Subir and WSQ Capital are profiled in the February issue of Mann on The Street (pages 50 and 51 for those of you with a subscription). The article features an overview of the services we provide, a summary of our investment philosophy and a very large picture of Subir’s face.
MA supreme court ruling on foreclosure only “apocalypse” for those who had a rosy outlook for residential real-estate.
The Massachusetts (MA) Supreme court upheld a ruling invalidating two foreclosures that were executed incorrectly. The judgement is quite clear cut, and says banks need to ensure they are following the letter of the law when transferring, selling or assigning mortgage notes amongst themselves if they hope to have the court’s protection when they go to foreclose. Nothing unusual here, and it is clear that documentation practices at many banking institutions and securitization firms were at best sloppy, and at worst fraudulent, heading into the real-estate crisis. The plaintiffs (Wells Fargo and US Bank, attempting to foreclose on two delinquent mortgaged properties) argued that invalidating foreclosures where the borrower was clearly delinquent or had defaulted would create “widespread confusion” and impose “significant costs to innocent parties” (i.e. themselves).
We thought that what the MA attorney general had to say was interesting on this score:
Plaintiffs’ claims that the Land Court’s ruling will cause widespread confusion or significant cost to innocent parties are greatly exaggerated, and such reasoning does not warrant ignoring the plain requirements of the law designed to protect Massachusetts consumers. Indeed, it is the foreclosing entities themselves who will bear the greatest cost of clearing title from their invalid foreclosures. Having profited greatly from practices regarding the assignment and securitization of mortgages not grounded in the law, it is reasonable for them to bear the cost of failing to ensure that such practices conformed to Massachusetts law. (emphasis ours)
and further on:
Distressed homeowners often face challenges in the foreclosure process. In certain cases, they may lack the technical knowledge and the financial resources to contest a wrongful foreclosure or otherwise ensure that the lender adheres to the obligation to serve the interests of the mortgagor in good faith. Thus, plaintiffs’ implication that the borrowers have waived their right to challenge the legitimacy of the sale because they had “ample opportunity to challenge the foreclosure proceedings prior to the sales but failed to do so” is particularly troubling when the plaintiffs themselves have failed to comply with the statutory requirements to foreclose.
Thus, the plaintiffs profited from the risks they took, at the expense of each of the borrowers. Having reaped the benefits of their casual attitude toward ensuring they possessed valid assignments of the mortgages, it is not unjust that plaintiffs should now bear the costs of their errors.
The MA supreme court found that the plaintiffs who had foreclosed on the properties in question did not have valid assignments that gave them an interest in the mortgage at the time of foreclosure. The documents they did have were either in incorrect form, or had been executed after the foreclosures. They also found that MA’s foreclosure notice requirement was not met because the mortgage holder was incorrectly identified in the notice (because the mortgages were never correctly assigned to the banks attempting to foreclose). In our view, there was really no other conceivable outcome for this case given the messy mortgage documentation.
Contrary to Felix Salmon’s view on the matter, we do not believe the court ruling is a housing-market catastrophe. We do agree that it raises many questions about title to homes that may have been foreclosed on incorrectly (Judge Cordy in a concurring opinion made much the same note), and that many, many parties to real-estate transactions over the past few years may need to go back and confirm both their title-insurance and the documentation chain for mortgage assignment and transfer. We also agree that banks who securitized mortgages will find that investors now have cause to question some of the representations made in the securities concerning transfer of mortgage documents. However, the key fact preventing wholesale catastrophe in our our mind, is the court’s view on prospective remedies to any flaw in documentation.
In essence, the MA supreme court found that a party attempting to foreclose in Massachusetts had a strict responsibility to ensure their documentation was in order and that they had followed the letter of the law. The court felt this was especially important since foreclosures in MA do not require judicial supervision, except for a couple of steps. That said, the court writes concerning mortgage assignments:
We do not suggest that an assignment must be in recordable form at the time of the notice of sale or the subsequent foreclosure sale, although recording is likely the better practice. Where a pool of mortgages is assigned to a securitized trust, the executed agreement that assigns the pool of mortgages, with a schedule of the pooled mortgage loans that clearly and specifically identifies the mortgage at issue as among those assigned, may suffice to establish the trustee as the mortgage holder. However, there must be proof that the assignment was made by a party that itself held the mortgage.
In one of the foreclosures, the bank failed to produce the schedule of loans and mortgages that comprised the trust. In the other case, the bank provided a schedule, but that did not identify the mortgage with adequate specificity. The court has, in our view, been very reasonable as to how this situation may be remedied:
A foreclosing entity may provide a complete chain of assignments linking it to the record holder of the mortgage, or a single assignment from the record holder of the mortgage.
where an assignment is confirmatory of an earlier, valid assignment made prior to the publication of notice and execution of the (foreclosure) sale, that confirmatory assignment may be executed and recorded after the foreclosure, and doing so will mot make the title defective. A valid assignment of a mortgage gives the holder of that mortgage the statutory power to sell after a default regardless whether the assignment has been recorded. Where the earlier assignment is not in recordable form or bears some defect, a written assignment executed after foreclosure that confirms the earlier assignment may be properly recorded. A confirmatory assignment, however, cannot confirm an assignment that was not validly made earlier or backdate an assignment being made for the first time.
Creating new assignments with fresh dates, or confirming a prior assignment so they are in correct form will be time-consuming, tedious and expensive. As will restarting foreclosure proceedings once all documents required by state law are in correct form. Ensuring staff who do this are competent and aware of the issues at stake will also be key, however, the problem is not insurmountable, nor is it prohibitively expensive. No doubt there will be cases where documents are in such poor shape that they cannot be remedied by banks or servicers alone. But that is exactly the sort of situation the land transfer process is supposed to help fix. In the two foreclosure cases covered by this ruling, the original mortgage was correctly executed and recorded, and the trustees may get an assignment from the holder of record (Option One, who was one of many mortgage originators supplying mortgages to banks for securitization). No doubt there will be cases where the mortgage originators no longer exist, but with sufficient time and effort, successor entities can be identified.
The court’s ruling suggests it has no patience with mortgage-holders whose own sloppy practices got them into this mess:
The legal principles and requirements we set forth are well established in our case law and statutes. All that has changed is the plaintiffs’ apparent failure to abide by those principles and requirements in the rush to sell mortgage-backed securities.
However, as we outlined above, it has left a route out for banks to cure problems with mortgage documentation, but is plainly unwilling to allow foreclosure proceedings when the process for real-property transfer has not been followed correctly. We believe this is an important and correct ruling. It clears the air for both consumers and mortgage-holders and should encourage banks to rectify errors in mortgage documentation. We believe the banks and mortgage servicers will incur additional costs in rectifying these errors (of their own making), and that this will slow down the foreclosure process.
We do not believe this is an “apocalypse” scenario. Rather, we believe the housing market will remain distressed for many years to come as these issues are sorted out and broader macroeconomic factors such as high unemployment fade. For those who had been expecting a relatively quick rebound in housing, construction and real-estate price levels, this may well constitute an apocalypse.
10 Economic Themes for 2010: Year-End Review
Since we’ve now closed the chapter on 2010, we’d like to review our “10 economic themes for 2010” from last January, to see how well our ideas performed.
We’ve graded ourselves using these symbols: Y Right N Wrong ? Not Exactly.
- ? We expect to see the US unemployment rate to peak at 11% in 2010: We were a bit aggressive with the numerical portion of this theme. While the US job market remains anemic, the headline unemployment rate stayed within the 9.5% to 9.9% range, ending the year at 9.8%. Over 15.1 million American workers were unemployed and actively seeking work at the end of 2010, this is a larger number than at any time since WW-II (except for late 2009 when there were 15.6 million). Private sector job-creation continues to be very slow, and the broader measure of underemployment, U-6 has stayed between 16.5% and 17.1% all year, ending the year at 17.0%. U-6 counts those working part-time involuntarily and workers discouraged from looking for a job.
- Y Investors will continue to re-allocate towards less volatile investment classes, like bonds in 2010: This scenario played out almost entirely as we had outlined. ICI reports that investors withdrew a net $29.6 billion from stock mutual funds through Nov 2010. Meanwhile, taxable and municipal bond funds saw net inflows of $266.4 billion.
- Y We expect a number of credit downgrades for developed nations as their persistent deficits come into focus. The US Dollar will strengthen in any ensuing flight to safety: We were almost entirely right on this one. Throughout the year, we saw major credit downgrades affecting Greece, Portugal and Spain, as well as the creation of an unprecedented EU bailout plan for peripheral economies. The US dollar started 2010 valued at 1.4323 per Euro, but strengthened as the situation in Europe deteriorated. It reached a level of 1.1875 per Euro on June 6th and ended the year at 1.3373.
- N Interest rates will remain effectively at 0% until the 4th quarter of 2010, where we will expect to see the Fed raise rates to the 1-2% range: We were wrong on this one. The Fed has continued to keep the fed funds rate at historically low levels and employed every form of monetary stimulus available to it. We underestimated the dovish tone of the current Fed, and the Chairman’s commitment to maintain easy monetary policy while unemployment remains high.
- Y Continuing the trend from 2009, paying down debt will remain the highest priority for US consumers as they attempt to get their financial houses in order: This was a major theme for consumers in 2010. For Q2 2010, the personal savings rate was 10.5%, and it is likely that the full year personal savings rate will be above 5%, which is far higher than the 2006 full year rate of 0%. Consumers continued to pay down credit card debt, the most recent data from the Fed (for Oct 2008) shows revolving debt at $800 billion, which is down from $866 billion at the start of 2010 and $958 billion at the start of 2009.
- N The US economy will see almost negligible growth for 2010: We will not have final estimates on 2010 GDP growth till the end of 2011, but it is likely that GDP grew between 2.5% and 3.0% (as compared to 0.0% and -2.6% in 2008 and 2009). The caveat, of course, is that this has been accomplished with record government stimulus.
- Y Corporations will increasingly turn to mergers and acquisitions to grow market share: We’ll take half a victory lap on this one. The New York Times estimates global M&A activity grew 23.1% (to USD 2.4 trillion) by value over 2010, though we are still nowhere near the $4 trillion level achieved in 2006 and 2007. This is partly due to lower stock market values and corporate treasurers who, after being shell-shocked by the turmoil in the commercial paper market in 2008-09, are now hoarding cash.
- Y Growth in emerging markets will continue to outpace developed economies. But this will not be enough to offset the stagnation in developed economies or lead to a robust global recovery: This trend appears to have held up well. Though we have our doubts about certain large economies (see below), emerging market economies and financial markets performed well in 2010. The MSCI emerging markets index ended the year up 16.36% in dollar terms, while the S&P 500 ended the year up 12.78% (neither number includes dividends).
- ? We believe there is continued risk for a massive correction in China: While we have not yet seen a “massive” correction in China, the Shanghai composite index ended the year down 10.61% (one of the few major market indices down in 2010). Residential real-estate prices have moderated in many markets and concerns about overbuilding continue to exist.
- N In 2010, certain commodities are poised for a sharp sell-off. Top of our lists for a correction are gold and oil: We were flat out wrong on this one. ICE’s Brent index rose from 77.85 to 93.49 over the course of 2010 and gold was up from 1096 to 1421 over the course of the year.
So the final tally is 5 themes right, wrong on 3, and not exactly on 2.
2011 Themes: These Go To Eleven
- Raise ‘em sort of high: We expect the Fed to raise short-term interest rates towards the end of the year, in response to slow but steady growth and a more hawkish group of voting members. We expect rates to end the year in the 1% to 2% range. We think it is likely that the Fed raises rates to the 2% range this year because moves during the 2012 presidential election year would be politically toxic. A rise in the short-term rate will result in a flatter yield curve (compared to the extremely steep levels today) and reduce bank earnings.
- Risk Off: We believe stock prices are quite a bit higher than underlying fundamentals support, at a trailing P/E of around 18.25, prices are at the upper end of historical range. Governments across the world have provided immense demand support and a low rate environment over the past couple of years. We also believe investor wariness and demographic changes (a large cohort of new retirees who will begin drawing down on savings) suggest much support for asset prices is weakening. We believe investors will continue to focus on fixed income investments, and rightfully should.
- United States of Europe: We expect the deterioration of sovereign credits in peripheral Europe to continue as these governments struggle with difficult but necessary financial decisions. We expect continued friction between fast-growing Northern European economies and Southern Europe. This will doubtless further strain the Euro and all European establishments. We believe the stresses created by the currency union existing outside of a strong federal structure will be resolved with a more federal Europe. The alternate solution where certain states opt to leave the currency union is less likely, but not outside the realm of possibility. In general, we believe European sovereigns will begin to be treated more like US states (which do not have the power to issue currency either) by the markets. Over time, we expect a move towards additional bond issuance at the European Union level, with each state having access to a certain amount of borrowing against the EU federal credit in exchange for heightened oversight and restrictions.
- Moody & Poor: We expect the US municipal bond market and state finances to continue as a topic of discussion. We expect certain weaker revenue and real-estate project linked bonds to default, we also expect acrimonious budget debates on benefits for public sector employees and pensions in many states. We think large scale defaults by major issuers (state GOs, water/sewer) are very unlikely, but investors will continue to discriminate between strong and weak credits and heavily discount informal support expectations and bond insurance.
- Running on Empty: The Chinese stock market did not fare well in 2010, and we expect the Chinese economy will experience lower growth in 2011. Overbuilding and overinvestment in physical infrastructure during the past few years has left a glut of underutilized buildings and this could lead to a sharp downturn in Chinese property prices and construction activity. Any such downturn would also impact Chinese banks, and potentially have a wider impact in the region, affecting commodity-driven economies like Australia and Canada.
- Consuming Confidence: We expect consumer de-leveraging to continue in the US as consumers pay down debt till it approaches historical averages. This will make for a more difficult general retail environment and generally depress big-ticket discretionary spending. The real-estate bubble has altered an entire generation’s perspective on housing, and we expect households and financial institutions both to be skeptical of high mortgage indebtedness and expectations of large capital gains in residential real-estate. We expect similar deleveraging to occur in commodity-boom fueled economies like Australia and Canada. We do not believe US residential housing prices will rise in 2011, and may indeed fall further.
- Help Wanted?: We expect unemployment in the US to remain high, slowly falling below 9% towards the end of the year. We also expect broader measures of unemployment and underemployment (the BLS’s U6) to stay above 15%.
- Arrested Development: Though it is notoriously capricious to forecast, we expect GDP growth in most emerging markets will continue at high single-digit rates, while slowing in the US and Europe to a sub-trend 2% rate till household and government deleveraging has run its course.
- Double Helix: We expect health-care technology related to genetic sequencing to increasingly take center stage in preventive and curative care as sequencers become cheaper and consumer testing becomes more prevalent.
- Feast and Famine: We expect 2011 to be a very volatile year for commodity prices. We believe the environment is ripe for a sharp price correction in some commodities, gold and oil for example, and perhaps certain base metals as well. Such a correction would be far more likely if China has a hard landing from the withdrawal of extreme stimulative fiscal policy and over-building over the past few years. We expect food prices to become a focus of attention in many parts of the developing world (as they were in 2008), and that governments will be forced to respond in whatever manner they can. In the developed world we expect a resurgence of interest in agricultural and timber land investment.
- Death and Taxes, It’s all Politics: In the run-up to the US presidential election in 2012, we expect the political discussion to focus on debt and tax reform. Corporate and higher-income tax-payer earnings will be the center of discussion and there is an off chance that the byzantine US tax code is simplified. In particular, trial balloons have been floated to withdraw the deductibility of mortgage interest, and tax life insurance benefits and municipal bond interest income. Similarly, we have seen increasing discussion of doing away with the estate tax and replacing it with an income tax on proceeds received by heirs. Each of these deductions is supported by sizable vested interests and we think it is unlikely that they would all be swept aside and the tax code completely over-hauled. Nevertheless, the possibility exists with a president and congress who are both eager to demonstrate their independence and fiscal sobriety to an irate electorate.
We hope you enjoyed a restful holiday season and have had a good start to the New Year.
We’ve attached two documents to this quarterly letter, one reviewing our economic themes for 2010, and another outlining our themes for 2011.
In the fourth quarter of 2010, risky assets (stocks, commodities) recovered sharply from mid-year lows, while safe-haven treasuries sold off dramatically in the last few weeks (the 10 Yr yield went from 2.81% to 3.30% in December). The Federal Reserve continued to keep short-term interest rates at 0.00-0.25% and began a second round of extraordinary monetary easing (QE2). Unemployment continued to remain high and over 15 million Americans (9.7% of the labor force) were unemployed over the holiday season. The mid-term election cycle was an expression of the electorate’s frustration with the lackluster recovery and increasing concerns about the national debt burden.
Our view remains that high levels of unemployment, household debt-reduction and relatively tight credit standards will continue to dampen growth in 2011. We believe stock market prices are higher than sustainable levels, and down-side risk has increased materially. We continue to recommend holding substantial cash allocations while waiting for more attractive values to deploy cash.
We look forward to speaking with you during our quarterly review and wish you the best over the coming year.
Subir Grewal Louis Berger