Some of the best shareholder letters that investors can read are those from Prem Watsa at Fairfax Financial Holdings. In his 2006 Shareholder Letter, Watsa predicted the sub-prime mortgage crisis saying:
Finally, we continue to worry about the unprecedented issuance of collateralized bonds, mortgages and loans (we hold none!). The assumption in the marketplace is that ‘‘structure’’ will eliminate or significantly reduce all risks. So a portfolio of 100% non-investment grade bonds, sub-prime mortgages or non-investment grade corporate loans, by sophisticated structuring, can transform into securities of which 80% or more are rated A or above.
This has resulted in thousands of collateralized bond issues being rated AAA while fewer than 10 corporations in the U.S. are AAA! We see an explosion coming but unfortunately cannot predict when. As Grant’s Interest Rate Observer said in its December 15, 2006 issue, ‘‘Blame for the distress at the fringes of subprime, we judge, cannot be laid at the feet of the U.S. economy. It should, rather, attach to the lenders and borrowers who piled debt on debt until the edifice sways even in a dead calm.’’
Following is the article from Grant’s Interest Rate Observer (December 15, 2006) titled – Up The Capital Structure:
(December 15, 2006) The not very shocking news that low-rated tranches of poorly underwritten mortgages on depreciating houses are susceptible to loss has nonetheless managed to shock. The cost of insuring the lowliest such slice on the standard subprime reference index has climbed by 25% in seven short days, according to the guardians of the untransparent mortgage derivatives market. Grant’s has had much to say about mortgage credit this year. Following is a speculation on 2007, if we have our timing right. In preview, we find that, under some not very adverse assumptions, even higherrated mortgage structures are vulnerable to infestation by credit termites. Insurance on these supposedly safe and sound mortgage derivatives is available for a song.
We write not only for the well-staffed professional investor who could actually buy protection on the penthouse levels of an arcane mortgage index. Our intended audience is, equally, the curious investment amateur who ordinarily has no truck with tranches and derivatives but is always prepared to make an exception for a $1 trillion market.
Our hypothetical layman should know that the experts, so-called, are almost as confused as he is. Certainly, they are of many minds. A few—a minority—believe that the troubles now unfolding at the margins of subprime are the leading edge of much deeper problems. We are in that camp. The majority contend that the derangement of the BBB-minusrated tranches is a fluke. The broad market, they say, even the broad subprime market, is hale and hearty.
Bear Stearns, the top mortgage-backed securities underwriter, is an exponent of this idea, as is Triad Guaranty (Grant’s, June 16). Both are expanding their businesses as if the bear markets in mortgage debt and residential real estate were already over and done with—if, indeed, they ever really got under way. The subprime arena is the Wal-Mart Nation of American leveraged finance. Like the Wal-Mart customer, it is a bellwether of financial disturbance.
Perhaps, it’s no accident that the giant retailer’s sales have weakened as the cost of insuring low-rated subprime mortgage tranches against default has risen. But there is something about the sudden blight of delinquencies and foreclosures in the bottom of the 2006 mortgage barrel that doesn’t quite add up. Yes, the median house price has fallen by 3.5%. But the jobless rate stands at only 4.5%. Nominal interest rates—even following 17 quarter-point jumps in the fed funds rate—remain low. The Russell 2000 Index the other day hit an all-time high. Blame for the distress at the fringes of subprime, we judge, cannot be laid at the feet of the U.S. economy. It should, rather, attach to the lenders and borrowers who piled debt on debt until the edifice sways even in a dead calm.
You can read the entire Fairfax Holdings 2006 Shareholder Letter here.
You can read a collection of Grants Interest Rate Observer articles, which includes the above mentioned 2006 article, here.
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