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Fixed Income War Story #3

This is one of my favorite episodes, because not only does it show how a creative investor can reap huge rewards, it also deflates a narrative about the 2008 housing crisis that unfortunately, many still believe. The story you are about to read is true. The name has been changed to protect the genius' identity.

There was an owner of a small fixed income trading shop, who we'll call "Bill," that specialized in offering and trading collateralized mortgage obligations, structured notes, and corporate bonds. It was a nice place to do business, and its size meant everyone was on a first name basis. Light and friendly, unlike the big institutions.

Even at this early stage in my career, I had quite a lot of experience selling CMOs, and if you remember your history, there were the ones securitized by the banks themselves, (as opposed to "agency" paper, like Fannie and Freddie) and with a little help from the ratings agencies, these looked like very safe investments, what with their AAA ratings and all. Which turned out to be less than kosher.

When the markets crashed, the value of these "private label" CMOs cratered to about half their Par value, and the portfolio meltdowns were horrific. These were the days when people didn't want to open their statement envelopes out of fear of an anxiety attack.

But a funny thing happened when this was going on, and a few of us started to notice it. These mortgage obligations pay the investor monthly. And not only did the the obligations keep paying off, they were paying the full coupon. Meaning there were little or no foreclosures wrapped in them, and what we had here was billions in performing securitized loans selling at half price, or even less, in the market.

And what Bill discovered, long before almost every analyst on the Street did, that if he avoided CMOs with mortgages originated in California, Florida, Arizona and Nevada, he was seeing some very clean paper with very few dings in them. These famously came to be known later as the "Sand States." And with the use of a Bloomberg terminal, Bill could sort out the good paper from the bad with a little screening. And Bill would call me.

"Hey, Don, look at this one! A $52 piece with a 6% coupon! No California!"

Now at this point, I can't even sell Yankee Stadium bonds, which were selling so cheaply, a New York resident could have gotten a 10% yield, even BEFORE they would add in their tax free equivalent. But no takers. It's not that people rationalized the Yankees would go out of business, but it illuminates the psychology that existed at the time. People just wanted to hoard cash, and stay as liquid as they could, and of course, the time tested lesson was this was the very moment they should have jumped in.

I ran into a similar situation with corporates. When the crisis hit, I had read that Ara Hovnanian was scooping up debt in his own company at absurdly low prices, and by the time I had seen this, I offered out Hovnanian bonds priced at 66 cents on the dollar. No takers. A few months later, when they recovered to 88 cents, THEN investors jumped in. That's investor psychology in a nutshell.

So Bill kept calling and sending me e-mails with all of this fantastic yield, but no one was touching them.

"Don, $54 bucks! Unbelievable!"

Real estate was radioactive in the market, and investors were just too scared. But as the weeks went by, Bill had proved his point. And not only was the effective yield very high, these CMOs were eventually redeemed at Par, doubling the investors money after they collected that fat coupon.

In any case, there's a few lessons here, but the one that stands out the most is that it wasn't government housing policy that blew up the market, contrary to the oft told myth. Housing in the "Sand States" got well and truly overheated, and fed by shoddy private label mortgage origination and syndication, they turned out to be time bombs. That's not to say the rest of the country was unscathed, but generally speaking, the areas you would think would need government assistance the most held up quite well, at least as far as servicing the mortgages went. After all, if you were still employed, even if the value of your home was down, the mortgage stayed the same.

“If you can keep your head when all about you are losing theirs...."


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