and more markets and businesses. It’s my guess that it will take years for this situation to fully work out and that players in the credit markets will see record stress before it’s all over.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Beware the Black Swan

I’ve been babbling for several months now on this blog (and, as my wife can attest, for several years before that) about the risk of low probability, high impact events–what Nassim Taleb refers to as Black Swans–particularly related to the housing market.

It seems that chicken may finally be coming home to roost in the housing market and the markets that rely strongly on the housing industry.

Before I crow too loud about the malaise that is occurring, I must freely admit that I did not place any money-making bets on this decline. Quite the contrary, all I did was try to stay away from such a risk.

In staying away, I missed out on the huge run-up that has occurred in mortgage lenders, mortgage insurers, bond insurers, home builders, etc. This made me look pretty stupid in the short run, but right now I’m quite happy I don’t own any companies in these industries.

Will these industries face a total collapse or a financial crisis? I have no idea. The odds are against it. But, like all Black Swans, I want to avoid such negative, low likelihood, high impact events.

I don’t have to be able to predict when they will happen or how bad it will get, I simply have to stay away from risks I cannot accurately assess or that do not provide sufficient compensation for their risk.

I will be very interested to see how bad such housing related markets get, but I still don’t think I’ll be participating there for quite some time. After all, because it seems to be a Black Swan, I don’t know how bad it will get, and so I’m staying away until I understand what’s going on.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.